RELEVANCE OF FINANCIAL REPORTING FOR FIRM VALUATION IN THE

CONTEMPORARY ERA

1.0 Introduction

It is an undeniable fact that accounting and financial management are the lifeblood
of the entire global business communities with respect to their economic health and
overall wellbeing. Both practitioners and academicians argue that, the nurturing and
managing of accounting fundamentals in the business world are embracing a
changing trend particularly influencing the role of financial reporting in business
entities. Such trend is said to have a critical implication on the valuation of firms
which is the finite concern of investors and shareholders. This situation portends
that, the accounting faculty in the business world is continuously challenged by
multiple factors in the business operating environment. However the impact of these
diverse factors from the capricious operating environment in both common law and
code law practicing economies is believed to have considerable effect upon the
relevance of reported accounting information (Hail, 2013), for the use in firm
valuation by external stakeholders.

Within the context of financial reporting, taking a broad view of the criticality of
“balance sheet and financial statement” the writer feels that the argument; “balance
sheet and financial statement” numbers have lost their relevance over the last thirty
years” is not a literal connotation of the precise situation existing in the real
accounting world. It is felt that such an argument needs to be reviewed from a
holistic perspective. Traversing through the circumstances that lead to changing
global trend in financial reporting may throw some light into the veracity of such an
argument.
2.0 Global Trend in Financial Reporting
Global trend shift in financial reporting and firm valuation seems to be a perennial
concern in the accounting world. Hail (2013) views that over the years, the role of
financial reporting for firm valuation has changed due to economic and financial
dynamics. Based on research reports from large international sample, academicians
also indicate the loss of relevance of the income statement and balance sheet in
particular in countries with strong institutions. However, the accounting fraternity
persistently views that the overall relevance of the income/balance sheet remains
stable, with exception to common law countries whose emphasis is on strong investor
protection and strict disclosure requirements including the concern for integrated
markets. Nevertheless, the existence of several caveats in support of strict financial
disclosures, there are other debilitating factors which make things difficult for firms to
subscribe to such requirements.

The most startling development over the last decade in the world of financial reporting is
the decisions of most of the world’s economies developed and emerging willing to
embrace the international financial reporting standards (IFRS) issued by IASB. However
in the “globalized” economy, US corporations chose to observe the GAAP rules
established by FASB, while corporations from other countries embrace international
financial reporting standards (IFRS) established by IASB or by accounting standards set
by their national accounting standards board. These differences in accounting
standards have led to differences among US corporations and the others’ financial
statements. These differences in turn have made it difficult for investors and creditors to
make valid comparisons and for prudential firm valuation in buy-sell-hold decision
making in global capital markets.

To resolve this issue, the international standard setting bodies FASB and the IASB
entered into an agreement to develop by way of harmonization, high quality compatible
accounting standards that could be used for both “domestic” and “cross-border”
financial reporting. To achieve this compatibility, the Boards agreed to work together to
achieve “short-term” convergence on a number of individual differences between US
and international accounting standards. However, after some intensive mulling over the
reporting standards over the last one decade US had remained elusive of realizing
compatibility in reporting standards. To date, several forums and discussions had been
going on between IASB and FASB to bring about convergence and harmonization of
rules and standards between the members of these two bodies. IASB Chairman
Hoogervorst, (2012) had to end his forum in London School of Economics on a
disappointing note after FASB postponed its decision to a later period to harmonize
reporting standards with IASB. Notwithstanding the above, greater controversies and
challenges from business world dynamics perpetually hinder the realization of the
efforts of FASB and IASB. These challenges and controversies resulting from various
forces at work can be observed from the both the divides, the traditional accounting
regime and the non-traditional accounting regime which is a recent shift in stakeholders’
perspective.

2.1 Factors influencing Shift in Global Trend

The traditional accounting regime and non-traditional accounting regime suggest
that there are number of factors involved in influencing the shift in global trend in
financial reporting, Refer table 1. The causes of diversity in accounting standards
including financial reporting emanates from various institutional, macroeconomic ,
historical and cultural factors. Larrotci, (2016) identified the following eight factors
had significant influence on the development of global accounting standards and
practices, (Refer table 1).

