Effects That Accounting Choices Have On Users Of Financial Statements

Abstract

The paper is an examination of the effects of accounting choices on users of financial statements. First of all, a historical examination in the subject matter was examined. It was found that most researches normally dwell on single characteristic effects of accounting decisions on financial statement users. Current GAAP on the matter also concurs with the latter matter.

It was therefore found that there may be a need to look at how these factors intertwine in affecting users of financial statements. Since firms may have to content with a number of effects at any one time, it is important to carry out a study on a combination of factors. Thereafter, an analysis ought to be done in order to investigate which factor is the mot important and which one takes least precedence. This can go a long way in assisting managers and other financial decisions makers about accounting choices in the future.

Introduction

There are a number of users of financial statements within any respective firm. Usually, some of the intended effects of accounting choices can become real effects. On the other hand, there are also foreseen consequences that may emanate from external or internal factors. The essay shall examine some of these issues through existing research on the matter. Suggestions will be made on problematic areas and possible courses of actions will also be laid out. The latter suggestions will be particularly useful to the public accounting body owing to the fact that some loopholes on the subject matter will be identified. (Riper, 2006)

Historical development of theory

A lot of research has been done with regard to voluntary accounting choices. This is largely because the effects of such choices are more clear cut and predictable. For instance, a number of accountants have utilized the issue of accounting discretion in order to understate their financial performances during periods of string performance and also to overstate their financial status during periods of low performance.

Research has shown that there are three major reasons why firms can choose to engage in certain income decreasing or income increasing activities. First of all, this may be motivated by the need to include the economic events that are prevailing at that time. Secondly, such accounting choices may be motivated by strategic objectives within the corporation under consideration. Lastly, engaging in such accounting choices can be motivated by a combination of both economics and company strategy. Usually, the accountant enacting these changes may be motivated in their very own expectations. (Hopwood, 2008)

Managers tend to use income increasing tactics when there are interested in enacting strategic changes. In fact, it has been shown that most financial users tend to believe that any income increasing measure enacted by their managers is in close relation to the overall nature of these kinds of objectives. In other words, employees are less likely to be influenced by positive or income increasing accounting decisions than by income decreasing accounting decisions. When managers opt to increase their income, chances are that employees may assume that this is part of a strategy to reach an industry benchmark. Consequently, they are less likely to believe it.

On the other hand, when managers make accounting decisions to decrease their overall incomes in their financial statements, then employees are much more likely to believe the latter results than if incomes had been increased. This is largely because such employees may assume that the reflections being put out by their employers have been one in order to reflect the economic situations prevailing at that time. In other words, it may be necessary for firms to prepare for skepticism in the former case than in the latter one.

In close relation to income decreasing or income decreasing acts in financial statements is the issue of qualification in making accounting decisions. Users are likely to regard qualified income reducing acts as being more strategic in nature than unqualified income decreasing acts. This is the case because when the acts are qualified, then chances are that the users would asses the firm in a more positive light than if the financial statement had not been qualified.

There is a need to compare financial statement user reaction to income increasing and income decreasing changes in comparison to reference point. Usually, most firms do not operate in isolation. Employees are well aware of the goings on within their industries. Consequently, when accounting decisions are made to either increase or decrease incomes within corporations, employees or other users tend to resort to reference points such industry benchmarks to see how far below the mark they are or how far above it they have reached. (Proell, 2008)

Statistics indicate that users react more positively to income decreasing changes even when comparing them to industry benchmarks. This is usually because most people may treat this as being representative of occurrences within the industry under consideration and therefore leaving room for growth.

On the other hand, when incomes are perceived as being way above industry benchmarks, then users are likely to assume that those benchmarks do not represent the goings on their particular industry. This means that they may treat such a change as being deviant from the norm. Because of this, users may assume that such a firm cannot survive within its industry of operation and that the assessment of that firm’s performance is therefore below par in reality.

