PUTTING SME FINANCIAL REPORTING INTO

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PUTTING SME FINANCIAL REPORTING INTO

THEORETICAL AND PRACTICAL PERSPECTIVE


by

Professor Richard G.P. McMahon,

Head, School of Commerce,

The Flinders University of South Australia,

GPO Box 2100,

Adelaide South Australia 5001.

Telephone: 08
-
82012840

Fac
simile: 08
-
82012644

Email: Richard.McMahon@flinders.edu.au


SCHOOL OF COMMERCE

RESEARCH PAPER SERIES: 98
-
10

ISSN: 1441
-
3906


Abstract

The intention in this paper is to summarise, synthesise and extend elements of two
theoretical perspectives on financial r
eporting by small and medium
-
sized enterprises
(SMEs) drawn mainly from the literature of economics and finance


that supplied by
neoclassical microeconomics as reflected in modern finance theory, and that provided by
so
-
called Austrian economics. The aim

is to sketch as succinctly as possible the likely
financial reporting scenario for SMEs in a less than perfect world, with a particular
concern for internal use of general purpose financial reports by owner
-
managers. The
resulting portrayal establishes a
conceptually sound but realistic backdrop against which
to view SME financial reporting practices. Most importantly, it reinforces the point that
owner
-
manager decisions regarding financial reporting are multifaceted, and not simply a
dichotomous choice be
tween two extreme positions.






2

PUTTING SME FINANCIA
L REPORTING INTO

THEORETICAL AND PRAC
TICAL PERSPECTIVE

1. Introduction

Reviewing the relevant literature, it seems possible to adopt either of two theoretical paradigms for
understanding and explaining fin
ancial reporting in small and medium
-
sized enterprises (SMEs):



That provided by neoclassical microeconomics which is reflected in modern finance theory, and
which represents mainstream thought on financial management of businesses. According to
this paradi
gm, historical and future
-
oriented financial reports, and analysis and interpretation of
such reports, have considerable decision usefulness.



That provided by Austrian economics which has not been widely supported to date, but which is
assuming greater sig
nificance as SMEs become more central to scholarly and policy
-
related
deliberations. According to this paradigm, historical and future
-
oriented financial reports, and
analysis and interpretation of such reports, have little decision usefulness.

These persp
ectives point to markedly different possibilities for financial reporting practices amongst
SMEs. The differences are most likely to be reflected in what is discovered about use of financial
reports for internal financial management purposes by owner
-
manag
ers and, to a lesser extent,
managerial employees.

The intention in this research note is to summarise, synthesise and extend elements of the two
theoretical perspectives on financial reporting by SMEs identified above. The aim is to sketch as
succinctly a
s possible the likely financial reporting scenario for SMEs in a less than perfect world. The
note proceeds by first examining the theoretical perspectives on SME financial reporting in more
detail.

1

The many ways in which SME financial reporting may be l
imited in practice are then
examined. Thereafter, various explanations are proposed for why SME financial reporting may be
limited in practice. The note closes with conclusions arising from the discussion.

2. Theoretical Perspectives on SME Financial Repor
ting




1

Because the neoclassical microeconomics/modern finance theory perspecti
ve on financial reporting


represents mainstream thought, its precepts and assumptions are not detailed. Rather, the focus is


on departures from these precepts and assumptions evident in Austrian economic theory. The


reader is referred to McMahon
e
t al
. (1993a) for a useful summary of the neoclassical


microeconomics/modern finance theory position.




3

A departure from the role ascribed to financial reporting within SMEs by modern finance theory,
rooted as it is in neoclassical microeconomics, is provided by the so
-
called Austrian school of
economic theory. The part played by financial reporting in
SME financial management in the Austrian
view of the world is explained by Young (1987) and Gibson (1992a, 1992b, 1992c, 1993). Justification
for considering this alternative perspective is furnished by Gibson (1992b, p. 221) on the grounds of
dissatisfact
ion with the assumptions of neoclassical microeconomics:

Substantial relaxation of these assumptions is often necessary to provide plausible
explanations for many observed practices such as the irregular use of financial information in
small firm decision
contexts. Rather than seeking to justify these departures within the extant
framework, understanding may be better accommodated by adopting a different perspective.

