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Financial Reporting & Analysis 8th Edition Lawrence Revsine
International GAAP 2021: Generally Accepted Accounting Practice under International Financial Reporting Standards Ernst & Young International Financial Reporting Group
18.4 Step 1. Identify the Contract(s) with a Customer 416
18.5 Step 2. Identify the Performance Obligations in the Contract 418
18.6 Step 3. Determine the Transaction Price 420
18.7 Step 4. Allocate the Transaction Price to the Separate Performance Obligations in the Contract 421
18.8 Step 5. Recognize Revenue when (or as) the Entity Satisfies a Performance Obligation 422
18.9 Construction Contracts 428
18.10 Contract Costs 431
18.11 Presentation and Disclosure 432
Summary 437
Exercises 437
19 Provisions, Contingent Liabilities and Contingent Assets 441
Objectives 441
19.1 Introduction 442
19.2 Problems Identified 442
19.3 Provisions, Contingent Liabilities and Contingent Assets 444
19.4 Accounting for Provisions, Contingent Liabilities and Contingent Assets 447
19.5 Specific Application of Recognition and Measurement Rules 451
19.6 Disclosure Requirements 454
Summary 456
Exercises 457
20 Income Taxes 461
Objectives 461
20.1 Introduction 462
20.2 The Expense Question 462
20.3 The Deferred Tax Problem 462
20.4 IAS 12 and Tax 470
20.5 IFRIC 23 and Tax Uncertainties 481
Summary 482
Exercises 483
21 Employee Benefits and Share-Based Payment 487
Objectives 487
21.1 Introduction 488
21.2 Accounting for Short-Term Employee Benefits 489
21.3 Accounting for Profit-Sharing and Bonus Plans 490
21.4 Accounting for Equity Compensation Benefits or Share-Based Payment 491
21.5 Accounting for Long-Term Employee Benefits: Pension Benefits 502
21.6 Termination Benefits 525
21.7 Accounting by the Pension Fund 526
Summary 527
Exercises 527
References 531
22 Insurance Contracts 533
Objectives 533
22.1 Introduction 534
22.2 Insurance Contract 534
22.3 IFRS 4 535
22.4 IFRS 17 537
Summary 541
23 Statement of Cash Flows 543
Objectives 543
23.1 Introduction 544
23.2 Profit versus Cash 544
23.3 Cash Flow Reporting 545
23.4 Requirements of IAS 7 546
23.5 Format of Cash Flow Statement 549
23.6 Preparation of Statement of Cash Flows 555
Summary 562
Exercises 562
24 Disclosure Issues 579
Objectives 579
24.1 Introduction 580
24.2 Disclosure of Segment Information 580
24.3 Events after the Reporting Period 591
24.4 Earnings per Share 596
24.5 Interim Financial Reporting 607
Summary 611
Exercises 611
Reference 616
PART THREE CONSOLIDATED ACCOUNTS AND THE MULTINATIONAL 617
25 Business Combinations 619
Objectives 619
25.1 Introduction 620
25.2 Accounting for the Business Combination: The Basics 621
25.3 Accounting for Purchased Goodwill 623
25.4 Specific Issues on Accounting for the Business Combination 629
25.5 Loss of Control 634
25.6 Disclosure Requirements of IFRS 3 635
25.7 Alternative Methods in Accounting for Business Combinations 637
Summary 640
Exercises 641
26 Consolidated Financial Statements 645
Objectives 645
26.1 Introduction 646
26.2 Control 646
26.3 The Need for Consolidated Accounts 649
26.4 Preparation of Consolidated Statements of Financial Position 650
26.5 Preparation of Consolidated Statement of Comprehensive Income 661
26.6 Investment Entities 665
26.7 Alternative Concepts on Consolidation 665
Summary 669
Exercises 669
27 Accounting for Associates, Joint Arrangements and Related Party Disclosures 681
Objectives 681
27.1 Introduction 682
27.2 Equity Accounting 682
27.3 IAS 28 Investments in Associates and Joint Ventures 683
27.4 Equity Accounting in Individual Financial Statements 687
27.5 IFRS 11 Joint Arrangements 688
27.6 Accounting for Joint Arrangements 692
27.7 Overview Activity on Accounting for Associates and Joint Arrangements 695
27.8 Related Party Disclosures 697 Summary 701 Exercises 701
28 Foreign Currency Translation 715
Objectives 715
28.1 Introduction 716
28.2 Currency Conversion 716
28.3 Currency Translation 716
28.4 IAS 21 Requirements for Entity’s Foreign Currency Transactions 717
28.5 IAS 21 Requirements for Translating Foreign Operations for Consolidation Purposes 720
28.6 Alternative Translation Methods for Financial Statements of Foreign Operations 722
28.7 Hedge Accounting 728
28.8 Some Other Issues 729 Summary 732
Exercises 733
PART FOUR FINANCIAL ANALYSIS 739
29 Introduction to Interpretation of Financial Statements 741
Objectives 741
29.1 Introduction 742
29.2 Accounting Information and Users 742
29.3 Benchmarking 744
29.4 Technique of Ratio Analysis 745
29.5 Additional Information 758
Summary 758
Exercises 759
30 Interpretation of Financial Statements 767
