CHAPTER 3
FINANCIAL REPORTING STANDARDS
Presenter’s name
Presenter’s title
dd Month yyyy
OBJECTIVE OF FINANCIAL REPORTING
• Objective of general purpose financial reporting
- To provide financial information about the reporting entity that is
useful to existing and potential investors, lenders, and other
creditors in making decisions about providing resources to the entity.
Those decisions involve buying, selling, or holding equity and debt
instruments and providing or settling loans and other forms of credit.
• Investors
- Buy, sell, or hold
• Lenders and other creditors
- Lend or not
- Amount and terms
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FINANCIAL REPORTING USE IN SECURITY
ANALYSIS AND VALUATION
• Decisions by investors to buy, sell, or hold securities depends on
expectations about returns (dividend yield and price appreciation).
• Expectations about returns depend on prospects for an entity’s future
cash flows, and assessing those prospects requires information about
an entity’s
- resources,
- claims on resources, and
- use of the resources by management and board.
• Financial reports are not designed to show the value of a reporting
entity; they provide information to help users estimate the value of the
reporting entity.
• Financial reports do not and cannot provide all the information needed
by investors and creditors. Other pertinent information must be
obtained from other sources.
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IMPORTANCE OF FINANCIAL REPORTING
STANDARDS IN SECURITY ANALYSIS AND
VALUATION
• Complexity involved in setting standards reflects the complexity of the
underlying economic reality.
• Complexity and uncertainty create the need for judgment by preparers.
• Judgment can vary among preparers, so standards are needed to
achieve consistency.
• Even though standards limit the range of acceptable approaches,
preparers still must make judgments and use estimates.
• By understanding how and when standards require judgments and
estimates that can affect reported numbers, an analyst can make better
use of the information.
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EXAMPLE
During an accounting period, Incook Inc., a hypothetical company that
imports gourmet cookware sets, had the following transactions:
• Acquired office equipment for $9,000 in cash
• Paid rent and other miscellaneous business expenses of $10,000
• Purchased 100 sets of cookware at a cost of $700 each and paid
100% on delivery
• Sold 60 sets to customers for $1,200 each ($72,000 total). In order to
make the sales, Incook had to offer credit terms to many customers. At
year-end, customers owed Incook $15,000 for cookware that had been
delivered (i.e., $57,000 cash was collected from customers and,
therefore, $15,000 remained outstanding from customers).
Incook’s two owners plan to split the profits 50/50. If no accounting
standards existed, what alternatives might be proposed as reasonable
ways to compute the profits?
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EXAMPLE
• Accounting standards limit the range of allowable approaches.
• Incook would report sales revenues of $72,000; however, that amount
would likely be reduced to reflect an estimate for uncollectible
accounts.
• Incook would report cost of goods sold of $42,000.
- It sold 60 units, each of which cost $700.
- If the per-unit costs were different, cost of goods sold would require
the choice of inventory cost method.
• Incook would report some amount of expense for at least part of the
office equipment. The amount of the expense would depend on
- Estimated useful life of the equipment,
- Estimated salvage value of the equipment at the end of its life, and
- Choice of depreciation method.
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STANDARD-SETTING BODIES AND
REGULATORY AUTHORITIES
• Generally,
- Standard-setting bodies set the standards and
- Regulatory authorities recognize and enforce the
standards.
• However, regulators often retain the legal authority to
establish financial reporting standards in their jurisdictions
and can overrule private sector standard-setting bodies.
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EXAMPLES OF STANDARD-SETTING BODIES
• The International Accounting Standards Board (IASB) sets
IFRS (International Financial Reporting Standards).
• The U.S. Financial Accounting Standards Board (FASB)
sets U.S. GAAP (generally accepted accounting
principles).
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EXAMPLES OF REGULATORY AUTHORITIES
Country
Regulatory authority with primary responsibility for
securities regulation in the country
Australia
Australian Securities and Investments Commission
Belgium
Financial Services and Markets Authority
Brazil
Comissão de Valores Mobiliários
China
China Securities Regulatory Commission
France
Autorité des marchés financiers
Germany
Bundesanstalt für Finanzdienstleistungsaufsicht
India
Securities and Exchange Board of India
Japan
Financial Services Agency
Morocco
Conseil déontologique des valeurs mobilières
Nigeria
Securities and Exchange Commission Nigeria
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EXAMPLES OF REGULATORY AUTHORITIES
(CONTINUED)
Country
Regulatory authority with primary responsibility for
securities regulation in the country
Portugal
Comissão do Mercado de Valores Mobiliários
Spain
Comisión Nacional del Mercado de Valores
South Africa
Financial Services Board
Turkey
Capital Markets Board of Turkey
United Kingdom
Financial Services Authority*
United States
Securities and Exchange Commission (SEC)
Uruguay
Banco Central del Uruguay
*FSA to be succeeded by the Financial Conduct Authority and the Prudential
Regulation Authority in 2013.
