**5. Communication in financial statements**

**4.2. Accounting statements**

124 Firm Value - Theory and Empirical Evidence

part of any organized businesses.

public accounting and public accountants.

**4.3. Auditing**

To be able to communicate with different information users about the affairs and business of the company, bookkeeping data need to be presented in a particular shape that is formatted like standard information. On the mathematical basis of bookkeeping, this standard information is provided in the form of accounting statements. The largest number of such statements should be prepared constantly to run all business operations. This makes public company managers on all executive levels who supervise operations, and employees who execute tasks, their basic users. Based on the mathematics principals, bookkeeping and accounting derivatives have become a standard business language for communication with business people, financial experts, and economists, in general. Therefore, accounting statements are an integral

Users of accounting information are the owners of the company, individuals, or a particular group of individuals. In the conditions of separation of entrepreneurial from ownership functions, especially in the conditions when the company becomes public, bookkeeping and the accounting statements based on it, become the basis of communication of public companies with a wide range of existing and potential owners. In this way, bookkeeping and accounting statements become an integral part of corporate management. Statements are subject to standardization and have a responsibility to the public; so, in a certain sense, one can talk about

Sole creation of accounting statements assumes one acquires the art of classifications and summary of bookkeeping data. This makes the data significant, relevant, and informative to the users enabling them to interpret it with a generally accepted business language [31]. The accounting statements which will communicate the bookkeeping information with the investor's public are those that summarize the entire business of the company: the balance sheet as well as the profit and loss statement. By expanding the requirements for communication and through modern systems of financial reporting, cash flow statements are becoming ever more common form of communication. These accounting statements are used to communicate with

Accounting statements are certainly an important part of corporate governance. They are the corner stone of public company communication with all stakeholders that have a direct interest in the company, as well as with potential stakeholders. This includes all those individuals and institutions who may find interest in that company through the mechanism of the financial markets. The corporate governance should focus on supporting to achieve the basic objectives of the company operations, which, for a public company is shown by increasing its common stock value in a long run. For corporate management, this is the most significant of those accounting statements, since through it they ensure continuous public company communication with its investor public over financial reporting mechanism. These are, therefore,

We mentioned earlier that public company communication with investors' public on financial markets is, among other things, a means of attracting money and capital. In other words,

the investor's public through ranked statements of changes in financial positions.

the balance sheet and profit and loss account, and cash flow statement.

Financial reporting is certainly one of the most important and the most intriguing area of finance standardization. For financial analysis, it is the basic analytical framework based on which it is possible to isolate and determine the underlying fundamental value factors of public companies and their stocks, as well as other instruments of financing. An important part of the financial reporting is the accounting of public companies. However, financial reporting as a whole goes beyond the scope of accounting. Financial supervision and various local practices significantly impact the content and the scope of financial reporting. As a means of communication with the investors, public company financial reporting is strongly influenced by the problem of agents in the conditions of asymmetry of information.

## **5.1. Contents of financial reporting**

Originally, financial reporting is a standard practice of public company communications with his investor's public. The existing and potential investors invest in stocks, bonds, and other financing instruments a public company offers to the entire public. These instruments are marketable financial assets and are classified, in general, as securities on an active market. They can be considered as consumer goods, i.e., financial assets intended for a wide circle of investors. In this way, the financial reporting becomes a standardized means of communicating the value of a public company and the values of its individual financing instruments, and therefore determines the contents of financial reporting.

**5.2. Accounting and financial reporting**

statements needed by the investor.

**5.3. Fair vs. historical value**

Accounting is inherent to all companies, small and big, private or state, public or private holding company. With all its flaws, accounting remains the best and therefore completely unavoidable part of the overall business statistics. Financial reporting is, on the other hand, different. Originally, it was intended only for the public companies which, in order to obtain the capital, have to communicate with investors. It is, therefore, inherent only to public company and basically unnecessary to all other forms of businesses. This does not mean that there is no need for data and information from other forms of businesses and privately owned companies. Without a doubt, there is a need to control the business and financial flows and to determine the proper tax base. Also, the law requires accounting in order to prevent fraud. Finally, it is an irreplaceable instrument of business people, managers, business and professional associations and chambers for account aggregation and mutual comparisons. In general, it is a necessary product of the existence of business statistics. Even though all these actions could be conducted using standard accounting, however it is rather illogical from the public reporting point of view. Specific reports and documents can be used for special purposes. For instance, tax reports are used to declare tax. During the investigation, the court will analyze various, if not all documentation coming from the company, and a statistician will do the same. All these data are given in a much less complicated form than the financial

