Chapter 7

Fairness, disclosure and future trends in accounting

Fairness in accounting

• This is generally associated with the measurement and reporting of information in an objective and neutral way

• It implies that accounting statements have not been subject to undue influence or bias

Unfortunate consequences of the fairness principle

• A failure to rely on concepts of justice that dedicate instead a fairness in distribution

• A failure to expand the scope of the disclosure in financial statements beyond conventional financial accounting information towards a fairness in disclosure

• Creates flexibility in income and earnings smoothing

• Creates a climate for fraudulent practices

‘True and fair’ doctrine

• There is no comprehensive definition of the concept of ‘true and fair’

• Much confusion exists among producers and users of accounting information as to its exact meaning

Williams’ definition of fairness

Williams characterised fairness as an evaluation process with the following attributes:• the evaluator is aware of the

conditions that any consequences of his or her actions will be judged as fair or unfair

• the evaluation attempts to adopt a perspective of impartiality

Fairness in distribution

According to Williams:• decision usefulness (the principle of

organising accounting research and practice) is incomplete, while accountability at least possesses fairness as an inherent property

• the concern of accounting with efficiency makes accounting’s fairness judgement implicit, not absent

Social accounting• Pallot proposed that a community

perspective be added to the predominantly individualistic perspective in accounting

• Corporate social responsiveness as an expression of fairness involves the identification, measurement and disclosure where necessary of the social costs and benefits of a firm’s economic activities

Fairness as a moral concept of justice

Rawls’ theory of justice is an egalitarian one under which people choose two principles:1. Each person is to have an equal right to

the most extensive basic liberty compatible with a similar liberty for others.

2. Social and economic liberties are to be arranged so that they are both:• to everyone’s advantage• attached to positions and offices open

to all

Rawls’ economic system

• Rawls’ theory would probably involve a ‘constitutional democracy’, which preserves equal basic liberties while promoting equal opportunity and guaranteeing a social minimum and a market-based economy

• There is great disagreement over whether or not Rawls’ ‘difference principle’ (calling for the establishment of social minimums) would assure an adequate supply of goods and services

Fairness in accounting according to Rawls

• Rawls calls for an accounting choice that will eventually lead to solutions that are neutral, fair and socially just

• Rawls suggests expanding the role of accounting in the creation of just institutions and the definition of the social minimum

• Expanding accounting’s role in creating just institutions would lead to the elimination of those aspects of the social world and accounting that seem arbitrary from a moral point of view

Nozick’s theory of justice• Nozick argues that theories such as Rawls’,

which are based on the patterned and end-state principles, violate people’s rights and exclude the entitlement principle

• According to Nozick:– a person who acquires a holding in

accordance with the principle of justice in acquisition is entitled to that holding

– a person who acquires a holding in accordance with the same principle from someone else entitled to that holding is also entitled to it

– no one else is entitled to a holding except through the above applications

Fairness in accounting according to Nozick

• Nozick’s is a libertarian theory of distribution based on justice in acquisition and transfer

• Nozick’s view sees distributive justice as relying on a free-market mechanism, and does not allow for dealing adequately with fairness as a distributive function

Gerwith’s theory of justice• Gerwith’s theory sees rights to freedom and

well-being as generic, fundamental and universal• Gerwith asserts that every agent logically must

acknowledge certain generic obligations, including:– ‘he ought to refrain from coercing and from

banning his recipients’– ‘he ought to assist them to have freedom and

well-being [when there is] no comparable loss to himself’

• Gerwith’s Principle of Generic Consistency (PGC) is: ‘act in accord with the generic rights of your recipients as well as yourself’

Fairness in accounting according to Gerwith

• Gerwithian principles demand recognition of the rights of all those affected by the activities of the organisation

• Gerwith’s view supports the emphasis in value-added reporting to report the total return of all members of the ‘production team’, such as shareholders, bondholders, suppliers, labour, government and society

