Examining the evolution of financial reporting


The first enterprises were micro in nature and commercial accounts were generally kept as records for the benefit of owners. However, as time went by business magnitude started to escalate, resulting in additional capital requirements. This increased the number of joint stock companies, with multiple owners holding a share in a company. To facilitate the administration of such entities, shareholders started to appoint stewards, to manage the entity on their behalf (Alexander, Britton & Jorissen, 2005).

The separation of owners and management brought the need for owners to be provided with an account on the stewards appointed. This information was provided through "accounting", which nowadays is more commonly referred as financial reporting (McKersie, 2010).Financial reporting, as a monitoring system of the agency relationship between owners and stewards, was generally unquestioned until the 1960s (Arai, 1970).

The second half of the twentieth century, saw the impetus of the capital markets, and the escalation of individual investors (Mattenseich, 2008). The evolution of the capital markets brought about new demands for financial reporting. Research done by the AAA in the 1960's introduced a new stance in accounting. In a statement issued in 1966, AAA defined accounting as "the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of information" (AAA, 1966).

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This information orientation resulted into the shift from the traditional stewardship objective to a decision usefulness perspective. In the early seventies, in an attempt to create a formal financial reporting framework, the US commissioned a number of studies. One of the studies was the Trueblood Report, conducted by a specifically appointed committee led by Robert Trueblood. In its report the Trueblood Committee proposed Decision Usefulness as the objective of financial reporting (Zeff, 1979). At the time, controversy whether decision usefulness or stewardship should be the main objectives sparked (Whittington, 2008).

Eventually the first Conceptual Framework (1978) set up by the FASB adopted decision usefulness as its core objective, although only 37% of the respondents to the discussion memorandum agreed with this standpoint (Miller, 1990). Decision usefulness was also adopted in the IASC [1] framework set up in 1989.

"The objective of financial statements [2] is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions." (IASB, 1989, Par. 12)

Thus the upsurge of the information orientation that emerged in the early seventies resulted in the two major global frameworks adopting a decision usefulness objective for financial reporting.

Flowing from the primary objective of decision usefulness, both the FASB and IASB Frameworks derive a secondary objective of financial reporting. Both Conceptual Frameworks set the ability to assess the cash flow prospects of an entity as a further objective (FASB, 1978:17; IASB, 1989, par. 15). This objective clearly designate that the role of the financial reporting is to help investors make economic decisions such as buying, selling or retaining their securities (Bullen & Crook, 2005).

Although the IASB framework acknowledged the fact that financial statements can be used to bridge the information gap between owners and stewards, it considered this information as being embraced within the economic decision making information. In fact, the Framework stipulated that: "Those users who wish to assess the stewardship or accountability of management do so in order that they may make economic decisions…" (IASB, 1989, par. 14).

Harmonisation Process:

In 2002 the FASB and IASB came to the Norwalk Agreement [3] , in which they committed themselves to compile a harmonised conceptual framework. The aim of this project was to set up a consistent financial reporting foundation (Whittington, 2008). A harmonised Framework would provide a congruent base on which both boards would set up accounting standards with the aim to eliminate the current differences between the US GAAPs and IFRSs (IASB, 2010).

The venture of the conceptual framework was divided in eight phases, with "phase A" specifically dealing with the objective of Financial Reporting. The project embarked in October 2004 and initially phase A was deemed to be one of the least controversy-prone from all phases. In fact, at first the boards contemplated whether there was the need to issue a Preliminary View or whether they afforded to commence with the exposure draft. However, it was decided to go through all the discussion process and as with all the subsequent phases a Preliminary View was issued in prior of the Exposure Draft (Whittington, 2008).

Preliminary View:

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The Preliminary View paper entitled "The Objective of Financial reporting and Qualitative Characteristics of Decision Useful Financial Information", was published in July 2006, with the comment period ending the following November. Decision usefulness objective was again confirmed in the Preliminary view. The requirements of investors were assumed to be "resource allocation decisions" which were to be served by providing "information to help… to assess the amounts, timing, and uncertainty of the entity's future cash inflows and outflows…" (IASB, 2006, OB3). Thereby, the boards appeared to be utterly narrowing the focus of decision usefulness on valuation usefulness (Gassen, 2008).

