What Does Financial Reporting Mean?
The scope of financial reporting is broader than just reporting information through income statements, balance sheets, authoritative pronouncements, and regulatory rules.
Financial reporting concerns not only monetary information but also non-monetary information. Financial reporting does not mean reporting information only through income statements and balance sheets.
If crucial information is contained in financial statements, then the reason for its inclusion is communicated through schedules and guiding notes, ensuring that the information is authentic and clear.
The basic objective of reporting information is to ensure that any person (internal or external) using this information can be guided properly when making a decision based on their requirements.
Definition by AICPA
The International Accounting Standards Board (IASB) offers the following definition of financial reporting:
The provision of information about the financial position, performance, and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.
As this definition indicates, financial reporting has a broader scope than simply producing financial statements.
Enterprises pass information to internal and external users through financial statements, along with other details (e.g., schedules and guidance notes), either voluntarily or due to regulatory rules, a tradition, or pronouncements concerning information disclosure.
The reported information is expected to cover not only monetary information but also non-monetary information (e.g., contributions toward social and environmental causes connected with social responsibility).
For example, if a hospital is built to provide free public healthcare facilities, the cost of construction and maintenance expenses are monetary information, whereas the number of patients is non-monetary information.
In fact, decision-makers do not depend purely on monetary information; they also consider non-monetary information to ensure that their decisions are well-informed.
Objectives of Financial Reporting
Financial reporting should be done so that the reported information is realistic, amenable to interpretation, and helps investors to make proper investment decisions.
Financial reporting should satisfy at least two basic objectives:
- The reported information should help users to make investment decisions.
- The reported information should provide information that users can consider to judge the performance and effectiveness of the enterprise.
Assisting Investment Decisions
Investors seek investments that provide the greatest return in the form of either interest or dividends with an acceptable level of risk.
Investors also expect capital appreciation at least over a reasonable period of time. When making decisions, investors assess an enterprise’s earnings potential to estimate their future return in the form of dividends and capital appreciation.
Business information relating to earnings power is assessed based on continuous earnings from operating assets over a reasonable period (e.g., 3-5 years).
Investors compare returns on alternative investments based on risk-return viability. Therefore, the reported information should be realistic and amenable to interpretation, and it should help investors to make proper investment decisions.
Judging Management Effectiveness
The information contained in financial reports should enable users to judge the effectiveness of an enterprise’s management based on several factors, including:
- Safekeeping of resources and their custody
- Efficient and profitable use of resources
- Future development plans
- Measures applied to avert adverse impacts on the enterprise due to changes in technology or price level (e.g., inflation, deflation, or recession)
Also, management effectiveness depends on information transparency and accountability. It is accountability that determines the effectiveness of an enterprise.
Therefore, the reported financial information should project a realistic and accurate view of the enterprise.
The historical development of financial reporting indicates that many accounting bodies and professional institutes worldwide have made contributions to ensure user-friendliness and that financial reports reflect the changing needs of information users.
Due to this, the objectives of reporting financial information have been increasing by leaps and bounds day by day.
Here, we highlight the objectives of reporting information developed by the American study group, appointed by the AICPA in 1971 and led by chairman Robert. M. Trueblood.
After the study group submitted its report in October 1973, the following objectives of financial reporting were established:
- To provide information that is useful for making economic decisions.
- To serve primarily the users who have limited authority, ability, or resources to obtain information relating to the economic activities of the enterprise.
- To provide information that is useful to investors and creditors about the potential cash flow of the enterprise to assist decision-making.
- To provide users with information for predicting, comparing, and evaluating an enterprise’s earning power.
- To provide information relating to resource utilization to judge the ability and effectiveness of the enterprise.
- To provide factual and interpretive information relating to the enterprise’s earnings power and to disclose assumptions made in this regard.
- To provide a statement of financial position useful for predicting, comparing, and evaluating an enterprise’s earnings power. (The events that are part of the incomplete earning cycle and the current and historical costs of the assets and liabilities, along with relative uncertainties, should be disclosed.)
- To provide information on factual aspects of an enterprise’s transactions that have (or are expected to have) significant cash consequences.
- To provide information on the net result of the completed earnings cycles and the progress made toward completion of incomplete earnings cycles.
- To provide information necessary for financial forecasts.
- To provide information that is useful for evaluating the effectiveness of resource management in achieving organizational goals.
- To provide information relating to the activities of the enterprise that affect society which can be determined and described or measured, and which are important to the role of the enterprise in its social environment.
The study group’s report sets out the objectives of financial reporting in such a way that the enterprise providing such information through financial statements cannot escape the responsibility of accountability.
The objectives mentioned above indicate that financial reporting is essential for decision-making among both internal or external users. This means that the quality of information should be such that it should command wider acceptance and recognition for making information useful.
In this sense, the reported financial information should have the following qualities:
The FASB Concept Statement No. 2 from May 1980, entitled Qualitative Characteristics of Accounting Information, recognizes relevance and reliability as primary qualitative characteristics, while the other characteristics are viewed as ingredients of these primary qualities.
The AAA states that:
To be useful in making decisions, financial information reporting must possess several normative qualities. The primary one is the relevance to the particular decision at hand of the attribute selected for measurement. The secondary one is the reliability of the measurement of the (relevant) attribute. Objectivity, verifiability, freedom from bias, and accuracy are terms for overlapping parts of the reliability quality. Other qualities such as comparability, understandability, timeliness, and economy are also emphasized. A set of such desirable qualities is used as criteria for evaluating alternative accounting methods.
If the reported financial information possesses the qualities cited in the above definition, then the information user may attribute different meanings to each of the characters and interpret the information to make proper decisions.
If the business enterprise is honest, sincere, and transparent in reporting financial information, then the quality of information is bound to satisfy the prescribed norms, and one can rely on such information for one’s own benefit.
Also, if financial reporting is adequate and reliable, it can be used for the following types of decisions:
- Economic decisions, such as those relating to the cost of capital or fluctuations in share and stock prices.
- Employee decisions, including those concerning job security, promotional opportunities, and bonus declaration.
- Customer decisions, including continuing supplies of goods, expected valuation in terms of prices of goods, and the robustness of financial institutions to assess present and future solvency.
- Managerial decisions, such as those relating to operating, financing, and investment decisions.
- Social decisions, particularly those relating to social and environmental responsibility.
Although users may have conflicting views based on their needs, an enterprise is expected to report financial information that serves the general purpose of every user.
If additional information is needed for a specific purpose, it can be furnished in the form of schedules, notes, and specific on-demand information. However, it is necessary for the reported information in financial statements and annexure to be relevant and reliable.
Importance of Financial Reporting
- Crucial information is communicated through financial statements.
- The basic objective of reporting information is to facilitate decision-making.
- Reported information should cover both monetary and non-monetary information.
- There are two basic objectives of financial reporting: first, to help users make investment decisions; and second, to provide information that enables a judgment about the effectiveness of the enterprise to be made.
- The objectives of financial reporting have been developed by experts and professional bodies to ensure accountability.
- The primary qualities of financial information reporting are relevance and reliability.
- Reported information should be adequate and reliable to enable both internal and external users to make decisions.