Fairness in disclosure

• The fairness in disclosure principle calls for an expansion of conventional accounting disclosures to accommodate all other interest groups in addition to investors and creditors

• Bedford called for the development of new tools under diverse new disciplines to provide management and decision-makers with useful information

Characteristics of disclosure to be expanded

• The scope of users should expand to include public groups

• The scope of users should expand to providing for inter-company coordination, meeting specific user information needs and developing public confidence in the firm’s activities

• The type of information disclosed should expand to reveal both internal activities and the environmental setting of those activities of a socioeconomic nature

Characteristics of disclosure to be expanded (cont’d)

• Measurement techniques should expand to encompass the total management science area

• The quality of disclosure should expand to offer improved relevance for specific decisions

• Disclosure devices should expand to encompass multimedia disclosures based on the psychology of human communications

Lev’s theory of equitable and efficient accounting policy

Equity of the capital markets• Equality of opportunity or symmetric

information• Risk-adjusted returns identical across

investors• The standard for the equity concept is:

– ‘The interests of the less informed investors should, in general, be favored over the more informed investors’

Gaa’s user primacy

• In Gaa’s user primacy, the interests of one group of users is given preference over others

• A standard setter would be established to enforce user primacy, thereby redressing imbalances between investors and managers

• The standard setter would aid all securities market agents in exploiting the potential trading gains provided by such a market

The Jenkins Committee• The Jenkins Committee was established

by the AICPA in 1991 to improve external reporting

• The committee’s aim was to determine:– the nature and extent of information

that should be made available to others by management

– the extent to which the auditors should report on the various elements of that information

Jenkins Committee findingsThe Committee found that, in order to meet users’ need for information, financial statements should be enhanced in the following ways:• improved disclosure of business-segment

information• disclosures and accounting for innovative

financial instruments to be addressed• improved disclosures about the identity,

opportunities and risks of off-balance-sheet financing arrangements, and accounting for such to be reconsidered

Jenkins Committee findings (cont’d)

• the effects of core and non-core activities and events to be reported separately, and non-core assets and liabilities to be measured at fair value

• improved disclosures about uncertainty of measurements of certain assets and liabilities

• improved quarterly reporting by reporting separately in the fourth quarter and by including business-segment data

Jenkins Committee modelThe model proposed by the Jenkins Committee enabled users to make projections, value companies or assess the prospect of loan repayments on the basis of the following five broad categories.

1. Financial and non-financial data:• financial statements and related disclosures• high-level operating data and performance

measurements that management uses to manage the business

2. Management analysis of the financial and non-financial data:

• reasons for changes in the financial, operating and performance-related data, and the identity and past effect of key trends

Jenkins Committee model (cont’d)

3. Forward-looking information:• opportunities and risks, including those

resulting from key trends• management’s plans, including critical

success factors• comparison of actual business

performance to previously disclosed opportunities, risks and management’s plans

4. Information about management and shareholders:• directors, management, compensation,

major shareholders, and transactions and relationships among related parties

Jenkins Committee model (cont’d)

5. Background about the company:• broad objectives and strategies• scope and description of business and

properties• impact of industry structure on the

company

Expanded accounting disclosures

• The distinction between recognition and disclosure is emphasised by the FASB and is consistent with the Australian position, in that recognition is seen stated in the FASB Concepts Statement No. 5 as:– ‘the process of formally recording or

incorporating an item into the financial statements of an entity as an asset, liability, revenue, expense, or the like’

– ‘[including] depiction of an item in both words and numbers, with the amount included in the totals of the financial statements’

Expanded accounting disclosures (cont’d)• The FASB statement also says that:

– ‘since recognition means depiction of an item in both words and numbers, with the amount included in the totals of the financial statements, disclosure by other means is not recognition’

– ‘Disclosure of information about the items in financial statements and their measures that may be provided by notes or parenthetically on the face of financial statements, by supplementary information, or by other means of financial reporting is not a substitute for recognition in financial statements for items that meet recognition criteria’

Purposes of disclosure

The FASB statement sees the purposes of disclosure as being:

