Module 1

Role of Financial Reporting in Capital

Market

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 What is Financial Reporting?

Financial Reporting involves the disclosure of financial information to the various

stakeholders about the financial performance and financial position of the
organization over a specified period of time.

These stakeholders include –

Investors,
Creditors,
Government and Government agencies
Suppliers
Customers
Employees
Management
Independent Auditor

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 Objective of Financial Reporting

According to International Accounting Standard Board (IASB), the objective of financial

reporting is “to provide information about the financial position, performance and changes
in financial position of an enterprise that is useful to a wide range of users in making
economic decisions.”
The following points sum up the objectives & purposes of financial reporting –

• Providing information to management of an organization which is used for the purpose

of planning, analysis, benchmarking and decision making.
• Providing information to investors, promoters, debt provider and creditors which is used
to enable them to male rational and prudent decisions regarding investment, credit etc.
• Providing information to shareholders & public at large in case of listed companies about
various aspects of an organization.
• Providing information to various stakeholders regarding performance management of an
organization as to how diligently & ethically they are discharging their fiduciary duties &
responsibilities.
• Providing information to the statutory auditors which in turn facilitates audit.

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 Components of Financial Reporting

Financial Reporting is usually considered as end product of Accounting.

Financial reporting is essentially a way of following standard practices to give the world
an accurate depiction of a company’s finances, including their:
• Revenues
• Expenses
• Profits
• Capital
• Cashflow
All of these financial KPIs are important, because they show the “health” of a company –
at least when it comes to money.

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 Components of Financial Reporting Cont..

The typical components of financial reporting are:

• The financial statements – Balance Sheet, Profit & loss account, Cash flow
statement& Statement of changes in stock holder’s equity
• The notes to financial statements
• Quarterly & Annual reports (in case of listed companies)
• Prospectus (In case of companies going for IPOs)
• Management Discussion & Analysis (In case of public companies)

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 Importance of Financial Reporting

The importance of financial reporting cannot be over emphasized. It is required by

each and every stakeholder for multiple reasons & purposes. The following points
highlights why financial reporting framework is important –

• To comply with Regulatory requirements.

• It facilitates statutory audit.

• It helps in financial planning, analysis, bench marking and decision making.

• To raise capital

• To meet the tax compliances

• Performance indicator of the organization as well as of its management.

• To facilitate the purpose of bidding, labor contract, government supplies etc.,

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 Importance of Financial Reporting

Financial statement analysis is a valuable activity when managers have

complete information on a firm’s strategies and more importantly, the
managers like the information reflected in the financial statement. In reality,
this is not often true. It enables the outside analysts create ‘inside
information’ from analyzing financial statement and thereby gaining valuable
insights about current performance and future prospects of the firm.

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 The role of financial reporting in capital markets

Savings

Net Savers
Financial Information
Intermediaries Intermediaries

Business
Ideas
Net Borrowers

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 The role of financial reporting in capital markets

What is the problem?

Matching savings to business ideas is complicated..
Entrepreneurs have better information
Entrepreneurs lack credibility because they have the incentives to be over
optimistic

These two reasons result in a classic “lemons” problem,* e.g., bad ideas “crowd out”
good ideas and investors lose confidence in this market. Suppose, initially there are
50% good firms and 50% bad firms. Both the types claim high prospect for the next
year. Investors fail to distinguish the two types and give them average credibility. For
example, 50% credibility turns up correct because 50% told lies. This demotivates the
good firms and they quit the market. The market now becomes full of ‘bad firms’. In
turn, among the bad firms, relatively good ones lose credibility because of bad firms,
and quit the market. At the end, it turns up that firms do not deserve perfect
credibility, that essentially leads to market break-down.

* “The market for Lemons: Quality Uncertainty and the market mechanism” is a well-known 1970 paper
by economist George Akerlof.

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 The role of financial reporting in capital markets

Objectives of Lemon law:

• Explain what adverse selection and moral hazards are.

• Provide examples of real-world markets affected by incomplete information

• Set up and solve models of decision-making in the presence of incomplete

information.

• Predict the effects of policies to address incomplete information on market

outcomes.

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 The role of financial reporting in capital markets

Types of Information Asymmetries

Hidden Information Problem : One side of the market cannot observe the
quality of the good being bought or sold in the market.

Hidden Action Problem : One side of the market cannot observe the
actions of the other side of the market.

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 The role of financial reporting in capital markets

Hidden Information Problem - Adverse Selection

Adverse selection occurs when, as a result of the hidden information problem, the only
products available on the market are low quality products.

Example:

Insurance Markets: If only people who engage in risky behavior buy insurance, there is
an adverse selection problem.

Labor Market: If the only workers available do not have the skills for the jobs available,
there is an adverse selection problem.

Stock Market: If the only stocks available in the market are of low quality, there is a
adverse selection problem.

