2.3 Financial Reporting Standards
** This note is summarized by Hui Wang.
Learning Outcomes
The candidate should be able to:
a. Explain the objective of financial statements and the importance of reporting
standards in security analysis and valuation;
b. Explain the role of standard-setting bodies, such as the International Accounting
Standards Board and the U.S. Financial Accounting Standards Board, and
regulatory authorities such as the International Organization of Securities
Commissions, the U.K. Financial Services Authority, and the U.S. Securities and
Exchange Commission in establishing and enforcing financial reporting
standards;
c. Discuss the ongoing barriers to developing one universally accepted set of
financial reporting standards;
d. Describe the International Financial Reporting Standards (IFRS) framework,
including the objective of financial statements, their qualitative characteristics,
required reporting elements, and the constraints and assumptions in preparing
financial statements;
e. Explain the general requirements for financial statements;
f. Compare and contrast key concepts of financial reporting standards under IFRS
and alternative reporting systems, and discuss the implications for financial
analysis of differing financial reporting systems;
g. Identify the characteristics of a coherent financial reporting framework and
barriers to creating a coherent financial reporting network;
h. Discuss the importance of monitoring developments in financial reporting
standards and evaluate company disclosures of significant accounting policies.
Financial reporting standard-setting bodies and regulatory authorities
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Standard-setting bodies are typically composed of experienced accountants,
auditors, users of financial statements, and academics and generally they make the
rules.
Regulatory authorities are governmental entities that have the legal authority to
enforce financial reporting requirements and exert other controls over entities that
participate in the capital markets within their jurisdiction and they have the right
to overrule the private sector standard-setting bodies.
International Accounting Standards Board
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IASB was reconstituted in 2001 from IASC (International Accounting Standards
Committee) and currently has 14 full-time board members. The four goals of the IASB
are:
a. To develop, in the public interest, a single set of high quality, understandable and
enforceable global accounting standards that require high quality, transparent and
comparable information in financial statements and other financial reporting to help
participants in the world’s capital markets and other users make economic decisions;
b. To promote the use and rigorous application of those standards;
c. In fulfilling the objectives associated with (a) and (b), to take account of, as appropriate,
the special needs of small and medium-sized entities and emerging economies; and
d. To bring about convergence of national accounting standards and International
Accounting Standards and International Financial Reporting Standards to high quality
solutions.
International Organization of Securities Commissions
“IOSCO was born in 1983 from the transformation of its ancestor inter-American
regional association (created in 1974) into a truly international cooperative
body…...Today IOSCO is recognized as the international standard setter for securities
markets. The Organization’s wide membership regulates more than 90% of the world’s
securities markets and IOSCO is the world’s most important international cooperative
forum for securities regulatory agencies. IOSCO members regulate more than one
hundred jurisdictions and the Organization’s membership is steadily growing.”
The three core objectives of IOSCO on securities regulation are:
 Protecting investors;
 Ensuring that markets are fair, efficient, and transparent;
 Reducing systematic risk.
Capital markets regulation in Europe
Each individual member state of the EU regulates capital markets in its own jurisdiction.
However, in 2001, the European Commission established two committees related to
securities regulation:
 European Securities Committee (ESC)-is composed of high-level representatives
of member states and advises the European Commission on securities policy
issues;
 Committee of European Securities Regulators (CESR)- an independent advisory
body composed of representatives of regulatory authorities of the member states .
Significant securities-related legislation in the United States
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Securities Act of 1933 (The 1933 Act) – in the aftermath of the stock market
crash of 1929, U.S. Congress enacted the Securities Act of 1933. The 1933 Act
requires that any offer or sale of securities using the means and instrumentalities
of interstate commerce be registered pursuant to the Act, unless an exemption
from registration exists under the law.
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Securities Exchange Act of 1934 (The 1934 Act) – this Act created the SEC and
gave the SEC authority over all aspects of the securities industry. Issuers of
securities registered under the 1934 Act must file various reports with the SEC.
Since 1964 this disclosure requirement has applied not only to companies with
securities listed on national securities exchanges but also to companies with more
than 500 shareholders and more than $5 million in assets.
Sarbanes-Oxley Act of 2002 – the Sarbanes-Oxley Act was passed in the wake of
a myriad of corporate scandals, such as Enron, WorldCom and Tyco covered up
or misrepresented a variety of questionable transactions, resulting in huge losses
to stakeholders. The major provisions of the act include:
 CEOs and CFOs are held responsible for their companies’ financial
reports
 Executive officers and directors may not solicit or accept loans from their
companies
 Insider trades are reported more quickly
 Insider trades are prohibited during pension-fund blackout periods
 Mandatory disclosure of CEO and CFO compensation and profits
 Mandatory internal audits and review and certification of those audits by
outside auditors
 Criminal and civil penalties for securities violations
 Longer jail sentences and larger fines for executives who intentionally
misstate financial statements
 Audit firms may no longer provide actuarial, legal, or consulting services
to firms they audit
 Publicly traded companies must establish internal financial controls and
have those controls audited annually
Some important filings for analysts
(1) Securities Offerings Registration Statement- disclosures about the securities being
offered for sale; the relationship of these new securities to the issuer’s other
capital securities; the information typically provided in the annual filings; recent
audited financial statements; risk factors involved in the business.