Public Company Communications with Equity Investors and Firm Value

http://dx.doi.org/10.5772/intechopen.76171

127

Because of the aforementioned characteristics of accounting, primarily because it is the best approach to business statistics, but also because of its ability to document, and in turn track the sequence of individual operations, it is logical that it is the basis for the preparation of financial statements. Therefore, aggregate accounting statements are an integral part of the financial statements. In accordance with the documentary nature, and the objectivity of accounting at the time of a documented business event, these accounts should be formulated on the principle of a historical value. To ensure the financial statements are complete and exhaustive, it is necessary to include the most important risks involving future business events together with these data concerning past operations and financial position of the company. This is due to the fact that investors buy stocks and other instruments of financing of the company on the

Today's practice of financial reporting is strongly influenced by various interest groups and various entities of the financial markets. One of the most significant impacts on the practice of reporting arises from the regulatory bodies and financial supervision. No matter what the role of the market regulator in protecting investors is, the preservation of the stability of the financial system is often imposed as the first objective of regulation and financial supervision. Because of the control of financial institutions, their financial placements and investments, financial supervision has imposed the principle where statements of financial assets are derived at the current fair market prices. In order to maintain the consistency of the report,

Efforts on financial reporting standardization and harmonization aim to solve a series of controversy of the different basis and practice of reporting. This standardization solved the

this principle has spread on all real property sections of the financial statements.

basis of expected results, and not on the basis of the achieved results.

Financial reporting is exclusively inherent to public companies which, as a legal entity, function both as investors and investments. Stocks have a central place in this dual nature of public companies that have been created as marketable financial assets, and at the same time represent ideal claims to real assets, or to real investments of the public company in business projects. Stockholders can also have dual roles in the public company. They are also the owners of that company and its real assets, but at the same time, they are investors in the company stocks, and therefore, investors in financial assets [24]. Regardless of the stakeholder's role in the company, their goal is to achieve greater wealth and higher value by conducting financial analysis on underlying financial reporting.

The essence of finance is contained in evaluation and management of value. The value is perceived in the context of economic value which is the result of interdependence of risk and reward. In this way, the financial reporting content comes down to communicating with the investors not only about the expected earning power of the company and the expected yields on its stocks, but also about the risks of achieving the expected results. So that the expectations would not be built solely on promises, financial statements must contain data and information based on which the investors will be able to objectify the expected earning power and the expected stock yields of public companies. Therefore, financial reporting must contain information about the achieved business results of public companies and the risks to which it is exposed. Based on the achieved business results, investors will form expectations about the businesses ability to earn (reward), and according to the determined risk, they will establish appropriate cost of the capital, discount the expected results, and evaluate stocks, as well as other instruments of the public society.

A public company as well as other forms of business use debt to finance their operation. Money lender can also be treated as company investors. This is particularly true for large money lenders of public companies who monetize it by investing in bonds and other fixed income securities of these companies. When borrowing is observed through the scope of a public bond issue that will have an active market, lenders are no longer just the institutional lenders, such as commercial banks, but also the institutional investors, so that the contents of financial reporting must extend to the needs of such investors for the value evaluation and management. They are interested in the public company's business results, but much more in the risks involving their position in the unfortunate event of the company's fall before they return the borrowed money, because they do not have mechanisms to reduce asymmetries of information embedded in direct financial relationships between commercial banks and enterprises, as users of their loan [32].

#### **5.2. Accounting and financial reporting**

**5.1. Contents of financial reporting**

126 Firm Value - Theory and Empirical Evidence

therefore determines the contents of financial reporting.

analysis on underlying financial reporting.

other instruments of the public society.

enterprises, as users of their loan [32].

Originally, financial reporting is a standard practice of public company communications with his investor's public. The existing and potential investors invest in stocks, bonds, and other financing instruments a public company offers to the entire public. These instruments are marketable financial assets and are classified, in general, as securities on an active market. They can be considered as consumer goods, i.e., financial assets intended for a wide circle of investors. In this way, the financial reporting becomes a standardized means of communicating the value of a public company and the values of its individual financing instruments, and

Financial reporting is exclusively inherent to public companies which, as a legal entity, function both as investors and investments. Stocks have a central place in this dual nature of public companies that have been created as marketable financial assets, and at the same time represent ideal claims to real assets, or to real investments of the public company in business projects. Stockholders can also have dual roles in the public company. They are also the owners of that company and its real assets, but at the same time, they are investors in the company stocks, and therefore, investors in financial assets [24]. Regardless of the stakeholder's role in the company, their goal is to achieve greater wealth and higher value by conducting financial

