Corporate Financial Reporting and Investment Decisions by Shareholders
Indian capital market showed smart recovery from the global financial crisis of 2008-09 and investors’ confidence has regained momentum as evidenced by increased activities and volume of trade in recent years. The number of investors seeking fortunes in the capital market is also increasing as indicated by the number of depository accounts maintained with NSDL and CDSL, the two depositories of the country. However, the philosophy of looking at stock investment as an avenue for long term wealth creation has been almost ignored by investors. They are doing more speculative trading rather approaching the market with a longterm perspective. The narrow volume of trade in the cash segment of the stock exchanges compared with the daily average turnover clearly supports this view. In this context, the investors need quick and continuous information about the capital market in general and about the companies in particular for taking investment decisions.
Are the investors well informed of the developments in the capital market and aware of all risk factors affecting their investment? Is the present system of corporate communication system sufficient and adequate? Can an average investor take independent and rational investment decisions based on the published information about the companies? These are relevant questions affecting investors in capital market.
The development of information technology has contributed to the fast exchange of financial information on a real time basis among the vast number of investors and stakeholders. There is free flow and ready access to this financial information to all users irrespective of the political or geographical boundaries. There is also wide acceptability of the financial reporting system which the listed companies are following today among the various users and stakeholders. The strict adherence to the accounting principles and acceptance of international accounting standards have significantly contributed to the quality of information being provided to the users of financial information. The present article intends to analyse the adequacy of the present system of Corporate Financial Reporting in taking investment decisions by investors in shares.
The Investment Environment
The investment environment is fast changing with time and developments in the economy. Several factors have affected the psychological and behavioural attitudes of investors recently. Firstly, a strong and rapidly growing economy has created large disposable income for millions of people paving the way for the entry of new class of investors in the capital market. Most of these new investors have little or no formal education in finance and financial investments. Secondly, the economy has seen one of the longest and strongest bull markets in its history in the recent past. These new investors would like to attribute their high return on investment to their own capabilities instead of being the consequence of investing during a bull market. Finally, the rise of the online trading system has led to increased investor participation in the investment process, allowing investors to trade, research and take quick investment decisions.
Investors have access to vast quantities of information. This information includes historical data like past prices, returns, and corporate operational performance, as well as current information like realtime news, prices and volume. Individual investors have access to information on the Internet that is nearly as good as the information available to professional investors. Because most individual investors lack the training and experience of professional investors they are less equipped to know how to interpret information.
Information needs of investors
Information is the key to successful investment in stock market. Investors are provided with vast information about companies both fundamental and technical but do the investors get the right information at the right time is a mute question. There are umpteen investment advisers and consultants both in the print and visual media flush with stock tips and ideas for investments. There is no dearth of information, research analyses about sectors, companies or managements so far as there is no control on the sources or authenticity of the information or reports.
It is a sound principle of investment that the investor should have some basic knowledge of the asset class and do some homework before selecting the investment. Financial reports of companies serve the information needs of investors to a great extent. It is a statutory requirement that every company must give transparent and comprehensive information to its shareholders periodically. But there is always the information gap between the preparers of these reports and the users of these reports. The adequacy of contents, the relevance of information, the reliability and timing of the reports are always objectionable subjects of discussion in corporate communication.
Financial Reports serve the needs of various classes of users of information like present and potential investors, creditors, lenders, suppliers, customers, employees, government and the general public. It is true that all the information needs of these stakeholders cannot be met by the financial reports. But they do serve the common needs of all these parties. However, since the investors provide the risk capital of the company, they need much more comprehensive information necessary for investment decisions. It is a fact that the majority of investors are in a bad need of future information while only a minority of them is interested in historical information. Generally, investors have greater demands for future information than historical one. Investors have greater demands for regular and temporary reports and their demands for financial reports become less with the shortening of financial report period.
Corporate Financial Reporting
Financial reporting is a critical process involving the collection, analysis, summarization, and presentation of the financial and non financial information relating to a business. A number of documents and communication medias are available through which companies provide information to the external users of such information. Annual Reports, interim reports, employees reports, environmental reports, discussion with analysts and media persons, letters to shareholders and creditors, press releases, notification in company website, information given to stock exchanges, speeches made by company officials etc. are the common methods used for corporate communication. Though there are different means and methods of corporate communication the Annual Report is regarded as the most important source of such information about a company’s affairs, especially to the shareholders and investors of the company.
The Financial Statements which form the core of Annual Financial Report provide the shareholders and other stakeholders useful and significant information about the company, which helps them to make their economic and financial decisions about the company. In order to make sound investment decisions it is imperative that the information on which such decisions is based is reliable comparable and free from bias. This necessitates the existence of sound, reliable and high quality financial reporting system. Meaningful and transparent financial statements serve a company favourably in the long run since it establishes its credibility to the investors.