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INTERNATIONAL ORGANIZATION OF
SECURITIES COMMISSIONS (IOSCO)
• Not a regulatory authority, but an international association of
securities regulators formed in 1983
• Objectives of IOSCO members:
- Develop international standards of market regulation to protect
investors and address systemic risks.
- Exchange information and cooperate in enforcement to enhance
investor protection and promote investor confidence.
- Exchange information to assist in development of markets,
infrastructure, and regulation.
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IFRS USE AROUND THE WORLD
Country
Argentina
Status for Listed Companies as of December 2011
Required for fiscal years beginning on or after 1 January 2012
Required for all private sector reporting entities and as the
Australia
basis for public sector reporting since 2005
Required for consolidated financial statements of banks and
Brazil
listed companies from 31 December 2010 and for individual
company accounts progressively since January 2008
Required from 1 January 2011 for all listed entities and
Canada
permitted for private sector entities including not-for-profit
organizations
China
Substantially converged national standards
All member states of the EU are required to use IFRS as
European Union
adopted by the EU for listed companies since 2005
India
India is converging with IFRS at a date to be confirmed
Convergence process ongoing; a decision about a target date
Indonesia
for full compliance with IFRS is expected to be made in 2012
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IFRS USE AROUND THE WORLD
Country
Japan
Status for Listed Companies as of December 2011
Permitted from 2010 for a number of international companies;
decision about mandatory adoption by 2016 expected around
2012
Mexico
Required from 2012
Republic of
Korea
Required from 2011
Russia
Required from 2012
Saudi Arabia
Required for banking and insurance companies. Full
convergence with IFRS currently under consideration.
South Africa
Required for listed entities since 2005
Turkey
Required for listed entities since 2005
Allowed for foreign issuers in the U.S. since 2007; target date
United States for substantial convergence with IFRS was 2011 and decision
about possible adoption for U.S. companies expected.
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CONTINUING DEVELOPMENTS IN FINANCIAL
REPORTING STANDARDS
• As illustrated on the preceding slides, although many countries have
adopted IFRS, not all countries have done so.
• Financial reporting standards (both IFRS and home-country GAAP)
continue to evolve for various reasons, including
- Changes in economic activity (new types of products and
transactions),
- Improvements to existing standards, and
- Convergence between international and home-country standards.
• An analyst needs to understand whether and how differences in
financial reporting standards affect comparability in cross-sectional
analysis.
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GLOBAL CONVERGENCE OF ACCOUNTING
STANDARDS: DIFFERENCES REMAIN
• Different reporting systems are used in different countries.
• For example, despite convergence efforts, differences remain between
U.S. GAAP and IFRS.
Inventory
• IFRS does not allow for the use of the LIFO (last in, first out) costing
methodology for inventory, which is permitted under U.S. GAAP.
• In the United States, the Internal Revenue Service (IRS) has
conformity provisions such that certain methods of accounting are
allowed for income tax purposes only if the entity also uses that
method for financial reporting purposes. LIFO is one such method
subject to conformity provisions.
• Thus, without a change in IRS rules, eliminating LIFO from U.S. GAAP
would, in effect, eliminate its use for tax purposes as well.
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GLOBAL CONVERGENCE OF ACCOUNTING
STANDARDS: DIFFERENCES REMAIN
• Despite convergence efforts, differences remain between U.S. GAAP
and IFRS.
Measurement of Certain Asset Classes (optionality permitted under
IFRS)
• Under IFRS, certain assets (e.g., capitalized acquired intangibles and
property, plant, and equipment) are initially recognized at cost. For
subsequent measurement, entities have a choice:
- to continue with a cost model or
- To revalue the assets within each class to fair market value (less any
subsequent accumulated amortization or depreciation).
• U.S. GAAP does not permit use of a revaluation model.
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GLOBAL CONVERGENCE OF ACCOUNTING
STANDARDS: DIFFERENCES REMAIN
• Despite convergence efforts, differences remain between U.S. GAAP
and IFRS.
Impairment (property, plant, and equipment; inventory; and intangible
assets)
• The IFRS models allow for reversals of impairments up to a certain
amount if there is an indication that an impairment loss has decreased
• U.S. GAAP does not allow reversals of impairments.
• The SEC staff believes that the distinction could result in differences in
the timing and extent of recognized impairment losses.