The Austrian perspective emphasises the role of the entrepreneur in economic activity and h
olds that
actions undertaken by entrepreneurs are mainly the outcome of alertness to opportunities found by
scanning the business environment for what Cheah (1990, p. 343) describes as 'profitable
discrepancies, gaps, and mismatches in knowledge and inform
ation that others have not yet
exploited'. In this scenario, the financial information provided by a conventional accounting system is
likely to have less importance to decision
-
making by owner
-
managers of SMEs.

Gibson (1992b, pp. 228
-
229) describes the ro
le of financial information in the Austrian model in
the following terms:

Decision makers do need financial information to help them determine if their capacity to
generate future profit (i.e., take a particular action) has been impaired. There is no assum
ption
that financial information has any other role. It is not assumed that future oriented information
will be used in evaluating the means by which desired ends can be achieved (although such
use is not precluded). Austrian economics offers no opportunit
y to prescribe a use for
information in the decision making process.

Thus, the principal role of financial reporting is essentially retrospective and confirmatory. In other
words, financial information is useful mainly in evaluating the success of past dec
isions and in
determining present position. In this context, the financial reporting requirements of taxation
legislation and/or corporations regulation legislation are more than likely to be sufficient to satisfy the
information needs of SME owner
-
manager
s. Their apparent disregard for more timely and decision
-
relevant financial information is therefore explicable.

Some empirical support for the Austrian perspective on financial reporting in SMEs is provided
by Carsberg
et al
. (1985) who asked owner
-
manage
rs in their sample of 50 small companies in the



4

United Kingdom what benefits, if any, they derive from producing annual statutory financial reports.
Management uses received some mention and Carsberg
et al
. (1985, p. 31) indicate that a significant
proport
ion of these (italics added for emphasis):

. . . were expressed to be
confirmation

of the results. Directors seem to have a rough idea of
the results of the business over the period, but find the annual accounts useful in dispelling the
uncertainty about p
rofitability.

Further underpinning for the Austrian view is forthcoming from McCahey (1986) who describes the
financial reporting practices of a sample of 40 Australian SMEs. Although owner
-
managers appear to
be the primary users of statutory reports, the
researcher considers it unlikely they have the ability to
properly interpret them. McCahey (1986, p. 123) suggests that (italics added for emphasis):

Managers review the financial statements to ensure that their expectations of the company's
performance, b
ased on knowledge of the business, are
confirmed

by the formally presented
results.

Finally, Gibson & Wallschutzky (1992, p. 10) find as follows on the basis of in
-
depth interviews with
owner
-
managers of 12 Australian SMEs concerning the role of accounting

information in their
strategic and operational decision
-
making:

Few of the participating small businesses in the case studies analysed . . . identified access to
accounting information and/or accountants as important when making decisions affecting
growth

and opportunity. However, in the routine control of their business, while accountants did
not play an important role, business data with an accounting connotation was used in a variety
of ways. Overall, the results support the alternative view of accounti
ng information use in small
firms: accounting information is not used because it has no implicit utility in making decisions.
This view is strongly supported in respect of planning decisions. In making control decisions,
however, accounting data (but not a
ccounting information) may have some utility although the
quality and source of data used does appear to vary extensively.

In the call for further research at the end of their paper, Gibson & Wallschutzky (1992, p. 11) indicate
that ‘Also necessary is a gr
eater understanding of the role of accounting information has in managing
small organisations and its association with performance’.