1. To describe recognised items and to provide relevant measures of those items other than the measures in the financial statements

2. To describe unrecognised items and to provide a useful measure of those items

3. To provide information to help investors and creditors assess risks and potentials of both recognised and unrecognised items

Purposes of disclosure (cont’d)

4. To provide important information that allows financial statement users to compare within and between years

5. To provide information in future cash inflows or outflows

6. To help investors assess return on their investments

Required financial statement disclosures – an analysis

1. The most frequently required disclosures relate to amounts recognised in the financial statements, particularly to disaggregating them and providing relevant measures other than the measure in the financial statements –disaggregation of recognised amounts represents 26 per cent of all required disclosures

2. Six subjects – stockholders’ equity, leases, pensions, income taxes, other post-retirement employee benefits and

Required financial statement disclosures – an analysis (cont’d)

commitments and contingencies – account for 45 per cent of all required disclosures; five standards – SFAS nos 15, 87, 88, 106 and 109 – account for 28 per cent

4. Few disclosures explicitly provide information on future cash inflows or outflows

5. Few disclosures provide measures of unrecognised items

6. Disclosure requirements have increased over time; few have been eliminated

New accounting disclosures New accounting disclosures under

the principle of fairness in disclosure are:• value-added reporting• employee reporting• human resource accounting• social accounting and reporting• budgetary information disclosures• cash flow accounting and reporting

Value-added reporting

‘Value added’ is the increase in wealth generated by the productive use of the firm’s resources before its allocation among shareholders, bondholders, workers and the government

Computing value added Step 1: The income statement computes retained

earnings as a difference between sales revenue, on one hand, and costs, taxes and dividends, on the other:

R = S – B – DP – W – I – DD – T (1)where:R = retained earningsS = sales revenueB = bought-in materials and servicesDP = depreciationW = wagesI = interestDD = dividendsT = taxes

Computing value added (cont’d)

Step 2: The value-added equation can be obtained by rearranging the profit equation as:

S – B = R + DP + W + I + DD + T (2)

or

S – B – DP = R + W + I + DD + T (3)

• Equation 2 expresses the gross value-added method

• Equation 3 expresses the net value-added method

Computing value added (cont’d)

Step 2 (cont’d)• In both cases, the left part of the equation

shows the value added among the groups involved in the managerial production team (workers, shareholders, bondholders and the government)

• The right-hand side is also known as the additive method and the left-hand side as the subtractive method

Benefits of the value-added statement

• With the disclosure of value added, employees get the satisfaction of knowing the value of their contribution to the total wealth of the firm

• Value added represents a better base for the computation of worker bonuses

• Value added information has been proven to be a good predictor of economic events and market reaction

Benefits of the value-added statement (cont’d)

• Value added is a better measurement of size than sales

• Value added may be useful to employee groups because it can affect the aspirations and thoughts of its negotiating representatives

• Value added may be extremely useful in financial analysis by relating various crucial events to added variables

Employee reportingEmployee reporting has been necessitated by the emergence of employees and unions as potential users of accounting information. Examples of headings for an employment report are:• number of people employed (analysed

in various ways)• location of employment• age distribution of permanent

workforce• hours worked during the year

(analysed)

Employee reporting (cont’d)

• employee costs• pension information• education and training (including

costs)• recognised trade unions• additional information (race relations,

health and safety statistics etc.)• employment ratios

Aims and reasons for reporting to employees

A survey of financial reporting literature by Lewis and others found that the main reasons for reporting to employees between 1919 and 1979 were:

• heralding changes• presenting management propaganda• promoting interest in understanding of

company affairs and performance• explaining management decisions• explaining the relationship between

employees, management and shareholders

Aims and reasons for reporting to employees (cont’d)