• Therefore, U.S. issuers could experience greater income statement
volatility if the IFRS models were incorporated (flowing from recoveries
of values previously written down).
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GLOBAL CONVERGENCE OF ACCOUNTING
STANDARDS: DIFFERENCES REMAIN
• Despite convergence efforts, differences remain between U.S. GAAP and
IFRS.
Certain Nonfinancial Liabilities
• The recognition of certain nonfinancial liabilities (e.g., contingencies and
environmental liabilities) is governed by the probability that a liability has been
incurred under both U.S. GAAP and IFRS. However, U.S. GAAP and IFRS
differ in their definitions of what is “probable.”
• For example, the definition of probable for contingencies is
- For IFRS, “more likely than not to occur.”
- For U.S. GAAP, “the future event or events are likely to occur.”
• “Likely” is considered to be a higher threshold than “more likely than not,”
meaning U.S. GAAP has a higher recognition threshold than does IFRS.
• Therefore, a liability will often be recognized earlier under IFRS than under
U.S. GAAP.
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IFRS CONCEPTUAL FRAMEWORK
Reporting Elements
Qualitative Characteristics
Objective
To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity
 Relevance*
 Faithful Representation

 Performance
o
o
o
o
o
 Financial Position
Income
Expenses
Capital Maintenance Adjustments
Past Cash Flows
Constraint
Reporting
Comparability, Verifiability,
Timeliness,
Understandability
o
o
o
Assets
Liabilities
Equity
Ele
 Cost (cost/benefit considerations)
Underlying Assumption
 Accrual Basis
 Going Concern
*Materiality is an aspect of relevance.
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IFRS CONCEPTUAL FRAMEWORK:
OBJECTIVE OF FINANCIAL REPORTING
• At the core of the Conceptual
Framework is the objective to
provide financial information that
is useful to current and potential
providers of resources in making
decisions.
Reporting Elements
Qualitative Characteristics
Objective
To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity
• All other aspects of the
framework flow from that central
objective.
 Relevance*
 Faithful Representation

 Performance
o
o
o
o
o
 Financial Position
Income
Expenses
Capital Maintenance Adjustments
Past Cash Flows
Constraint
Reporting
Comparability, Verifiability,
Timeliness,
Understandability
o
o
o
Assets
Liabilities
Equity
Ele
 Cost (cost/benefit considerations)
Underlying Assumption
 Accrual Basis
 Going Concern
*Materiality is an aspect of relevance.
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IFRS CONCEPTUAL FRAMEWORK:
FUNDAMENTAL QUALITATIVE CHARACTERISTICS
• Two fundamental qualitative
characteristics that make
financial information useful:
- Relevance: Information that
could potentially make a
difference in users’ decisions.
- Faithful Representation:
Information that faithfully
represents an economic
phenomenon that it purports
to represent. It is ideally
- complete,
- neutral, and
- free from error.
Reporting Elements
Qualitative Characteristics
Objective
To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity
 Relevance*
 Faithful Representation

 Performance
o
o
o
o
o
 Financial Position
Income
Expenses
Capital Maintenance Adjustments
Past Cash Flows
Constraint
Reporting
Comparability, Verifiability,
Timeliness,
Understandability
o
o
o
Assets
Liabilities
Equity
Ele
 Cost (cost/benefit considerations)
Underlying Assumption
 Accrual Basis
 Going Concern
*Materiality is an aspect of relevance.
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IFRS CONCEPTUAL FRAMEWORK:
ENHANCING QUALITATIVE CHARACTERISTICS
• Four enhancing qualitative
characteristics that make financial
information useful:
Reporting Elements
Qualitative Characteristics
- Comparability: Companies record
and report information in a similar
manner.
Objective
To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity
 Relevance*
 Faithful Representation
- Verifiability: Independent people
using the same methods arrive at
similar conclusions.
- Timeliness: Information is available
before it loses its relevance.
- Understandability: Reasonably
informed users should be able to
comprehend the information.
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
 Performance
o
o
o
o
o
 Financial Position
Income
Expenses
Capital Maintenance Adjustments
Past Cash Flows
Constraint
Reporting
Comparability, Verifiability,
Timeliness,
Understandability
o
o
o
Assets
Liabilities
Equity
Ele
 Cost (cost/benefit considerations)
Underlying Assumption
 Accrual Basis
 Going Concern
*Materiality is an aspect of relevance.
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IFRS CONCEPTUAL FRAMEWORK:
REPORTING ELEMENTS
• Elements directly related to the
measurement of financial position:
Reporting Elements
- Assets: Resources controlled by
the enterprise as a result of past
events and from which future
economic benefits are expected to
flow to the enterprise.