The preliminary view reconfirmed also that the decision usefulness view incorporates also the stewardship objective (IASB, 2006, OB28). This implication attracted some internal contradictory views within the boards. In fact, an Alternative View compiled by two IASB board members [4] was incorporated within the Preliminary View (IASB, 2006, AV 1.1 - 1.7). The alternative view suggested that stewardship contributed a vital dimension to financial reporting, and thus it necessitates specific acknowledgment in the conceptual framework objectives (Lennard, 2007).

The Preliminary View and its over-emphasis on economic decision making, re-ignited the stewardship versus decision usefulness debate, with some authors arguing that focus on decision usefulness was carried too far (Whittington, 2008). Lennard (2007) substantiates this matter by noting that the argument that stewardship is subsumed in decision usefulness is scarcely tackled towards the end of the Preliminary View. By contrast this argument was tackled just after the objective in the IASB Framework.

179 comment letters were submitted to the boards, with 86% of the respondents disagreeing with the proposed objective of financial reporting (IASB, 2007, 20th feb). The disagreeing commentators argued that the objective was too restrictive since it referred solely for making "investment, credit and similar resource allocation decisions" (IASB, 2007, memo). Most of the respondents proposed stewardship as the core objective or at least promoting stewardship as a separate objective but at an equal standing with decision usefulness. Furthermore the mainstream of the commentators, who contested decision usefulness as the sole objective, also disagreed with the spotlight resting on future cash flows projections (IASB, 2007).

A common disquiet amongst critics was the fear that not emphasising stewardship amongst the objectives could entail in information useful for stewardship purposes being ignored by future standards (Whittington, 2008; Lennard, 2007; DCoetsee, 2006). The UK ASB in their comment corroborated this concern with an example, in which they claim that "related party disclosure may not be included in financial statements on the grounds that it is not thought to be 'decision-useful' for resource allocation purposes" (ASB, CL 160).

Most of the comments demonstrated that contrary to the contentions made in the Preliminary View paper, users are concerned also with other aspects apart from the projection of future cash flows (PAAinE, 2007). A member of the ASB in one of his papers prepared subsequent to the Preliminary View argued that financial reporting is a means of dialogue between management and shareholders. Thus in his view, one of the fundamental objectives of financial reporting is to provide shareholders with information in order to make steward-related decisions, such as change or confirming management (Lennard, 2007).

Gebhardt and Dean (2008) also argued that the downgrading of stewardship and the importance given to future cash flows shifted prominence on potential investors and creditors at the expense of existing investors and creditors. They further highlight that this swing was more targeted to satisfy short term investors' requirements and ignored long term investors.

Obviously the debate caught the eye of the boards, which discussed the objective on a number of meetings following the release of the first discussion paper. The boards even issued a specific memo that tackled exclusively stewardship (REFERENCE).

Exposure Draft:

On May 2008, the FASB/IASB issued the conceptual framework exposure draft which integrated a more general financial reporting objective (Henderson, 2010). Indeed, the exposure draft saw a rephrasing of the objective. The boards opted to replace the restrictive uses of financial reporting "making investment, credit, and similar resource allocation decisions" (IASB, 2006) with a broader "making decisions in their capacity as capital providers" statement (IASB, 2008).

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The boards portrayed that they never had the intention to promote decision usefulness at the expense of stewardship.

Conversely, the boards re-affirmed that stewardship decisions can be catered for through the same information valuable for decision usefulness. Implicitly, the board assumed that there is no conflict between the two objectives (Henderson, 2010). This implicit assumption was not corroborated in an empirical study conducted by Gassen in 2008, where he concluded that "decision usefulness and stewardship are conflicting objectives of financial accounting" (Gassen, 2008, pg. 39). This was long-established in an earlier study by Gjsedal (1981), in which he theoretically demonstrates that the criteria's for stewardship usefulness and valuation-usefulness are different.