1. Sources of finance
2. Culture
3. Legal system
4. Taxation policy
5. Political and economic ties
6. Level of economic development
7. Inflation
8. National education level
However, it is likely that the decision-relevance of information varies by type. Strategic and financial
types of information have obvious decision relevance to investors and are widely discussed in
the literature (e.g., Tonkin [1989]). Nonfinancial information is directed more toward a
company's social accountability and is aimed at a broader group of stakeholders than the
owners/investor
FACTORS INFLUENCING VOLUNTARY ANNUAL REPORT DISCLOSURES BY U.S., U.K. AND CONTINENTAL
EUROPEAN MULTINATIONAL CORPORATIONS Gary K. Meek* Oklahoma State University Clare B.
Roberts** University of Exeter Sidney J. Gray*** University of Warwick
Palgrave Macmillan Journals is collaborating with JSTOR to digitize, preserve, and extend access to
Journal of International Business Studies, 1995. JOURNAL OF INTERNATIONAL BUSINESS
STUDIES, THIRD QUARTER 1995

2.2 Accounting Regime Challenges and Controversies

The Global Financial Crisis: Causes, Consequences

and Countermeasures
https://www.rba.gov.au/speeches/2009/sp-so-150409.html

Causes
As with any large event in any field of human endeavour, it is never about just one thing.
There were many causes of the financial crisis, some recent and some longstanding. I
would like to focus on three of those causes today: the misperception and mismanagement
of risk; the level of interest rates; and the regulation of the financial system.

Perhaps the most basic underlying driver of the crisis was the inherent cycle of human
psychology around risk perceptions. When times are good, perceptions of risk diminish.
People start to convince themselves that the good times will go on forever. Then, when the
cycle turns, risk aversion increases again, often far beyond normal levels, let alone those
seen during the boom.

We can see in Graph 1 how investors' perception of risk changed in the years leading up to
the crisis. Yields on emerging market bonds or US companies at the riskier end of the
spectrum all narrowed relative to those on US government bonds and other securities that
are seen as very safe. More recently, those spreads have widened out dramatically, as
investors became more risk-averse, and the ‘search for yield’ turned into a ‘flight to safety’.

The effects of this boom-bust cycle of psychology are amplified when investors use
leverage. Borrowing to purchase assets is lucrative when asset prices are rising, because all
the upside beyond the interest costs goes to the investor, not the lender. But when times
are bad and asset valuations are falling, investors' losses are magnified by leverage.

Causes of FC

A disturbance to financial markets, associated typically with falling asset prices and insolvency
amongst debtors and intermediaries, which ramifies through the financial system, disrupting the
market’s capacity to allocate capital.

What are the key causes of financial crises? • Financial market failures 1. Irrational exuberance
among agents(overvaluing the market) (Shiller) 2. Increased complexity arising from financial
innovation 3. Minsky hypothesis – stability breeds instability • Policy failures 1. Unintended
consequences of financial deregulation 2. Banks too big to fail? Risky behaviour due to moral
hazard? 3. Interest rates too low for too long (e.g. USA, EZ 2002-2007) 4. Large models of the
economy which assume agents (businesses and consumers) always behave rationally 5. Failures of
ratings agencies in pricing risk accurately • Structural changes in the global economy 1. Economic
imbalances including global savings glut and low /zero real interest rates 2. Media and modern
communications – immediate feedback

1. Financial Crises in Developed / Emerging Countries • Financial crises have become more
frequent and severe in both developed markets (DM) and emerging markets (EM) • Recent
developed markets crises • US housing and sub-prime crisis in 2006-2008 • Global Financial
Crisis (GFC) of 2008-2009 • Sovereign debt crises and economic crisis in the Eurozone
(2010- 2013): Greece, Ireland, Portugal, Spain, Italy, Cyprus, Slovenia. + continuing Grexit
Risk. • (Brexit: regarded by most as a shock rather than a crisis) • Recent emerging market
crises: • Mexico (1994), East Asia (1997-98), Russia (1998), Turkey and Argentina (2001) •
China’s 2015-16 financial market turmoil • Turkey 2017-17
2. 4. Types of Financial Crisis • Currency crisis when a fixed exchange rate regime collapses or
a currency goes into a free-fall e.g. in Turkey • Balance of Payments (BoP) or external debt
crisis – when a country cannot attract the capital needed to finance a current account deficit
– recent example Mongolia • Sovereign debt crisis – when a government cannot afford to
pay the interest on their existing debts e.g. Greece • Banking crisis – when stability of
banking system is low for example in Italy and Cyprus • Household debt crisis – for example
 in the UK and USA • Broad financial crisis that combines many elements of the above crises
(Argentina in 2001)