All three studies cited above provide what amounts to anecdotal evidence of a confirmatory
rather than a decision role for
financial information obtained in SMEs, and in this respect uphold the
Austrian position. However, given the present state of scholarship in the field, it is not yet possible to
choose unequivocally between this perspective and that of modern finance theor
y. Having made this
point, it should be acknowledged that, for many researchers and professionals who have worked



5

closely with SMEs, the dynamic disequilibrium model of Austrian economic thought has an intuitive
appeal over the static equilibrium represent
ation of neoclassical microeconomics. As Gibson (1992a,
1993) implies, this might be so for no other reason than the former view does not require a conclusion
of irrational behaviour on the part of economic agents generally recognised for their pragmatism
and
self
-
interest.

In closing, it is appropriate to augment the theoretical concerns about the role and significance
of SME financial reporting just expressed with two of a more practical nature. Those who have reason
to make use of the financial reports o
f smaller business concerns may be well advised to heed the
caution of Levin & Travis (1987, p. 30) that:

. . . standard financial statements tell only half the story about private companies. After all,
when wealth flows freely between the owner and the bu
siness, personal finances are really part
of the organization. Yet financial records look only at corporate operations.

Even if the portrayal of an SME’s financial position and performance in its financial statements has
integrity, there is the further iss
ue of whether its owner
-
managers are sufficiently skilled to be able to
meaningfully interpret the information presented. Commenting on the findings of their research into
use of financial ratio analysis in SMEs, Thomas & Evanson (1987, p. 570) venture tha
t:

The lack of association between financial ratio use and either survival or profitability may . . .
indicate that the level of sophistication in use of ratios has not reached a high enough level . . .
to make a discernible difference between those who us
e them and those who do not.

3. How SME Financial Reporting May Be Limited in Practice

There is considerable evidence available that, as a group, owner
-
managers of SMEs make
considerably less use of standard financial reports, whether historical or future
-
oriented, in financial
management of their businesses than would be proposed or predicted by neoclassical
microeconomics/modern finance theory (McMahon & Holmes, 1989, 1990; Holmes & Nicholls, 1990;
McMahon & Davies, 1991a, 1991b; McMahon & Holmes, 1991; M
cMahon & Davies, 1992a, 1992b;
McMahon & Holmes, 1992; McMahon
et al
., 1992a, 1992b; McMahon
et al
., 1993a; McMahon &
Davies, 1994; McMahon
et al
., 1994a). Moreover, financial reporting practices in SMEs seem to fall
well short of what is dictated by vario
us external financial reporting imperatives that exist for them
(McMahon
et al
., 1992c, 1993b, 1994b). Owner
-
managers appear particularly reluctant to procure
financial reports which might become accessible to outside parties either directly or through the

offices of regulatory authorities.




6

One means of anticipating what might be broadly found in the way of financial reporting
systems actually employed amongst SMEs is via a continuum devised by Friedlob & Plewa (1984,
1992) as follows:



Strictly cash based a
ccounting with no accruals.



Income tax basis accounting (in compliance with income tax legislation) which includes
accruals for inventories, receivables and depreciation.



Basic full accrual accounting with no compliance to accounting standards.



Basic full
accrual accounting with footnote disclosures of departures from accounting
standards.



Full accrual accounting for private companies in which certain accounting standards are
considered irrelevant, and therefore are not required to be complied with (for exa
mple, an
accounting standard dealing with consolidated financial statements).



Full accrual accounting as for public companies with compliance to all accounting standards
unless it can be demonstrated that adherence to a certain accounting standard would re
sult in
misleading financial reports being produced.

A key issue is the extent to which external auditors are permitted/are able to attest to the veracity of
the financial reports produced using these various financial reporting systems.

The discussion thu
s far suggests it is realistic to anticipate that the financial reporting practices
found in SMEs may not accord with mandated, recommended or preferred practices in some or all of
a number of specific respects:



Not all financial statements may be prepared



preferably balance sheets, profit and loss
statements and cash
-
flow statements should all be obtained, and both historical and future
-
oriented reports should be prepared.



