Objectives of Financial Reporting
Table of Contents:
Most organizations devote a fair amount of time and effort to considering their goals and objectives. These endeavors are often reduced to a mission statement and strategic plan. In a similar fashion, the Financial Accounting Standards Board spent years in developing a series of Statements of Financial Accounting Concepts (SFAC). These should not be confused with the many Statements of Financial Accounting Standards (SFAS) that provide specific accounting rules on various matters (e.g., how to calculate EPS, etc.). The SFAC are far more general and define the objectives of accounting, the qualities that make accounting information useful, and so forth. The FASB is the primary beneficiary of the SFAC, as the conceptual guidance is used in the development of specific accounting rules.
SFAC No. 1 examined the objectives of financial accounting and reporting. It is a fairly lengthy document. Foremost among the objectives is to provide useful information for investors, creditors, analysts, government, and other financial statement users. Importantly, accounting information is general purpose and should be designed to serve the information needs of all types of interested parties. To be useful, information should be helpful in assessing the amounts, timing, and uncertainty of an organization's cash inflows and outflows; assist in the study of an enterprise's resources, claims against those resources, and changes in them; and, be helpful in examining an enterprise's financial performance (i.e., earnings and its components). Additionally, accounting should help decision makers monitor and evaluate how well management is fulfilling its stewardship responsibilities.
Of what value is accounting? Why is so much time and money spent on the development of accounting information? To fairly answer these questions, one must think broadly. Investors and creditors have limited resources and seek to place those resources where they will generate the best returns commensurate with the risks they are willing to take. Accounting information is the nexus of the decision-making process. When accounting fails to provide valuable signaling to help investors and creditors choose wisely, then capital can be misallocated (i.e., placed in the wrong endeavors). Misallocation of capital can result in inefficient production and shortages of critically needed goods and services, causing severe economic disruption. Although it is difficult to fully comprehend, at least consider that when you go to the store with the expectation of acquiring certain items, they are usually there; investors and creditors provided capital to get those goods in place for you. And, the decision-making process for those investors and creditors was driven by accounting information! So, when we say that the objective of accounting is to provide useful information for investment and credit decision making, the implications are much broader than just helping investors and creditors make their profit. There is a broader societal role for accounting that has to do with enabling capital flows in a way that facilitates the production of desired goods and services.
Qualitative Characteristics of Accounting
Having first identified that the primary objective of accounting is to provide useful information, the FASB then turned its attention to the qualities of information that serve to make it useful. SFAC No. 2 notes that useful information must have the characteristics of relevance, reliability, and comparability/ consistency:
• Relevancy - Information should be timely and bear on the decision-making process by possessing feedback and/or predictive value.
• Reliability - Information must be faithful in representation; free from bias, neutral, and verifiable.
• Comparability - Even though different companies may use different accounting methods, there is still sufficient basis for valid comparison.
• Consistency - Deviations in measured outcomes from period to period should be the result of deviations in underlying performance (not accounting quirks).
Perhaps the greatest challenge facing the accounting profession is to develop measurement and presentation methods that can capture and report complex business activity in a way that is understandable. Importantly, accounting reports should be comprehensible to those with a reasonable understanding of business and economic activities. It is assumed the users will study information with reasonable diligence, but it is equally presumed that those users do not need to be accounting experts. In other words, it is imperative that financial information serve the needs of individuals who may not be fully versed in the details of accountancy, but must still rely upon the reports. This is a delicate balance to strike; oversimplification may exclude valuable information while excessive detail may overload the user to the point of obscuring key issues.
Be aware of the growing complaint that accounting has become too complex. Many persons within and outside the profession protest the ever growing number of rules and their level of detail. The emerging debate is generally couched under the heading "principles versus rules."
• Advocates of a principles-based approach argue that general concepts should guide the judgment of individual accountants. Detailed and specific rules only serve to encourage financial engineering by those who seek to have transactions fall within or outside of some specific criteria driven accounting rule.
• Others argue that the world is quite complex, and accounting must necessarily be rules-based. Reliance on individual judgment will lead to wide disparities in reports that will render meaningful comparisons impossible.
This is an interesting debate, and it is quite difficult to predict the ultimate outcome. Both points are seemingly valid and resolution will more likely be through evolution than revolution.
SFAC No. 2 makes it clear that the profession need not concern itself with immaterial items; those things that are so slight as to not influence decision outcomes. Of course, materiality is like beauty, being in the eye of the beholder. In addition, accountants admit that accounting information comes at a high cost, and nothing in accounting should be required to the extent that its cost exceeds the benefits it will produce. But, costs of accounting information are hard to measure, and weighing the benefits is even harder. So, while there is a conceptual embrace of threshold issues, these concepts are very difficult to quantify and implement.
The FASB did not rest with only two concepts statements. Others have been issued on:
• Elements of financial statements - defining and discussing the building blocks that make up financial statements (assets, liabilities, revenues, etc.)
• Recognition and measurement - alternative approaches to measuring elements and when to recognize transactions and events
• Cash flows and present value - proposing that the assessment of cash flow timing and probability is important in accounting outcomes
• Objectives for nonbusiness entities - alternative financial information goals for nonbusiness entities (e.g., charities)
Each SFAC is lengthy and thought provoking. Typically, an accounting student will delve deeper into each of these in an upper level course on accounting theory and concepts.