Disclosure innovations in financial reporting

Disclosure innovations in financial reporting – This is a note on the innovative history of Philips’ financial reporting, see the ‘Introduction to a history of innovation in financial reporting‘.

In the Netherlands formal legislation concerning financial reporting was introduced rather late in the early 1970s. The lack of formal legislation was a stimulants to applying innovative financial reporting disclosures, bluntly said ‘anything was possible’ there were no legal minimum levels.

This part is based on a research overview by Camfferman (1996) in his paper ‘Voluntary annual report disclosure by listed Dutch companies, 1945 – 1983’. Camfferman’s work identifies 9 disclosure items. The nine disclosure innovations are discussed in here.

(1) Disclosure of Sales Disclosure innovations in financial reporting

The movement towards disclosure of sales, or turnover, probably illustrated as well as any other change in disclosure the transition from earlier, more secretive, stages in the development of financial reporting to the present, relatively open practices. Sales are an elementary fact of business performance, as a result of which it has been a focal point in financial reporting early on.

On the other hand, disclosures of sales were relatively rare before the Second World War, because fear of competitors was widely perceived as a valid argument for not making this information public. In the later stages of financial reporting regulation, sales became required. Disclosure innovations in financial reporting

(2) Disclosure of comparative figures Disclosure innovations in financial reporting

The inclusion of comparative data increased the usefulness of financial reporting of enterprises significantly. Comparison of similar information about different companies and similar information of one and the same company is a powerful performance analysis tool. Disclosure innovations in financial reporting

Comparability between enterprises and consistency in the application of methods over time increases the informational value of comparisons of relative economic opportunities or performance. The significance of information, especially quantitative information depends to a great extent on the user’s ability to relate it to some benchmark.

(3) Consolidation into a Group Disclosure innovations in financial reporting

Disclosure innovations in financial reportingWhen a business acquires control over one or more others through the acquisition of a majority of the outstanding voting stock, stockholders of the acquiring company (the parent company) have an interest in the assets of combined parent / subsidiary entity.

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It is logical to presume that financial statements that combine the results of both parent company and subsidiary operations and financial position would be more meaningful1, at least to parent company stockholders, than presenting the separate financial statements of the parent company and each individual subsidiary company.

(4) Disclosure on segments Disclosure innovations in financial reporting

Due to the aggregate form of consolidated financial statements, it is difficult to find out how the various affiliates have performed. The problem is particularly serious when the group is diversified by product line and/or market. In this case, there is a greater likelihood that the aggregated results mask differences in performance within the group. Companies started to provide more clarity by disclosing segmental information.

Larger diversified companies provide a breakdown of sales and, less frequently in Europe, profit by both industry and geographical area. These disclosures helped to explain past changes in a firm’s aggregate sales and earnings and enhance possibilities for analysts to make more accurate forecasts of future performance.

At a certain moment in time, legislation stated that a firm must determine its ‘dominant source and nature’ of risks and returns. If the dominant source is its lines of business, then the primary segmental report should focus on business segment activities. If it is the geographical areas in which it produces or sells its products, then the important primary segment reporting should focus on geographical segment activities.

The lesser important segment could be the subject of a secondary report. Therefore, the reasoning was that the primary segmental report must contain more extensive segmental disclosures than the secondary report.

(5) Current cost accounting Disclosure innovations in financial reporting

The rationale behind replacement- or current2 costs is that management considers that the accounts provide more up-to-date and therefore more relevant information when assets are stated at current values.

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The impact of inflation on asset values is especially marked for assets with long or indefinite lives, such as buildings and land. Supporters of the current value methods argue that the income statement3 is more useful, too.

Under current value accounting, the current costs of inputs –and that includes depreciation- are matched against current revenues. Under historical cost accounting, the historical costs of inputs are matched against current revenues. The latter resulting in higher profits and as a result a higher risk to pay (too) high dividends, potentially hurting the long time financial survival of a business.

(6) Employee related disclosure Disclosure innovations in financial reporting

Considerable differences are observed between the disclosures of labor related costs and disclosure of the number of employees. Companies appeared more willing to disclose the number of employees than their aggregate remuneration, even though they show aspects of the same facet of the enterprise.

This is explained in literature as follows. Users of financial statements utilize employee data to calculate productivity ratios. They can make use of FTE’s to calculate sales per full time equivalent staff. A better ratio is added value per FTE, which controls for the fact that a company can save on its employee use and have a high turnover.

Related to employee numbers obviously is employee cost. High pay and benefits can more than offset high labor productivity. Thus investors and others monitor labor cost ratios as well as productivity ratios.

(7) Provision of funds statement Disclosure innovations in financial reporting

A major objective of accounting is to present data that allows investors and creditors to predict the amount of cash that will be distributed in the form of dividends and interest, and allow an evaluation of risk. The ability of an enterprise to generate cash from operations is an important indicator of its financial health and the degree of risk associated with investing in the firm (…) the past cash flows from a firm are one of the best available basis for forecasting future cash flows.

(8) Disclosure of Earning per Share (EPS) Disclosure innovations in financial reporting

EPS is an important statistic. It’s often cited in the annual report along with sales, operating profits and dividends. Some firms set a minimum annual percentage growth in EPS (= after-tax profit or loss in a period attributable to ordinary (common) shareholders / weighted average ordinary shares outstanding during period) as a financial target. Its influence is greater still because it is employed in other key ratios4.

Under deferred tax accounting, the company records the full income tax expense or benefit in each period of reporting now and in the future. This full income tax expense has two components:

  1. The income tax currently payable or refundable, known as current tax expense or benefit.
  2. The future tax impact of the current year’s accounting profit or loss, known as deferred tax expense or benefit.
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In the Netherlands, changes in tax structure caused deferred tax to occur. Before the Second World War, Dutch companies were not subject to a tax on income or profit. Income was subject to taxation only to the extent that it was distributed as dividends.

An important aspect of the switch from a tax charge on dividends to an tax charge on income was that, without further measures, retained earnings form before the new tax would escape taxation altogether.

This was prevented by the transformation of part of retained earnings from previous periods into a tax-free reserve on which the tax authorities retained a deferred claim.

Even if, in the future there would be no differences between taxable and reported income, this tax-free reserve confronted companies with the question of whether or not to recognize the deferred claim in their balance sheets (…). Hence in successive stages between 1940 and 1950, Dutch corporations were confronted with, and became more and more aware of, the increasingly complex issue of deferred taxation. The same changes in the tax law that gave rise to the issue of deferred taxation also gave rise to an increased importance of tax costs as a disclosure.

Disclosure innovations in financial reporting

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