Objectives 767
30.1 Introduction 768
30.2 Industry Analysis 768
30.3 Accounting Analysis 773
30.4 Accounting Analysis: The Available Accounting Discretion 790
30.5 Entity Analysis 798
30.6 The Reversal Effect 802
30.7 Quality of Disclosure 803
30.8 Non-GAAP or Pro-Forma Accounting Measures 804
Summary 809
Exercises 809
References 810
31 Techniques of Financial Analysis 815
Objectives 815
31.1 Introduction 816
31.2 Elements of Non-Comparability in Financial Statements 817
31.3 Trend Analysis or Horizontal Analysis 827
31.4 Common Size Analysis 830
31.5 Segmental Analysis 833
31.6 Ratio Analysis 834
31.7 Ratio Analysis and the IAS/IFRS Accounts 836
31.8 Cash Flow Statement 845
31.9 Limitations of Ratio Analysis 847
31.10 Multivariate Analysis 848
31.11 Investment Perspective 849
31.12 Disclosure of Non-Financial Data 850
Summary 857 Appendix I 858
Appendix II 874
Exercises 885
References 899
Index 901
PREFACE
WHY THIS BOOK?
Financial reporting is changing. Accounting has always been a reactive service, changing and developing to meet the practical needs created by the environment in which it operates. This process of change can be illustrated by both time considerations and place considerations. In particular, in the days when most business operations were largely organized within national boundaries, accounting thought, practices and regulation grew up in significantly different ways in different countries, consistent with national environments and characteristics, a process discussed in more detail in Chapter 2.
Now, however, big business is international, and the process and its implications are moving at a very fast rate. Big business is global in its operations; the demand for finance is global and the supply of finance is global. The provision of information, the oil which lubricates any working market, is global in its reach and instantaneous in its transmission. Financial reporting must of necessity be global too. From slow beginnings, the International Accounting Standards Board (the Board) is now poised to become the generally accepted regulator at this international level. Since 2005, every listed EU, Australian and New Zealand company has been required to produce its group financial statements in accordance with International Accounting Standards (IAS® Standards) and International Financial Reporting Standards (IFRS® Standards). Many countries followed this example and now require compliance with IFRS Standards for their listed companies (e.g. Argentina, Brazil, Canada, South Korea). Other countries, as diverse as the US and China, are seeking closer convergence, as a minimum, with IASB ® requirements. The US allows accounts prepared in accordance with IFRS Standards without reconciliations for US stock exchange listings for foreign registrants.
The effects on accounting and reporting for business entities operating at a national or local level, many of them small- and medium-sized enterprises (SMEs), are unclear and are likely to vary in different places. Two points are very clear to us, however. First, national needs, characteristics and ways of thinking will remain significant at the SME level. Second, the application of agreed IAS Standards, a subjective process of necessity, will continue to be influenced by the context and environment in which the application takes place.
This book is written to reflect this situation and its implications. A knowledge of the requirements of IFRS Standards is now essential to anyone studying financial accounting and reporting, whether the aim is the preparer focus implied by a desire to enter the accounting professions or the user focus implied by finance, business or MBA-type programmes aimed at management or the educated public.
But, of course, knowledge is not enough. A critical understanding of issues and alternatives, of the whys and wherefores, is also required. The author team has been carefully constructed to contain significant academic, pedagogic and writing experience and to reflect the diversity of European and international thought and experience. Our approach is to expose the reader to the issues by a carefully developed sequence of exposition, student-centred activity and constructive feedback. This process provides a framework with which the reader can assimilate, understand and appraise the exposition of international requirements that follow. Only with such an overall understanding, enhancing both depth and breadth, will the reader be able to follow, and hopefully participate in, the future development of financial accounting and reporting as the process of international change continues.