Financial statement users are likely to remain indifferent to changes made by their employees in the event that the accounting decision is an income decreasing one but a qualified one. This is largely because users are likely to attribute such changes to either strategic reason or to reflect economic conditions within a certain industry. This means that those changes may indicate the overall problems facing these groups when it comes to the process of enacting these changes.

Income increasing acts may also solicit different reactions in the vent that they have been qualified or if they are not qualified. Expert opinion suggests that financial statement users are much more likely to believe them if they are qualified.

In the agency theory, firms are treated as a point of convergence of contracts. This means that a number of users of financial statements view accounting choices as means against which firms can get incentives. The incentives are important determinants in the process of making accounting decisions largely because they can make the difference between the detriment or survival of a number of corporations.

Healthy and financial firms often find that they have to make accounting decisions. However, the forces or determinants affecting these two types of firms are dependent on the kind of arrangement being made. In certain reviews, some analysts have assumed that the type of incentives facing these two types of firms is the same. However, this may not necessarily be true because financially distressed firms may be challenged to engage in certain contracts depending on the type of benefits that they may derive from certain contract incentives. (Proell, 2008)

One of the drivers of accounting decisions in financially distressed firms is the issue of debt covenant isolation. Financial debts are a particularly pressing issue for such firms and it is likely that their accounting choices can be adversely affected by these decisions and vice versa (that the accounting choices they make can change their prevailing situations)

In other circumstances, firms facing financial distress may be motivated to make accounting decision that can subsequently affect their jobs or their firms altogether. In other words, some troubled firms may consider their situations as being temporary. This means that their greatest concerns may not be to get accounting bonuses. Instead, their focus may be on restoring the financial position of their firms and making the most of their kind of arrangements.

It has also been shown in a number of researches that new CEO tend to deflate their incomes when accompany has been recording poor financial management during the previous year. This is an aspect that has been carried forward in a number of companies that may be considered as financially troubled ones.

It should also be noted that accounting decisions in the latter category may also made in order o reduce incomes. This creates an image of a corporation that is vulnerable. In this regard, such firms are likely to obtain concession from the government through government subsidies or they may find that labor unions offering incentives to poorly performing firms my be motivated to consider them if they record lower incomes. In other words, it can be said that such firms may make be affected positively by such decisions since they may gain favor from the government or from labor unions. On the other hand, if these income deflations are discovered, then a financially distressed firm may be required to close. (Riper, 2006)

In other circumstances, forms undergoing financial distress may be motivated to make accounting decisions in order to cope with management changes that may have occurred at the time. This is usually the case when the incumbent management finds that the new firm he or she is operating is dealing with lower performance than was the case in the previous regime. Such mangers may be interested in displaying positive light to internal and external stakeholders of the company under consideration.

In other situations, it may be possible to find that other firms are undergoing government assistance investigations. These are usually those firms that are in a position of getting incentives from the government if it found that their management principles are in order. Usually, such firms are likely to make accounting decisions that would affect them in a positive light by making them liable to receive incentives from the investigators.

In other researches, it has been found that firms facing financial difficulties may be required to deal with large accrual especially during their first year in dividend reductions. This means that a firm may be faced with more than one particular financial challenge at a time.

With regard to accounting decisions and the effect that the choices have on financial statement users; a number of researches have also been done on the user expectations. In other words, this is another factor that can affect the overall decision made by a certain corporation and how the users within that firm are affected by it. For instance, one is likely to find that within certain forms, the users under consideration have very little regard for the kind of decisions that they may be making because of the fact that there may be a match between their expectations and actual occurrences. However, in instances where financial statement user expectations are quite varied from actual occurrences, then it is likely that these issues may not affect them positively. (Belkaoui, 2007)

Risk management has also been shown as an important predictor of accounting choices and hence highly influential in determining some of the effects of these choices. This is largely because financial statements have a shocking effect on users when the information being displayed is included.

