Jennifer Maynard Financial Accounting, Reporting and Analysis Chapter 4: Published financial statements of companies © Oxford University Press, 2013. All rights reserved. Learning objectives After this lecture you should be able to: • Draw up the four main financial statements in accordance with the requirements of IASs 1 and 7, including alternative presentations where permitted • Explain the underpinning principles relating to presentation contained in IAS 1 • Understand the purpose and nature of notes to the financial statements • Understand the significance of accounting policies, when changes to these and accounting estimates can be made, and how this is presented Jennifer Maynard: Financial Accounting, Reporting and Analysis Underpinning principles of financial statement presentation • “Financial statements shall present fairly the financial position, performance and cash flows of an entity” (NB – true and fair) • Accruals basis (apart from cash flows) • Going concern – Key issue post financial crisis – Link to risks and uncertainties – Sharman enquiry and recommendations • • • • Materiality – disclosure required Aggregation Offsetting generally not permitted Consistency from year-to-year to enable comparison Jennifer Maynard: Financial Accounting, Reporting and Analysis IAS 1 Presentation of Financial Statements A complete set of financial statements comprises: 1. A statement of financial position (balance sheet) 2. A statement of profit or loss and other comprehensive income (income statement and other comprehensive income / expenses – presented as one or two statements) 3. A statement of changes in equity 4. A statement of cash flows (cash flow statement) 5. Explanatory notes to the 4 financial statements, including a summary of the accounting policies applied • Comparatives for previous year must be presented • Statement of financial position for beginning of earliest comparative period if retrospective changes Jennifer Maynard: Financial Accounting, Reporting and Analysis IAS 1 Presentation of Financial Statements • Minimum line items specified • Additional line items or disaggregation of figures permitted – if material • Some flexibility in presentation – Where “balance” of statement of financial position is drawn – Statement of comprehensive income – one statement or two – Columnar format for income statement to show “exceptional items” separately • IAS 7 specifies presentation of statement of cash flows (see later slides) Jennifer Maynard: Financial Accounting, Reporting and Analysis Statement of comprehensive income • Comprehensive income – the change in equity arising from all transactions other than with the owners in their capacity as owners • i.e. Excludes share and dividend transactions • Profits and losses shown in income statement • Other comprehensive income includes: – Revaluation gains and losses – Changes in fair value of available-for sale financial assets – Exchange differences on translating foreign operations – Actuarial differences on defined benefit pension plans • Effectively ... changes in some asset/liability values, which are not considered part of profit or loss Jennifer Maynard: Financial Accounting, Reporting and Analysis Comprehensive income examples Which of the following items will be included in the statement of comprehensive income, and if so, in which part? Yes – income • Profit after tax of £500,000 statement • Issue of new shares for £2 million • Dividends paid of £200,000 No – transaction with owner No – transaction with owner • Increase of £100,000 in air value of financial assets Yes – either income statement or other comprehensive income Jennifer Maynard: Financial Accounting, Reporting and Analysis Issues with statement of comprehensive income • Distinction between what is part of profit or loss and what is other comprehensive income not always clear • Some items initially accounted for as other comprehensive income are subsequently ‘recycled’ through profit and loss • Clarity for users needed • Future project of IASB? Jennifer Maynard: Financial Accounting, Reporting and Analysis Alternative presentations for income statement Expenses analysed by nature £ Revenue Other income Changes in inventories of finished goods and work in progress xx Raw materials and consumables used xx Employee benefits expense xx Depreciation and amortisation expense xx Other expenses xx Total expenses Profit before taxkey figure is missing from this What income statement? Jennifer Maynard: Financial Accounting, Reporting and Analysis £ xx xx (xx) xx Alternative presentations for income statement Expenses analysed by function £ Revenue xx Cost of sales (xx) Gross profit xx Other income xx Distribution costs (xx) Administrative expenses (xx) Other expenses (xx) Profit before tax xx Allocation of expenses to function headings arbitrary – comparability? Jennifer Maynard: Financial Accounting, Reporting and Analysis Statement of changes in equity • Equity = Share capital and reserves • For each component of equity, this statement shows a reconciliation between the carrying amount at the beginning and the end of the period, separately disclosing changes resulting from: – Profit or loss – Items in other comprehensive income – Transaction with owners in their capacity as owners – (contributions by and distributions to) • This will provide investors with details of how net resources in the entity