Financial Reporting

  • Created by: PJ
  • Created on: 28-12-12 21:10


  • International FInancial Reporting Standards - Set by the International Accounting Standards Board (IASB)
  • Single set of comprehensive, clear rules that are widely accepted around the world
  • Provides unified framework for the preparation and presentation of firms' financial statements
  • Principle based, private, BS approach (fair value accounting)
  • Principles mean there it provides for fewer exceptions than in a rules-based system
  • Seeks transparency and comparability, enhancing efficiency of financial markets globally, lowering costs of capital for firms
  • Comparison to FASB setting GAAP and SEC which in US regulates investment
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IFRS Problems

  • Not Mandatory to follow IFRS, not truly globally accepted
  • India postponed convergence to IFRS (IAS 41 - Agriculture), US uses GAAP
  • IFRS is no more principle based than US GAAP (rule based)
  • Principle-based framework leads to uncertainty (potential of different interpretations for similar transactions) and need for extensive disclosures in financial statements
  • Disclosures allows managers to manipulate headline figures, making high quality auditing difficult
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IASB and Problems

  • International Accounting Standards Board, set up IFRS
  • Independent, private standard setting body consisting of 16 full-time numbers
  • Is it truly independent? Operating funds come from corporate donations and large firms - Big 4
  • Close political links, pressurising the globally acceptance of IFRS
  • Very slow in executing changes, fatal in a dynamically changing business environment
  • Not accountable to any one particular government or nation
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Financial Reporting Stakeholders

  • Competitors - To compare performance
  • Managers - To assess success of firm
  • Lenders - To assess credit worthiness
  • Suppliers - To assess reliability of clients
  • Analysts - To produce forecasts
  • Investors - To seek out profitable investments
  • Employees - To track the value of their pensions
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  • Concerned with WHEN to measure sales/revenue
  • Important in long term contracts
  • IFRS: Recorded when customer begins to enjoy economic benefits but fails to accurately reflect the performance of the business (IS Approach). E.g building a mall, has to wait for mall to be built and customer to enjoy economic benefits?
  • IAS 11: %Completion method: Costs incurred to date/ total costs x total value of contract
  • If market values cannot be used, use the discounted cash flow method
  • Alternatives exist but problems with recording revenue when cash received, when customer recieves product.
  • Where to record the revenue though? On the IS or BS?
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  • Financial Reports recognise transactions at the point of sale or transfer of legal ownership
  • Timing of revenue recognition
  • Recognition is a continuous process and realization is the process that ends recognition
  • Recognition is an estimate and can be manipulated but realization is accurate and exact.
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Relevance & Reliability

  • 2/4 qualitative characteristics of accounting (other two are understandability and comparability)
  • Relevance, Timing is key, users need it and expected to affect their decisions
  • Reliability, Info should be accurate, true & fair
  • TRADE OFF between the two.
  • IFRS, fair value increases relevance
  • Historical Cost Accounting, notion of reliability more important.
  • Relevance has bigger role in dynamic business environment in global markets whilst reliability is important when if FRs are not, stakeholders can make bad & irreversible decisions
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  • A charge against the revenues of a period to represent wearing out, usage or consumption of non-current fixed assets in that period
  • IAS 16: Firms have a choice between using HCA and FVA for fixed assets, financial reports are still incomparable and inconsistent.
  • Straight line depreciation method, reducing balance (accelerated depreciation method)
  • Amortization is the depreciation of intangible assets
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  • Cautious, conservative judgement-making in accounting
  • asset depreciation accounted for on financial statement, but not asset appreciation - in line with HCA
  • prudence makes sure that assets & income are not overstated and liabilities & expenses not understated = worst-case scenario
  • IFRS: Prudence rejected as the 'true' market value of assets is used, including both appreciation & depreciation.
  • BUT prudence is still evident in the form of BDP (bad debt provision), impairment tests (goodwill)
  • Entity must apply same method continously for accounting treatments
  • When the consistency can't be maintained, reporting entity must disclose fact that it changed with reason and impact of change on FS.
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  • FRs help users with their decisions
  • Ability of information to affect the decisions of the users of FRs
  • Information is material either due to the amount invovled or due to the importance of the event
  • Where should this information be recorded? Remuneration paid to directors is material
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Matching (Accrual concept)

  • To obtain an accurate net income figure for any particular financial time period income & expenses in that period should be matched
  • On an accrual basis, expenses are recognised when they are incurred, and then these expenses are offset against revenues generated from these expenses
  • Monthly salaries can be matched with revenue generated
  • Bonus should be expensed in year it matches revenue generated by employee though it may be paid in another year
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Deferred tax assets