It is important to be clear that our emphasis is on the IASB requirements and on a full understanding thereof. How those requirements will actually be applied in detailed practice in the many different countries and cultures involved has to be largely outside our scope. As already indicated, we certainly believe that there will continue to be material differences in the practical interpretation and application of international standards. We give a full justification and explanation of that belief and provide a framework for analyzing its implications. Nevertheless, it has to be up to the individual reader and/or teacher, situated in a ‘local’ context, to explore what the implications of that local context might be.
The discussion of all standards has been updated for this eighth edition and brought in line with the latest developments in the IFRS ® standards-setting programme of the Board. This implies that at the time of writing, attention has been paid to current evolutions and possible changes in the standards taking place in the near future. For this new edition, we have included new numerical examples and extracts from company reports from a variety of international corporations to provide students with illustrations of standards and real-life insight into financial accounting.
STRUCTURE AND PEDAGOGY
The broad structure of the book is as follows: Part One provides the essential conceptual and contextual background. Parts Two and Three explore the detailed issues and problems of financial reporting both in general and through the specific regulatory requirements of the Board – for individual company issues in Part Two and for group and multinational issues in Part Three. Part Four provides a summation through an in-depth consideration of financial statement analysis within a dynamic international context.
Each chapter follows a similar pattern in terms of pedagogic structure. Learning objectives set out what the student should be aiming to achieve, with an introduction to put the chapter into context. There are frequent activities throughout the chapter, with immediate feedback so that students can work through practical examples and reflect on the points being made. The chapter closes with a summary and exercises. Answers to some of the exercises can be found on our dedicated digital resources and the remainder on the Instructor online support resources.
SUPPLEMENTARY MATERIALS
Students have access to the following resources on the book’s companion website:
• Answers to students’ exercises (at the end of chapters).
• A glossary of accounting and finance definitions.
• Related links.
Instructors have access to the following additional resources (via specific login details which they can request from the Cengage learning consultant after adoption of the book):
• Answers to students’ exercises.
• Answers to instructors’ exercises.
• PowerPoint slides.
The publishers would like to thank Matt Pinnock, Isthmus Consulting, Ltd, for his contribution to the supplementary materials. The publishers would also like to thank John Taylor (formerly Leeds Beckett University, UK), Sulaiman Aliyu (Middlesex University London, UK), James Griffiths (freelance writer and lecturer, finance and auditing, UK) and Adriana van Cruysen (Zuyd Hogeschool, The Netherlands) for their contributions to the digital resources.
This is not a book for those without prior exposure to accounting. A one-year introductory course in accounting and a basic understanding of the principles of double-entry, or some practical business exposure, are assumed. However, we recognize that such earlier work may have taken any variety of different forms, or you may have approached the subject from any one of several different directions; indeed you may well not have studied in the English language. The book will be particularly suitable for the middle and advanced years of undergraduate three- or four-year degree programmes, for postgraduate programmes requiring an internationalization of prior studies of a national system and for MBA-type programmes where a true understanding of the issues and implications of accounting subjectivity and diversity is required.
LIST OF REVIEWERS
The publishers would like to thank the following academics for their insightful feedback and suggestions which helped shape the eighth edition: Dimos Andronoudis, University of Bristol, UK
Nicola Hobday, University of Bath, UK
Hannes Hofbauer, Johannes Kepler University, Austria
Nikos Tsileponis, University of Bristol, UK
Anis Zras, University of Southampton, UK
OFFICIAL EXAM QUESTIONS
We are grateful to the Association of Chartered Certified Accountants (ACCA) and the Chartered Institute of Management Accountants (CIMA) for permission to reproduce past examination questions. The suggested solutions in the exam answer bank have been prepared by us, unless otherwise stated.
IFRS STANDARDS
This product contains copyright material of the IFRS® Foundation in respect of which all rights are reserved. Reproduced by Cengage Learning EMEA Limited with the permission of the IFRS Foundation.
No permission granted to third parties to reproduce or distribute. For full access to IFRS Standards and the work of the IFRS Foundation please visit http://eifrs.ifrs.org
The authors and publishers wish to thank the organizations who have kindly given permission for the use of their Annual Reports and Accounts, specifically Unilever, Walt Disney and adidas.
ACKNOWLEDGEMENTS
We are grateful for constructive help and support from several quarters. Our family members have coped with the conflicting demands on our time and thoughts. Now, perhaps, it is your turn to help us, or to help us to help you. Suggestions for further development and improvement would be gratefully received by authors or publisher.
Finally, to come back to where we started, we hope that you, the reader, will be interested and stimulated. The internationalization of accounting is an unstoppable force which will create new and demanding challenges. We believe that participation in this process will be a fascinating and rewarding experience. We hope you will agree when you have finished studying this book.