Risk management sis usually something that may be firm specific mostly because different companies are faced with different obstacles at any one time. For instance, when a company was faced with a number of security risks, then chances were that they would classify those security risks in manner that would portray them in a positive light. Additionally, benchmarks set up in accounting standards were highly influential in determining whether certain issues were considered as security risks or whether they were not. This means those weaker banks are much more likely to treat fewer securities as being lower than the accounting benchmark than vive versa.

Interest risks that come with securities are also an important factor in determining effects of such accounting decisions. This is because levels of interest risks on a certain bank portfolio can go up depending on how that particular issue had been classified by the parties involved in the preparation of the financial statements (Warfield, 2008)

Research has also shown that there are also other factors that may affect financial decisions being made by respective individuals in terms of the perceived expectations and actual occurrences.

Current GAAP

Financial statement users are adversely affected by the accounting choices made within certain firms. One such group are financial investors. Research has shown that the manner in which financial statements are presented to non processional financial statement users such as investors has a very important role to play in influencing their choice to invest in that respective firm. When a firm opts to make an accounting decisions in which there it highlights the effects of a net income on the goings on within a certain firm, then chances are that one might have to deal with these scenarios in a relatively different manner. In other words, an investor may make the choice to invest in such a firm if the information given is forthcoming in this regard.

The converse is as true, when accounting decision are made such that investors have now ay way of understanding the fair value that they have on a particular investment, then chances are that that group may be persuaded to look elsewhere for investment. Usually, information about financial statement interpretation can be done on the same document but as a note or on the margin of the financial statement. Consequently, firms that may be in unhealthy situations may be affected positively by making such an accounting choice. On the other hand, failure to make such a decision may also influence them negatively owing to the reduced level of awareness given to these kinds of approaches. (Warfield, 2008)

It should b noted that a number of financial statement users are highly affected by the accounting policies in certain firms or the level o adoption of accounting standards. This is usually the case when considering foreign investment. In other words, there are situations in which a certain investor may be dealing with the issues surrounding that particular scenario especially with regard to the kind of changes affecting a certain party.

An example of how this can be displayed is through looking at the relationship between two countries such as the US and Australia. It is likely that a US foreign investor will be more interested in making investments within countries that are US GAAP aligned. This factor is quite important in accounting decisions and hence accounting effects because only has to look at accounting policies of a number of developed nations to understand this. The US is one of the heaviest foreign investors in Australia. In order to appeal to the latter group, it was found that Australian accounting standards took a turn and began conforming to the US institutional frameworks and also to their GAAP.

There are a number of reasons identified in literature for selecting certain accounting choices and these reason include:

  • Improves financial statement credibility
  • Reduces processing costs

When accounting policies are voluntarily done in order to come up with the most influential choices on foreign ownership, then chances are that they can attract greater investments if they are aligned to the foreign investor’s institutional holdings or if they are also associated with the joint determinants under consideration.

The following table illustrates the example of US foreign investors interested in Australian companies

Variables

Statistic

Companies with US investments

Companies matched by size and industry

p-value

Total assets

Mean

Median

24,157

2, 890

3, 924

525

<0.001

Policies

Mean

Media

0.723

0.75

0.428

0.5

<0.001

US sales

Mean

Media

1

0.934

0

0.793

<0.001

BIG 5

Mean

Media

1

0.699

1

0.6

<0.001

Source: (Bath, 1996)

As it can be seen form the latter table, there is a link between the level of investment by US firms in Australia and the amount of matching being done. Consequently, financial statements have an adverse effect on the kind of investment being done in a certain country.

