This report is divided into 3 parts. Firstly, it summarizes the research evidence examining the usefulness of reporting to investors and other providers of capital. Secondly, there is an analysis about advantages and disadvantages of rules-based and principles-based financing. Thirdly, this report consider some financial reporting issues and evaluates the options available to address them from two aspect off balance sheet finance and influence of lobbyists. At each part of our report, we make a conclusion.
2. Usefulness of reporting
The regulation of corporate reporting disclosure contribute to enhance the corporate transparency or image, improve corporate performance and bring the benefit for the investors. Under the basis of literature review on annual company reporting, we conclude the usefulness of financial reporting, including social and environmental reporting.
The usefulness of financial reporting
2.1.1 To improve the securities market efficiency-the basis of investors' trade
Under Fama(1998), one of the important evidence for the measure of the securities market efficiency is the accuracy and reliability of the of accounting information disclosure by listed companies. It can be inferred that the benefits of financial reporting disclosure by listed companies is usually reflected in the improvement of market efficiency.
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Specifically, analysis of financial reporting reflects authentic operations performance and development prospects of the company. Therefore, one the one hand, financial reporting can contribute to exchange information and choose normal trading between the seller and the buyer. As a result, it is inevitable to promote effective operation and healthy development of the securities market. On the other hand, financial reporting is conducive to maintaining financial order. An efficient market is the basis of trade between investors, which can obtain investment income through sell or buy corporate share, or directly invest in company in efficient market.
2.1.2 To reduce the capital cost of both investors and listed companies
Increased transparency from the financial reporting will improve the liquidity of the stock of the company, and thereby reduce the cost of equity capital and securities transaction costs. Most companies raise funds by selling shares to investors, but in the incomplete capital markets, adverse selection is resulted from the different levels of information investors hold. Generated by asymmetric information, the formation of additional transaction costs will urge the investors require the company to provide discount for the stake sales and ultimately make the capital cost increase, in order to control their investment risk. Therefore, the trade cost of both the company and investors is closely linked with the degree and efficiency of financial reporting information disclosure.
During the research evidence, Botosan(1997, 2002) firstly provide direct evidence of the negative correlation between the company transparency and the capital cost; Sengupta(1998) further finds that financial reporting disclosure also helps to reduce the issuance cost of the bonds; Welker(1995) through empirical analysis concludes that there is a clear negative correlation between the bid-ask spread and the debt cost, and then the level of financial disclosure reduces the information asymmetry in the part of the capital cost.
2.1.3 To provide a scientific basis for to investment decisions of investors
Financial reporting reveals the financial position, operating results and cash flow of company comprehensively and systematically in a certain period. Investors can use specific methods to research and compare data in the financial reporting, and further review the company's financial position and operating results.
Firstly, for the investors, through the day-to-day analysis and regular analysis of financial statements, business managers make deep understanding of the financial and economic information,. On this basis, it is conducive to make the evaluation of management performance and formulate measures to improve the management level what's more, entrepreneurs can keep dynamic eyes on financial information, which contributes to identify problems in the changing objective situation in a timely manner. Furthermore, it provides the convenience of estimating the current financial position and further helps to adjust operating direction and evaluate investment programs. Therefore, with the help of accurate forecasting, internal investors make reasonable decisions and improve economic efficiency.
Secondly, financial reporting transmit information about the company's profitability and financial position, which is conducive to other providers of capital like creditors and other interested parties to use as the main basis for funds decision.
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According to the capital cost theory, the financial information conveying from about the corporate profitability, solvency, investment income, and development prospects allows investors to the company's financial forecast accuracy, thereby reducing investors predict risk and equity capital cost. In other words, if the predicted risk is not dispersed, an increase in transparency resulted from the financial reporting can improve investors' understanding of the company's true value, and then reduce the company's capital cost. Based on the information disclosed by the company, the investors can decide how to select the portfolio and disperse predicting risk. (Clarkson et al, 1996)
2.1.4 To understand the operational status of the national economy.
Financial reporting may contribute to optimize the allocation of resources and ensure the sustainable development of the national economy. Through the collection and analysis of the financial reporting provided by each company, National economic management departments understand and master the economic development of the regional and various industries economic, in order to macro-control economic stable operation . In particular, based on the financial reporting, finance, taxation, audit bureau may examine and monitor whether all corporate compliance comply with state laws, rules and regulations, or exist tax evasion behavior.
2.2 The usefulness of social and environmental reporting
As one important part of annual company reporting, social responsibility report generates from the perspective of corporate value and the pursuit of business success and tries to answer the motivation how enterprises actively fulfill their social responsibility. The disclosure of social and environmental reporting
Corporate social responsibility, both government and community expectations, requirements and constraints, but also to enhance the core competitiveness, achieve sustained and healthy development of the internal needs. Corporate Social Responsibility Report from general corporate values and the pursuit of business success perspective on the power of the enterprises to actively fulfill their social responsibility to answer.
