Chapter 7

1. Chapter 7 Fairness, disclosure and future trends in accounting

2. 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

3. 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

4. ‘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

5. 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

6. 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

7. 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

8. Fairness as a moral concept of justice Rawls’ theory of justice is an egalitarian one under which people choose two principles: • Each person is to have an equal right to the most extensive basic liberty compatible with a similar liberty for others. • 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

9. 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

10. 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

11. 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

12. 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

13. 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’

14. 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

15. 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

16. 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

17. 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

18. 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’

19. 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

20. 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

21. Jenkins Committee findings The 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

22. 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

23. Jenkins Committee model The 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. • Financial and non-financial data: • financial statements and related disclosures • high-level operating data and performance measurements that management uses to manage the business • 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

24. Jenkins Committee model (cont’d) • 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 • Information about management and shareholders: • directors, management, compensation, major shareholders, and transactions and relationships among related parties

25. Jenkins Committee model (cont’d) • Background about the company: • broad objectives and strategies • scope and description of business and properties • impact of industry structure on the company

26. 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’

27. 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’

28. Purposes of disclosure • The FASB statement sees the purposes of disclosure as being: • To describe recognised items and to provide relevant measures of those items other than the measures in the financial statements • To describe unrecognised items and to provide a useful measure of those items • To provide information to help investors and creditors assess risks and potentials of both recognised and unrecognised items

29. Purposes of disclosure (cont’d) • To provide important information that allows financial statement users to compare within and between years • To provide information in future cash inflows or outflows • To help investors assess return on their investments

30. Required financial statement disclosures – an analysis • 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 • Six subjects – stockholders’ equity, leases, pensions, income taxes, other post-retirement employee benefits and

31. 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 • Few disclosures explicitly provide information on future cash inflows or outflows • Few disclosures provide measures of unrecognised items • Disclosure requirements have increased over time; few have been eliminated

32. 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

33. 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

34. 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 earnings S = sales revenue B = bought-in materials and services DP = depreciation W = wages I = interest DD = dividends T = taxes

35. 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

36. 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

37. 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

38. 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

39. Employee reporting Employee 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)

40. 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

41. 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

42. 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

43. 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: • use of new technology in the workplace • increased mergers in the corporate sector • emergence of anti-union sentiment • fears of economic recession

44. 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

45. 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

46. 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

47. 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

48. 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

49. 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’

50. Socialist arguments for employee reporting The case for employee reporting using the socialist argument rests on two fundamental principles: • that employee reporting helps employees establish greater democratisation of decision-making in industry • 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