(2) Forms 10-K, 20-F, and 40-F- filing on a annual basis, disclosing historical
summary of financial date, management’s discussion and analysis (MD&A) of the
company’s financial condition and results of operations, and audited financial
statements. Form 10-K is for U.S. registrants, Form 40-F is for certain Canadian
registrants, and Form 20-F is for all other non-U.S. registrants.
(3) Proxy Statement/ Form DEF-14A- the material accompanying solicitation of a
proxy from stockholders. The proxy statement lists the items to be voted on
including nominees for directorships, the auditing firm recommended by directors,
the salaries of top officers and directors, and resolutions submitted by
management and stockholders. Proxy statement are required by the SEC.
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(4) Forms 10-Q and 6-K- interim filings that include unaudited financial statements,
an MD&A for the interim period and disclosures of nonrecurring events.
(5) Form 8-K- filed with SEC when a company is going through major events as
acquisitions or disposals of corporate assets, changes in securities and trading
markets, matters related to accountants and financial statements, corporate
governance and management changes, and Regulation FD disclosures.
(6) Form-144- filed with the SEC as notice of the proposed sale of restricted
securities or securities held by an affiliate of the issuer in reliance on Rule 144.
(7) Forms 3, 4, and 5-filed by director or officer of a registered as well as beneficial
owners of greater than 10% of a class of registered equity securities to report
beneficial ownership of securities.
(8) Form 11-K- filed annually to report employee stock purchase, savings, and
similar plans.
The Norwalk Agreement
In the Norwalk Agreement, both the IASB and FASB pledged to make best efforts to:
(1) Make their existing financial reporting standards fully compatible as soon as
practicable;
(2) Coordinate their future work programs to ensure that, once achieved,
compatibility is maintained.
IFRS framework for the preparation and presentation of financial statements
(1) Objective of financial statements- to provide a fair presentation of financial
position, financial performance and cash flows of an entity for potential users
(include investors, creditors, suppliers, customers, employees, lenders,
government agencies, the public, and analyst)
(2) Qualitative Characteristics of financial statements
Qualitative Characteristics
Understandability
Relevance
Reliability
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Meaning
Readily understandable by users with a
basic knowledge of business, economic
activities, and accounting, and a
willingness to study the information
with reasonable diligence.
Will influences economic decisions of
users
Free from material error and bias:
 Faithful representation
 Substance over form
 Neutrality
 Prudence
Presented in a consistent manner over
time and in a consistent manner
between entities to ensure users to make
significant comparisons
Comparability
(3) Underlying assumptions in financial statements
 Accrual basis- under accrual basis accounting, income is reported in the
fiscal period it is earned, regardless of when cash is received, and
expenses are deducted in the fiscal period they are incurred, whether they
are paid or not.
 Going concern- a company will continue to operate indefinitely, and will
not go out of business and liquidate its assets. For this to happen, the
company must be able to generate and/ or raise enough resources to stay
operational.
Measurement of financial statement elements
Historical cost
Current cost
Realizable value
Present value
Fair value
Required financial statements
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Asset
Acquisition price of an asset
less discounts plus all
normal incidental costs
necessary to bring the asset
into existing use and
location.
The amount of money that
would have to be paid to
buy identical or an
equivalent asset today.
Amount of money that
could currently be obtained
by the disposal of the asset.
Liability
The amount of proceeds
received in exchange for the
obligation.
Undiscounted amount of
cash or cash equivalents
that would be required to
settle the obligation today.
Undiscounted amount of
cash or cash equivalents
expected to be paid to
satisfy the liabilities in the
normal course of business
Present discounted value of Present discounted value of
the future net cash inflows
the future nest cash
that the asset is expected to outflows that are expected
generate
to be required to settle the
liabilities
The amount agreed upon between knowledgeable, willing
parties in an arm’s length transaction
According to IAS No. 1, a complete set of financial statements includes:
 A balance sheet
 An income statement
 A statement of changes in equity showing either:
all changes in equity, or
changes in equity other than those arising from transactions with equity holders
acting in their capacity as equity holders
 A cash flow statement
 Notes comprising a summary of significant accounting policies and other
explanatory notes.
Fundamental principles underlying the preparation of financial statements
A company may state in the note to its financial statements that it is in compliance with
IFRS only when it is in compliance with all requirements of IFRS.
