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The Main Purpose Of Annual Reports Accounting Essay

The purpose of the annual report is to inform shareholders as to the financial status of a company. Coy and Pratt (1998) conclude that the annual report serve as a communication tool and determines the reality of the organization in the public mind. However for this reality to be recognized, it depends on the quality of information provided in the annual reports. Annual reports are extremely significant sources of company information (Stanga,1976). Furthermore studies by Chang and Most (1985) and Hawkins and Hawkins (1985) concluded that even though individual investors do not find the annual report useful in decision making and do not meet their information needs, still the annual report is the document used as reference for investors and managers. Though annual report is not the only source of information for a company, as in New Zealand newspapers and magazines were also found as a source of information, nevertheless the annual report is considered to be an important resource due to its large reporting and availability. Therefore the fundamental aims of preparing financial reports are for decision making and accountability.

Accountability

Annual reports are considered as the main accountability mechanism. In 1975, the American Accounting Association (AAA) defined the purpose of accounting as “to provide information for making useful economic decisions and which, if provided will increase social welfare”. Thus annual report can be one tool for communicating economic information to allow update decisions and judgements by users.

According to Stanton and Stanton (2002) the annual report “uses the tools of management, marketing and communication theory to construct a picture of the organization”. Thus, annual report is a tool for a firm to classify its accountability for managing and controlling business activities. Moreover, a number of researchers (Winfield, 1978; Chang and Most, 1985; Boyne and Law, 1991), have noted the importance of annual reports as a ‘vehicle’ releasing accountability.

Furthermore accountability is involved in the monitoring, evaluation and control of organizational agents to make sure that they perform in the welfare of shareholders and other stakeholders (Keasey and wright,1993). It can be classified as a requirement for one party to another party for its performance over certain time. In short, accountability is simply a must to report upon as it gives an extent to which an entity has met its responsibilities towards its owners and to fulfill this role, financial reports should reflect the nature and extent of performance that are related to the entity. Moreover accountability requires broadening the capacity of disclosure beyond the financial focus to ensure that adequate and meaningful qualitative information is also contained in the annual report.

Besides, the owners of the companies, the shareholders, have a right to know what actions and what developments are taking place within the organization. Thus, the organizations are accountable to its shareholders and the annual report plays a great role in conveying the firm’s performances to them.

Decision making

As per IAS 1, the financial statements’ objective is to offer and inform the performance and the evolution of the financial situation, that could be helpful to a wide range of potential users for evaluating and making economic decisions .It is further claimed that, when the general purpose of financial reports meet this objective, they will also enable entities to discharge accountability.

Consequently the first aim of the Trueblood Report is the provision of information for economic decision making is being interpreted as being the primary function of financial statements. Hence financial reports should seek to satisfy the information needs of users. In 1989, the Solomons Report, commissioned by the ICAEW (1989) reaffirmed that decision usefulness is the fundamental aim of financial reporting. Financial reports should provide information that will be accommodating to several users who have interest in financial performance and making decisions about investing and lending.

Gray (1994, pp9), have proved that accounting literature is presently dominated by the idea of decision usefulness which mean that financial reporting will have to be maintained in order to meet the need of all users of accounting information. It is seen that nowadays there has been a rise in the users of accounting information for decision making hence objectives of annual reports are regarded as the major means by which companies distribute information to the external users (Firth, 1979).

OBJECTIVES OF ANNUAL REPORTS

According to FASB the main goals of annual reports can be classified in three parts:

Objectives for making potential economic decisions;

Objective of providing information about the financial position, performance and changes in financial position of an entity;

Objectives for presenting and disclosing of information.

Hence it is the attributes of the qualitative characteristics that make accounting information to be useful in annual reports.

Characteristics of accounting information

The quality of the information provided in annual reports determines the usefulness of those reports to users. FASB and the IASB propose that if Financial Statement setters study the standards and qualitative features in the process of preparation of financial statements only then the financial station would give the “true and fair view”.

Many researchers like (Alford et al. 1993, Amir et al. 1993, Banyopadhyay et al. 1994, Harris et al. 1994, Joos and Lang 1994, Barth and Clinch 1996, Joos 1997, Lewitt 1998 and Pope and Walker 1999) had conduct studies with the aim to identify higher quality as it is related to the ability of financial statements to pass useful information to the users.