Contents of Financial Reports
Any stock investor should become familiar with Financial Statements. This is absolutely necessary to take good investment decisions. Financial Statements are the statements that report the financial position, operating results and cash flows of companies. Thus Financial Statements include the Balance Sheet, Income statement or Profit and Loss account and the Cash flow Statement.
1. Income statement
Income statement is also called ‘Statement of Operating Results’ or ‘Profit and Loss Account’. The Income Statement summarizes a company’s sales (also called revenues or turnover) and expenses. The final net figure is either profit (if total of revenues exceed expenses) or loss (if expenses exceed revenues).
2. Balance Sheet
Balance Sheet is a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and what it owes to outsiders, as well as the amount invested by the shareholders.
3. Cash flow Statement
A Cash flow Statement is prepared to disclose the inflow and outflow of cash during an accounting year. These include cash flows from operating activities, investment activities and financing activities.
4. Mandatory Disclosures
The Securities and Exchange Board of India (SEBI) regulations require the mandatory disclosure of certain facts and information in the annual reports of companies. It is one part of financial reports to disclose the risks and uncertainty that the company is facing. However, the current financial reporting system, focusing on the disclosure of some possible market risks and credit risks for relevant financial instruments, fails to convey the overall risks to information users. The mandatory disclosures include information on related party transactions, means of shareholder communication like address of company website, listing of shares in stock exchange, market price data of shares, movement of share price vis a vis Sensex/Nifty movements, distribution of shareholding pattern etc. An in-depth analysis of factors like promoters holding of equity shares, that again includes domestic and foreign promoters, those held by FIIs, Domestic Financial Institutions, Mutual Finds and public shareholding are very relevant information affecting the shareholder value and company’s share prices. It is also common these days that management may raise funds by pledging part of promoter’s stake in the company that has an adverse impact on share prices. The promoters may also be holding warrants or options which are converted into shares in future. This will affect dilution of the future EPS of the company at the same time increase the promoter’s holding in the company. Investors must scrutinize these information since they affect the investment decisions of investors in securities.
In addition to these documents a holding company is required to provide the following statements:
1. Statement showing the extent of holding company’s interest in the subsidiary company at the end of the financial year.
2. Net amount of profit of the subsidiary or subsidiaries separately for the current year and for the previous year.
In terms of the SEBI regulations, the following disclosures under Employees Stock Option Scheme (ESOS) in the Directors Report are also made. These include Options granted, the pricing formula, Options vested, Options exercised, the total number of shares as a result of exercise of Option, Options lapsed, amount realized by exercise of Options, total number of Options in force and employees-wise details of Options granted etc.
5. Report on Corporate Governance
The Securities and Exchange Board of India mandates good corporate governance practices of companies listed on the Indian stock exchanges. These regulations are notified under Clause 49 of the Listing Agreements of all stock exchanges of the country. They specify the standards that Indian companies have to meet and the disclosures that they have to make, with regard to corporate governance. Analysis of the Corporate Governance Report together with Additional Shareholders Information and Management Discussion and Analysis reports give valuable information on the value system, integrity of management, transparency and fairness of business operations.
Limitations of current Financial Reporting System
The basic quality of financial reports is that it must be readable an understandable by ordinary users as majority of investors do not have specialized knowledge of finance or accounting. It is also essential that the investors have some basic knowledge of economic and business activities and they take a keen interest in studying the reports with reasonable deligence. The current system through its strict adherence to a traditional reliability concept is actually producing less-reliable information when viewed from a holistic approach. Financial reports and statements are far from accurate in communicating the real value of the enterprise and its future performance potential.
Financial statements provide financial statistics of past events; but they are not forward looking. They don’t provide key non-financial information like quality of revenues, types of customers and potential risk factors. Certain qualitative elements are not considered in the financial statements like the quality and reputation of the management team and employees because they are incapable of being measured in monetary terms. Compared with tangible assets, intangible ones have uncertain future economic profit and are more difficult to be measured as well as dominated by enterprises. Therefore, most intangible assets, such as the reputation of business and human resources, are thrown out of financial reports due to their failure to meet the strict standards.
The figures provided in financial statements cannot be attributed to future since future earnings depend on many more factors like local and global market conditions, inflation etc. Limitations, apart these, are the numbers which an investor depends for future decisions. The assumption is that, a company which has given excellent numbers in the past is capable of delivering improved results in the future also.
