CHAPTER 14
Issues in financial reporting by
multinationals
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Contents
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Investor relations
Income smoothing
Supplementary information
Financial instruments
Pension obligations
Environmental disclosures
Intellectual capital
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© 2005 Peter Walton and Walter Aerts
Investor relations
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Investor relations is a company department
whose job it is to maintain continuing
relations with financial market professionals
(to respond to their questions, organize
‘roadshows’, etc.)
Financial market professionals tend to
become company specialists
Internet brokers facilitate private investors as
active market participants
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Income smoothing
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Income smoothing is a kind of earnings
management (‘managing’ reported
earnings to meet analysts’ expectations)
Earnings management is stimulated by
the direct link between accounting
earnings and share price (P/E ratio)
Income smoothing refers more
specifically to the preference of reporting
steadily rising profits
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Price/earnings ratio
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The P/E ratio reflects the degree of risk which
the market considers inherent to a particular
company within a particular industry
Market professionals use P/E to value shares
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Current market price is evaluated as a function of
the historic P/E * forecast earnings per share
Changes in expected earnings directly affect
market price of a share
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Managing earnings
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Management of discretionary costs
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R&D, staff training, advertising
Temporal adjustments in cost levels
Closure of loss-making divisions
Changing the consolidation scope
Cookie jar accounting
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Stash accruals in ‘cookie jars’ during good times
and reach into them when needed in bad times
Misuse of provision accounting
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Big bath accounting
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Taking a one-time loss through a major
cleaning-up exercise (‘big bath’) of the
balance sheet
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Identifying and adjusting over-valued assets and
under-valued liabilities
Usually explained as an exceptional one-time
operation
Restructuring charges make room for future
profit enhancements
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Supplementary disclosures
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Supplementary disclosures are used as a way
of dealing with events which are too difficult
to measure reliably
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Contingencies (IAS 37)
Supplementary disclosures are used as a way
of informing investors on events which do not
relate to the accounting period but may have
an impact on future years
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Post-balance sheet events (IAS 10)
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Contingencies
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A contingency is a condition or situation, the
ultimate outcome of which (gain or loss) will
be confirmed only by the occurrence or nonoccurrence of uncertain future events not
wholly under control of the company
IAS 37 Provisions, Contingent Liabilities and
Continent Assets
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Provisions
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A provision is a present obligation as a result of
a past event, whereby
It is probable that settlement of the obligation will
lead to a future outflow of company resources
 The amount or timing of future outflow is uncertain
 A reliable estimate of the amount of the obligation is
feasible
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Borderline between provisions and contingent
liabilities
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IAS 37 – Provisions, Contingent Liabilities
and Contingent Assets (Extracts)
Definitions
10. A contingent liability is:
(a) a possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain
future events not wholly within the control of the entity; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will
be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.
A contingent asset is a possible asset that arises from past events and whose
existence will be confirmed only by the occurrence or non-occurrence of one or more
uncertain future events not wholly within the control of the entity.
Source: IAS 37 – Provisions, Contingent Liabilities and Contingent Assets
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© 2005 Peter Walton and Walter Aerts
Figure 6.1 Decision tree - Recognising a
provision
Start
Present
obligation as a
result of an
obligating event
No
Possible
obligation ?
No
Yes
Probable
outflow ?
No
Remote?
Yes
No
Yes
Reliable
estimate ?
No (rare)
Yes
Provide
Disclose
contingent liability
Do nothing
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Source: IAS 37 – Provisions, Contingent Liabilities and Contingent Assets
Contingent liabilities
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A contingent liability refers to
1.
2.
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A possible obligation that arises from past
events, or
A present obligation that is not recognized
because the future expenditure is not probable or
the obligation cannot be measured with sufficient
reliability
Requires disclosure in the notes to the
accounts as it may affect the assessment of
future profitability
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Onerous contracts
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Pending contracts in general need no special
accounting treatment except if they are
‘onerous’
Onerous contracts are contracts where the
expected unavoidable costs of meeting the
contract are greater than the benefits
expected to be received from it
If a contract is onerous, the present
obligation under the contract terms should be
recognized as a provision
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Contingent assets
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Contingent assets refer to events which give
rise to the possibility of an inflow of economic
benefits to the company
If the inflow of economic resources is
probable, the material contingent gains
(contingent asset) should be disclosed in the
notes
If the inflow of economic resources is either
possible or remote, disclosure is not required
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© 2005 Peter Walton and Walter Aerts
Post-balance sheet events
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Events between the balance sheet date
and the date the financial statements
are authorized for issue with a
significant bearing upon the future of
the company
IAS 10 Events after the Balance Sheet
Date
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Types of post-balance sheet events
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Adjusting events are those that provide
evidence of conditions that existed at the
balance sheet date
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These shall be reflected in the financial statements
by adjusting the amounts recognized
Non-adjusting events are indicative of
conditions that arose after the balance sheet
date
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If material, their nature and estimated effect
should be disclosed in the notes to the accounts
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IAS 10 – Events after the Balance
Sheet Date (Extract)
Definitions
3. Events after the balance sheet date are those events, favourable and
unfavourable, that occur between the balance sheet date and the date
when the financial statements are authorised for issue. Two types of
events can be identified:
(a) those that provide evidence of conditions that existed at the balance
sheet date (adjusting events after balance sheet date);
and
(b) those that are indicative of conditions that arose after the balance
sheet date (non-adjusting events after the balance sheet date).