Hendriksen and Van Breda (1992, P.123), has described qualitative characteristics as components of accounting information which lean to improve its usefulness.

The Corporate Report of the Accounting Standards Steering Committee, Institute of Chartered Accountants in England and Wales (ICAEW), (1975) has identified seven qualitative characteristics viewed as desirable to make the annual reports useful:

relevance;

understandability;

reliability;

completeness;

objectivity;

comparability;

timeliness.

Relevance

Relevance refers to the capacity of information to influence the decision making process of users. The Solomons Report (1989) has emphasized on this point: “Relevance must come first, for if information is irrelevant, it does not matter what other qualities it has”.

FASB Concepts Statement 2,says in paragraph 27, to be relevant accounting information must be able to make a difference in a decision by facilitating users to form predictions about the result of past, present and future events. It also proposed that there is a trade-off between relevance and reliability that is accounting information should be both relevant and reliable.

A number of research by Stanga (1980), and Mores and Duncan (1988) have already been conducted to deal with the issue of relevance and reliability and that optimistic association exists between the two, with minimum levels of reliability necessary to achieve relevance.

UNDERSTANDABILITY

Understandability is viewed as a user-specific property in the FASB model. Information cannot be useful to decision makers who cannot understand it, even though it may otherwise be relevant to a decision and be reliable. Information is understandable when users will be able to reasonably grasp its meaning. Thus useful information should be capable of being understood by users with reasonable knowledge of business and accounting and the way information is presented in annual reports.

In addition, researchers like Subramanian, Insley, and Blackwell (1993), had evaluated the relationship between the performance of companies and the readability of their annual reports, concluding that the annual reports of companies that done well were easier to read than those of companies that did not perform well.

RELIABILITY

Reliability involves the completeness of information. Information is reliable when it is free from material error and bias and can be depended upon by users to signify faithfully.

FASB has also concluded that verifiability is a major factor of reliability. Verifiability is the ability through consensus among measurers to guarantee that information represents what it purports to represent. It also focuses on whether a particular basis of measurement is properly pertained, rather than on whether it is appropriate.

While Lev and Thiagarajan (1991) , got proof that the market does not retort to certain balance sheet information results of other studies suggested that it may wait until the balance sheet information shows up in future earnings which make accounting information more verifiable and reliable.

COMPLETENESS

Good Accounting information is complete when it provides all its potential users with all the required information that are vital to fulfill their needs and requirements. Moreover reported information in annual reports should provide a complete image of the activities of the organization. Completeness is also when all transactions and events that should have been recorded have been recorded and classified properly. It also assumed that there will be no error of omission in the information. Thus information in the financial reports must be complete within the bounds of materiality and cost is a vital element of faithful representation.

OBJECTIVITY

According to Hines (1991), it is in the benefit of accounting profession to publicly produce information that is objective. Financial information being objective means it should be free from bias in accounting decisions and shall be a measurement of having supporting proof. In other words together with objectivity, information should be both reliable and uniform.

COMPARABILITY

Comparability is the quality of information that allows users to identify similarities in and differences between two sets of economic phenomena. Moreover compliance with accounting standards helps to attain comparability. Thus, information about an entity gains more importance if it can be contrasted with similar information about other entities and with similar information about the same entity for some other period or some other point in time. Comparability is different from consistency because comparability is the goal while consistency is a means to achieve that goal. Users must be informed of the accounting policies used in the preparation of financial statements, any changes in those policies and the effects of those changes. However it is argued that any consideration of comparability must come after relevance and faithful representation. As noted by Sterling, Robert, R (1985), “Comparability alone cannot make information relevant.”

TIMELINESS

Timeliness is considered an ancillary aspect of relevance. Timeliness is about having relevant information available sooner before it loses capacity to influence decisions. Kross and Schroeder, (1984), indicated that “the timeliness of annual reports is relative to the abnormal return around the release date of reports, corporations that released their annual reports earlier held higher cumulative abnormal returns than that of later releases.”

Researchers like Dyer Iv, and McHugh (1975),Whittred (1980) and Dwyer, and Wilson (1989), found that timeliness is affected by factors reporting lag such as auditing opinion, profitability and company size. Therefore the use of technology may enhance position of all users and improve regularity of timeliness with which information is received.

In addition to the qualitative characteristics mentioned above, there is two more qualities proposed in the accounting literature which is essential; they are faithful representation and materiality.