• explaining the objectives of the company• facilitating greater employee participation• responding to legislative or union pressure• building company image• meeting information requirements peculiar

to employees• responding to management fears of wage

demands, strikes and competitive disadvantages

• promoting a higher degree of employee interest

Increased interest in reporting to employees

Lewis’s survey found that in the years between 1919 and 1979, the level of interest in reporting to employees was higher when four socio-economic factors were present:1. use of new technology in the workplace2. increased mergers in the corporate

sector3. emergence of anti-union sentiment4. fears of economic recession

Reasons for increased levels of employee reporting

Lewis’s survey also speculated that management may have hoped to:• allay fears of lost rank, skill or employment

due to technological advances• counter fears of ‘bigness’, monopoly power,

employee relocation and loss of identity through corporate mergers

• take advantage of community anti-union sentiments by bypassing union communication channels, emphasising management prerogatives and the need

Reasons for increased levels of employee reporting (cont’d)

to control wages and associated costs, and generally weakening the unions’ potential to disrupt operations

• prepare employees for hard times, confirm or dispel rumours of imminent company failure, allay fears of unemployment and urge employees to greater efforts in difficult economic times

Management benefits of employee annual reports

Taylor, Webb and McGinley identified the following personal benefits that management might attempt to seek for itself by providing an annual report to employees:• building a favourable employee impression

of the management group• reducing the resistance of employees to

changes initiated by management• providing a useful response to union

pressure for more corporate financial information from management

Employee benefits from employee reporting

Taylor, Webb and McGinley also identified the following personal benefits that might accrue to employees through employee reporting:• having the basis for deciding whether to

continue employment with the company or an organisation section of the company

• having the basis for assisting the relative position of the employees within the corporate structure, particularly in terms of getting a ‘fair go’

• understanding the image of the company as a basis for deciding at a personal level whether to identify with its image

Arguments for direct disclosure to employees

Foley and Maunders identified arguments supporting disclosure direct to employees:• feedback of information to employees will

improve job performance via learning effects and also serve to increase motivation

• the role of employee reporting is crucial to effective worker participation, which will contribute to the efficiency of the company

• the fundamental change in the nature of the firm and its ‘social responsibility’ legitimises employee reporting

Arguments for direct disclosure to employees (cont’d)

• employee reporting may be seen by some employers as a possible way of resurrecting the concept of joint consultation as a means of avoiding unionisation

• the socialist tradition, with its ultimate objective of changing the basis of ownership and the control of resources, sees employee reporting as a step to increase ‘workers’ control’ and develop workers’ ‘self confidence’

Socialist arguments for employee reporting

The case for employee reporting using the socialist argument rests on two fundamental principles:

1. that employee reporting helps employees establish greater democratisation of decision-making in industry

2. that employee reporting may usefully act as a check on those aspects of the market system which result in adverse external effects in the form of pollution and environmental degradation

Social accounting and reporting

The measurement of social performance falls in the general area of social accounting. The four various activities are:1. social responsibility accounting

(SRA)2. total impact accounting (TIA)3. socioeconomic accounting (SEA)4. social indicators accounting (SIA)

Definition of social accounting

Ramanathan defines social accounting as:– ‘the process of selecting firm-level

social performance variables, measures and measurements procedures; systematically developing information useful for evaluating the firm’s social performance and communication of such information to concerned social groups, both within and outside the firm’

Who is pushing for corporate social reporting?

• According to Gray and others, corporate social reporting (CSR) is a dialectic between four different positions, which are:

1. the extreme left wing of politics 2. acceptance of the status quo3. the pursuit of subject/intellectual

property rights4. the extreme right wing of politics

Who is pushing for corporate social reporting? (cont’d)

• Position 2 appears to represent the true advocates of CSR and seems to include people who assume that:– CSR’s purpose is to enhance a firm’s

corporate image, and who see corporate behaviour as fundamentally benign

– the purpose of CSR is to discharge an organisation’s accountability, assuming that a social contract exists and that this demands the discharge of social accountability

– CSR is effectively an extension of traditional financial reporting and its purpose is to inform investors