  • FR income may differ from the taxable income determined by tax regulations
  • Some portion of this difference will be permanent and the company has to bear this burden
  • The remaining temporary part is still paid and treated as a prepayment, giving rise to a deferred tax asset
  • However, it is only refunded as a discount in the future tax liabilities
  • Deferred assets have an expiry date
  • For those two reasons, they are very unsafe and illiquid assets
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Fair Value Accounting (BS Approach) vs Historical

  • IS measures the performance of the company
  • BS gauges the overall health of the company
  • FVA: revalued at market value annually, profit/loss (IS) recorded on a continual basis as the difference between net assets
  • Exception are available-for-sale securities
  • HCA: Profit/loss only recorded when assets sold (realised profit)
  • FVA Better: HCA BS does not reflect true value of net assets, little relevance for investors. Land does not depreciate, it's current market price is actually higher
  • FVA Flawed: costly making annual revisions, illiquid markets have no clear price, mark-to-model unreliable whilst HCA is inconsistent
  • Pro-cyclical nature of FVA - Volatility, good economic times - normal markets, bad leads to distressed markets and depressed prices. Eurozone crisis, banks having to write down their values
  • FVA allows firms to book profits when the market value of its own liabilities fall, even though financial position of firm deteriorates
  • Built on efficient market hypothesis, but markets may not reflect the true value of the assets
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Revaluation Reserve

  • Firms enters a double-entry under the shareholder's equity due to the upward revaluation of an asset
  • HCA: huge profits shown in one off manner which means higher tax and dividends
  • This however means unrealised profit which means not part of retained earnings
  • Realised profit when asset is sold, profit under other income section of IS
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Global Standardisation: Good or Bad?

  • Comparability & transparency enhanced = more efficient markets
  • Transparency = reduces scope for creative accounting
  • Lower costs of capital and easier cross-border transactions - no need for multiple reports
  • Facilitates the creation of a single capital market in EU for e.g.
  • Comparability achieved on the surface but all the different assumptions that feed into impairment tests and revaluations, in practice, it is lost in the footnotes
  • No competition between accounting models, lack of Darwinian progression, how can we be sure it has benefits if no alternative models for comparison?
  • Different countries have different emphasis on the key objective of FRs
  • Varying interpretations of transactions according to cultural/national context
  • Uniformity ignores size
  • Conflict-ridden political standardisation process
  • Logical conclusion, too simplistic, too hard/impossible
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Stock Options

  • Stock options are promise to employee that allows them to buy shares in x years at a certain price, alligning interests of owner and employees
  • TRADITIONALLY: no line entry when SO issued, upon exercising SO: (BS) Cash x/ SE x
  • NOW: FVA: expensing of SO when issued: Stock option expense (IS)/ Stock Option (BS)
  • We shouldn't expense as Black-Scholes model used to calculate future share price requires 6 inputs which makes unrealistic estimates based on stable market
  • SO only a promise = no transaction
  • SOs impact always been partly visible through diluted earnings per share, calculated on basis of outstanding SOs
  • We should expense because without expensing the profits of many companies may loook inflated as large proportion of CEOs and execs paid through SOs
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  • Traditional: the brand, synergy, future cash inflow = REJECTED
  • Amount paid for a company in excess of the value of its net assets (BS)
  • Recent M&A has made goodwill more significant
  • Accounting for goodwill
  • Yes: FVA needs true value of firm, but why is internal goodwill not shown on BS: inconsistency
  • No: too ambigious and arbitrary to measure accurately & fairly
  • HCA: users of FR already factored in brand, synergy etc into their analysis hence goodwill was already reflected in the share price. By using BS approach job of analyst needlessly transferred from users of FR to issuer = conflict of interest
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Accounting for goodwill

  • After initial reallocation, goodwill used to be written off immediately - illusive & intangible nature justified this prudent approach (BEFORE)
  • However, this entails large one-off loss on IS, loss recorded when positive activity M&A happened, lack of matching between potential future revenue = inappropriate
  • Goodwill then came to be capitalised, followed by amortisation over useful lifetime = HCA IS approach
  • Lack of comparability as different companies use different length of useful lifetime, decline of relevance of goodwill value after mathematical amortisation process doesn't reveal 'fair value' of assets
  • Latest treatment of Goodwill
  • Stop amortisation, hold goodwill permanently and introduce annual impairment tests, losses recorded on IS
  • Inconsistency land allowed to appareciate, goodwill fails to represent future benefit, impairment test relies on prediction of cash flows 50 years into future = manipulation?
  • Increased revenue from goodwill is not matched with impairment expense = inflated profits
  • HCA Ammortisation method might be best?
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Consolidated Accounting