FAITHFUL REPRESENTATION

Faithful representation is attained when information is representing faithfully the transactions and other actions it either claims to represent or could reasonably be expected to represent. However faithful representation does not mean total freedom from error in the representation of an economic phenomenon because economic phenomenon presented in financial reports is normally evaluated under conditions of uncertainty. Thus, to attain a faithful representation, it sometimes may be essential to clearly disclose the degree of uncertainty in the reported financial information.

MATERIALITY

Materiality does not involve only relevance but also faithful representation. Information is material if it could persuade users’ decisions taken on the basis of the annual reports. Materiality depends on the nature and amount of the item in case of omission or misstatement. It forms the threshold for recognition of information and only material information is contained in the annual reports.

According to SEC (1999), is a symmetric in emphasizing that small misstatements may be material for qualitative reasons but “SAB 99 is silent on whether, and when, a quantitatively large error could be immaterial,” (Taub 2007). Thus, many registrants and practitioners consider that this guidance prevents judging quantitatively large misstatements to be immaterial.

COMPONENTS OF ANNUAL REPORTS

The annual report encloses a huge amount of information about a company. As formal communication documents the annual reports also contains quantitative information, narratives, photographs and graphs. There have been several survey-based studies in accounting conducted that the annual reports is useful source of information (e.g., Briggs, 1975; Lee and Tweedie, 1975, 1976,1981; Anderson and Epstein, 1995; Abu Baker and Naser 2000; Ho and Wong 2004). Ho and Wong (2004) conducted a research in Hong Kong and concluded that annual reports are consisted of high value of information in comparison to other sources, even though the respondents are not fully satisfied with the amount of information disclosed.

Thus in Mauritius, the section 221 of the CA 01 specifies the contents of an annual report. Hence it includes the following:

Chairman’s Report

Lee and Tweedie (1975), Barlett and Chander, 1997, p.246 found that the most common read sections of the annual reports is the chairman’s statement .This was attributed to the simplicity of the chairman’s report, which clarifies the more technical information, contained in other parts of the report. On the other hand, Wilton and Tabb(1978) surveyed about 300 shareholders and concluded that the chairman’s report was the most widely read followed by the income statement. However, Barlett and Chander have also disclosed that the majority of respondents in their sample desired less information in the form of a summary report rather than the annual report itself.

Directors Report

The Directors’ report supply useful information to investors about the activities of the company, the dividend policy and information about the decision makers of the company.

Anderson (1998) spot out that despite majority of investors found the basic financial statements to be most valuable, the most thoroughly items read in the annual report are the directors’ report. Lee and Tweedie (1975) found that the executive’s report was of great to less importance, over one-third of the respondents believed the directors’ report to be of no value.

Corporate Governance Report

Corporate governance (CG) has been a foremost policy issue in developed market economies for more than a decade. Hashim (2009) defines CG as “a combination of processes and structures conducted by the board of directors to authorize, direct and oversee management towards the achievement of the organization's objectives”.

The Report on Corporate Governance for Mauritius, states that companies that are listed on the Stock Exchange of Mauritius shall abide to all provision of the code and there should be a separate corporate governance section in the annual report. Dividend policy, Directors profile and going concern of the corporate governance report might be useful to user of accounts. Shareholders will attain valuable information about the amount and timing for payment of dividends declared by the company. On the other hand the disclosure of the qualifications and experience of the board members is useful to investors as such information specify that people with required experience, qualifications and integrity are managing the company hence it boost up the confidence of shareholders. Cohen, Krishnamoorthy and Wright (2004) recommend that CG can be one of the main functions in ensuring the quality of financial reporting.

Auditors’ Report

The auditors are required to report to the shareholders of the company as to whether in their opinion the financial statements have been prepared accordingly with the accounting standards and whether they give a true and fair view of the transactions of the company. The fundamental aspects of an Auditor’s report are set by ISA 700-The Auditors Report on Financial Statements. This ISA gives guidance on the type and content of the auditors’ report as a result of an audit carry out. The auditor’s report was the most understandable section of the annual report while the balance sheet was the forth (Nasser and Rutherford’s 1996). Hence it is useful to users of accounts as it offers assurance that the users are making economic decisions based on reliable information. However, Bartlett and Chandler (1997) found that the auditor’s report was read the least by individual shareholders.