Financial reports mainly focus on historical cost to provide enterprises with the historical financial information. Due to its basis on the past transactions, financial information, especially the information embodied in financial reports, is mainly based on the past. In spite of the importance of historical information in predicting the future, the users are unable to make their decisions only based on it. Prospective information, which seems increasingly important in the decision-making process, cannot be reflected in the current financial reports.
Financial reports contain a lot of information, data and schedules which are redundant from the point of investors. These make the reports voluminous and often distract the attention of investors from core information.
Another limitation is that the Financial Statements are not really reflective of the long-term value of an enterprise. As financial information only involves a short term, it is unable to show the dynamic process of an enterprise’s operation and production, hence failing to explain its long-term value.
Some non-financial elements not listed in them, such as technological innovation, human resource management, corporate reputation, energy sources and sales channels and so on. Unable to be described in monetary form, these factors cannot be listed in financial reports.
New IFRS and Corporate Reporting
In the present era of globalization, businesses are expanding across the borders and companies are accessing global markets for resource mobilization. In such a scenario investors and stakeholders of companies are not limited to a single country. The demand of stakeholders all over the world has lead to the movement for convergence of accounting practices across the globe. There is a consensus that integration of capital markets is facilitated if companies all over the world use common business language for communication.
IFRS issued by the IASB are increasingly being recognized as global financial reporting standards. This has motivated many countries to pursue convergence of their national accounting standards with IFRS. India has to fall in line with new IFRS in the context of many Indian companies emerging as multinational corporations and India needs foreign capital for its economic growth.
Indian Accounting standards would be converged with the new set of IFRS. In the first stage, certain category of listed companies and public interest entities have to adopt the converged standards, called IND AS from accounting year commencing from 1st April, 2011. These entities are estimated to be around three hundred companies including their subsidiaries. IFRS has emerged as the benchmark for reporting because it is issued by the world body and it aims at convergence of international accounting standards including the US GAAP. IFRS ensures more transparency, consistency and uniformity in accounting policies but it is incorrect to assume that IFRS accounting principles and methods are the best suited for all. Some experts argue that IFRS should be simplified and modified to the suit the needs and situations prevailing in many countries.
Suggestions for Improving Current Financial Reporting
The regulators, equity analysts, Chief Finacial Officers, accountants and investors have all developed, in their own way, analytical tools and techniques to overcome the limitations of financial statements and reports. Analysts have developed tools to value a company’s performance beyond financial results, taking into consideration factors like the management pedigree, business models, leadership styles, human resources, patents, corporate image and brand equity. In addition, many companies, to reduce the amount of uncertainty and market speculation, voluntarily disclose information about their strategy, management objectives, and key success factors in supplements to their financial reports. But this information is not at the disposal of ordinary investors. Therefore, it is ideal if the financial reports include the following features:
Predictive Information
If analysts and investors had better indicators of the company's future earning potential then they would be in a better position to make more informed decisions, and thus not merely react to short-term results. In this context the practice among some software companies in giving guidance of their financial performance in advance is highly commendable.
Non-financial Information
Besides financial performance variables like revenue and profit growth, non financial information like the business model, the management team and their vision, strategic positioning, project execution skills, evaluation of corporate environment and management perception of future outlook of business are important factors affecting investment decisions. Before going into financial analysis, these non-financial factors will give the investor first hand information about the company and to where it is headed in future. Other non financial information includes segment performance, product legs, market leadership, customer satisfaction, media reports etc.
Continuous Reporting
Information dissemination and reporting must be continuous process. The dynamic investment environment requires timely information on a regular and continuous basis. Investors may be provided with abridged quarterly information on financial performance.
Benchmarking
Accounting bodies like the Institute of Chartered Accountants of India have great responsibility in evolving uniform accounting principles and reporting standards. In the event of any deviation from the mandatory accounting standards it will be the duty of the auditor to make adequate disclosures in their audit reports so that the users of these financial reports may aware of these deviations.
Conclusion
To sum up, the current financial reporting system is far from satisfying the information needs of investors in shares and securities. The financial statements are generally general purpose statements intended for all parties mainly complying with statutory and regulatory requirements. The financial report information comes from the accounting information created in the framework of accounting hypotheses and principles, the employment of which will result in the gap between the given information and the demanded one. Therefore, there is an urgent need for improvement of in the quantity and quality information as well as the level of standardization and frequency of reporting. The Annual Reports together with quarterly financial performance reports would definitely help the investors in making some own research about companies and taking important investment decisions. However, in a complex and changing investment environment the investors must be more cautious and capable of reading beyond the numbers and facts contained in financial reports.
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also read my article on PMS
also read my article on PMS
Copyrights©Dr.A.M.Viswambharan
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