  • Consolidation accounting is needed to measure the true performance of group companies
  • A company's FS also reflects the assets of its subsidiary (controlling stake) or associates (20%-50%)
  • Minority interests - the net assets of minority shareholders
  • Tax and dividend issues are still connected to individual financial reports
  • Problems
  • Given number of cross holdings involved, difficult to determine
  • Value judgements with the new definitions of control & significant influence under IFRS
  • Consolidation mixes everything together & hides detailed contexts, internal management should be used but companies will be hesitant to open this information, moves away from segment reports which provides info about specific parts of the business
  • SPE (Special Purpose Entities) do not need to be consolidated
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Ratio Analysis

  • Allows for rapid analysis in a rapid business environment based upon specific parameters
  • simplifies FRs, necessary in time-pressurised environments
  • comparability made easy: between years, between competitors, etc
  • Discrepancy between how to calculate/define financial ratios - no right answer
  • For example: ROE: numerator may be PBIT or PAIT
  • ROE & ROCE: should revaluation reserve be included or not? It is part of SE under FVA
  • Open to manipulation, any illegitimacy negated via use of small footnotes
  • Merely reading ratios as numbers, not in the context of the firm can mislead investors
  • Ratios are purely quantitative, macro/contextual factors ignored
  • Ratios only useful when differentiating between hundreds/thousands of companies based upon clear indicators with minimal scope for manipulation
  • They only scratch the surface and offer superficial analysis that may prove misleading, thus requiring individual, in-depth work
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Ratios: Profitability and Performance

  • Return on Shareholders' Equity (ROE)
  • Net Profit after (before) Interest and Tax/(Share capital + Reserves) X100
  • Return on capital employed (ROCE)
  • Net Profit after (before) Interest and Tax/(Share Capital + Reserves + Long Term Loans) X100
  • Net Profit Margin
  • Net Profit after (before) interest and Tax/ Sales X100
  • Gross Profit Margin
  • Gross Profit/ Sales X 100
  • Asset Turnover
  • Sales/Assets
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Ratios: Efficiency and Effectiveness

  • Average Stock Turnover Period
  • Average Stock Held/ Cost of Sales x 365
  • Average Settlement Period for Debtors
  • Trade Debtors (Average)/ Credit Sales x 365
  • Average Settlement Period for Creditors
  • Trade Creditors (Average)/ Credit Purchases x 365
  • Sales to Capital Employed
  • Sales/ Long Term Capital Employed
  • Sales per Employee
  • Sales/ Number of Employees
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Ratios: Liquidity and Stability

  • Current Ratio
  • Current Assets / Current Liabilities
  • Acid Test/ Quick Ratio
  • Current Assets (excluding Stocks) / Current Liabilities
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Ratios: Capital Structure, Investment and Financia

  • Gearing Ratio
  • Long Term Liabilities / (Share Capital + Reserves + Long Term Liabilities)
  • Interest Cover Ratio
  • Profit before Interest and Taxation / Interest Payable
  • Dividend Pay-Out Ratio
  • Dividends announced for the year / Earnings for the Year Available for Dividends X 100
  • Earnings Per Share (EPS)
  • Net Profit/ Number of Shares
  • Price/Earnings (PE) Ratio
  • Market Value per Share / Earnings per Share
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XBRL: Extensible Business Reporting Language

  • A Universal, open, and free standard (Data Format) for exchanging business info & FRs electronically
  • XBRL = not-for-profit ------> Created by IASB
  • Extensible Mark-up Language (XML) = Basis of XBRL, info presented uniformly on web so that web-based applications can process & exchange the info easily
  • Quicker, FRs converge to same form = global harmonising = more efficient & quicker financial markets, same tags used for different terms under XBRL
  • Cheaper, Data only needs to be entered once, eliminating costs of re-entry and potential for errors. Data can be pulled directly from company web site.
  • Comparability, Data from several companies and different time frames can be compared
  • Better Data, More accurate, more easily understood as the ambiguity of definitions is removed
  • Too quick, XBRL may not allow investors time to make rational decisions, as much financial data not trustworthy. Automated nature of XBRL makes it too conveniently, skipping essential details
  • Costs, inexperienced users of XBRL have to outsource its implementation HIGHER COSTS, Other start-up costs, security big problem as so much data vulnerable to hacking
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Cash is Fact, Profit is someone's opinion?

  • YES
  • Many notions of profit exist: gross, operating, net etc
  • When a line item is to be recorded on the IS, there is considerable scope to manipulate any one of these profits because the item can be placed in a number of places
  • For example: Inventory is damaged beyond repair, operating expense maintains healthy profit margins, CoS makes business look efficiently run
  • HCA: traditional net profit = realised profits
  • FVA: comprehensive income: assets (t) - assets (t-1) = realised profits + unrealised profits
  • Profit and loss figures can change very easily with different treatments of goodwill, R&D costs, deferred revenue, LIFO vs FIFO
  • Accounting is used for many differnet purposes
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CSR (Corporate Social Responsibility) Reporting