have changed: – As a result of the company’s performance (profit or loss) – Or from other transactions and items Jennifer Maynard: Financial Accounting, Reporting and Analysis Statement of cash flows • Cash is the ‘life-blood’ of an organization • Cash is ‘real’ – profits are based on accruals, estimates and judgements • Decisions by investors about whether to provide resources are based on entities’ cash flow prospects (IASB Conceptual Framework) • Many corporate collapses (e.g. BCCI in early 1990s) result from businesses being profitable but running out of cash • Statement to show how a business generates and uses cash flows of importance to investors • Used in conjunction with other financial statements Jennifer Maynard: Financial Accounting, Reporting and Analysis IAS 7 Statement of Cash Flows • A statement to show the sources and uses of cash over the accounting period according to activity: – Operating activities – Investing activities – Financing activities • It reconciles the opening and closing cash and cash equivalents balances: Net cash flow X Opening balances X Closing balances X • Cash and cash equivalents - bank and cash balances and short-term, highly liquid investments Jennifer Maynard: Financial Accounting, Reporting and Analysis Cash flows from operating activities Two methods • Direct – Shows major classes of gross cash receipts and payments – Recommended by IAS 7 • Indirect – Starts with profit or loss before tax and adjusts to cash flows from operating activities – Usual method chosen by UK companies – If direct method chosen, reconciliation of profit/loss before tax to cash flows from operating activities disclosed – Provides useful information about management of working capital Jennifer Maynard: Financial Accounting, Reporting and Analysis Statement of cash flows example Dewberry Limited Income Statement for the year ended 30 June 20X6 £000 Revenue Opening inventory 500 Purchases 16,400 16,900 Closing inventory 1,500 Cost of sales Gross profit Expenses (including depreciation of £395) Interest Profit before tax Corporation tax Profit for the year Jennifer Maynard: Financial Accounting, Reporting and Analysis £000 21,000 (15,400) 5,600 (3,370) (200) 2,030 (520) £ 1,510 Statement of cash flows example Dewberry Limited Statement of changes in Equity for the year ended 30 June 20X6 Ordinary Share Retained Total share premium earnings capital £000 £000 £000 £000 Balance at 1/7/X5 400 600 1,000 Issue of share capital 200 15 215 Profit for year 1,510 1,510 Dividends paid (500) (500) Balance at 30/6/X6 600 15 1,610 2,225 Jennifer Maynard: Financial Accounting, Reporting and Analysis Statement of cash flows example Dewberry Limited Statements of financial position at 30 June 20X6 and 20X5 20X6 20X5 £000 £000 Property, plant and equipment Cost 2,190 1,310 Accumulated depreciation 895 500 1,295 810 Current assets Inventory 1,500 500 Receivables 2,680 890 Bank 60 4,180 1,450 Total assets 5,475 2,260 Jennifer Maynard: Financial Accounting, Reporting and Analysis Statement of cash flows example Equity Share capital Share premium Retained earnings Non-current liabilities Long-term loan Current liabilities Bank overdraft Payables Taxation Total equity and liabilities Jennifer Maynard: Financial Accounting, Reporting and Analysis 20X6 £000 20X5 £000 600 15 1,610 2,225 400 600 1,000 60 260 1,810 1,100 280 3,190 5,475 680 320 1,000 2,260 Statement of cash flows example Know where you are heading: £000 Net cash flow during year Balance at 1 July 20X5 Net cash outflow Balance at 30 June 20X6 (balancing figure) Jennifer Maynard: Financial Accounting, Reporting and Analysis 60 (1,870) (1,810) Statement of cash flows example Cash flow from operating activities – Direct method £000 Cash received from customers: Sales 21,000 Closing receivables (2,680) + Opening receivables 890 Cash paid to suppliers: Purchases Closing payables + Opening payables £000 19,210 16,400 (1,100) 680 (15,980) Cash paid to employees and other suppliers: Expenses (from Inc. St.) 3,370 Non-cash expenses: Depreciation (395) Cash generated from operating activities (2,975) £ 255 Jennifer Maynard: Financial Accounting, Reporting and Analysis Statement of cash flows example Cash flow from operating activities – Indirect method Profit before tax Add back: interest expense Add back: non-cash expenses: Depreciation Movement in inventory – increase (1,500 – 500) Increase in receivables (2,680 – 890) Increase in payables (1,100 – 680) Cash generated from operating activities Jennifer Maynard: Financial Accounting, Reporting and Analysis £000 2,030 200 395 (1,000) (1,790) 420 £ 255 Statement of cash flows example Statement of cash flows for the year ended 30 June 20X6 Cash flows generated from operating activities Interest paid Corporation tax paid (320 + (520 – 280)) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (2,190 – 1,310) Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital (615 – 400) Repayment of debentures (60 – 260) Dividends paid (500) Net cash used in financing activities Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Jennifer Maynard: Financial Accounting, Reporting and Analysis £000 255 (200) (560) (505) £000 (880) (880) 215 (200) (485) (1,870) 60 £(1,810) Notes to the financial statements • Listed companies typically have >50 pages of notes to four key financial statements! • Notes provide a break-down of headline, aggregated