Corporate social responsibilities (CSR)

CSR can be described as the “process of communicating the social and environmental effects of organisations’ economic actions to particular interest groups within society” (Gray et al 1996 p.3). Corporate social disclosure is referred as the provision of financial and non financial information that intend to discharge social accountability of an organisation (Gray et al 1987).Gelb and Strawser (2001) states that CSR disclosure is a form of socially responsible behaviour, thus by providing more information to the public will help companies to meet their responsibilities towards their stakeholders in a better manner.

However research studies have shown that most users use the information of financial statements for financially based decisions. IAS 1, of IASB, 2004: (para.7) states that the objective of financial statements ‘is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions’.

So the financial statements are made as follows:

Statement of financial position

Statement of comprehensive income

Statement of changes in equity

Statement of cash flow

Notes to the accounts

Statement of financial position

This statement provides a snapshot summary of what a business owns or is owed-assets-and what it owes-liabilities-at a particular date thus it is referred as a statement of net worth. It shows how solvent a business is, how liquids its assets are and how much capital is being spent.

It also consists of non-current assets, current assets, capital and reserves, non-current liabilities and current liabilities. The non-current can be classified as assets that are not quickly and easily realizable, and current assets are assets that can be readily convertible into cash within a short time. Furthermore share capital represents amount receives in respect of shares issued by a particular company, non-current liabilities and current liabilities are obligations that are not aimed to be liquidated within a year and one that are expected to be settled within one year respectively.

Statement of comprehensive income

The main purpose of the comprehensive income statement is to report a company’s earnings over some pointing period of time. This statement reflects the company’s revenues, expenses and earnings; it gives information about the financial performance of a company. Users of accounts who are concerned about the profitability can obtain relevant information in the comprehensive income statement and they can make use of ratios to take out information they need therein.

Statement of changes in equity

IAS 1 requires that companies should prepare a statement of changes in equity to be presented with the same value as the other primary statements. According to Barry and Jamie Elliot this statement is vital because a quantity of gains and losses are required by law or accounting standards to be managed through directly with reserves, so as to prevent the financial statement from being incomplete.

The shareholders acquire more information about any changes made to share capital, retained earnings, revaluation reserves, share premium other reserves and to proposed dividends. Sometimes gains and losses may be easily traced by reserve accounting, which permits items to bypass the income statement. Hence the statement of changes in equity provides more transparency in reporting these gains or losses.

Statement of cash flow

Section 217 of the CA 01 requires all companies to include in their annual report a statement of cash flow and the latter should be prepared in accordance with IAS 7. The purpose of IAS 7 is to include the provision of information about the historical changes in cash and cash equivalents of a company by means of a statement of cash flow. Cash flow statement has become useful sources of information for users (Day (1986) and Yap (1997)).

Thus cash flows are classifies during a period from:

operating activities-the cash effects of transactions concerning trading activities;

investing activities-cash flows from the purchase and sales of non-current assets and short term investments;

financing activities-involve receipts from or refund to external providers of finance in respect of the primary amount.

Notes to the accounts

Notes to the accounts can be refers as explanatory notes that accompany the financial statements. These are intended to give further detail of the items appearing in the financial statements, to provide surplus information, to represent attention of related party transactions and to give existence of interest to stakeholders, other than the shareholders. It includes the IAS, concepts, depreciation policies and methods of valuation that an entity has used.

Furthermore studies conducted by Anderson (1981), found that the most readable sections of the annual report were seen to be the balance sheet, profit and loss account, notes to the accounts, and the chairman’s statement respectively. The comprehensive income statement, however, was seen to be more essential than the balance sheet. However this author failed to carry out any test whether there are major differences between the users’ usage of annual reports sections and on the other hand observed its importance of those sections.

Epstein and Pava (1993) has developed on the work of Epstein (1975) and found that there has been an increased in the importance of annual report as a source of information. Furthermore, they found that the importance of the balance sheet had extended, and that over the same period the perceived usefulness of the income statement had declined.

Anderson and Epstein (1995) argued that in Australia they found that the comprehensive income is more useful in making an investment decision rather than the directors’ report. In this respect the respondents had also demand for simplification and more explanation of the balance sheet, statement of cash flow, and the income statement.