The essence of finance is contained in evaluation and management of value. The value is perceived in the context of economic value which is the result of interdependence of risk and reward. In this way, the financial reporting content comes down to communicating with the investors not only about the expected earning power of the company and the expected yields on its stocks, but also about the risks of achieving the expected results. So that the expectations would not be built solely on promises, financial statements must contain data and information based on which the investors will be able to objectify the expected earning power and the expected stock yields of public companies. Therefore, financial reporting must contain information about the achieved business results of public companies and the risks to which it is exposed. Based on the achieved business results, investors will form expectations about the businesses ability to earn (reward), and according to the determined risk, they will establish appropriate cost of the capital, discount the expected results, and evaluate stocks, as well as

A public company as well as other forms of business use debt to finance their operation. Money lender can also be treated as company investors. This is particularly true for large money lenders of public companies who monetize it by investing in bonds and other fixed income securities of these companies. When borrowing is observed through the scope of a public bond issue that will have an active market, lenders are no longer just the institutional lenders, such as commercial banks, but also the institutional investors, so that the contents of financial reporting must extend to the needs of such investors for the value evaluation and management. They are interested in the public company's business results, but much more in the risks involving their position in the unfortunate event of the company's fall before they return the borrowed money, because they do not have mechanisms to reduce asymmetries of information embedded in direct financial relationships between commercial banks and Accounting is inherent to all companies, small and big, private or state, public or private holding company. With all its flaws, accounting remains the best and therefore completely unavoidable part of the overall business statistics. Financial reporting is, on the other hand, different. Originally, it was intended only for the public companies which, in order to obtain the capital, have to communicate with investors. It is, therefore, inherent only to public company and basically unnecessary to all other forms of businesses. This does not mean that there is no need for data and information from other forms of businesses and privately owned companies. Without a doubt, there is a need to control the business and financial flows and to determine the proper tax base. Also, the law requires accounting in order to prevent fraud. Finally, it is an irreplaceable instrument of business people, managers, business and professional associations and chambers for account aggregation and mutual comparisons. In general, it is a necessary product of the existence of business statistics. Even though all these actions could be conducted using standard accounting, however it is rather illogical from the public reporting point of view. Specific reports and documents can be used for special purposes. For instance, tax reports are used to declare tax. During the investigation, the court will analyze various, if not all documentation coming from the company, and a statistician will do the same. All these data are given in a much less complicated form than the financial statements needed by the investor.

Because of the aforementioned characteristics of accounting, primarily because it is the best approach to business statistics, but also because of its ability to document, and in turn track the sequence of individual operations, it is logical that it is the basis for the preparation of financial statements. Therefore, aggregate accounting statements are an integral part of the financial statements. In accordance with the documentary nature, and the objectivity of accounting at the time of a documented business event, these accounts should be formulated on the principle of a historical value. To ensure the financial statements are complete and exhaustive, it is necessary to include the most important risks involving future business events together with these data concerning past operations and financial position of the company. This is due to the fact that investors buy stocks and other instruments of financing of the company on the basis of expected results, and not on the basis of the achieved results.

Today's practice of financial reporting is strongly influenced by various interest groups and various entities of the financial markets. One of the most significant impacts on the practice of reporting arises from the regulatory bodies and financial supervision. No matter what the role of the market regulator in protecting investors is, the preservation of the stability of the financial system is often imposed as the first objective of regulation and financial supervision. Because of the control of financial institutions, their financial placements and investments, financial supervision has imposed the principle where statements of financial assets are derived at the current fair market prices. In order to maintain the consistency of the report, this principle has spread on all real property sections of the financial statements.

#### **5.3. Fair vs. historical value**

Efforts on financial reporting standardization and harmonization aim to solve a series of controversy of the different basis and practice of reporting. This standardization solved the dilemma of reporting on either cash or on the accrual basis in favor of the accrual approach. Even though this implied replacing the relatively straightforward approach with the complexities of the philosophy of the recurring profit measurement, this approach was almost unanimously decided between the creators of the standardization of the financial reporting, regulators and supervisors. In order to unify the profit reports, the community seeks to standardize certain methods of calculation, and since it is not possible to ascribe to any universal benefits in all possible circumstances, the application of different methods is allowed, which has to be clarified in the notes on financial statements.

on finding the fair market value come down to the problem of estimation. All estimates are subjective, and they are the targets. Because estimates are made by those who use the financial statements to attract the investors, it is clear that this presents a problem. Such a decision can make the presentation of the aggregate account the result of creative accounting