  • CSR = reporting on both financial and non-financial info to key stakeholders on a company's coail, environmental, operational % financial activities = accounting for others
  • GRI (Global Reporting Initiative) = dominant CSR guidelines, increasing adoption worldwide, not regulatory body or mandatory
  • Qualitative elements of CSR = difficult to audit verify
  • Problems, investors rarely base their decisions on CSR reports, cosmetic PR exercise, PLCs pay large sums to auditors to verify CSR reports
  • Pros: mainstream accounts externalise 'others', need to be transparent about a broad range of non-financial issues
  • Satellite accounts, BUT don't show connection to moneymaking activities
  • new market based on new accounts, very costly and time consuming
  • full cost accounting, internalising, but hard to calculate all costs
  • SOLUTION: Pragmatic accounting: Oxfor Financial Reporting Framework: works by showing line entry on IS
  • No altruism and just part of form
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CSR Reporting and Sustainability reporting be stan

  • Currently CSR reports are not closely regulated in many jurisdictions & stock markets: many TNCs are following GRI
  • Criticisms: without regulation, it becomes PR exercise
  • No established standard = lack of comparability across firms
  • No clear relationship between CSR reports & Financial statements
  • These Criticisms suggest that international regulation % standardisation would improve the situation however literature also suggests regulation prevents free evolution of better reporting
  • Who should regulate and for whom?
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Regulating FRs and CSRRs

  • No
  • Free market principles: perfect information, competition & deregulations are sufficient in automatically punishing 'bad' accounting
  • Prevents free evolution of accounting
  • Yes
  • Regulation is crucial in preventing businesses from creating their own reality using creative accounting
  • Prevents harmful scandals and naive belief in markets
  • How should we regulate?
  • Nationally, international regulation would be step towards standardization but IFRS doesn't reflect different contexts, only politically attractive & cosmetic, quicker changes made on national scale and national regulator is more accountable
  • Public regulator is accountable to people/governement and unlike more experienced and more knowledgable private bodies aren't as plagued by vested interests
  • Principle based, good as no two transactions identical, less loopholes but if we use both we can draw benefits from both HCA and FVA. Loss of comparability
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Reclassification of Assets by Banks

  • What: banks reclassify assets at cost, as apposed to fair market value
  • Why: reporting assets at fair value in distressed markets causes them to write down assets by billions, exacerbated by illiquid markets
  • many banks hold assets to back long term liabilities and many assets are infrequently traded, fair value revaluation increases volatility
  • Using HCA, value assets at cost, any gains are spread evenly over asset lifetime
  • BUT: hasty revision in accounting rules, footnotes and disclosure requirements
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Cashflow Statement

  • Net Cash Inflow from operating activities
  • PBIT
  • Depreciation
  • Expense
  • Stock
  • Accounts receivables
  • Accounts payables
  • Prepayments
  • Accruals
  • Not included: capital, long term debt etc
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Financial Analysis

  • Mention size of the firm and the industry
  • GIve an overview, state your aim and mention the different sections of the analysis
  • Operational performance: Sales, CoS, Gross Profit, Other Expenses - Profitability, Profit Margin (PBIT/Turnover), Return on Assets, Asset turnover, ROE
  • Short Term Solvency: curremnt assets vs liabilities, quality of the current assets (liquidity): current ratio, acid test ratio, debtors collection period, creditors collection period, stock holding period
  • Long term solvency, capital structure and cash flows: Long term borrowings, shares and dividends: Interest cover, divident cover, gearing ratio
  • Other: exceptional loss etc.
  • Conclusion and limitation of analysis: long term, non financial data, industry analysis, competitor data, targets/strategies, accounting policies, markets, gov/ext influences
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Creative Accounting Examples

  • Accounting for R & D
  • Expense, expense increase this year but profits are higher in the following years as no amortization. (IS) Expense/ Cash (BS)
  • Capitalize and amortize in the following years (BS) Cash X/ Sales X-Y(IS) Y is deferred revenue
  • Microsoft expensed R&D: higher long term profits, product life short; makes sense expensing, assessment of technical feasibility may come very late in process
  • Income smoothings - deferred revenue saved for year of low income
  • Deferred revenue to match costs to revenue as there will be updating and other service costs
  • Microsoft manages its earnings to manage analyst's expectations, avoiding complacency within firm, to avoid regulatory intervention
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  • Steps of Auditing
  • Pre-Contract Inspection
  • Contract
  • Assessing internal control and risk
  • Audit plan
  • In-term routine audit
  • Stock taking, inventory checking at the end of the year
  • Unaudited financial statements received
  • Audit reports and annual reports published
  • Oligopoly of Big 4 in 2010 they audited 99% of FTSE 100 firms, which change auditors every 48 years
  • Worsening audit standards with IFRS, encouraged box-ticking and reduced scope for auditors to exercise judgement to reach fair view
  • Where is PRUDENCE!
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interesting financial reporting!

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