In fact, many countries have already had the corporate social responsibility rise to the legal level, and even moved towards a mature stage. For example, most states in U.S.A. Have enacted legislation on corporate social responsibility. In 2002, President Bush signed the "Corporate Responsibility Act" to punish the behavior of corporate misconduct and false accounts, especially those executives who directly damage the interests of the people, in order to improve the U.S. market confidence. Some countries are more refined, such as in May 2005, the Swedish Parliament introduced a new law which requires all Swedish companies must be submitted to a sustainable development reporting except the financial reporting in their annual report. In specific, the reporting must contain information on the corporate efforts and outcome in environmental protection, resource utilization, and social harmony, etc. Therefore, the disclosure of corporate social responsibility is both expectations, requirements and constraints of government and community, but also the internal needs for the corporate to enhance the core competitiveness, and achieve sustained development.
According to E1laJoseph(2000), Despite the willingness of enterprises to improve their social responsibility performance is driven by the system of rule, moral, and economic factors, but the economic motivation is the most fundamental intrinsic motivation. Bhattacharya (2003) said, A positive image of social responsibility is easier for customers to be identified with, and thereby improve the management performance. The disclosure of social and environmental reporting can help to enhance the company's image, convey the support for government policies and attract investment. Through the social reporting, investors can know about complement of corporate social responsibility, measure the degree of corporate support for government policies, and further make investment decision.
Rules-based and principles-based financing
Both rules-based and principle-based financing systems could provide best possible financial statement to investors. Principles-based financing ensure managers have discretion on recording transactions. Rules-based financing requires specific rules should be followed. In this section, we make a comparison of the two system to identify the advantages and disadvantages of them.
In a general way, principle-based financing is based on certain standards that guide the direction of a set of desired outcomes. These standards always provide direction of how to reach these outcomes but lack of detailed implementation guidance. By contrast, rules-based financing is based on certain detailed rules which restrict firm's behavior. These rules could provide detail way for firms to comply with law. (SEC2003). That is to say, in an given financial reporting situation, requirement of principle-based standards is ensure accounting professional to exercise judgment and rules-based standards is ensure accounting professional to expertise on studying authoritative literature. There is many differences of the two standards, but one of the most distinct difference is professional judgment. Principle-based standards are softer and include much room for the professional judgment. Rule-based standards are more severe and require strict application based on limited technical estimation.
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After give definitions on the two standards, we now discuss the advantages and disadvantages of them. In present research, here is no obvious preference on either system. For example, ICAS (ICAS, 2006) likes the principles-based system when Benston et al. (2006) consider that rules-based system has more advantages.
Rules-based accounting always list detail rules that should followed when preparing financial statement. It is favored by accountants because when rules are absent, they would be brought to court when they making incorrect judgments of financial statement. Under rules-based system, the probability of lawsuits will be decreased. What's more, accuracy will increase and ambiguity will decrease. That is the consistency and comparability of financial statement will be enhanced. Moreover, there is a large number of countries using IFRS which makes it easier for accountants from different countries to have a review and interpretation of other countries. Bennett et al. (2006) consider that under this system, CFOs and auditors will be provide flexibility in mind and will concentrate on economic reality. It also increase the verifiability for auditors and regulators and reduce the opportunity for earnings management and improve the communication of standard setters' intention. However, as to the scandals happened on Enron and Worldcom, the accounting way which is rules-based in US has suffered much criticism. Therefore, there are also some disadvantages. Firstly, it is cannot be comprehensive and arbitrary. What's more, the rules making is complex which could cause unnecessary trouble or complexity when preparing the financial statements.
Principle-based accounting's main objective is to set out to make sure the reporting is good. The guidance is based on common or usual examples. The biggest advantage is that it can be used in a wide way and various situation and it is more piratical. What's more, the increased disclosure requirement the principle-based accounting system will decrease the differences or diversity in judgment. FASB and SEC both consider that when there is no identify lines in standards, the preparers will consider the substance of transactions (FASB 2002, SEC 2003). Principles-based approach implicate that if people in the community consider the practices is not appropriate or not real, you have an issue of confidence in your practice. This will move all the members to a higher requirement that small compliance will not bear by most people. It also enable firms a room to make continuous improvement in the future. The most obvious limitation is difficulties of enforcement (Schipper, 2003).The disadvantage of it is that it lacks of guidelines which could bring unreliable and inconsistent message or information that makes it hard to make a comparison among organizations. What's more, under this system, extensive professional judgments are required that will lead to diversify on financial reporting. (Niemeier, 2008). Moreover, the third disadvantage is that the principles-based accounting standards is more rely on the opportunistic essence. CFOs would take advantage of aggressive method to measure events about accounting.
There is always a mixture of the two system in most accounting systems. When record new type of asset, principles are always needed for example that no rules defines assets like foreign mortgage securities. When investors' interest is being aggrieved, rules are always useful for example that company classify a transaction way depend on its' desire.
In conclusion, when making choice between these two accounting methods, it should be make certain that the message or information given by the financial statement is related, credible and comparable among different reporting periods and entities.