Arguments for measuring and disclosing social performance

1. The existence of a social contract2. Rawls’ and Gerwith’s models argue

for a concept of fairness that is favourable to social accounting

3. Users’ needs4. The existence of social investment

Budgetary information disclosure

• Accountants and non-accountants alike have recommended that forecast information be incorporated into financial statements

• One objective of financial reporting set forth in the Trueblood Report supports such disclosures:– ‘An objective of financial statements is to

provide information useful for the predictive process. Financial forecasts should be provided when they will enhance the reliability of users’ prediction’

Including forecasts in accounting reports

• In the UK, the revised version of the City Code on Takeovers and Mergers requires profit forecasts to be included in takeover-bid circulars and prospectuses

• In February 1975, the US Securities and Exchange Commission (SEC) first announced its intention to require companies disclosing the forecasts to conform with certain rules to be laid down by the SEC

• In 1976, the SEC called for voluntary filing of forecasts

Problems encountered by the SEC• The definition of earnings forecasts:

– concerns determining which forecasted items are to be disclosed (the two possible solutions are disclosing budgets or disclosing probable results (forecasts))

– Ijiri makes the distinction as follows:• ‘Forecasts are estimates of what the

corporation considers to be the most likely to occur, whereas budgets may be inflated from what the corporation considers to be most likely to occur in order to take advantage of the motivational function of the budget’

Problems encountered by the SEC (cont’d)

– from the point of view of the user, therefore, the disclosure of forecasts, rather than budgets, may be more relevant

– the trend seems to be in favour of the disclosure of forecasts

• Whether disclosure should be mandatory or optional:– the principle argument in favour of

mandatory disclosure is that it creates a similar and uniform situation for all companies

Problems encountered by the SEC (cont’d)

– mandatory disclosure could create an unnecessary burden in terms of competitive advantage, and certain firms would have to be viewed as exceptions

– some firms lack adequate technology, experience and competence to disclose forecasts adequately, and outlays to correct this situation may create an unnecessary burden on these firms

• The possible advantages of such disclosure:– both companies and analysts have been

unsuccessful in accurately forecasting earnings

Ijiri’s primary issues in corporate financial forecasts

• Reliability:– related to the relative accuracy of the

forecasts• Responsibility:

– related to the possible large liabilities of firms making forecasts and accountants auditing such forecasts

• Reticence:– related to the degree of silence and inaction

of firms that are at a competitive disadvantage due to forecast disclosure

The usefulness of published forecasts

Acccording to Mautz, three kinds of difference must be considered when evaluating the usefulness of published forecasts:1. differences in the forecasting agilities of

publicly owned firms2. differences in the attitudes with which

managements in publicly owned companies might be expected to approach the forecasting task

3. differences in the capacities of investors to use forecasts

Cash flow accounting and reporting

Stewardship function• Management is entrusted with control of

the financial resources provided by capital suppliers

• The purpose of financial statements is to report to concerned parties to facilitate the evaluation of management’s stewardship

• To accomplish this objective, the reporting system favoured the accrual system

The accrual basis of accounting

• Refers to a form of keeping those records not only of transactions that result from the receipt and disbursement of cash, but also of amounts that the entity owes others and that others owe the entity

• At the core of this system is the matching of revenues and expenses

• The system is challenged by proponents of cash flow accounting

Cash flow accounting

Defined as the recording not only of cash receipts and disbursements of the period, but also of the future cash flows owed to or by the firm as a result of selling and transferring the title to certain goods (the accrual basis of accounting)

Accrual accounting versus cash flow accounting

• Accrual accounting facilitates the evaluation of management’s stewardship and is essential to the matching of revenues and expenses

• The efficiency of the accrual system has been questioned

• Many decision-usefulness theorists advocate a cash flow accounting system based on the investor’s desires to predict cash flows

Accrual accounting versus cash flow accounting (cont’d)

• Most advocates of cash flow accounting feel that the problems of asset valuation and income determination are so formidable as to warrant a separate accounting system, and propose the inclusion of a comprehensive cash flow statement in company reports