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 The role of financial reporting in capital markets

Solution to Adverse Selection:

1. Mandate purchase or mandatory disclosure: In most US states, drivers are

required to provide proof of automobile insurance in order to register their
vehicle.
2. Signaling: a way to indicate that your product is high quality.
Example: Owners of high quality cars purchase warranties.
Mandatory auditing of the financial statement, ratings
given by rating agencies.

As long as the cost of warranty is such that owners of high quality cars will buy
it, but owners of low quality cars won’t, the signal will effective at solving the
hidden information problem. It is called as separating equilibrium.

If the cost of the warranty is such that owners of all cars buy it, the signal will
be ineffective at solving the hidden information problem. It is called as pooling
equilibrium.
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 The role of financial reporting in capital markets

Hidden Action Problem

Principal-Agent Problem:

Principal = owner(s) of a company (stockholders)

Agent = manager of day-to-day operations of the company

Principal’s goal is to incentivize the agent to work in such a way that the company’s
profits are maximized.

Problem: The principal cannot observe the agent’s effort, only the results (output or
profit) of the effort.

Sometimes, profits or output will be high, even if the agent’s effort is low.

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 The role of financial reporting in capital markets

Principal-Agent Problem:

Moral Hazards: Moral hazard results when, as a result of the hidden action problem, the
agent engages in behavior that is damaging to the principal.

Examples: Drivers engage in more risky driving practices because they are insured.

Employees of investment firms make trades that ultimately, cause financial damage to the
firm. (PNB fraud case)

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 The role of financial reporting in capital markets

Solution to Moral Hazards

1. Incentive Compatible Payment Scheme

If the principal can design a way to reward the agent that incentivizes the agent to engage
in the type of behavior that the principal desires, we say that the reward system is
Incentive Compatible.

2. Monitoring

Mutual monitoring, in which member of a group monitor each other’s performance, is

often used in microfinance to ensure loan repayment.

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 The role of financial reporting in capital markets

Intermediaries can prevent the market breakdown which resulted from the lemons
problem since they provide independent certification.

Intermediaries can be:

 Financial Intermediaries: Venture capital firms, investment banks, merchant banks,
banks, mutual funds, and insurance companies. These institutions rely on information
of financial statements and supplement this with other sources of information to
analyze investment opportunities.

 Information Intermediaries: Auditors, financial analysts, bond rating agencies and

financial press. These firms add value by enhancing the credibility of financial reports
(as audit firms do) and by analyzing the information in the financial statements (as
analysts do).

Both types add value by distinguishing bad ideas from good ones

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Intermediaries in the Market
 Intermediaries in the Market

Meaning of Intermediaries

• Firm or person (such as broker or consultant) who acts as a mediator on a link

between parties to a business deal, investment decision, negotiation etc. In money
markets, for example, banks act as intermediaries between depositors seeking
interest income and borrowers seeking debt capital.

• Intermediaries usually specialize in specific areas and serve as a conduit for market
and other types of information.

• Intermediaries are service providers in the market including stock brokers, sub-
brokers, financiers, merchant bankers, underwriters, depository participants ,
registrar and transfer agents, FII/sub accounts, mutual funds, venture capital funds,
portfolio managers, custodians etc.
Intermediaries in the Market
 Intermediaries in the Market

Stock Brokers : A stockbroker is a regulated professional individual, usually associated with

a brokerage firm or broker-dealer, who buys and sells stocks and other securities for both
retail and institutional clients, through a stock exchange or over the counter in return for a
fee or commission. Such as initiate the process of block deal and bulk deal.

Financiers : is a person or a business entity who makes their money from investments,
typically involving large sums of money and usually involving private equity and venture
capital, leveraged buyouts, corporate finance, investment banking and/or large scale asset
management.

Merchant bank: A merchant banker usually refers to a firm or organization involved in all
aspects of issue management. Their services include providing consultancy or advisory
services to corporates for issue management, making arrangements for buying, selling or
subscribing to shares in an issue or any other consultancy or services such as underwriting,
analysis and advice related to mergers and acquisitions, arranging offshore funding or
venture capital, credit syndication and portfolio management.
Example: SBI capital markets Ltd., PNB, BOM, ICICI securities Ltd., Axis Bank Ltd.
 Intermediaries in the Market
Underwriting: Underwriting is a guarantee given by the underwriters to take up whole
or part of the issue of securities not subscribed by the public. The two most common
types of underwriting are bought deals and best effort deals.

Depository participant: A depository is an organisation which holds securities (like

shares ,debentures, bonds, government securities, mutual fund units etc.) of investors
in electronic form at the request of the investors through a registered depository
participant. It also provides services related to transaction in securities.
Example: NSDL, CDSL

Registrar and Transfer Agent (RTA): An RTA is an agent of the issuer. RTA acts as an
intermediary between the issuer and depository for providing services such as
dematerialization, rematerializationn, IPO and corporate actions.

Mutual Funds: A mutual fund is a type of professionally managed collective investment

scheme that pools money from many investors to purchase securities.