- Liabilities: Present obligations of
an enterprise arising from past
events, the settlement of which is
expected to result in an outflow of
resources embodying economic
benefits.
- Equity: Residual interest in the
assets after subtracting the
liabilities.
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Qualitative Characteristics
Objective
To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity
 Relevance*
 Faithful Representation

 Performance
o
o
o
o
o
 Financial Position
Income
Expenses
Capital Maintenance Adjustments
Past Cash Flows
Constraint
Reporting
Comparability, Verifiability,
Timeliness,
Understandability
o
o
o
Assets
Liabilities
Equity
Ele
 Cost (cost/benefit considerations)
Underlying Assumption
 Accrual Basis
 Going Concern
*Materiality is an aspect of relevance.
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IFRS CONCEPTUAL FRAMEWORK:
REPORTING ELEMENTS
• Elements directly related to the
measurement of performance:
Reporting Elements
- Income: Increases in economic
benefits in the form of inflows or
enhancements of assets or
decreases of liabilities that result
in an increase in equity (other than
increases resulting from
contributions by owners).
- Expenses: Decreases in economic
benefits in the form of outflows or
depletions of assets or increases
in liabilities that result in decreases
in equity (other than decreases
because of distributions to
owners).
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Qualitative Characteristics
Objective
To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity
 Relevance*
 Faithful Representation

 Performance
o
o
o
o
o
 Financial Position
Income
Expenses
Capital Maintenance Adjustments
Past Cash Flows
Constraint
Reporting
Comparability, Verifiability,
Timeliness,
Understandability
o
o
o
Assets
Liabilities
Equity
Ele
 Cost (cost/benefit considerations)
Underlying Assumption
 Accrual Basis
 Going Concern
*Materiality is an aspect of relevance.
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IFRS CONCEPTUAL FRAMEWORK:
CONSTRAINTS AND ASSUMPTIONS
• Constraint: The benefits of
information should exceed the
costs of providing it.
Reporting Elements
Qualitative Characteristics
• Underlying Assumptions:
Objective
To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity
- Accrual Basis: Financial
statements should reflect
transactions in the period when
they actually occur, not
necessarily when cash
movements occur.
 Relevance*
 Faithful Representation
 Performance
o
o
o
o
o
- Going Concern: Assumption
that the company will continue
in business for the foreseeable
future.
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
 Financial Position
Income
Expenses
Capital Maintenance Adjustments
Past Cash Flows
Constraint
Reporting
Comparability, Verifiability,
Timeliness,
Understandability
o
o
o
Assets
Liabilities
Equity
Ele
 Cost (cost/benefit considerations)
Underlying Assumption
 Accrual Basis
 Going Concern
*Materiality is an aspect of relevance.
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FINANCIAL STATEMENTS
A complete set of financial statements includes
• Statement of financial position
• Statement of comprehensive income
• Statement of changes in equity
• Statement of cash flows
• Notes
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GENERAL FEATURES OF FINANCIAL
STATEMENTS
• Fair presentation
• Going concern
• Accrual basis
• Materiality and aggregation
• No offsetting
• Frequency of reporting
• Comparative information
• Consistency
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STRUCTURE AND CONTENT REQUIREMENTS
FOR FINANCIAL STATEMENTS (IAS NO. 1)
• Classified statement of financial position: Balance sheet required to
distinguish between current and noncurrent assets and between
current and noncurrent liabilities unless a presentation based on
liquidity provides more relevant and reliable information (e.g., in the
case of a bank or similar financial institution).
• Minimum information on the face of the financial statements: Minimum
line item disclosures on the face of, or in the notes to, the financial
statements are specified.
• Minimum information in the notes (or on the face of financial
statements): Disclosures about information to be presented in the
financial statements are specified.
• Comparative information: For all amounts reported in a financial
statement, comparative information for the previous period is required.
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COHERENT FINANCIAL REPORTING
FRAMEWORK
Characteristics of a coherent
financial reporting
framework
• Transparent
• Comprehensive
• Consistent
Barriers to creating such a
framework
• Valuation: alternative
measurement approaches
• Standard-Setting
Approach: balance
between principles and
rules.
• Measurement: alternative
emphasis on balance
sheet versus income
statement.
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DISCLOSURES OF SIGNIFICANT ACCOUNTING
POLICIES
• Companies are required to disclose their accounting
policies and estimates in the notes to the financial
statements.
• Companies also discuss in the management commentary
(MD&A) those policies that management deems most
important.
• Many of the policies are discussed in both the
management commentary and the notes to the financial
statement.
• Companies also disclose information about changes.