Evaluation the options available to address two financial issues
Off balance sheet finance OR earnings management
Based on the information asymmetry, the agent always has a part of the private information that will never be completely understood by the principal or other users of accounting information. Therefore, there exists parts of companies take advantage of various accounting policies to conceal important financial information and refuse to provide the actual corporate financial position, just like off balance sheet finance or earnings management.
Off balance sheet financing is meant the financing don't need to be included in the balance sheet. It is the financing that is neither increases the asset side of the balance sheet, not manifests as an increase in liabilities in the equity and liabilities side. On the other hand, earnings management is the behavior that though the selection of accounting policies company maximizes executives interests or the corporate value. In practice, fact of the enterprise market behaviour and control of enterprise earnings management accounting earnings or profits, earnings management does not increase or decrease the actual earnings, but will change the distribution of the actual profitability in different accounting periods. It is "how can we best report desired results".
Although these accounting methods may bring about large private gain of control or tax concessions for company, at the same time these lead to lower quality financial information, and then mislead potential investors in the market. Taking into account the negative impact of accounting management, our country should seek countermeasures to suppress the occurrence of these adverse deeds.
First, to improve legislation and accounting standards. When we define and identify accounting elements, we should ensure the specificity and clearness in order to reduce the choice of alternatively accounting methods and the scope of: elastic interpretation; or earnings management. On the one hand, we establish an effective regulatory regime to move the off finance into the balance sheet; on the other hand, our government try hard to shrink the space of earnings management.
Second, to strengthen the market efficiency. Under the different level of development and perfection in the different stock market from the different countries, there are different characteristics. It is necessary for the government sector to boost the establishment of capital markets and securities markets, and to strengthen external supervision. What's more, we should make the accounting management which seriously damage the interests of investors punished severely.
Third, to strengthen the scientific concepts and understanding. Investors, other principals as well as other users of accounting information should understand the corporate accounting policies. It is necessary for investors to master the knowledge and skills of corporate accounting policies. This makes sure that the users of accounting information adjust the accounting data or earning to fulfil their specific need in decision. In addition, regulators should strengthen the independence of audit from Certified Public Accountant, and timely make the off balance sheet finance or earnings management public.
Fourth, from the view of business, interested parties (such as investors, managers, etc.) is conductive to draft the compensation contracts, in order to push agent work following ethics and law.
Fifth, to reduce accounting management motives from the source, the regulators relax administrative intervention to some extent.
The influence of lobbyists
Lobbyists are a group of people who try to affect public officials through support or against some specific issues (Campos and Giovannoni , 2007). They are hired by interest groups and these groups wish public officials to support their requirements and causes. As to the origin of lobbyists, they are parts of political system and could trace back to 19th century in UK. The original meaning of it is that non-government senator waiting on the front porch to persuade senators accept their requirement or wishes and passed by parliament. To some extent, existence of lobbyists satisfy the demand of various aspects: congress could hear voice from all accounts; at the same time, senators could adjust their position under debating or voting through understand the state of public opinion from lobbyist.
Lobbyists exit in various organizations like business, industry and other segments and they are used to facilitate legislation implementation which will be in favor of them financially.
Ways that a lobbyist could influence public officials is various. For example, formal meeting. During meeting with public officials, they could share information which back interest groups and lobbyists. What's more, they may make friend with public officials through dinner together or take them out to entertainment. Harstad and Svensson (2008) consider that lobbyists could influence public officials in an indirect way as well. For example, get citizens to put pressures on officials through organize some citizen activities. What's more, public media like advertisement is also a way that attract public attentions.
As to good influence, lobbyist could make their voice heard by the members involved in law making. What's more, these organizations always have large amount of fund that could limit politicians' mobility. It also provide a method for minorities to have a way to say in government. Lobbyists could influence legislative process in good ways like help legislators about caseload because the more though put into bills the more reasonable law is (Baldwin and Nicoud, 2002). The law makers or legislators will consider various aspect of prospective law after lobbying. Thus, not only lobbyist get benefits, citizens also benefits from better law regulation. However, in general lobbyists are always under critics. Lobbyists usually try to influence senators through verbal persuasion, but there still exist illegal and unethical methods: bribery. Therefore, lobbying is always under strict regulation. In order to prevent unethical or illegal actions of lobbyists, interest groups and individuals should register with government to ensure them lobby in a reasonable way. What's more, benefits which given to public officials should be reported in detail. Another bad influence is that lobbyists always influence the legal decision which good for citizens and put it in a more profitable position for their groups. Through lobbying, legislative process that designed to protect citizens' right will be abused. The reason is that lobbyist's organizations use their financial power to affect public officials' decisions from benefiting citizens to those organization or groups which give them profits. For example, General Electric Corporation use 94million dollars in lobbying and Northrop Grumman use 83million dollars. Apparently, when these organizations spend so much money on lobbying, they are expect to get equal or even more benefits to fix the gap of money they used. Hence, the public interest will be harmed through their manipulation.
In conclusion, the influence of lobbyists should be divided into two perspectives. Appropriate regulation should be conducted over the lobbyist related activities.