Introduction
Financial reporting plays a crucial role in the decision-making process of managers, investors, lenders, and other stakeholders. A substantial body of literature has examined how accounting influences real decisions, particularly in the realms of investing and financing. This paper delves into the real effects of financial reporting on these decisions, offering an overview of existing research and identifying potential areas for further investigation.
The conceptual framework established by the U.S. Financial Accounting Standards Board (FASB) defines the purpose of financial reporting as providing useful information for stakeholders to make decisions about providing resources to an entity. In essence, financial reports should convey data on the timing, amount, and uncertainty of a company’s future cash flows. However, financial reporting encompasses more than just a mere forecast of these flows. It allows managers the discretion to decide how and when to report, thereby influencing the financial statements. This flexibility leads to situations where companies with similar economic fundamentals can present divergent financial reports. Understanding the impact of these reporting choices on investing and financing decisions is essential for a comprehensive grasp of financial reporting’s role in business operations.
The Impact of Financial Reporting on Investing Decisions
Financial reporting impacts investment decisions in two primary ways: through managerial discretion and the inherent attributes of the financial reporting system.
Managerial Discretion and Transaction Structuring
Managers can strategically use financial reporting rules to achieve specific outcomes. For instance, managers may structure transactions to keep liabilities off the balance sheet, thus influencing financial outcomes. Numerous studies confirm that managers often structure transactions to meet financial reporting objectives, sometimes to their personal benefit, such as enhancing compensation metrics tied to financial performance (e.g., Core, 2020). Such manipulations can distort the true economic picture of a company and affect investment decisions.
The Role of Accounting System Attributes
Three key attributes of the financial reporting system influence investment decisions: disclosure policy, accounting quality, and timely loss recognition.
- Disclosure Policy: Financial disclosures, whether mandatory or voluntary, play a significant role in investment decisions. Both financial and non-financial disclosures contribute to the information available to investors, influencing their decisions.
- Accounting Quality: High-quality accounting reduces the risk of misinformation. Accounting quality can be measured through both direct and indirect proxies. Direct measures include accruals, earnings properties, and the nature of disclosures. For example, abnormal accruals—those that deviate from what is expected based on a model of accruals—are seen as a sign of reduced transparency. Indirect measures include audit quality and regulatory interventions, with the presence of internal control issues often indicating low accounting quality.
- Timely Loss Recognition: Timely loss recognition is a crucial feature of financial reporting. The principle of recognizing losses more quickly than gains helps provide a more accurate and transparent view of a company’s financial health. By reducing uncertainty, timely loss recognition allows investors to make more informed decisions and mitigates the risk of underinvestment.
Research consistently finds that higher-quality accounting and prompt loss recognition correlate with more efficient investment decisions. By improving transparency and reducing information asymmetry, these attributes help ensure that investments are made based on accurate and timely information.
The Impact of Financial Reporting on Financing Decisions
Financial reporting also plays a critical role in financing decisions, influencing both the choice of financing instruments and the timing of issuance.
Financing Instruments and Market Reactions
The choice between equity and debt financing is a fundamental decision for firms. Research has shown that financial reporting directly impacts this decision-making process. For example, firms may manipulate earnings before issuing equity, as the financial performance depicted in reports can influence investor perception and market conditions. Such earnings manipulation can, in turn, explain subsequent underperformance after the equity issuance.
Financial reporting also affects debt issues, influencing aspects such as interest rates, collateral, and covenants. The quality and transparency of financial reporting can make it easier for firms to obtain favorable financing terms. Conversely, poor financial reporting can lead to higher borrowing costs and more restrictive terms.
Transaction Structuring in Financing Decisions
Accounting has certain weaknesses that allow firms to structure transactions to achieve preferred financial statement outcomes. One key issue is the lack of a comprehensive model that distinguishes between liabilities and equity. The differing treatments of these two categories can lead to transaction structuring designed to achieve a particular financial appearance. This flexibility has significant implications for firms’ financing strategies.
The Macroeconomic Implications of Financial Reporting
While the bulk of research has focused on the effects of financial reporting at the firm level, a growing body of research is examining the macroeconomic implications of financial reporting. Preliminary findings suggest that accounting plays a significant role in macroeconomic outcomes, including measures such as real and nominal Gross Domestic Product (GDP).
Accounting has been found to predict revisions in macroeconomic measures, indicating that it can improve the accuracy of GDP assessments. Given that GDP is a key indicator of economic health, directly influencing financing and investing decisions, understanding the link between financial reporting and macroeconomic performance is an area ripe for further exploration.
Conclusion
Financial reporting undeniably influences both investing and financing decisions. Through managerial discretion in transaction structuring and the inherent attributes of the accounting system, financial reporting shapes how managers and stakeholders make decisions. High-quality accounting systems and timely loss recognition improve transparency, reduce information asymmetry, and enhance investment efficiency. Similarly, financial reporting impacts financing decisions, from the choice of instruments to the terms of issuance.
