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RAPPORT

Professional investors and the decision usefulness of financial reporting

Stewardship and valuation objectives

A recent review of the academic literature for ICAS and EFRAG (Cascino et al., 2013) concluded that there are two main roles for financial reporting. The first is to provide information for estimating the future cash flows associated with both debt and equity capital, often referred to as the valuation role. The second is the stewardship role, where financial reporting information is used in the preservation of investors’ capital and in the control and incentivisation of managers. The downgrading of stewardship as a primary objective in the joint 2010 International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) Conceptual Framework for Financial Reporting generated significant debate and disquiet in the professional, regulatory and academic accounting communities. Despite the significance of this debate, the 2013 ICAS and EFRAG sponsored review of the literature showed that there is a lack of direct empirical evidence on the stewardship role and whether it requires information with different properties to that required for estimating future cash flows. This report aims to address this gap by providing empirical evidence on professional investors’ assessments of the usefulness of financial reporting information for both valuation and stewardship decisions. Evidence-based research on the decision usefulness of financial reporting information is particularly timely, given the current developments of the IASB Conceptual Framework for Financial Reporting.

The literature acknowledges that in many cases, setting valuation objectives for financial reporting results in information that is useful for stewardship decisions. For instance, investment value is of primary concern to capital providers and will also form an important part of managerial performance assessments. However, theoretical studies also show that the two objectives sometimes require information with different properties. This is particularly the case where information on future cash flows is relevant for valuation irrespective of whether it reflects the effort of managers, whereas a stewardship objective typically sees information reflecting events outside managers’ control as irrelevant. Indeed, one of the arguments against share prices being included in managerial performance arrangements is that they are influenced by factors outside management control, such as macro-economic changes. Moreover, share prices contain significant forward looking information and are therefore influenced by expectations of future outcomes, not just realisations of actual outcomes. Because it can be more informative of managers’ actions than share prices, financial reporting information is often used in executive compensation arrangements in an attempt to align the interests of shareholders and managers. However, these arrangements may threaten the neutrality of financial reporting information because those responsible for preparing the information are being rewarded on the basis of what they report. Managers therefore have incentives to produce information that serves their interests rather than faithfully informs investors about the firm’s financial position and performance. In short, prior literature indicates that a stewardship objective prioritises financial reporting data that are informative about managerial performance and requires more verifiable information with enhanced credibility from independent certification by auditors. What remains unclear, however, is the extent to which the use of financial reporting information for incentivising management affects assessments of its decision usefulness, particularly its representational faithfulness.

Prior research comparing stewardship and valuation objectives often assumes that financial reporting systems are only capable of producing one ‘signal’ to investors. This is unrealistic because investors are presented with multiple measures of financial performance and financial position in the various financial statements companies prepare. The current mixed measurement model for financial reporting produces information across (and within) different financial statements with different properties (such as the level of managerial judgement involved and the degree of verifiability). Furthermore, an assessment of the decision usefulness of financial reporting for different objectives needs to recognise that investors have a range of information sources at their disposal, both within and outside the financial reporting system.

 

The literature also indicates that companies’ corporate governance mechanisms can strongly influence the properties of financial reporting information. Mechanisms such as the external audit and having an independent board of directors have evolved over time to complement (and/or substitute for) financial reporting information. Hence, even where compensation arrangements may lead to incentives to produce financial reporting information that is not faithfully representative, professional investors may assess preparers’ corporate governance characteristics to be sufficiently robust to guard against biased reporting.

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