figures shown in the primary financial statements, e.g.: – Segmental information – Different classes of PPE – Break-down of payables balances • Key reasons: – To enable users to understand the figures – To give measurement bases – To provide information about figures have been derived • Notes include accounting policies Jennifer Maynard: Financial Accounting, Reporting and Analysis Accounting policies • Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements • Usually determined by the specific IAS/IFRS that applies to a particular transaction, event or condition: – In order that the financial statements contain relevant and faithfully representative information – To assist users’ understanding and aid comparability • If no IFRS, management judgement required to develop policy Jennifer Maynard: Financial Accounting, Reporting and Analysis Accounting policies What accounting policies should be disclosed? • Those which assist users in understanding how transactions, other events and conditions are reflected in the financial statements – e.g. the measurement bases used for a specific item or transaction • Particularly where alternative accounting methods are allowed in IFRSs or management has to make choices, e.g.: – Methods of depreciation and asset estimated useful lives – Cost v. revaluation models for non-current assets – Method of estimating the stage of completion for construction contracts Jennifer Maynard: Financial Accounting, Reporting and Analysis Estimates, judgements and risks • Many figures in statement of comprehensive income based on estimates and management judgement, e.g.: – – – – Estimates of useful lives and residual values for depreciation Inventory obsolescence When internal development costs can be capitalised The financial impact of ongoing legal cases • Arises from principles based IFRSs • IAS 1 requires disclosures of assumptions relating to uncertainties that have a significant risk of resulting in material adjustments in future periods • Reporting of risk of particular concern post financial crisis Jennifer Maynard: Financial Accounting, Reporting and Analysis Changes in accounting policies • Changes are allowed if they result from a new/updated IFRS or a new policy is more relevant or reliable • A change in accounting policy is applied retrospectively – i.e. comparative figures and opening balances are adjusted • Changes in estimates/ judgements are recognised prospectively – included in profit and loss in the period the change occurs • i.e. No adjustment of opening/comparative figures – e.g. Changes in provisions for doubtful debts; inventory obsolescence; fair value of financial assets or financial liabilities; the useful lives of, or expected pattern of usage of depreciable assets; warranty obligations • Correction of errors is retrospective Jennifer Maynard: Financial Accounting, Reporting and Analysis Examples Classify the following as changes in accounting policy, changes in estimates or errors • Development expenditure now capitalised instead of being written off Accounting policy • Revision of the life of a non-current asset Estimate • Change from straight-line to reducing balance depreciation Estimate • Mis-calculation of depreciation charge Error Jennifer Maynard: Financial Accounting, Reporting and Analysis Issues with current IAS 1 • Too many alternative presentation methods permitted • Principle financial statements contain information that is too highly aggregated • Inconsistent presentations between statements – e.g. Statement of financial position split of assets/liabilities into non-current/current; statement of cash flows splits activities into operating, investing and financing • Differences in presentation between IAS 1 and US GAAP • Large ongoing IASB/FASB convergence project – To produce a replacement to IAS 1 and IAS 7 – To address the presentation of other comprehensive income – To address the presentation of discontinued operations Jennifer Maynard: Financial Accounting, Reporting and Analysis Proposals Statement of financial position Statement of comprehensive income Statement of cash flows Business section Operating category Business section Operating category Operating finance subcategory Business section Operating category Operating finance subcategory Investing category Financing section Debt category Equity category Investing category Financing section Debt category Investing category Financing section Multi-category transaction section Multi-category transaction section Income tax section Discontinued operation section, net of tax Income tax section Discontinued operation section Income tax section Discontinued operation section Other comprehensive income, net of tax Jennifer Maynard: Financial Accounting, Reporting and Analysis Proposals • Statements drawn up on core principles of: – Cohesiveness – clarity in the relationship between items in different statements – Disaggregation – resources are separated by the activity in which they are used and their economic characteristics • Expenses in statement of comprehensive income disclosed according to their function • Statement of financial position – assets/ liabilities grouped under each section/ category as short or longterm • Statement of cash flows presented using direct method • More line items and subtotals enabling better comparison Jennifer Maynard: Financial Accounting, Reporting and Analysis