Fundamental principles specified by IAS in preparing of financial statements include:
 Fair presentation
 Going concern
 Accrual basis
 Consistency
 Materiality
Presentation requirement
Under IAS No. 1, the basic presentation principles include:
 Aggregation- each material class similar items is presented separately
 No offsetting- assets and liabilities, income and expenses are not offset unless
required or permitted by an IFRS.
 Classified balance sheet
 Minimum information on the face of the financial statements- there is requirement
about the minimum line item disclosures on the face of financial statements or in
the notes to them
 Minimum information in the notes
 Comparative information- comparative information on all items reported in a
financial statement should be provided for the previous period unless another
standard requires or permits otherwise
U.S. GAAP
Generally accepted accounting principles (GAAP) is a collection of methods used to
process, prepare, and present public accounting information. It defines the sources of
accounting principles and a framework for selecting the right principle.
Summary of Differences between IFRS and U.S. GAAP Frameworks
U.S. GAAP (FASB) Framework
Purpose of the framework
The FASB framework is similar to the
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Objectives of financial statements
Underlying assumptions
Qualitative characteristics
Constraints
Financial statement elements (definition,
recognition, and measurement)
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IASB framework in its purpose to assist in
developing and revising standards, but it
resides at a lower level in the hierarchy- a
very important difference. Under IFRS,
management is expressly required to
consider the framework if there is no
standard or interpretation for that issue.
The FASB framework does not have a
similar provision.
There is general agreement on the
objectives of financial statements: both
frameworks have a broad focus to provide
relevant information to a wide range of
users. The principal difference is that the
U.S. GAAP framework provides separate
objectives for business entities versus
nonbusiness entities rather than one
objective as in the IASB framework.
Although the U.S. GAAP framework
recognizes the importance of the accrual
and going concern assumptions, these are
not given as much prominence as in the
IASB framework. In particular, the going
concern assumption is not well developed
in the FASB framework.
The U.S. GAAP framework identifies the
same qualitative characteristics but also
establishes a hierarchy of those
characteristics. Relevance and reliability
are considered primary qualities, whereas
comparability is deemed to be a secondary
quality under the FASB framework. The
fourth qualitative characteristic,
understandability, is treated as a usespecific quality in the U.S. GAAP
framework and is seen as a link between
the characteristics of framework indicates
that it cannot base its decisions on the
specific circumstances of individual users.
There is similar discussion of the
constraints in both frameworks.
 Performance elements. The FASB
framework includes three elements
relating to financial performance in
addition to revenue and expenses:
gains, losses, and comprehensive
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income. Comprehensive income is a
more encompassing concept than
net income, as it includes all
changes in equity during a period
except those resulting from
investments by and distributions to
owners.
Financial position elements. The
FASB framework defined\s an asset
as “a future economic benefit”
rather than the “resource” from
which future economic benefits are
expected to flow to the entity as in
the IASB framework. It also
includes the term “probable” to
define the assets and liabilities
elements.
Recognition of elements. The
FASB framework does not discuss
the term “probable” in its
recognition criteria, whereas the
IASB framework requires that it is
probable that any future economic
benefit flow to/ from the entity. The
FASB framework also has a
separate recognition criterion of
relevance.
Measurement of elements.
Measurement attributes (historical
cost, current cost, settlement value,
current market value, and present
value) are broadly consistent, and
both frameworks lack fully
developed measurement concepts.
Furthermore, the FASB framework
prohibits revaluations except for
certain categories of financial
instruments, which have to be
carried at fair value.
-from CFA® Curriculum
Characteristics of an effective financial reporting framework
 Transparency- users should be able to see the underlying business operations
through a company’s financial statements. Full disclosure and fair presentation
entail transparency.
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 Comprehensiveness- the information contain in financial statements should be
universal enough to provide guidance for recording both existing and newly
developed transactions.
 Consistency- financial statements should ensure reasonable consistency across
companies and time periods.
Barriers to a single coherent framework
 Valuation- different cost measures require different degree of judgment and give
different values of identical assets or liabilities.
 Standard- setting approach- financial reporting standards can be either principlesbased (meaning it provides a broad financial reporting framework with little
specific guidance on how to report a particular element or transaction) or rulesbased (meaning that it establishes specific rules for each element or transaction)
IFRS has been referred to as a “principles-based approach.” The FASB, which has been
criticized for having a rules-based approach in the past, has explicitly stated that it is
moving to adopt a more objectives-oriented approach to standard setting.
 Measurement-the conflict between taking an “asset/liability” approach and taking
an “revenue/expense” approach can result in either balance sheet or income
statement being reported in a theoretically sound manner, while the other
statement reflecting less relevant information.
Monitoring developments in financial reporting standards
There are three areas that worth analysts’ attention:
 New products or transactions
 Actions of standard setters and other groups representing users of financial
statements
 Company disclosures regarding critical accounting policies and estimates
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Exercise Problems: (provided by Stalla PassMaster for CFA Exams.)
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EXPLANATION
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