Although the rephrasing of the objective in the exposure draft was welcomed by many commentators, still many implied that stewardship should be enlightened as a separate objective of equal status to decision usefulness (Peasnell, Dean, & Gebhardt, 2009). Peansell, Dean and Gebhardt (2009) argued also that the confirmed de-emphasis on "Prudence" which is grounded in the stewardship function, confirms that stewardship was still not given the necessary eminence in the framework.

Final Definitive Version:

The final version of the exposure draft underwent some cosmetic changes, rather than drastic changes. Due to translation snags, the boards opted not to use stewardship and instead articulated what stewardship encapsulates (IASB, 2010, BC 1.28). The primary objective was slightly reworded with final phrasing being the following:

"The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit." (IASB, 2010, OB 2)

The framework goes on to say that decisions made by users are chiefly based on the expected return. On its turn "expectations about returns depend on their assessment of the amount, timing and uncertainty of (the prospects for) future net cash inflows to the entity" (IASB, 2010, OB 3). Thus, the Boards confirmed the derivative objective of assessing future cash flows.

The conceptual framework retained also the concept that information concerning stewards is incorporated in the evaluation of future cash flows. In fact, objective four claims that in order to assess the entity's future cash flows, users "need information about the resources of the entity, claims against the entity, and how efficiently and effectively the entity's management and governing board have discharged their responsibilities to use the entity's resources" (IASB, 2010, OB 4) [emphasis added].

The Boards also made it clear that they had no intention "to imply that assessing prospects for future cash flow or assessing the quality of management's stewardship is more important than the other. Both are important for making decisions about providing resources to an entity" (IASB, 2010, BC 1,27).

Maltese Bearing:

A good number of the stakeholders that disagreed with the decision usefulness objective came from EU countries especially from the UK (Whittington, 2008). This could be due to the fact that the accounting legal system in UK is inclined towards stewardship. In a paper on auditor liability Bush, Fearnley and Sunder declared that in UK "the decision usefulness approach is found in accounting standards but not in company law" ( Bush, Fearnley & Sunder, 2007, pg 39).

This fact was also highlighted in a study conducted by Tim Bush on behalf of the ICAEW in 2005. This study revealed that the US accounting regulation emanated from the Securities Act 1933, and for such reason it caters capital markets and emphasise decision usefulness and prediction of future cash flows. On the other hand, accounting regulation in UK is grounded in the companies act and takes more of a stewardship outlook in order to safeguard shareholder's rights. In fact, according to Bush the UK's legal system provides for a reporting model that

"…insulates accounting from any likely market reaction and instead gives the shareholders the right to know, in a more concrete evidential way, of anything that is a significant reflection of stewardship, as distinct from forward valuation". (Bush, 2005, pg 16)

The Maltese Companies Act which came into being in 1995 is primarily based on the UK Companies Act (Muscat, 2009). Nonetheless, the stewardship orientation appears to be also embedded in our local jurisdiction. The underlying act in fact stipulates that the financial statements are presented to the shareholders at an annual general meeting with the latter assigned the competence to approve the financial statements, vote for directors, and endorse dividends.

Local judiciary on a number of occasions also relied on English case law in the field of company law (Muscat, 2009). This could be of great significance when considering the stewardship oriented case laws that are available in UK. A case in point is the case Caparo Industries plc vs Dickman and others (1990) [5] . In this case it the Lords established that the function of financial reports was to enable shareholders exercise control over management (Bartlett & Chandler, 1997). This case underlined the importance of stewardship in UK financial reporting (Bush, 2005). In fact, in their English law book Smith and Keenan states that:

"The Caparo Judgment has angered some in the business world because investors have, in a sense, lost their right to make investment judgements on the basis of annual accounts. This is not really surprising because annual accounts are in essence stewardship statements, i.e. how the directors have conducted the company's business during the year covered by the accounts. They are by their nature backward looking and not a suitable vehicle to help speculators to predict a future which is uncertain, nor they are intended to be. Decision- Usefulness is not the primary purpose of annual accounts." (Smith & Keenan, 2007, pg 868) [Emphasis added].