Inter alia, in the accounting regime, it is discernible that strengthening regulations and
harmonizing financial reporting has been a keen concern in the accounting fraternity
with particular emphasis on balance sheet numbers. The use of fair values over
historical cost in the preparation of financial reporting had also taken pole position giving
more relevance to the actual value of assets in relation to present market value.

Stream of recurring occurrence of financial scandals, market bubbles and

financial crises had also raised the concern over the relevancy of existing income
statement and balance sheet reporting.

According global bankers and financiers financial crises arising from market
bubbles and scandals are inevitable, particularly in a globally integrated
market, (Anderson 2000). Retrospectively, a number of financial crises over
the last 40 years (refer Appendix 1 for details) indicate a high degree of
commonality in attributes: ineffective regulatory oversight, dodgy
accounting practices, excessive over valuing of the market, herd
mentalities and in many instances a sense of false confidence and
infallibility.

What is financial leverage and why is it important?

Financial leverage is the amount of debt that an entity uses to buy more assets.
Leverage is employed to avoid using too much equity to fund operations. An excessive
amount of financial leverage increases the risk of failure, since it becomes more
difficult to repay debt,
Instead, UN agencies continued to prioritise development goals, humanitarian
access, and quiet diplomacy — an approach which “demonstrably failed.”

2.2 Non-Financial Regime Challenges and Controversies

Over the years, besides income statement, the balance sheet has been the critical component
of financial reporting. It helped boardroom decisions in developing business strategy and
portfolio investments. It was also a confidence driver to investors and shareholders that enabled
entities with renewed vigour by augmenting financial contributions. However, in the
contemporary era of accountability and transparency, the question is, to what extent does the
balance sheet representation is valid and gainful, and how much does it really says about the
organization?

Ramanan (2018), views that, today less than 15% of a company’s market value can be
accounted for by its financial and physical assets. On the contrary, he also observes
that other elements, especially relationships, and intellectual and human capital, make
up a greater percentage of a company’s value.

In the recent past, it has been explicitly remarked by industry practitioners that financial
metrics are no longer the only measure of success. The expectation is that, to be
reckoned as a top-notch entity you have to act with ethics and integrity and be socially
responsible. In fact there has been a major paradigm shift in the viewing lens of
financial reporting. It has been noted that, these days, non-financial regimes such as
customer satisfaction, brand awareness and loyalty, quality of corporate governance
and corporate social responsibility have a greater traction and persuading power in
decision making by outside stakeholders, (Ramanan, 2018) .

In view of all these developments in the past, the American Institute of Certified Public
Accountants (AICPA), suggests that business organizations should shift from
conventional approach to integrated thinking and reporting approach, that takes the
necessary broad view of the interests of the company’s stakeholders and the value
creation potential (Ramanan, 2008).

3.0 Observation and Critical Analysis

 Identify Major Themes & key findings.
 Evaluate current trend against traditional trend then make proposals.
 There are 3 systemic reasons for the crises discussed above, namely theyare:
a. Pervasive misaligned incentives
b. Badly managed risk – companies did not manage risks correctly
c. Market complexity- the biggest problem of the market.