Public Company Communications with Equity Investors and Firm Value

http://dx.doi.org/10.5772/intechopen.76171

129

Previous discussion demonstrated that the market value of firm's assets is equal to the present value of free cash flows from firm's operation and market value of firm's financing instruments only in the conditions of perfect or extremely efficient capital market in equilibrium. Therefore, fair value concept is primarily oriented toward current market prices and it is straightforward to expect that the prices oscillate around real intrinsic value. In addition, fair value concept is targeted and burdened by subjectivity. Furthermore, accounting value of assets is focused on tangible assets rather than intangibles which are rarely the subject of bookkeeping evidence. There is no doubt that is necessary that the public company communicates information concerning intangibles with investor's public, [33, 34], but this communica-

Owners' equity can be recognized as a solution to the balance sheet equitation which makes it easy to observe the connection between the recorded and the market value of the stocks. Once the capital is acquired (paid-in capital), its recorded value of stocks increase as the earnings are retained. Earnings are retained so that the company can make profitable investments. This will increase the company's earnings directly from investment operation. Retaining these additional earnings will increase the value of stocks. Capital market is always observing the business operation and investments made by the company. As soon as the market recognizes a profitable investment, their present value will be incorporated in the stock price before it increases earnings from profitable effectuation of the investment. Due to the time it takes the investment firms to boost their recorded values, the values themselves will fall behind the market values so that they can serve as an indicator of the stock price, but at the same time,

Another problem of book value for evaluating stocks stems from the residual position of the owner equity in the balance sheet. Starting from the balance sheet equitation it is evident that the owner equity is a variable that depends on two factors: assets value and liabilities value. In this way, the value of the ownership equity depends on the mode in which the positions of assets and debts are evaluated in the balance sheet. In principle, there are two approaches to valuation of the position in the balance: on the concept of historical cost and on the concept of fair value. Today's balance sheet shall be drawn up according to a model that combines these

• On one hand, evaluation on historical cost will fall behind the fair value, especially for assets that are present longer in the company operations, because its recorded value is burdened with the passed time and the corrections that only coincidentally match the loss

two approaches. This has a dual effect on the value of the ownership equity.

of economic value due to the expiration of the asset lifetime.

manipulation.

**5.4. Disadvantages of fair value**

tion is different from financial reporting.

cannot reflect their fair value.

Contemporary circumstance replaced a previous dilemma with the dilemma between the historical and fair price, at which the items will be evaluated in the financial statements. In practice, however, the applications of the combination of these two fundamental approaches to evaluation, as well as frequent changes to financial reporting standards are present. In this sense, one can conclude that in modern conditions, high complexity and variability of regulatory financial reporting basics are present [23]. This practice, of course, implies the need for a trained eye to interpret the presented information of a public company's business operations and other fundamental factors of stock and other financing instruments value.

Traditionally, accounting has been using historical prices to evaluate all items. They were the basis for accounting statements which, together with bookkeeping, enable one to more easily control and revise the financial transactions due to objectivity. Each of these reports reflects the realized prices and values at the time of a transaction and could be verified through a document under which it entered in the bookkeeping evidence. This characteristic of accounting is the key quality that ensured that it is so often used to indicate the status of a business, and the financial health of the company [29]. The problems of the complexity in the philosophy of profit stem from the accounting's orientation to the accrued basis.

Historical price can become questionable the more its booked positions are longer present in the evidence. For non-financial companies this will be reflected on the value of the fixed asset, although these values can be further provoked with the mechanism of calculating accounting depreciation. Financial companies use much more marketable assets whose prices change frequently in the financial markets. It is particularly emphasized at the open-and investment funds, for which the custody bank must daily establish the net asset value (NAV) at which the fund should redeem units from its members. Because the supervision focuses on financial relations and financial institution's supervision, as an active participant in the standardization of financial reporting, it is imposing a fair value for the valuation of items in these reports. This way, the financial statements incorporated additional subjectivity and other problems related to the evaluation.

In principle, there is nothing wrong with the commitment on a fair market value as the basis of valuation of items in the financial statements. The fair market value must include the risks on holding and managing the public company assets, as well as how they are perceived by the investors in the market. This then means that it is enough to present the balance sheet and profit and loss account, as well as complementary aggregate statement on the principle of the fair market value. The problem arises when one needs to determine the fair market value. There is nothing absolute in it, so it is not objective, which makes the assessment based on finding the fair market value come down to the problem of estimation. All estimates are subjective, and they are the targets. Because estimates are made by those who use the financial statements to attract the investors, it is clear that this presents a problem. Such a decision can make the presentation of the aggregate account the result of creative accounting manipulation.