Venture Capital : VC is financial capital provided to early-stage, high-potential, high risk,

growth start-up companies. The VC fund makes money by owning equity in the
companies it invests in. Venture capital is a subset of private equity. Therefore, all VC is
private equity, but not all private equity is venture capital.
 Intermediaries in the Market

Portfolio Manager: Is either a person who makes investment decisions using money
other people have placed under his or her control or a person who manages a
financial institution’s asset and liability (loan and deposit) portfolios. On the
investment side, they work with a team of analysts and researchers and are
ultimately responsible for establishing an investment strategy.

(Discussion in class: Role of financial intermediaries in dot com bubble 2000

Role of financial intermediaries in sub-prime crisis 2008)
 From Business activities to financial statements

Business Environment Business Strategy

Labor markets Scope of business:
Capital Markets Degree of diversification
Business Activities
Product Markets:
Operating Types of diversification
Suppliers Investing Competitive positioning:
Customers Financing
Cost leadership
Competitors
Product Differentiation
Business regulations
Accounting system Key success factors and
risks
Measures and reports
Accounting economic consequences of
environment business activities
Capital market structure Accounting strategy
Contracting and governance Financial statements Choice of accounting policies
Accounting conventions and Managers’ superior information Choice of accounting
regulations on business activities estimates
Tax and financial accounting Estimation errors Choice of reporting formats
Third-party auditing Distortion from managers’ Choice of supplementary
accounting choices disclosures
Legal system for accounting
disputes
 From Business activities to financial statements

A firm’s business activities are influenced by its business or

economic environment and its own business strategy
The business or economic environment includes the firm’s
industry, its input and output markets, and regulations.
 Business strategy determines how the firm positions itself in
its environment to achieve competitive advantage.
The firm’s accounting system provides a mechanism through
which business activities are selected, measured, and aggregated
into financial statement data. Thus, in its turn depends on
accounting environment and accounting strategy.
 From Business activities to financial statements

A firm’s financial statements summarize the economic

consequence of its business activities. However, the firm
cannot report everything either because they are too
numerous or because they fear losing competitive
advantage.
 Thus Financial Statement data are influenced by both the
firm’s business activities and by its accounting system.
Understanding the Accounting system is therefore very
important!
 A Critical Approach to
Institutional Features of Accounting System

Accounting System (AS) Feature 1: Accrual system

• Accrual system against cash based one
• Investors’ preference for calendar based performance
against function based one

Accounting System (AS) Feature 2 (a): Delegation to

corporate management
• Regarding future consequence of current activities
(expected realization of credit sales). This might be
realistic (benefit) or fabricated (cost)

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 A Critical Approach to
Institutional Features of Accounting System (Contd)

AS Feature 2 (b): Conservatism and Uniform accounting

standard
• Accounting standard limits the freedom of
management by cost and conservatism principle
• Accounting standards ( GAAPs like FASB, IAS, BAS for
example) limit the freedom through uniform
accounting standard for different organizations.
AS Feature 2 (c): Role of auditing and law
• External auditing may curtail the freedom
• Legal environment may curtail the freedom

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 A Critical Approach to
Institutional Features of Accounting System (Cont)

AS Feature 3: Managers’ reporting strategy

• The strategy may be to make either more or less difficult for
external users
• Makes voluntary disclosure when accounting regulation
restricts certain disclosure
• Competitive dynamic might hinder superior disclosure
• Optimistic assessment of performances or hiding the
weakness of the firm may be necessary to influence
investors’ perceptions.
• Information content of Financial Statements about the
business varies across firms and time, which provides for
both opportunity and challenge in business analysis.

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 Business Analysis using Financial Statements
Financial Statements Business Application context

Influenced by managers’ superior information on Credit analysis, Securities

business activities, noise from estimating errors, and analysis, Merger & Acquisition
Distortions from managers’ accounting choices analysis, Debt/Dividend
analysis, Corporate
Other Public Data communication strategy
Like Industry and Firm data outside Financial analysis, and General business
Statements analysis

ANALYSIS TOOLS
Business Strategy Analysis
Accounting Generate performance expectations
Analysis through industry analysis and Prospective
Evaluate accounting competitive strategy analysis Analysis
quality by assessing Financial Analysis Make forecasts and
accounting policies value business
and estimates Evaluate performance using
ratios and cash flow analysis
 Steps of Business Analysis
 Step 1: Business Strategy Analysis
 Identifies the key profit drivers and business risks, and makes an
Assessment of profit potentials at a qualitative level
 Industry analysis to evaluate the sustainability of competitive advantage
 Step 2: Accounting Analysis
 Evaluates the degree to which a firm’s accounting captures the underlying
business reality
 Identifies the sources of distortion in accounting data, and makes a
revision
 Step 3: Financial Analysis
 Systematic and efficient analysis of sustainability of current performances
by using financial data
 Ratio analysis makes time series and cross section study, and Cash flow
analysis evaluates the cash management and liquidity
 Step 4: Prospective Analysis:
 Synthesis of all 3 above to predict future