Financial statements may not be prepared with sufficient detail


preferably finan
cial data
should be provided on major segments of business.



Financial statements may not be prepared appropriately


preferably generally accepted
accounting principles should be followed, and the specific requirements of applicable
accounting standards, t
axation law and corporations law should all be met.




7



Financial statements may be prepared irregularly and/or infrequently


preferably financial
statements should be routinely prepared at least annually, with monthly or quarterly reporting
intervals being m
ore appropriate.



Veracity of financial statements may not be appropriately established


preferably financial
statements should be validated by an independent external auditor at annual intervals.



Financial statements may not be provided to all parties wit
h reasonable expectations of
receiving them


preferably financial statements should be supplied to non
-
managing owners,
owner
-
managers, managers, key employees, creditors, financiers, advisers, taxation authorities
and corporate regulatory bodies as neede
d, requested or mandated.



Financial statements may not be used appropriately


preferably financial statements should be
routinely analysed and interpreted using accepted techniques for this purpose such as
inspection of key figures, trend analysis, inter
-
firm comparisons and variance analysis.

Of course, in reaching judgments on the adequacy of financial reporting practices in particular SMEs,
the recommended or preferred practices identified above must be moderated to some degree by the
distinctive charac
teristics and circumstances of the businesses concerned.

4. Explaining Limited Financial Reporting in SMEs

In addition to inevitable claims of insufficient time from owner
-
managers, limited financial reporting
undertaken in SMEs could arguably arise for on
e of the following reasons:



Owner
-
managers are not rational economic decision
-
makers and do not seek to be better
informed on the financial consequences of their decisions. This is the position taken by many
researchers, but it may not stand up to closer s
crutiny. It is nevertheless the easiest explanation
for less assiduous and probing researchers to invoke.



Owner
-
managers are rational economic decision
-
makers but have correctly assessed that the
circumstances of their businesses are so undemanding that ex
tensive financial reporting is not
needed. Self
-
employment, very small enterprises, home
-
based concerns and life
-
style
ventures, especially where they are not growing and are fully self
-
funding, are examples of
businesses in which direct observation and on
ly rudimentary cash
-
based reporting might be
perfectly adequate for financial control purposes. This explanation could be seen as an extreme
case of the next, but its separate recognition is considered justified.




8



Owner
-
managers are rational economic decisi
on
-
makers but believe, often wrongly, that the
costs of being better informed on the financial consequences of their decisions outweigh the
benefits. The costs would include those involved with preparation of standard financial reports
(including set
-
up co
sts for a bookkeeping/accounting system), as well as those associated with
education/training in their use. Perceived uncertainty may make the cost of preparing future
-
oriented financial reports appear prohibitive. These costs tend to be fixed in nature an
d are
therefore more of a burden, in relative terms, for SMEs (Horowitz & Kolodny, 1982; Nair &
Rittenberg, 1982; Abdel
-
Khalik, 1983; Nair & Rittenberg, 1983; Friedlob & Plewa, 1984;
Knutson & Wichmann, 1984; Carsberg
et al
., 1985; Hiltebeitel, 1986; Fried
lob & Plewa, 1992).

By and large, the direct benefits of financial reporting to financial management of a business
tend to be less tangible and more difficult to identify and measure than necessary out
-
of
-
pocket
expenditures on financial reporting. Some be
nefits of more extensive financial reporting are
likely to become most evident when a business experiences financial stress, such as when
growth leads to cash
-
flow difficulties


making cash
-
flow forecasting and cash
-
flow statements
particularly helpful. T
he full benefits of comprehensive financial reporting may only be
recognised when and if, in pressing circumstances such as securing essential growth funding,
an owner
-
manager seeks to attract and retain outside financial support from new equity holders
an
d/or medium
-

to long
-
term debt providers. The costly consequences of refusal or withdrawal
of such support are usually readily apparent. The assessed benefits of financial reporting are
unlikely to include avoidance of the probable societal costs of poor d
ecisions leading to a
moribund or failed business and/or losses to external stakeholders, even though these
externalities should rightly be considered.