### **5.4. Disadvantages of fair value**

dilemma of reporting on either cash or on the accrual basis in favor of the accrual approach. Even though this implied replacing the relatively straightforward approach with the complexities of the philosophy of the recurring profit measurement, this approach was almost unanimously decided between the creators of the standardization of the financial reporting, regulators and supervisors. In order to unify the profit reports, the community seeks to standardize certain methods of calculation, and since it is not possible to ascribe to any universal benefits in all possible circumstances, the application of different methods is allowed, which

Contemporary circumstance replaced a previous dilemma with the dilemma between the historical and fair price, at which the items will be evaluated in the financial statements. In practice, however, the applications of the combination of these two fundamental approaches to evaluation, as well as frequent changes to financial reporting standards are present. In this sense, one can conclude that in modern conditions, high complexity and variability of regulatory financial reporting basics are present [23]. This practice, of course, implies the need for a trained eye to interpret the presented information of a public company's business operations

Traditionally, accounting has been using historical prices to evaluate all items. They were the basis for accounting statements which, together with bookkeeping, enable one to more easily control and revise the financial transactions due to objectivity. Each of these reports reflects the realized prices and values at the time of a transaction and could be verified through a document under which it entered in the bookkeeping evidence. This characteristic of accounting is the key quality that ensured that it is so often used to indicate the status of a business, and the financial health of the company [29]. The problems of the complexity in the philosophy of

Historical price can become questionable the more its booked positions are longer present in the evidence. For non-financial companies this will be reflected on the value of the fixed asset, although these values can be further provoked with the mechanism of calculating accounting depreciation. Financial companies use much more marketable assets whose prices change frequently in the financial markets. It is particularly emphasized at the open-and investment funds, for which the custody bank must daily establish the net asset value (NAV) at which the fund should redeem units from its members. Because the supervision focuses on financial relations and financial institution's supervision, as an active participant in the standardization of financial reporting, it is imposing a fair value for the valuation of items in these reports. This way, the financial statements incorporated additional subjectivity and other problems

In principle, there is nothing wrong with the commitment on a fair market value as the basis of valuation of items in the financial statements. The fair market value must include the risks on holding and managing the public company assets, as well as how they are perceived by the investors in the market. This then means that it is enough to present the balance sheet and profit and loss account, as well as complementary aggregate statement on the principle of the fair market value. The problem arises when one needs to determine the fair market value. There is nothing absolute in it, so it is not objective, which makes the assessment based

and other fundamental factors of stock and other financing instruments value.

profit stem from the accounting's orientation to the accrued basis.

related to the evaluation.

has to be clarified in the notes on financial statements.

128 Firm Value - Theory and Empirical Evidence

Previous discussion demonstrated that the market value of firm's assets is equal to the present value of free cash flows from firm's operation and market value of firm's financing instruments only in the conditions of perfect or extremely efficient capital market in equilibrium. Therefore, fair value concept is primarily oriented toward current market prices and it is straightforward to expect that the prices oscillate around real intrinsic value. In addition, fair value concept is targeted and burdened by subjectivity. Furthermore, accounting value of assets is focused on tangible assets rather than intangibles which are rarely the subject of bookkeeping evidence. There is no doubt that is necessary that the public company communicates information concerning intangibles with investor's public, [33, 34], but this communication is different from financial reporting.

Owners' equity can be recognized as a solution to the balance sheet equitation which makes it easy to observe the connection between the recorded and the market value of the stocks. Once the capital is acquired (paid-in capital), its recorded value of stocks increase as the earnings are retained. Earnings are retained so that the company can make profitable investments. This will increase the company's earnings directly from investment operation. Retaining these additional earnings will increase the value of stocks. Capital market is always observing the business operation and investments made by the company. As soon as the market recognizes a profitable investment, their present value will be incorporated in the stock price before it increases earnings from profitable effectuation of the investment. Due to the time it takes the investment firms to boost their recorded values, the values themselves will fall behind the market values so that they can serve as an indicator of the stock price, but at the same time, cannot reflect their fair value.

Another problem of book value for evaluating stocks stems from the residual position of the owner equity in the balance sheet. Starting from the balance sheet equitation it is evident that the owner equity is a variable that depends on two factors: assets value and liabilities value. In this way, the value of the ownership equity depends on the mode in which the positions of assets and debts are evaluated in the balance sheet. In principle, there are two approaches to valuation of the position in the balance: on the concept of historical cost and on the concept of fair value. Today's balance sheet shall be drawn up according to a model that combines these two approaches. This has a dual effect on the value of the ownership equity.

• On one hand, evaluation on historical cost will fall behind the fair value, especially for assets that are present longer in the company operations, because its recorded value is burdened with the passed time and the corrections that only coincidentally match the loss of economic value due to the expiration of the asset lifetime.