This statement by Smith and Keenan contradicts the main purpose of financial reporting forwarded in IASB Framework. Thus, although the Maltese entities are to abide with the IFRSs which are predominantly oriented towards decision usefulness, our legal regime, being primarily based on the UK legal system, seems to be more stewardship oriented.

Objective impetus:

Some authors argued that the inclusion of stewardship is merely a matter of emphasis, and alleged that this debate is purely academic with no impetus on the accounting standards. The main backing argument used by these individuals is that currently the Conceptual framework is not mandatory (Bradbury, 2008). However, others imply that the objective can have a brunt on future standards (Lennard, 2007; Gassen, 2008). Gassen (2008) argues that the objective of the joint conceptual project is likely to influence the development of accounting standards for the many years to come.

The objective of financial reporting is often correlated to the measurement base of financial reporting (Gjesdal, 1981; Ijri, 1975; Whittington, 2008; Lennard, 2007). This was supported by Ian Hague, who advocated that the boards should establish the objective of financial reporting before embarking in the quest for solving the measurement quandary (Hague,).

There seems to be a widespread belief that stewardship implies a preference towards historical costs over current value alternatives. This was also portrayed by Lennard, when he claims that historical costs are more adequate to "provide a clear, factual account of the transactions that took place in an accounting period". (Lennard, 2007, pg 21). Equally, another author Paterson alleged that:

"By switching the focus to the future rather than the past, the company's results are no longer to be reported as they unfold: instead, guesses about future results are impounded into today's balance sheet, making the outcome more like a valuation model than a report on the outcome of an expired period" (1999, pg. 90).

The alternative view proposed in the first discussion paper stipulates that by focusing merely on decision usefulness, accounting is likely to completely lose its past orientation at the expense of stewardship (IASB, 2006, AV 1.4). In effect stewardship is primarily past oriented, by providing information on how effectively management has fulfilled their role. In contrast, decision usefulness information is more future oriented and deals with prediction of future cash flows on which economic decision can be taken (Henderson, 2010). Lennard (2007) argues that placing the spotlight on decision usefulness has led to excessive emphasis on the forecasting of future cash flows and on current values, particularly on Fair Value.

Notwithstanding this fact past information can be also valuable to make future predictions. Thus although the stewardship function caters more the past when compared to the broader decision usefulness, the two functions typically overlap (Whittington, 2008). Nonetheless, although the objectives do overlap a complete overlap is not possible (Henderson, 2010). In fact, according to Whittington and Lennard the objectives are not mutually exclusive but parallel objectives (Whittington, 2008; Lennard, 20017).

Although both boards insist that decision usefulness incorporates also the stewardship dimension, stewardship is by time being given less prominence (Whittington, 2008). The ever-increasing emphasis on Fair Value measurement is a proof of the priority given to decision usefulness. Fair value gives prominence to the statement of financial position, as a valuation statement. Fair value predominantly seeks accounting information that is forward looking in nature, which can serve better capital market requirements (Whittington, 2008).

Henderson, in his paper suggests that fair value is not necessarily incompatible with the stewardship objective. In his opinion Fair Value will contribute to more timely information, thus making better in assessing the management stewardship (Henderson, 2010). Whittington (2008) and Lennard (2007) also open to this possibility, and affirm that timely information can be functional for controlling stewards. Lennard specifically declares that "better information on stewardship may sometimes be produced by using more current values than historical costs" (Lennard, 2007, pg. 21).

From the opposing standpoint, critics of Fair Value often centre on the reliability of estimates. Fair Value and its concern on futuristic outcomes, involve estimates and are not embodied in realised transactions. For such reason, an objective root for Fair Value estimates does not exist. Using such predisposition, management may prejudice estimates to achieve awaited outcomes, since judgment of management is inevitable in arriving at Fair Values (Henderson, 2010).

Ijri contributed a number of studies on this regard in the late 1970s. Ijiri suggest that stewardship requires objective and verifiable information. By objectivity Ijri implies that information should be independent of its preparer, while verifiability refers to data that can be traced back. According to Ijri these objectives cannot be met by Fair Value and consequently he suggests that Fair Value is unsuitable for the stewardship objective (Ijri, 1975).

