Analysing how corporate reporting is supposed to help improve corporate governance

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There has been much discussion on the effects of corporate reporting on efficient corporate governance. Corporate governance is defined as "the formal mechanisms to direct, supervise, and control the decisions and actions of senior managers and to ensure the interests of those who contribute the operations of the company compatible and consistent with shareholders" (Thomas, 2006). Undoubtedly, corporate reporting is one of the most material elements of modern corporate governance and it offers articulate and precise information concerning the public firms' financial position and performance.

The debate on the influence of corporate reporting in corporate governance has been far from temperate with groups claiming that there exists a great quantity of accounting frauds in the statements together with the limitations of financial statements. For example, some items on the reports are subjective, that means it can be manipulated by the managers. Louis (1996) asserted that, in order to boost net income or sales figures, managers often "prettify" the items such as return on assets, return on equity and other similar measurements on the statements. However, this essay will attempt to explore the impact of corporate reporting critically and demonstrate the contributions of corporate reporting to corporate governance as well as some shortcomings. In order to demonstrate this, first, the benefits of corporate financial statements to corporate governance will be discussed. Second, the accusations made against corporate reporting regarding accounting frauds will be argued in brief.

2.0 Introduction of corporate reporting

2.1 The purpose of corporate financial reporting

According to international accounting standards board, the objective of corporate reporting is to provide information about the financial position, performance of an enterprise. Louis (1996) argued that good financial reporting should provide analysts and investors with a wealth of useful detail about profitability, trends and values of the corporation. Hence, corporate reporting serves a wide range of users for different purposes with information about company's profitability, cash flows, and financial position.

Firstly, financial statements enable managers to identify value creation opportunities that affect its continued business. Secondly, employees require financial reports to make collective bargaining agreements in discussing their wage, promotion and rankings. Thirdly, it reduces information asymmetries at a large extent among investors and tends to permit investors and creditors to make rational investment decisions. At last, financial institutions depend on financial statements to decide whether to extend debt securities to corporate expenditures.

2.2 Main corporate financial statements

Financial statements can be considered as the products of internal corporate accounting and external reporting systems that measure and routinely disclose the financial position and managers' performance of publicly held firms. There are three basic financial statements:

1. The income statement reports on a company's sale, costs, expenses and profits over a period of time.

2. The statement of cash flows documents company's cash flow activities including its operations, investments and financial activities over a period.

3. The balance sheet reports on a company's assets, liabilities, and ownership equity at a particular time.

3.0 How does corporate reporting improve corporate governance?

As Ball (2001) points out, timely information in the published financial statements increases the effectiveness of corporate governance and debt agreements in motivating and monitoring managers. Based on the governance role survey in accounting (Bushman 2005), they believe corporate reporting contributes directly to the governance by guaranteeing efficient management of assets in place, better project selection, and reduced expropriation of investors' wealth by the managers. Thus, it has enhanced the corporate governance in regulating and promoting the behaviors of managers.

To illustrate, because of the existence of agency conflicts, managers usually made a decision primarily benefit themselves rather than the shareholders' and company's interests. Additionally, it is certain that managers care about their compensation and reputation; thus, sometimes they prefer insistence on some losing projects rather than timely abandonment of losing projects. For example, the senior executives of Enron Corporation believed Enron should be the best under their management. However, when their business and trading ventures began to perform poorly, they tried to cover up their failures at the expense of the shareholders' and company's interests. Given this fact, a special mechanism is needed to supervise, and control actions of managers. Under the pressure of the corporate reporting, corporate executives are supposed to behave more efficiently and honestly for their performance are open to public's scrutiny. Corporate governance is therefore potentially improved by preventing the manager form expropriating the owner's interests.

Moreover, Bushman (2005) argued that even without agency conflicts between managers and investors, quality financial reporting enhances governance efficiency by enabling managers to identify and evaluate the investment opportunities with less error. Financial statements contain important information which had to be focused on by the managers because it is related to the success and loss of the company. In case of profit margins, executives can take advantage of this item of other companies to identify promising new investment opportunities, acquisition candidates, or strategic innovations.

On the other hand, numerous researches suggest that the collapses of many companies are caused by managers' neglecting the information on the financial statements such as inventory levels, speedy cash collections from customers, and prompt payments to suppliers, thus leading the company to the cash flow crisis, even the bankruptcy. Corporate reporting therefore should be regarded as material part of corporate governance for directing managers to make sensible and profitable decisions. This would further lead to more reasonable allocation of capital to highest valued uses, as lowest estimation of risk.

4.0 Accusations against corporate reporting

The two criticisms most often heard about the corporate reporting system are (1) accounting frauds (b) limitations of the financial statements.

4.1 accounting frauds

One of the main concerns is that the financial statement is always related to accounting frauds. As Louis (1994) points out, manipulation of the reported earnings is so tempting. Respectable companies repeatedly manipulated such items as its inventory values and its depreciation and pension expenses, all with the consistent effect of reporting better "earnings." For example, there are many causes of the Enron collapse, and the majority one of them is making accounting frauds in its business operations. The company made use of accounting limitations to manage earnings while modifying the balance sheet in order to portray a favorable depiction of its performance. As a result, it had a negative effect on its corporate governance, and then led the company to bankruptcy at last.

4.2 limitations of financial statements

Another concern for corporate reporting is there are some accounting limitations in the financial statements. In case of the balance sheet, it is a statement of financial position at a single point in time. Having said this, the data on the balance sheet can't reflect the completed financial performance of the company. In addition, it reports assets on a comprehensible mixture of historical costs, replacement costs, market values and present values (Thomas, 2006). While some accounting numbers used to generate indictors of corporate performance are subjective, that means the statistics on the reports can be manipulated by senior managers.

4.3 In defense of 'corporate reporting'

However, in fact, the essence of accounting frauds is depended on the agency problem and information asymmetry between managers and investors. In other words, we can't attribute the negative effects of accounting frauds to corporate reporting. On the contrary, the existence of financial reporting is to reduce the agency conflicts and information asymmetry problems in the investment market.

Furthermore, according to Louis (1996) explanation, nothing as inherently imprecise as financial reporting will be perfect. It is clear that the FASB and the SEC continue to struggle with a whole range of financial disclosure system. In a sense, it is the effort applied to enhance financial disclosure.

5.0 Conclusion

In conclusion, this essay has presented empirical evidence on the controversy of the effect of corporate reporting. Although there are some limitations of the financial statements which create the chances for managers to make accounting frauds in order to portray a favorable depiction of its performance, it is unfair to characterize corporate reporting as the root cause of the accounting frauds.

Indeed, evidence in European countries suggests that corporate reporting can counterbalance the negative effects of agency conflicts and information asymmetry in the public companies and keep the efficiency of the corporate governance through motivating and monitoring managers automatically. Hence, the mechanism of corporate reporting does improve the corporate governance and performance.