• On the other hand, fair value contains subjectivity in its estimate, because most often there is no possibility to objectively estimate fair market value. Moreover, this estimate is burdened with the subjective views of the reporting manager, Chief Executive Director who represents the company, and the executive management. For them, financial statements are the means for attracting investors as suppliers of capital, so it is logical that the presented statements suffer, in some extent, from creative accounting.

Financial statements are the means of communication with the public company's investor's public. They are also the means of attracting investors, and serve as a sort of advertising material which the company gradually creates for its capital "suppliers." Certainly, the power of this promotive sheet stems from the creation of the economically eligible earnings through an extended period of time. Also the creation of economically eligible earnings is a prerequisite for preserving the independence of the company, and the defense against hostile takeovers. One could compare the company's financial statements with a person's CV. In the curriculum vitae, as well as in the financial statements, individuals will strive to present the facts in a way

Public Company Communications with Equity Investors and Firm Value

http://dx.doi.org/10.5772/intechopen.76171

131

No doubt that the financial reporting standardization and harmonization increase the quality of financial reporting worldwide. It is to be expected that this practice decreases the level of earnings management. Many countries with different tradition of financial reporting and investor's protection practice adopted International Financial Reporting Standards (IFRS). However, earnings management practices tend to be distinct for each country [39]. Furthermore, the application of IFRS does not guarantee the elimination of earnings management. IFRS ever more applies fair market value principles for judging aggregate accounts in financial statements which extend the subjectivity and target estimations. However, it is pos-

All estimates of the market value have a subjective nature. When they are performed for public presentation, these estimates are also targeted. The fear of loss of capital suppliers, or the fear of falling stock prices caused by dissatisfied stockholders and which might attract hostile actions toward the company management, are the reasons enough for the management to reach for little creativity in its estimates. Even more logical is that the person who wants to paint a good picture of him or herself to the public, sees himself in a fairer light, rather than see through the eyes of independent objective observer. Does it not seem illogical that the investors, who should create their estimates on the basis of published reports, receive esti-

Earnings management is partly limited with the necessity for financial statements auditing which reinforces their legitimacy. Auditing is a strong tool for agency cost reduction. However, auditing has its limitations as well. Partly these limitations come from difficulties in the possibility of eliminating the subjectivity from the estimated financial statement items. The second limitation is related to the fact that an audit is performed for the needs of shareholders and the investor's public in order to objectify published data in the financial statements. The fact is, however, that the auditors are hired and paid by the company's management board,

The practice of targeted evaluation regarding the prices manipulation and fraud related to financial reporting is more intense in conditions of the overheated financial markets, when things are going well and control mechanisms are relaxed, rather than after the fall, when all the market participants "are cold" and scarred. Therefore, the history of the financial markets can be observed through various forms of manipulation and fraud, and the efforts in regulations to minimize or even avoid them completely. The results of regulatory efforts are additional creativity, new procedures, and methods of manipulation and fraud. More significant cuts and changes to the regulations are performed normally after the collapse, as was the case

which helps them accomplish the expected results.

sible to achieve the same effect through historical price estimates.

mates from those who seek money from these investors?

which the audit should control.

Apart from the fact that the book value will lag behind the market value, it may not reflect other market views according to the unique property which the analyzed company utilizes in its operations [14]. Book value also does not reflect the views of the unique and total earning power of the company or the earning power of specific segments of the overall operations of the company. Throughout the history of the capital market, it has been proven time and time again that the market favors activity from which it expects rapid growth and the benefits of using new technologies. Here we indicate only some of the problems that impair the ability to use the book value as a substitute for the fair market value of the stocks:


#### **5.5. Earnings management**

Earnings management, creative accounting, or window dressing are euphemisms that talk about using the allowed methods and procedures of financial reporting, which certainly do not reflect the spirit of fair reporting. Earnings management aims to paint a more favorable (or unfavorable) image of a company in the presented financial reports. Even though it is not illegal, earnings management is highly nonethical, especially when it is made to create the greater basis for management compensations.

Financial statements are the means of communication with the public company's investor's public. They are also the means of attracting investors, and serve as a sort of advertising material which the company gradually creates for its capital "suppliers." Certainly, the power of this promotive sheet stems from the creation of the economically eligible earnings through an extended period of time. Also the creation of economically eligible earnings is a prerequisite for preserving the independence of the company, and the defense against hostile takeovers. One could compare the company's financial statements with a person's CV. In the curriculum vitae, as well as in the financial statements, individuals will strive to present the facts in a way which helps them accomplish the expected results.

