Financial Theories and Positive or Normative Accounting Reporting - Literature review Example

Financial Theories

Information Gap and Role of Disclosure

Capital markets trade stocks and securities of listed companies, but the equilibrium of most capital markets depend on flow of information among investors and managers of listed companies. Potential investors are outsiders to the companies they indent to venture in while current investors are insiders always insiders of the firms where they monitor performance of their investments (Mcguire, & Silvia, 2010). Therefore, corporate disclosure marks is a critical element that promotes effective functionality of capital markets. Organizations supply financial information through controlled financial reports, such as balance sheets, income statements, statement of cash flows, management’s discussion and analysis, regulatory filings, press releases, and auditors’ reports among others. How does the information gap between investors and managers of firms arise? Agency theory explains the relationship between principals (shareholders or investors) and agents (firms’ executives). Agents act on behalf of the principals, which implies that they are trusted to make decisions that maximize income to the shareholders. Agency complication arise because investors are willing to pump capital into organizations, but they are not willing to take active role in managing such firms (Case Study 3, 2013). Consequently, principals delegate the duties of firm’s management to the agents. However, decision perspective by both investors and agents differ because of the operation setting. Since agents have more information about the financial position of a firm than investors, it creates a gap on how much agents should disclose because of many issues at stake. Information gap between investors and agents creates a temporary “information problem” that influence how principals’ understanding of accounting information availed to the capital markets is affected by various accounting policies applied when preparing financial statements.

Regulated Financial Reporting and Disclosure

The International Accounting Standards Board (IASB) provides a conceptual framework that identifies investors as the primary consumers of financial statements. While investors’ obligation involves guidance of the management, they also make decisions concerning their investments such as whether to buy, sell, or hold. Decision as when to buy, sell, or hold indicates the valuation role of financial statements and other associated accounting information. Whenever financial statements are available for public scrutiny, potential investors use it to value the firm for a possible venture opportunity while the current owners use it to assess their earnings as well future orientation of the firm. For a long time, researchers have evaluated how different accounting policies influence valuation of stocks and the varying valuation perspective of investors from that of agents. Value relevance of financial statements shifts the valuation issue to the international variations. Resultantly, firms listed in capital markets follow regulatory framework to disclosure rules set by various stock market regulators. For instance, in the United Kingdom (UK) the regulatory authority is UK Listing Authority (UKLA) while in the US it is Security Exchange Commission (SEC).

A critical question is the influence of disclosure regulation in helping shareholders and lenders solve their information gap problem. The assumption is that capital markets are perfect, which sometimes make agents disclose optimal information after careful balance of costs and benefits. According to Leftwich (1980) and Zimmerman (1998), accounting information is regarded as public good because shareholders pay for its production but have no control how potential investors or other financial information consumers utilize it. In other words, potential investors enjoy free information thereby leading to limits on information in the financial markets. Again, Leftwich (1980), Wats and Zimmerman (1986), and Beaver (1998) provide another perspective of regulating disclosure of financial information. According to the authors, disclosure control results from concerns that are not related to market failures. For example, a section of financial information users may not have sophisticated financial knowledge thereby creating a minimum threshold requirements for disclosure. In other words, regulators minimizes the information gap between the informed and the uninformed consumers of accounting information. The latter explanation for disclosure regulation implies that regulation aims at equitable distribution of wealth, but not improving economic efficiency. By creating an information deficit environment, the regulators creates perfect conditions for varying valuation of different industries that influence stock prices. After all, the investors with sophistication concerning financial matters can hire intermediaries such as banks to get desired information necessary for informed decision making.

Clearly, the above justifications for disclosure regulation create suspense on what happens in case of market crisis. It is not clear whether disclosure regulation improves situation when a stock market financial crisis strike the way it did in 2008. For the sake of financial health of company, every detailed financial related information is critical when making investment decisions. Since disclosure regulation limits the quantity of information available in financial statements, then it is possible that shareholders are at risk of making bad investment decisions. For example, sales related complications may not be revealed in incomes statement or balance sheet, but its development can adversely influence position in future. Therefore, when shareholders and lenders rely on the fair representation of facts in the financial statements, it creates a possibility of worst investment actions.

Financial Reporting Choices

Asset Revaluation Model

When preparing balance sheet, chief financial officers may decide to value the assets purposefully to increase reported income. Ideally, asset revaluation increases the value of assets initially recorded as cost. However, the increased interest as well as asset value is nothing to smile about because it increases the provision to account for appreciated value. Revaluation model promotes upward adjustments of operating assets. According to Missonier-Piera (2007), asset revaluation enhances the financial picture of a firm to its shareholders and creditors while increasing its borrowing capacity. From a positive perspective, revaluation sends a credible signal to a potential investor that the company is good for venturing into and will yield earnings.