On the other hand there are authors who argue that historical cost is unsuitable for valuation purposes, since historical cost is outdated and irrelevant (Bradbury, 2008). However this standpoint has been contradicted by Penman, which in his study proposed a model by which future valuation of a quoted company can be arrived at using historical costs (Penman, 2007).

Maltese Private Individual Shareholder:

Understandability & the Financial Reports:

A number of local studies highlighted the lack of financial acquaintance amongst local shareholders (Cassar 2007; Attard 2006; Ebejer 2001). This lack of understandability is not synonymous merely to the local scenario. In fact, the lack of understandability amongst non-professional shareholders featured in a number of studies conducted worldwide. Lack of understandability emerged in both developed countries such as US (Epstein & Pava, 1993), UK (Lee & Tweedie, 1975; Bartlett & Chandler, 1997) and Australia (Anderson & Epstein, 1995) and developing countries such as Qatar (Alttar & Al-Khater 2007) and South Africa (Stainbank & Peebles, 2006).

Financial Reports:

Article 180(1a) of the Companies Act stipulates that shareholders are to be provided with a copy of the annual accounts. Financial information through annual reports is considered to be one of the most important information sources that shareholders can avail from (Lee & Tweedie, 1976). However, the lack of understandability of private shareholders is limiting the possible benefits that shareholders can reap from financial reports. To make things worse financial reports by time are getting even more complex. This was clearly portrayed in a paper compiled by Wild (2000), where he quoted Tweedie the IASB Chairman:

"Financial reporting is useless if it fails to communicate. As the financial world has become more complex, financial statements have had to mirror those changes through new measurement techniques and disclosures. This development has left further behind those many private shareholders for whom accounting has always been something of a mysterious black box."

The lack of understandability is making it hard for the non-professional shareholder to utilise financial reports (Tafler, 1984). Lee and Tweedie (1977) argued that evolution in accounting information is ignoring non-professional shareholders, and feared that accounting is becoming suitable solely for professional investors.

Financial reports do not seem to be particularly popular amongst private individual shareholders (Lee & Tweedie, 1976; Bartlett & Chandler, 1997; Anderson & Epstein 1995, Epstein & Pava, 1993). That financial reports lazed idle with non-professional shareholders was also portrayed in a number of local studies (Cassar 2007; Briffa 2006; Ebejer 2001). Excessive complexity and length are widespread motivations why shareholders refrain from using annual report (Cassar, 2007; Briffa, 2006; Bartlett & Chandler 1997; Anderson & Epstein, 1995).

In a study conducted in UK it was establish that financial reports ascended from an average 37 pages in 1974 to an average of 90 pages in 2000 (Campbell, Moore & Shrives, 2006). However, one is to note that since 1974, financial reporting experienced radical changes, such as the introduction of cash flow statements and enhanced disclosure. Notwithstanding this fact, shareholders' appetite for financial reports does not seem to be swelling (Bartlett & Chandler, 1997).

Conversely, although financial reports are being equipped with supplementary, systematic information, this seems to be backfiring. Some authors attribute the amplified complexity and length of the financial report to the decision usefulness orientation. In a comment made by the academic institution ACCA on the objectives of financial statements it claimed that:

"The undue emphasis on the provision of information which is useful as input to investing or credit decisions is the source of much of the explosion of disclosure requirements that have rendered accounts both lengthy and hard to understand." (ACCA, 2006).

Many studies correlated to private individual shareholders pinpointed the desire amongst shareholders for less information through abridged Annual Reports (Bartlett & Chandler, 1997; Alttar & Al-Khater 2007). Some countries like the US [6] are already making use of abridged annual reports. Other countries such as UK are seriously considering the matter. In fact, UK ASB tackled the subject in an explicit paper in 1999 (ASB, 1999). Conversely, not all authors agree that financial reports are to be summarised. Bagshaw (2000) and Hammill (1979) argued that simply reducing the information would not increase the understandability of non-professional shareholders. Rutherfood (2000), also highlighted the risk that individual shareholders will be competing with larger institutional investors but with less complete information.