• On the other hand, fair value contains subjectivity in its estimate, because most often there is no possibility to objectively estimate fair market value. Moreover, this estimate is burdened with the subjective views of the reporting manager, Chief Executive Director who represents the company, and the executive management. For them, financial statements are the means for attracting investors as suppliers of capital, so it is logical that the presented

Apart from the fact that the book value will lag behind the market value, it may not reflect other market views according to the unique property which the analyzed company utilizes in its operations [14]. Book value also does not reflect the views of the unique and total earning power of the company or the earning power of specific segments of the overall operations of the company. Throughout the history of the capital market, it has been proven time and time again that the market favors activity from which it expects rapid growth and the benefits of using new technologies. Here we indicate only some of the problems that impair the ability to

• Failed company. Over-indebtedness of the company which has not filed bankruptcy because its debts are not yet due can have an added value with respect to the recorded value. This is due to the effects of agents making high-risk investments, or the distribution of earnings to the owners, etc. It is about taking full advantage of the optional value of unlimited liability as a put option on the value of the property contained in the equity of the

• Positive assessment of efforts in R&D from the market. Although it is difficult to recognize the true net present value of an investment in the research and development, market can pay a premium on option for a company which is assessed as innovative in a particular industry expecting positive cash flows from exploitation of the results of R&D in the future,

• Positive assessment of the company's additional future investment opportunities due to the undertaken investment in technology changes, production processes, the introduction

• Market assessment of the impact of acquired subventions or guarantees from the State or

• Market assessments of several externality effects as well as externalities which occur be-

Earnings management, creative accounting, or window dressing are euphemisms that talk about using the allowed methods and procedures of financial reporting, which certainly do not reflect the spirit of fair reporting. Earnings management aims to paint a more favorable (or unfavorable) image of a company in the presented financial reports. Even though it is not illegal, earnings management is highly nonethical, especially when it is made to create the

or the added value of patents and licenses resulting from this research [36].

of new products, and the entry into new markets [37].

tween the company and its investment opportunities, etc.

statements suffer, in some extent, from creative accounting.

use the book value as a substitute for the fair market value of the stocks:

indebted enterprises [35].

130 Firm Value - Theory and Empirical Evidence

local community [38].

**5.5. Earnings management**

greater basis for management compensations.

No doubt that the financial reporting standardization and harmonization increase the quality of financial reporting worldwide. It is to be expected that this practice decreases the level of earnings management. Many countries with different tradition of financial reporting and investor's protection practice adopted International Financial Reporting Standards (IFRS). However, earnings management practices tend to be distinct for each country [39]. Furthermore, the application of IFRS does not guarantee the elimination of earnings management. IFRS ever more applies fair market value principles for judging aggregate accounts in financial statements which extend the subjectivity and target estimations. However, it is possible to achieve the same effect through historical price estimates.

All estimates of the market value have a subjective nature. When they are performed for public presentation, these estimates are also targeted. The fear of loss of capital suppliers, or the fear of falling stock prices caused by dissatisfied stockholders and which might attract hostile actions toward the company management, are the reasons enough for the management to reach for little creativity in its estimates. Even more logical is that the person who wants to paint a good picture of him or herself to the public, sees himself in a fairer light, rather than see through the eyes of independent objective observer. Does it not seem illogical that the investors, who should create their estimates on the basis of published reports, receive estimates from those who seek money from these investors?

Earnings management is partly limited with the necessity for financial statements auditing which reinforces their legitimacy. Auditing is a strong tool for agency cost reduction. However, auditing has its limitations as well. Partly these limitations come from difficulties in the possibility of eliminating the subjectivity from the estimated financial statement items. The second limitation is related to the fact that an audit is performed for the needs of shareholders and the investor's public in order to objectify published data in the financial statements. The fact is, however, that the auditors are hired and paid by the company's management board, which the audit should control.

The practice of targeted evaluation regarding the prices manipulation and fraud related to financial reporting is more intense in conditions of the overheated financial markets, when things are going well and control mechanisms are relaxed, rather than after the fall, when all the market participants "are cold" and scarred. Therefore, the history of the financial markets can be observed through various forms of manipulation and fraud, and the efforts in regulations to minimize or even avoid them completely. The results of regulatory efforts are additional creativity, new procedures, and methods of manipulation and fraud. More significant cuts and changes to the regulations are performed normally after the collapse, as was the case with millennial collapse and the efforts of regulatory bodies and States to rectify the situation for the future. Of course, such a regulation causes additional costs of corporate governance for public companies. It has, of course, happened and with the already mentioned SOX [40–42].

managers have the possibility to reinforce yield on options in short term due to asymmetries of information. In addition, dividend payments vs. retention of earnings in the public company represent means of reducing the problem of agents and the potential costs of the agents. That being said, the payout of the bonus becomes direct cost of agents, which does not make