In general, the above arguments signify that there had been a shift in global
accounting trends involving both financial and non-financial factors. Inevitably these
are systemic effects that the accounting world had to traverse as result of growth
and development over the years. Since the dawn of professional accounting from
the 15th century to date, myriads of variables had evolved in the operating
environment of the accounting fraternity ( ).
Over the last one decade, strengthening of accounting regulations and harmonizing
of standards had been relentlessly staged by global standards body such as IFRS
and IASB. However, the outcome from such efforts had brought mixed results;
disappointingly there is neither plausible convergence nor harmonization of
regulations and standards as expected, particularly from key global players. US
being the key market player in the global economy, to date operates with its FASB’s
GAAP rules as opposed to hundred over nations adopting IFRS standards from
IASB. Though US recognizes the effectiveness of the IFRS system, it drags its feet
on resolving the harmonization matter with IASB.
It may be difficult to shift away from capitalist characteristics of the global economy
where US is the key market player hence greater traction. Therefore successful
convergence and harmonization in the accounting standards in order to facilitate a
common playing field for all global players is far from desire. Capitalism in itself offers
much vertical and lateral flexibility as an economic platform unlike socialist economic
domain. The diversities among global players are extremely widespread in the capitalist
economy. A host of other factors further compounds the difficulty in harmonizing the
standards.

However, the commitment of tireless efforts by the international accounting bodies to

bring about convergence and harmonization in accounting standards does not
guarantee a foolproof solution for the financial reporting woes. Irrespective of designing,
developing and enforcing any kind of standards may narrow the gap of harmonization,
but the element of risk emanating in the form of financial crises can never be eliminated.
Risk is an inherent element of the ecosystem.

The writer observes that all efforts taken attempting to bring about a common and
robust standardized system in the accounting fraternity is directed at improving the
processes with the latest technological advancements. From the discussions above, it is
discernible that such efforts taken over decades to narrow down the differences and
harmonize standards for use in the global market, has in no way accomplished the
objective of securing transparent financial disclosures and had positively impacted the
firm’s valuation. Market bubbles, financial scandals and crises are the doings of human
factor. From the above discussion, it is felt that, with the shift in stakeholders focus from
the financial regime to non-financial regime due to the integrated global market and the
need for standardization, the existing balance sheet and income statement reporting, in
essence remains as a lynch-pin between the internal users and external users, in the
accounting world. On the overall its relevance is not lost at all. The key issue is the
human factor, particularly the preparers of the financial disclosures, who for one or other
reasons manipulate the numbers and portray masked picture of the firm’s financial
performance.

As Ball, (2001) pointed out that the efficiency of a country's financial reporting and
disclosure system is crucial to its development of economically efficient public
corporations and public securities markets as well as to maintain the overall health of its
country’s economy. Hence, unethical behaviours of the trusted agents in the corporate
environment are the causes of all the market glitches and disrupted economy. From a
general lens perspective, the human factor is the detractor and not the accounting
processes or standards. The key issue with processes and standards is harmonization.
That said, resolving the issue of harmonization by the global standard setting bodies
does not relieve the accounting world of cooking the books and masking the financial
reports by detractors. The problem here is the human, not the process or technology.

factors more so arbitrary in capitalist economies as opposed to socialist economies

and the legal jurisdictions in these economies are different from one another.

In countries that practice capitalistic economy, some practice common law system
few practice coded law system and the rest have hybrid system. Common law offers
greater public engagement and inputs in judicial rulings in a state, on the contrary
coded law does not allow such privilege. Coded law jurisdictions are purely based
on statutes made by the state’s parliament and the judge acts within the confines of
the interpretation of the statute. This in itself portends the degree of political traction
the state has in decision making, let alone the economic front.
 In the global arena, academics and practitioners argue that the element of politics
seem to play a dominant role in determining the accounting and financial
management standards through established institutions such as GAAP and IASB.
Currently US is applying GAAP standards whilst EU nations and others are using
IASB standards. What is more important in this global integrated economy is the
convergence and harmonization of accounting and reporting standards that will
favour all, both from the East and West in their economic pursuit.

Notwithstanding the above, certain quarters also argue that institutional,

macroeconomic factors and other instruments of power from respective countries do
contribute towards such diversity.
This is so because of the inherent nature of diverse societal characteristics which
contribute towards the diversity in worldwide accounting practices.

4.0 Conclusion

 Financial reporting at crossroads - Myth or reality

 Inter alia, the key focus of reporting should be on shareholders’ interest and
social value.