Locally, complete financial reports are to be imparted to shareholders. Thus opting for concise reports can be done only supplementary to the original annual report, obviously incurring supplementary costs. It is also worth mentioning the fact that local banks are regulated by "The Publication of Audited Financial Statements of Credit Institutions Directive". This directive imposes tight regulations on the financial reports of credit institutions. Thus, in the case of banks abridged reports are unlikely to be issued unless laws are not amended.

Another common suggestion to aid the understandability is the use of graphical information. In fact, many studies portrayed that shareholders aspire the use of graphical information in financial reports (Cassar, 2007; Briffa, 2006; Bartlett & Chandler, 1997). Various authors found out that graphical information does enhance understandabilty of non-professional shareholders (Schmis & Schmis, 1979; McCullary, 1995; Beatties & Jones, 1997; Courtis, 1997). Notwithstanding this widespread preference for graphical information amongst shareholders, Beattie and Jones argued that graphs can be easily manipulated by companies to portray better impressions and thus misguide shareholders. (Beattie and Jones, 2002).

The chairman report and Income statement were identified to be the most popular sections of financial reporting by various authors (Bartlett & Chandler, 1997, Briffa, 2005). This confirms that shareholders are highly interested in getting an overview of the company and its performance. Thus this corroborates that unprofessional shareholders see the stewardship function as valuable information.

Nonetheless this does not mean that the valuation function of financial statements is trivial. Indeed, one is to note that in an array of empirical studies, the Statement of Financial Position closely followed Income Statement when it comes to popularity (Briffa, 2005; Bartlett & Chandler, 1997). This confirms the theory of Whittington (2008) and Lennard (2007), that Valuation and Stewardship objectives are not alternatives, but are parallel, equally important objectives.

Passive versus Active investors:

Studies in UK identified that the mainstream of non-professional shareholders are passive shareholders (Bartlett & Chandler, 1997; Lee & Tweedie, 1976). This seems also to be the situation locally, when considering that the level of share trading in the Malta Stock Exchange is very low (Rizzo, 2010). Lee and Tweedie accused inadequate communication as the perpetrator contributing to the passiveness of individual shareholders. Lee and Tweedie argued that financial reporting should be a means which private shareholders read and find useful, otherwise they are forced to rely on stockbrokers or develop into sheer passive investors (Lee & Tweedie, 1976).

Dividends versus Capital Gains.

Shareholders can generate earnings from two sources, being dividends and Capital Gains. Dividends can be defined as the profits distributed to shareholders. Conversely, capital gains refer to the appreciation of the capital invested (Pike & Neale, 2006).

A detailed pragmatic study on the preference of local shareholders between the two was conducted by Sammut in 2009. The study showed that the majority of local shareholders preferred Dividends as opposed to capital gains. The same preference towards dividends was found in Dutch and Greek private shareholders (Kent Baker, 2009 -dividends and dividend policy). Sammut (2009) in his study also highlighted the fact that local shareholders who exposed preference for dividends were not ready to invest in shares that never paid dividends.

Such dividend orientation by shareholders elucidate why in Malta the absolute majority of the listed companies distribute dividends. In fact, last year thirteen of the nineteen local listed companies distributed dividends (Rizzo, 2010). When considering the local tax regime, this preference of dividends over capital gains can be considered a sort of anomaly. In fact, locally dividends are subject to tax at source [7] , while capital gains are exempted from taxation (Income Tax Act, 1949).

One of the reasons identified for preference of dividends over capital gains by Barberis and Thaler was "self-control". According to Barberis and Thaler shareholders perceive shares as a form of saving. For such reason shareholders are willing to allow themselves devour from the yearly income, but keep the capital invested intact (Barberis and Thaler, 2003). This could act as a corroborate logic why shareholders prefer Dividends over Capital Gains.

Nonetheless, reasons for the preference of one over the other can be various, some of these include Life cycle stage of shareholders (Sherfin and Thaler, 1988), perceived lower risks (Brigham & Houston, 2004), and the related taxation and transaction costs (Dong, 2005).