Public Company Communications with Equity Investors and Firm Value

http://dx.doi.org/10.5772/intechopen.76171

133

Financial statements are determined as accounting reports on realized earnings power and financial potential. Based on them, one can make judgments about the expected earning power, as well as about the presentation of the risks associated with them. Financial statements presented on the fair market value basis implicitly include risks, but they do not elimi-

Risk is implicitly included in fair market value, because market prices oscillate around assets' intrinsic value, and that is established as present values of expected cash flows discounted by risk-adjusted discount rate. However, this does not mean it satisfies the needs of reporting

First, the fair market value can be determined relatively easily for a very small number of company assets, and it is possible to provoke if so the determined values are truly fair. This means that for the majority of assets, it is all about the estimated value instead of the fair market value. Furthermore, it is a subjective assessment made by the company's management as an agent of stockholders and future company equity suppliers Rational investors with risk aversion could not make unbiased decisions based on that information, regardless of what

Second, due to the assessment subjectivity and its burdens of potential conflict of interests between management and stockholders, such assessments are targeted and subjected to manipulation significantly more than this was thought possible based on historic values. These extremely biased information that are based on management's estimates, should serve

Third, only on the perfect market is the value of the company assets equal to the value of its liabilities and equity, and these assets are valued fairly only in conditions of the market equilibrium. Presentation of the assets' fair market value in financial reports does not include a majority of intangibility. It is presented as the sum of the estimated value of the individual, mostly tangible, assets, rather than its value as a whole. Namely, the company's earning power depends not only on the assets which it holds, but also on how those assets are used. The ability to use assets could be judged by observing how it is used in business projects. This means that the earning power is committed by the company's business portfolio, so the value of the business portfolio should match the value of the liabilities and equity, with included

sense from the standpoint of motivation and management monitoring.

about the risks of a company's earning power. It is just the opposite.

**6. Communication on risk**

nate the need for risk reporting.

**6.1. Risk contained in fair value**

behaviorists thought about them [45].

the investors for their assessment.

The practice of financial reporting is under the influence of financial supervision and obtains the stability of the financial system primarily oriented to the protection of creditors, not the investors and their need for fundamental analysis. The stand point of the possibilities of manipulation and the missing tools against them that have investors toward financial supervision and its direct control subjects, and the standpoint of the implementation of the fundamental analysis of the orientation toward the fair market value seem illogical. Presentation of the aggregate account with estimated entries on the undisputed documented historic value together with the practice of publication of the risk which is exposed to the operations of the public company seems more logical for the purposes of the valuation of the company as investments, or for the purposes of the valuation of its common stock. Starting from the previous practice, it is possible that the financial statements contain a set of aggregate accounts estimated at fair market value and documented historic value together with a report about the risks.

#### **5.6. Management compensation**

The practice of rewarding the management of companies on the basis of the achieved business results has additional forces to earnings management. In this way, the company managements are double motivated for publishing the good business results; once for securing capital provider and second time for personal gain made through shares in the profits and protection from risk of takeover and loss of its position in company.

Manager's reward system is certainly one of the key controversies in modern public companies. One of the recommendations for the investment of the famous Warren Buffett is to buy shares of companies that are run by the fair management. Fair management is one who does not take excessive fees for their work, especially the options on the stocks of the company which they run [43]. With this, Buffet has directly linked to Graham [24], who is also against management compensation in stock options. In addition, here, EFFAS [44] recommendation is: *Remuneration systems should be based on the sustainable, long term development of a company. Extremely high remuneration packages (including base salary, bonus, and stock options) should not occur, since they will not be based upon any realistic underlying business trend. If this is the case, management assumes neither responsibility nor risk. People who are excessively highly remunerated will not necessarily be interested in the long lasting success of their company.*

The significance of the problem of rewarding managers illustrates this EFFAS [44] recommendation about paid out dividends vs. paid out bonuses: *This is a crucial and short-term orientated issue. Investment banks, or universal banks in which investment banking is a very significant component, have been paying out overall bonuses in amounts that are similar in size to the overall annual dividend. This practice should be ceased, because shareholders have the right to receive an appropriate dividend payout that is directly related to the overall net profit of a company.* In addition, problem is that this reward, in fact, grants management to itself rather than stockholders. Furthermore, managers have the possibility to reinforce yield on options in short term due to asymmetries of information. In addition, dividend payments vs. retention of earnings in the public company represent means of reducing the problem of agents and the potential costs of the agents. That being said, the payout of the bonus becomes direct cost of agents, which does not make sense from the standpoint of motivation and management monitoring.