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MD&A DISCLOSURES OF SIGNIFICANT
ACCOUNTING POLICIES: EXAMPLE 1
“In certain instances, accounting principles generally accepted in the United
States of America allow for the selection of alternative accounting methods. The
Company’s significant policies that involve the selection of alternative methods
are accounting for shipping and handling costs and inventories.
“Shipping and handling costs may be reported as either a component of cost of
sales or selling, general and administrative expenses. The Company reports such
costs, primarily related to warehousing and outbound freight, in the
Consolidated Statements of Income as a component of Selling, general and
administrative expenses. Accordingly, the Company’s gross profit margin is not
comparable with the gross profit margin of those companies that include
shipping and handling charges in cost of sales. If such costs had been included
in cost of sales, gross profit margin as a percent of sales would have decreased
by 750 bps, from 57.3% to 49.8% in 2011 and decreased by 730 bps in 2010
and 2009, with no impact on reported earnings.”
Excerpt from MD&A in Colgate Palmolive Company’s 2011 Annual Report
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FOOTNOTE DISCLOSURE OF SIGNIFICANT
ACCOUNTING POLICIES: EXAMPLE 1 (CONTINUED)
Shipping and Handling Costs
“Shipping and handling costs are classified as Selling, general and
administrative expenses and were $1,250, $1,142 and $1,116 for
the years ended December 31, 2011, 2010 and 2009, respectively.”
Excerpt from footnotes in Colgate Palmolive Company’s 2011 Annual Report
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FOOTNOTE DISCLOSURE OF SIGNIFICANT
ACCOUNTING POLICIES: EXAMPLE 1 (CONTINUED)
Use of Estimates
“The preparation of financial statements in accordance with accounting
principles generally accepted in the United States of America requires
management to use judgment and make estimates that affect the reported
amounts of assets and liabilities and disclosure of contingent gains and losses at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. The level of uncertainty in estimates and
assumptions increases with the length of time until the underlying transactions
are completed. As such, the most significant uncertainty in the Company’s
assumptions and estimates involved in preparing the financial statements
includes pension and other retiree benefit cost assumptions, stock-based
compensation, asset impairment, uncertain tax positions, tax valuation
allowances and legal and other contingency reserves. …Actual results could
ultimately differ from those estimates.”
Excerpt from footnotes in Colgate Palmolive Company’s 2011 Annual Report
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FOOTNOTE DISCLOSURES OF ACCOUNTING
PRINCIPLES AND METHODS: EXAMPLE 2
“General Information. The consolidated financial statements of Henkel AG &
Co. KGaA as of December 31, 2011 have been prepared in accordance with
International Financial Reporting Standards (IFRS) as adopted by the European
Union and in compliance with Section 315a of the German Commercial Code
[HGB]….”
“Scope of consolidation. In addition to Henkel AG & Co. KGaA as the ultimate
parent company, the consolidated financial statements at December 31, 2011
include seven German and 170 non-German companies in which Henkel AG &
Co. KGaA has a dominating influence over financial and operating policy, based
on the concept of control..... Compared to December 31, 2010, four new
companies have been included in the scope of consolidation and eleven
companies have left the scope of consolidation. Seven mergers also took place.
The changes in the scope of consolidation have not had any material effect on
the main items of the consolidated financial statements.”
Excerpt from footnotes of Henkel 2011 Annual Report
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FOOTNOTE DISCLOSURES OF ACCOUNTING
PRINCIPLES AND METHODS: EXAMPLE 2
Accounting estimates, assumptions and discretionary judgments
Preparation of the consolidated financial statements is based on a
number of accounting estimates and assumptions. These have an impact
on the reported amounts of assets, liabilities and contingent liabilities at
the reporting date and the disclosure of income and expenses for the
reporting period. The actual amounts may differ from these estimates.
“The accounting estimates and their underlying assumptions are
continually reviewed....The judgments of the Management Board
regarding the application of those IFRSs which have a significant impact
on the consolidated financial statements are presented in the explanatory
notes on taxes on income
… intangible assets..., pension obligations…, financial instruments and
share-based payment plans...”
Excerpt from footnotes of Henkel 2011 Annual Report
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SUMMARY
• Objective of financial reporting is to provide financial information about
the reporting entity that is useful to existing and potential investors,
lenders, and other creditors in making decisions about providing
resources to the entity.
• Fundamental qualitative characteristics that make financial information
useful include
− Relevance and
− Faithful representation (complete, neutral, free from error)
• Enhancing qualitative characteristics that make financial information
useful include Comparability, Verifiability, Timeliness, and
Understandability
• Constraint: benefits of info should exceed costs
• Underlying Assumptions
− Accrual accounting
− Going concern
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