Source: IAS 10 – Events after the Balance Sheet Date
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© 2005 Peter Walton and Walter Aerts
Financial instruments
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Financial instruments follow specific recognition
and measurement rules (see chapter 18) and
require extensive disclosures, especially on their
risk management implications
IAS 32 Financial Instruments: Disclosure and
Presentation
IFRS 7 Financial Instruments: Disclosures (from
2006 on)
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Pension obligations
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Pension obligations with regard to extra-legal
pension schemes have to be recognized and
properly disclosed
Two main types can be discerned: defined
contribution plans and defined benefit plans
IAS 19 Employee Benefits specifies the
accounting rules and requires extensive
disclosures on pension scheme details
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© 2005 Peter Walton and Walter Aerts
Defined contribution plans
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Under a defined contribution plan, the
company pays fixed contributions to a
pension fund and has no obligation to pay
further contributions if the fund does not hold
sufficient plan assets to pay the pension
benefits
No special accounting rules apply contributions payable under the plan are
recognized as an expense as the employee
provides services
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© 2005 Peter Walton and Walter Aerts
Defined benefit plans
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Under a defined benefit plan, the company
guarantees to provide to the retired employee
a pension which may, for example, be a
proportion of the final salary of the employee;
the employee accumulates rights to a bigger
and bigger portion with each year of service
IAS 19 requires an estimate of the defined
benefit obligation at balance sheet date and
the recognition of a pension liability, net of
the fair value of the funded plan assets
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Defined benefit obligation
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The defined benefit obligation (DBO)is
estimated based on a set of actuarial
assumptions which encompass demographic
and financial characteristics
The funding rate of the pension plan affects
the defined benefit liability recognized un the
balance sheet, but not the DBO
DB liability = DBO minus Fair value of funded
plan assets
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Pension cost
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The cost of providing pension benefits should
be recognized in the period in which the
benefit is earned, not when it is paid
The pension cost is determined as the change
in the defined benefit liability for the year and
charged to the income statement
Pension costs details are separately disclosed
in the notes to the accounts
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© 2005 Peter Walton and Walter Aerts
Actuarial assumptions
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Actuarial assumptions relate to distant time
horizons and significant uncertainties
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Future characteristics of current and former
employees (and their dependents), mortality rates,
rates of employee turnover and early retirement
Discount rate, future salary levels, expected return
on plan assets
DB calculations are sensitive for these actuarial
assumptions
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© 2005 Peter Walton and Walter Aerts
Actuarial gains and losses
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Changes in actuarial assumptions and
unexpected changes in the fair value of plan
assets result in actuarial gains and losses
IAS 19 provides for a ‘corridor’ of 10% of the
DBO or of the fair value of the plan assets
within which the actuarial gains and losses
need not be immediately recognized
The corridor functions as a cushion against
short-term fluctuations
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© 2005 Peter Walton and Walter Aerts
Environmental disclosures
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Majority of environmental disclosures
(included in management commentary, a
stand-alone section of the annual report or in
the notes to the accounts) are voluntary and
company-specific
Mandatory reporting requirements dealing
with environmental liabilities and
contingencies
Decommissioning costs as a specific topic
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Decommissioning liabilities
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Decommissioning liabilities arise if a company,
when it purchases or constructs an asset,
takes on a contractual or statutory obligation
to decommission the asset or restore the
asset site to certain minimum standards at
the end of the asset’s life
A provision is recognized as soon as the
dismantling obligation exists and the
provision expenses are capitalised as part of
the asset’s acquisition cost
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Intellectual capital
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Large parts of intellectual capital (intellectual
resources/assets) fall outside the bounderies
of the financial accounting model
However, as intellectual capital fits into the
framework of analysts’ concerns about
assessing the quality of management and its
resources, companies tend to discuss these
issues in the voluntary sections of the annual
report
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© 2005 Peter Walton and Walter Aerts