Revaluation uses fair value rather than net value by taking inflation into consideration and the present asset condition. In as much as asset valuation aims at providing fair value of assets, it is a subjective matter because different valuing experts always get different results when valuing the same assets. As a result, companies constantly revalue their assets to avoid selective revaluations and inconsistent reports. The final figure after revaluation is considered as increased reserve if positive or reduced reserve if negative. Lin and Peasnell (2000) argued that specialized land and buildings value depreciate based on replacement cost while the remaining part is applied when valuing the asset. Demski, Lin, and Sappington (2008) indicated that other tangible assets are best valued at fair value. Brown et al. (1992) found that revaluations are characterized by the presence of debt contracts, reduced political costs, high leverage, avoidance of unfavorable takeover bids, and other uncertainties. Similalry, Ghicas et al. (1996) illustrated a positive correlation between tax benefits resulting from fixed asset revaluation as the motives behind companies using the model. Among the implications of asset revaluation include increased book value of fixed assets as well as the increase in owner’s equity.

Several factors may influence revaluation process including issuance of bonus shares, takeover uncertainties, company size, and rigidity of lending contracts, ineptness, raising new capital, declining operating cash flows, growth stagnation, liquidity issues, and reputation control (Anson, Fabozzi, & Jones 2011).

It is clear that revaluation method can give misrepresentation of the financial position of the business organization. Since asset revaluation compose of both objective and subjective measurement parameters, no financial statements show brand value of the assets. Profits are objective and users of financial information can interpret them based on income and expense figures. In short, asset revaluation increase values in the balance sheet because net assets value adjust upwards. However, high value priority in financial reporting increases the provision for depreciation, which reduces the reported profit in the statement of income. Existing shareholders or potential shareholders may not be privy to the real reason behind using revaluation methods in preparing financial statements. Therefore, chances are high that high profit records based on asset revaluation approach may give misleading positive signal to shareholders. It is tricky because decision concerning selling, holding, or buying depends on capital structure of a firm as well as its reported income.

Leroy (2010) argues that efficient market hypothesis (EMH) assumes investor’s responds quickly the release of finical information. A weak form of (EMH) reflects financial data about past prices and sales volumes while strong form confirms that public companies share prices are influenced by new financial information. If investors expect higher future income of the company, then its share prices will increase in the stock market. That is to say, shareholders and creditors expectations shall takes into count future systematic aspects of the economy before making decision. Therefore, a misleading asset revaluation can cause chaotic shifts in shares prices, purchases, and sale.

Dividend and Retained Earnings

Dividends and retained earnings form part of balance sheet reported a financial information. The amount of dividend payout has direct influence on the retained earnings. In short, directors should apply an accounting policy that maximize owners’ equity, which is according to the principles of shareholders and agency theories. However, some school of thought have argued that dividends are irrelevant in determining the valuation of a firm. Dividends are relevant in a firm’s valuation in two aspects, that is, directors can opt to pay large dividends or pay small dividends.

Residual income theory provides that value of a firm is based on its equity and all discounted cash flows. In other words, a company should invest in all projects that demonstrate positive net present values and pay remain earnings as dividends. Under this provision, the shareholders’ wealth depend on the projects a company indents to or currently invests in rather than the dividend policy it operates. When company directors takes such an approach to paying dividends, the dividends become irrelevant in valuation of a firm. Modigliani and Muller (1959) argued that earnings within a year or short periods depend on various random elements and distortions. Current income reported refers to an imperfect measure of free earnings that allow rational investors to base their valuations. The authors proposed that companies have a choice of either using retain earnings in investments or pay dividends and issue new shares or borrow capital for finance new projects. However, Modigliani and Muller (1959) indicate that shareholders’ wealth will remain the same irrespective of the choice taken in financing new projects thereby rendering dividends irrelevant in firms’ valuation. Shareholders can sell some shares to establish homemade dividend or sell to purchase new shares altogether. Therefore, maximizing owners’ equity is only through investing in projects with positive net present values.

Gordon, (1959) argued that dividends are relevant in determining the value of a company. Dividends contain some information content such as a firm’s permanent earnings and price-to earning (P/E) ratios. Hence, dividends are indications of future company earnings as well as illustrate accounting approach used in valuation model. Dividend payout ratio and price earnings ratios are related, which implies that high dividend payout translates into high share prices based on current earnings. Dividends are like the proverbial bird in hand thereby making them less risky compared to capital gains. However, investors and creditors may use such perspective to interpret ate that high dividends equals prosperity while low dividends equals deteriorating financial health.