Owner
-
managers are rational economic decision
-
makers but believe that standard financial
reports prepare
d conventionally do not provide sufficiently reliable information on the financial
consequences of their decisions. The accounting profession’s continued adherence to the
historical cost convention in preparation of standard financial reports could partial
ly explain
such a position. Real or perceived technical complexity of modern accounting practices may
lead to misconceptions as to the reliability of financial information obtained, as could numerous
elective treatments of financial transactions and mutual
ly exclusive inconsistencies between
financial reporting imperatives.




9




Owner
-
managers are rational economic decision
-
makers but believe that standard financial
reports do not provide them with the type of primary information they really need to carry out
t
heir function effectively and efficiently. The Austrian school of economic thought would suggest
that this might be the case. Recall, however, that historical financial reporting may still play a
confirmatory role in an Austrian world; and, strictly speaki
ng, use of future
-
oriented financial
reports is not precluded.



Owner
-
managers are rational economic decision
-
makers but are so preoccupied with
concealing the financial consequences of their decisions from those they consider to be free
riders (for example
, taxation authorities and corporate regulatory bodies; and possibly also
competitors, through public access to financial information provided to corporate regulatory
bodies) that they inevitably conceal financial information from themselves. It may be con
sidered
more morally acceptable, less costly or less risky to truthfully indicate that certain financial
information has not been collected and reported than it is to obtain the information and then
deny its existence. For this behaviour to appear rational
, the likelihood and quantum of
sanctions for not undertaking mandated financial reporting to legitimate authorities, or for not
meeting contractual obligations to report to outsiders, must be perceived as insufficient to
motivate compliance.

One intention

in identifying the possible reasons for owner
-
managers of SMEs not facilitating
more comprehensive financial reporting on their businesses is to establish that irrational behaviour in
an economic sense on the part of the owner
-
managers is not essential to

explaining this
phenomenon. In the smallest concerns, extensive financial reporting simply may not be required.
Where financial management demands are more stringent, human failing on the part of owner
-
managers in not recognising this is so, in not acknow
ledging their limited financial management
competence, and in not choosing to remedy this through education/training, or by securing expert
advice, may also be factors. Furthermore, deficient and conflicting accounting practices, poorly
functioning regulat
ory frameworks, limited recourse to affordable legal enforcement of contracts, and
misconceptions as to the role of financial reporting (that is, faulty assumptions), may all contribute
explanations in which economic agents other than owner
-
managers also p
lay a significant part.





10

5. Conclusions

In contemplating the two theoretical perspectives on financial reporting by SMEs identified in this
note, there is inevitably a risk that financial reporting alternatives for SMEs thus represented are seen
in terms o
f a dichotomy between two extreme positions. As this note has attempted to demonstrate,
however, the reality is that owner
-
manager decisions regarding financial reporting are multifaceted.
There are, in fact, numerous ways in which SME financial reporting
may be limited in practice; and
there appear to be a variety of explanations for why this may be so


many of which do not
necessarily suggest irrational thinking on the part of owner
-
managers. Clearly, financial reporting
practices of SMEs need to be seen

in terms of a continuum which may indeed have the neoclassical
microeconomics/modern finance theory and the Austrian economic theory positions at opposite ends.
The location on the continuum assumed by any particular SME may be dictated by the distinctive

characteristics and circumstances of the business concerned, possibly moderated by rational and/or
irrational views subscribed to by its owner
-
manager(s). It is believed that this portrayal of SME
financial reporting establishes a conceptually sound but r
ealistic backdrop against which to view
existing empirical evidence on financial reporting practices in SMEs.

6. References

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-
Khalik, R. 1983,
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11

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12

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13

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, vol. 14, no. 4,
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Abacus
, vol. 23,
no. 1, pp. 10
-
16.