Ethical and Legal Obligations of Financial Reporting

Financial reporting is a process that has been under a great deal of scrutiny currently. It is also one of the most important functions that an organization will take care of and requires a higher code of ethical behavior; particularly in the public markets where finance reports will help to determine a stockholders decision to buy or sell the stock of a company.

Geoffrey Whittington, in the article “Trust in Financial Reporting”, said, “The directors of the company have responsibility for producing financial reports, and the shareholder-director relationship is a classic example of an agency relationship. This relationship is characterized by information asymmetry: the directors know more than the shareholders, and the financial reports are supposed to redress this imbalance to some extent. The effectiveness of the financial reports depends upon shareholders being able to trust directors to tell the truth. In the impersonal environment of national and international capital markets, probably shareholders cannot be expected to have this level of trust. Directors have incentives to show their performance in a favorable light, and shareholders know that and will demand a large risk premium to compensate for the uncertainty arising from this lack of trustworthiness.” (2000, p. 181)

There are a few entities that have the distinct role of watching over accounting practices and ensuring the fair and balanced reporting of financial statements is a part of organizations affairs with the public. The FASB (Financial Accounting Standards Board) has declared their mission is “to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information.” (www.fasb.org)

“The FASB develops broad accounting concepts as well as standards for financial reporting. It also provides guidance on implementation of standards. Concepts are useful in guiding the Board in establishing standards and in providing a frame of reference, or conceptual framework, for resolving accounting issues. The framework will help to establish reasonable bounds for judgment in preparing financial information and to increase understanding of, and confidence in, financial information on the part of users of financial reports. It also will help the public to understand the nature and limitations of information supplied by financial reporting.” (www.fasb.org)

Another legal organization concerned with financial reporting is the SEC (U.S. Securities and Exchange Commission). The primary goal of the SEC is to protect investors and to police the ethical and moral integrity of the securities market. The SEC website explains that “the SEC requires public companies to disclose meaningful financial and other information to the public, which provides a common pool of knowledge for all investors to use to judge for themselves if a company’s securities are a good investment.” (www.sec.gov)

A third agency is known as the PCAOB (Public Company Accounting Oversight Board). Their website explains that they are, “a private-sector, non-profit corporation, created by the Sarbanes-Oxley Act of 2002, to oversee the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports.” (www.pcaobus.org)

All three of these organizations were set in place to act as watchdogs for corporate America, in an effort to provide fair and accurate financial reporting. We have seen that methods of unethical reporting can cause major problems within an organization and the economy as a whole. “Financial reporting is designed to meet the needs of users by providing information that is relevant to making rational investment and credit decisions, and other informed judgments. The users of accounting information are assumed to be reasonably astute in business and financial reporting practices. However, each user reads the financial statements with her or his own judgment and biases and must be willing to take responsibility for her or his own decision making.” (Marshall, p.17, 2003)

There are several accounting principles that are outlined through Accounting: What the Numbers Mean. The assumptions include the idea that the organization will continue to operate in the future. Transactions are recorded at their original cost when measured in dollars. This is a matter of objectivity that means accountants prefer to record transactions in the same way for all situations. Financial reporting is completed at the end of a period of time consistently; this provides clear and consistent times for financial reporting to be completed. Revenues and expenses should match, in an effort to fairly represent the expenses and revenues incurred during a period of time. It provides a more accurate picture of net income or net losses.

Another principle is that revenue is recognized at the time of the sale, this rule means that there should be no cases of revenue being reported more than it should be. This is a method of accrual accounting that also accounts for expenses being recorded at the time that they happen. Principles that are of high importance include consistency, full disclosure, materiality and conservatism.

Consistency is important in being able to recognize comparisons between time periods and also between different organizations. Accounting theories and methods will need to be consistent throughout time to give an accurate picture of the history of an organization. Full disclosure means that all information is provided and that none of the statements will be able to mislead the reader. The SEC has set the benchmark for financial statement disclosure and organizations are expected to meet those requirements or face penalties.

Materiality is the matter of financial statements being completely accurate. Accuracy in reporting is of utmost importance. Conservatism is a method of making judgments and estimates that result in lower profits and lower evaluations rather than bumping the numbers higher in order to attract stockholders. The rule is to be realistic but conservative when in doubt. (Marshall, p.19, 2003)

The rule to be realistic is paramount to the importance of accounting in business. The ethical boundaries that accounting needs to stay within is to hold honest and accurate, complete and concise reporting as the most important function to the organization and to the shareholders. This is why organizations like the SEC and FASB have been put in place to ensure that accounting standards and ethics are held to a higher degree and will serve the financial statement readers with complete information that will provide support for well considered decisions and comparisons.

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