When a directors decides to use small dividend payout policy, investors may interpret that and shy away from venturing into the firm. According to Modigliani and Muller (1959) proposal, we understand that investors shy away from low dividend reporting company may be losing it because the company may be prioritizing investments rather than large dividend payouts. Arguments for low tax payout indicates that taxation on dividends can make directors to adopt an accounting policy that permit low dividend payout to save on tax deductions. Since companies attract investors based on their policy, firms should be careful not to scare many potential investors. According Eisdorfer, Giaccotto, & White (2015), directors always perceive that shareholders prefer steady flow of dividends and may make adjustments towards the set target in each financial year if a company trades in the stock market, low dividend payout may cause speculation and result into a bearish behavior of its share prices when in the real sense they should behave bullish. Correcting imperfection in using the residual earning theory depends on the disclosure policy by the regulatory body. All in all, shareholders still remain in the dark because directors may not reveal the actual reason behind a given accounting approach in the pretense of guarding company secrets.

Bonus Plans Hypothesis

Watts (1977) and Zimmerman (1978) argued that bonus plans establish motivation for managers to choose accounting policies that increase the net present value of a company. Bonus plans may be based on pre-tax profits, post-tax profits, sales revenue, and other parameters. Different bonus plans award managers differently depending on the performance of company shares in the stock market. When a company puta a target of high share price performance in the market upon which its achievement comes with a huge bonus to the management, directors may opt for accounting procedures that always maintain high share prices. In a typical world, bonus plans are equivalent to performance contracts and directors understand that their careers are at stake without achieving the set targets.

The combined pressure on directors may force them to adjust figures to indicate a positive health of the company while the real picture is a deteriorating one. Haussmann (2014) asserts that most public companies use bonus plans as the basis for remunerating directors and company CEOs. Consequently, managers select discretionary accruals based on what they stand to benefit rather than bigger benefit for the firm. For instance, a director can opt to use a depreciating fixed assets or can accelerate inventory delivery at the end of financial year, and many other adjustments. With discretionary accruals that influence timing of reported earnings, the manager can transfer earnings one period to another. Assuming that the cash flows affects projects that are directly financed by stock issues, it will not affect the company’s investment decision (Krolick, 2005). Companies with higher gearing levels may use account choice to avoid defaulting a lending covenant, which is just a temporary problem before the actual financial crisis strikes. Interesting enough, sometimes managers can adjust figures to increase profits as way of avoiding security by shareholders. On the contrary, companies that do not want close scrutiny by the authorities may influence their reported profits to a low value; move called voluntary non-disclosure.

Positive or Normative Accounting Reporting

From the above theories, it is evident that directors influence accounting approach to adapt when preparing financial statements, which can either be positive accounting framework or voluntary disclosure. While positive accounting theory focuses on managements financial choices, voluntary disclosure focuses on management’s disclosure decisions.

First, positive accounting framework is a strong signal of management’s intentions for when the stock markets are relative strong and efficient. Positive accounting methods is influenced by the nature of contracts between management and shareholders, and contract between management and creditors (Avelé, 2014). Additionally, political considerations such as taxes and regulatory activities comes into the mix. In most instances, positive accounting techniques measures managers’ ability to reduce the costs of violating company targets, increase shareholder’s value, and implications of taxes. However, positive accounting theory does not record actual economy value of a company because of many noise when selecting accounting approach. While it creates a picture that agents are making significant efforts to maximize wealth, the reality on the ground may indicate otherwise. Investors and lending partners who use accounting information based on positive accounting framework may end up making uninformed financial decision when buying or selling shares (Deegan, 2014 p320)

On the contrary, voluntary disclosure decisions occur when a firm decides to underreport its earnings to avoid unnecessary questions from relevant authorities (Bagnoli, & Watts, 2016). Whether the stock market operations is efficient or not, company managers still hold superior information than outside investors, especially when it comes to future financial orientation of the company. Again, financial industry regulators and auditing sometimes yield imperfect results. Therefore, directors are more than willing to balance how much information they rely to the public based on political, performance contract, and corporate governance considerations. When selecting an accounting approach based on voluntary disclosure, managers mainly face six forces: shares transactions, corporate control, stock compensation, litigation cost, management talent elements, and propriety costs.

When a company holds important superior information that determines acquisition of another firm, investors will always overvalue its shares index price. Therefore, the company managers may opt for voluntary disclosure to raise share prices to stable value before giving out the information. Corporate control hypothesis asserts that shareholders and investors put managers to task for current stock performance (Kolb, 2012). As a matter of fact, directors turnover in most public listed companies related to poor share price index. Therefore, financial information reported in financial statements may not necessary reveal true picture of those companies yet most investors rely on them to make stock trade decisions. Book value of a company is never equal to its market value because of information deficit that exist among players in stock market.