Suggested changes or problem areas revealed in the debate

As it can be seen in the GAAP and historical development, most authors tend to focus on one particular accounting choice with reference to financial statements yet there are instances in which these effects may be more complex. There is a need to look at how effects of accounting choices can intertwine and hence affect the way a firm comes to make its respective decisions. Most of the time i.e. 87% of the time, it has been found that most firms may be dealing with two or more of the following issues

  • Management change
  • Government negotiations
  • Labor union contracts
  • Dividend reductions

It is therefore possible to find that a firm may be forced to contend with a number of changes that may occur after the accounting decisions have been made. In other words, most researches usually dwell on a particular effect yet situations are hardly that simple. Some correlations ought to be done in order to see how these various effects intertwine of financial statement users. (Hopwood, 2008)

An example of how this can be done is through the employment of multivariate regression analysis in which a firm can make a trade off between the negatives or positives associated with some of the decisions that they could be making at any one time. Additionally, it is impotent no to generalize the occurrences that exist within various firms because certain companies may be financially healthy while others may be financially unhealthy. Consequently, one must clarify this matter prior to making a research. However, a lot of articles on the latter topic have very little information about this matter. (Bath, 1996)

Public accounting can greatly improve if there was a way in which studies differentiated between healthy and unhealthy firm so as to ascertain that the process of auditing financial statements made by either firms an be clearly distinguished. It should also be note that the following categories of individuals heavily rely on financial statements and any information provided in these reports is quite important. These professionals include

  • Employees
  • Union leaders
  • Government representatives
  • Financial analysts
  • Creditors
  • Investors

It is therefore important to determine which if any of the latter mentioned decisions could be the most important determinant in making financial decisions. In other words, some accounting decisions may have heavier repercussion on the firm under consideration or they may have an ability to change the way certain issues are being treated in a certain firm. This also means that greater precedence should be given to such accounting decisions in the future.

Suggested courses of action

A co relational study is essential in this arena. By conducting such a study, there will be  more realistic display of the goings on within certain firms. This is because a number of firms may be facing more than one effect at any time.

However, because of the difficulties in a data analysis that may arise on such a study i.e. by suing a combination of variables, it may be necessary to tackle one factor at a time. For instance, a co relational analysis can be done to find the relationship between foreign investments and accounting decisions, then another on can be done to find the relation between employee assessments of a firm and accounting decisions, another one can be done on accounting decision and union contracts and many more. After all these comparisons have been done, then co relational values obtained from each one of them can then be carried out. The comparison with the highest co relational value should then be ranked as the same thing should be done to the least. A summation of all the occurrences can be done in one graph to show the most determinant factor in accounting decisions. (Belkaoui, 2007)

Conclusion

Form the latter study; it was found that there are a series of effects that accounting decisions can have on users of financial statement users. For instance, some users may be influenced to invest in a certain firm if the statements are positive. This is usually the case for foreign investors. Additionally financial statements may cause governments to support firms through subsidies. In other scenarios, it is possible to find that accounting decisions can cause renewal of contracts by labor unions.

In other situations, they may cause employees to think that the firm is doing well compared to its counterparts in the industry. In other situations, accounting decisions can cause employees to treat their management with skepticism especially when the accounting decisions was income decreasing. Sometimes, the choices may show that a firm is performing at par with some of its counterparts in the respective business arena. This means that there can be no other scenarios when some of the latter effects can intertwine.

There is a need to provide a co relational study on how these factors affect users. A study on the most important or the least important determinate can go a long way in ensuring that accounting choices are more informed and therefore solicit the intended consequences.

References

Warfield, T. (2008): Financial Statement presentation and on professional interpretation of fair value; Journal of Accounting research, 45, 4, 620-724

Proell, C. (2008): Effects of actual and expected accounting choices on judgments and decisions: Accounting Review, 13, 49

Bath, M (1996): International differences and their relation to share prices – evidence from UK, Canada, US and Australia

Riper, R. (2006): Setting standards for financial reporting; Contemporary Accounting Research; 13, 135

Belkaoui, A. (2007): Accounting in the dual economy; Journal of Accounting Research, 10, 67

Hopwood, A. (2008): The Economics and Politics of Accounting; Political Economy Journal, 7 69-74

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Source by Yvonne Miller