More emphasis should shift towards corporate social responsibility and human
governance in the corporate world.
Research Common law and Code law

Common law gives judges an active role in developing rules; civil law is based
on fixed codes and statutes. Civil law (legal system) ... Civil law, civilian law, or

Roman law is a legal system originating in Europe, intellectualized within the framework of
Roman law, the main feature of which is that its core principles are codified into a referable
system which serves as the primary source of law.

What is the Difference Between

Common Law and Civil Law?
January 28, 2014 by Piyali Syam

Washington University Law Publications

As lawyers know, legal systems in countries around the world generally fall into one of
two main categories: common law systems and civil law systems. There are roughly
150 countries that have what can be described as primarily civil law systems, whereas
there are about 80 common law countries.

The main difference between the two systems is that in common law countries, case
law — in the form of published judicial opinions — is of primary importance, whereas in
civil law systems, codified statutes predominate. But these divisions are not as clear-cut
as they might seem. In fact, many countries use a mix of features from common and
civil law systems. Understanding the differences between these systems first requires
an understanding of their historical underpinnings.

Common Law Countries:

  The United States
 England UK
 India
 Canada

Civil Law Countries:

 China
 Japan
 Germany
 France
 Spain

CSR

• businesses exist at the pleasure of society and that their behaviour and methods of
operation must fall within the guidelines set by society; and • businesses act as moral
agents within society.

Mathew Nelson Changing trend in financial reporting – non financial regime

“Is your non financial performance revealing the true value of your business to
investors?

With that as a back-drop, we see signs that constructive change is occurring and new
reporting practices are being adopted across industries and geographies.

Financial Disclosures are each establishing crucial benchmarks and standards

designed to better define what’s effective, credible and comparable.

Well, by contributing to practices that lead, not only to greater transparency and better constructs for
long-term value, but also to fostering a sense that stewardship around the planet’s people, resources
and environment will be central to how well our world works in the future
An Introduction to XBRL
The basics of XBRL for business and accounting professionals.
https://www.xbrl.org/the-standard/what/an-introduction-to-xbrl/

Financial reporting and disclosure are complementary means of ameliorating

information asymmetry between managers and parties contracting with their firm,
including shareholders, lenders, suppliers, customers, and employees. The efficiency of
a country's financial reporting and disclosure system therefore is crucial to its
development of economically efficient public corporations and public securities markets
as well as to the development of its economy. 1

Ball, R. (2001). Infrastructure Requirements for an Economically Efficient System of Public Financial
Reporting and Disclosure. Brookings-Wharton Papers on Financial Services 2001, 127-169.
Brookings Institution Press. Retrieved August 19, 2018, from Project MUSE database.

Depending on how the message is conveyed, the user will obtain an image of the firm that will
enable him to make an appropriate decision. If the message is unclear or fuzzy, it would project an
inaccurate image of the firm. This will confuse the user, and result in him making a wrong decision. If
this is a large company, that wrong decision could cause the user to suffer tremendous losses. Since
in most cases these users are external to the company, for example the shareholder, they have no
choice but to rely on the message conveyed by the accountant. Therefore, there should be some
form of control over the quality of the message prepared by the accountant. This control comes in
the form of accounting standards that prescribes the way the message or financial report is
prepared.
 Appendix 1

Causes Of Global Financial Crises Over The Last Four Decades

1. US savings and loan crisis – 1980

Cause: Policy changes and deregulation

2. Latin American sovereign debt crisis owing to excessive foreign debt – 1982.

3. Stock market crash – 1987

4. US savings and loan crisis – 1980

5. US Junk bond crash – 1989

6. Mexico Tequila Crisis – 1994

7. Asian financial Crisis – 1997

8. Dotcom bubble – 1999 to 2000

9. Global Financial Crisis – 2007 to 2008

Causes of Crises

1. Subprime lending
2. Growth of housing bubble
3. Weak and fraudulent underwriting practices
4. Predatory lending
5. Deregulation
6. Increasing debt burden or overleveraging
7. Financial innovation and complexity
8. Incorrect pricing of risk
9. Boom and collapse of shadow banking system
10. Commodities boom
11. Systemic crises
12. Role of economic forecasting