In another study by, Abdelsalam (1990­) it was highlighted that the comprehensive income and information about the future of the company as well as information about directors was seen to be important part of the annual report. Ba-owaidan (1994) also found the profit and loss account to be the most influential part of the annual report followed by the balance sheet but has also concludes that some respondents faced some problems in understanding the contents of the annual reports.

The Kruskal Wallis test revealed that the cash flow section was the only section of the annual report that the user groups have significant differences regarding its value. This is not surprising as the findings reported by Lee and Tweedie (1975), Wilton and Tabb (1978) and Yap (1997) for developed countries disclosed that individual and institutional investors have little interest in the cash flow statement and may not rely upon, as they are not a sophisticated group.

In New Zealand, Chang and Most (1985), disclosed that newspapers and magazines were the preferred source of information and the comprehensive income statement was found as the main statement in the annual report for decision making.

Moreover, Anderson (1979) and Courtis (1982) also found that the balance sheet and the profit and loss statement were regarded as the two most essential statements for decision-making.

In addition, Anderson and Epstein’s (1997) study revealed that in Australia, New Zealand and US, the comprehensive income and financial position statement were ranked as the most essential items but the cash flow was less important to New Zealand and Australian investors than to US respondents.

Moreover, Stephen L.Buzby carried a research in 1974 on the usefulness of annual reports and his aim was to find the perceptions of professional financial analyst on selected items in the annual reports.

To summarize Daniels and Daniels (1991) found that information present in financial statements is important and very useful but not sufficient enough to evaluate the financial condition of a company.

USERS OF ACCOUNTS

According to IASB, financial information is prepared for users, “presuming that they have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence.” The different users and their needs are identified below:

Investors

Investors need information to decide whether they should continue to invest in an entity, to assess whether that particular organization will be able to pay out dividends as well as how the enterprise has been managed. The investors require information about profitability, volumes, sales, amounts invested, assets owned, share price and information about competitors. Epstein and Pava (1993) document that individual investor’s demand for more financial and non financial information in the annual reports.

Shareholders

Shareholders are the owners of the company. Thus, they have the right to receive dividends from the company’s profit. Information in annual reports is very important to shareholders as profit acts as an indicator of the amount of dividends they ought to obtain.

According to Cook and Sutton (1995), companies should prepare summary annual reports based on information requirements of shareholders in order to satisfy their needs. Thus, companies should disclose essential piece of information in a clear and understandable format that will enhance the relevance and value of annual reports in communicating company information to shareholders.

Lenders and Financial institutions

Lenders such as insurance companies, pension funds use FS information to decide the loan amount, the interest rate and security needed for business loan and they should also make sure whether the company would be able to repay back both the principal amounts and the interest’s payments. The key accounting information for lenders is therefore:

-Cash flow

-Investment requirements in business

Thus such information required by lenders is available in the annual report.

Employees

Employees demand annual report for the stability and profitability of the business. They are interested in information about employment prospects, security of their jobs and retirement benefits. Furthermore, Clark and Craig (1991) conclude that relevant information for investors is also relevant for employees.

Government

The government group makes use of an annual report for tax purposes. The tax authorities such as the Inland Revenue needs information on the profitability of an entity to levy corporation tax and custom and excise make use of information to check VAT returns. Hence tax authorities use FS information as a source for enhancing social welfare by establishing tax policies.

Public

The public are usually considered as ‘stakeholders’ and businesses form part of society at large and as a result create much public interest. Marston and Shrives (1991, pp196), found annual report as the main document available for the public thus is being regarded as the main “disclosure vehicle”.

Moreover despite some improvements has taken place in reporting in recent years, the users groups of annual reports wish to have more information than is currently provided (Abu-Nassar and Rutherford, 1996; Hatif and Al-Zubaidi, 2000; Naser and Nuseibeh, 2003).On the other hand, Dye and Bowsher (1987) concluded that most users seek an annual report to include other information that will enhance their understanding. Hay and Antonio (1990) found that users demand for highly detailed disclosures in annual reports. In addition users want information on future prospects, company products, publication of quarterly reports and management audit reports(Anderson 1981). Furthermore Benston (1976) reported that annual report were the least important source of information compared to financial press and newspaper reports.

In summary, results from preceding studies shows that users believed that annual reports is the main sources of information; though each section was not considered as of equal significance. The results also disclose a necessity to establish some changes to the annual reporting that allow the information to be more understandable and sufficient for potential users.


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