David Alexander, University of Birmingham
Ann Jorissen, University of Antwerp
Martin Hoogendoorn, Erasmus University Rotterdam
Carien van Mourik, Open University
Collette Kirwan, Waterford Institute of Technology
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Cengage’s peer-reviewed content for higher and further education courses is accompanied by a range of digital teaching and learning support resources. The resources are carefully tailored to the specific needs of the instructor, student and the course. Examples of the kind of resources provided include:
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PART ONE FRAMEWORK, THEORY AND REGULATION
This first Part is meant to help you structure your thinking about general purpose financial reporting in an international context. We hope this will help you better grasp the technical aspects of preparing financial statements in Part Two, consolidated financial statements in Part Three and the interpretation of financial statements in Part Four. At the same time, we hope that it will also stimulate you to develop the ability to think critically about the theories, approaches and techniques you will encounter throughout the book.
If you are new to studying accounting, you are likely to find the current level of integration in international financial and capital markets perfectly normal. The International Accounting Standards Board (the Board) and its International Financial Reporting Standards (IFRS Standards) have been around for some 15 years. Chapter 1 will explain what we mean by international financial reporting, what financial reporting standards and IFRS Standards are meant to achieve, who uses general purpose financial reporting information, and the main challenges for IFRS Standards.
Although international trade dates back as long as there have been nation states, and international investment was quite common in the late nineteenth century, there was great international diversity of accounting practices and standards. Chapter 2 discusses international accounting differences in the past as well as the present. Before IFRS Standards, multinational companies seeking to raise financing needed to communicate information about their financial performance and financial position to investors in ways that they could understand. Conversely, investors wanting to invest in companies in other countries had to make an effort to understand the information in the financial statements of such companies.
During the 1980s, the globalization of financial, capital and product markets progressed at an unprecedented rate, as did the harmonization of financial reporting practices. Chapter 3 will consider the rise of the IASC and later the Board and the development of international financial accounting standards going hand in hand with the deregulation of financial and capital markets in most economically advanced countries. As the IASC was a private organization claiming to serve the public interest, it needed to have a conceptual framework that could lend it intellectual credibility and its international accounting standards intellectual legitimacy. Chapter 4 will discuss the history and development of the IASB® Conceptual Framework as well as its structure and content. The IASB Conceptual Framework defines the objective of general purpose financial reporting and sets out how to define, recognize, measure, present and disclose the elements of financial statements so as to achieve this objective. Chapter 4 therefore also discusses accounting theory and points to theories that are relevant to the IASB Conceptual Framework and IFRS Standards today.
As the determination of income and equity (financial performance and financial position) are important purposes of financial accounting, it is necessary to understand the main perspectives on income and equity, and how they impact the IASB Conceptual Framework and IFRS Standards today. Chapter 5 discusses the traditional accounting and economic perspectives on income and equity, and Chapters 6 and 7 talk about the theoretical approaches that have developed as compromises between the economic and accounting perspectives. Defining, recognizing and measuring financial statement elements is complemented by the different perspectives on presenting and disclosing the elements on the face of the financial statements or in the notes. Chapter 8 introduces the presentation and disclosure of financial statements in accordance with IAS 1 and the EU Directives.
IFRS Standards apply to companies, predominantly those whose securities are listed on a stock exchange. Financial reporting for companies is one means of alleviating the principal-agent problem and reducing the cost of the information asymmetry between managers and shareholders. Chapter 9 introduces corporate governance
as the system by which a company is administered to achieve the objectives of the company in the interests of its shareholders and balance their interests with those of the other stakeholders in the company. Because there are many different stakeholders who are affected by the company’s actions, it is not possible to encompass all these conflicting interests and relations in law. Chapter 10 discusses business ethics and corporate social responsibility (CSR) and CSR reporting, and how socially responsible investors use CSR reports to inform their investment decisions. It is clear that accounting is very much about conflicting interests, and professionally qualified accountants have a responsibility for the public interest. In Chapter 11 you will learn about the ethics of the accounting profession. On the one hand, professionally qualified accountants are meant to serve the public interest, but on the other, they have to satisfy their customers’ needs. This causes a conflict of interest between the customer, the accountant, the accountant’s employer and the general public that may never be satisfactorily resolved by a code of ethics and a commitment to public interest. But accountants must try if they are to survive and thrive as a profession.
1 A BRIEF INTRODUCTION TO INTERNATIONAL FINANCIAL REPORTING
OBJECTIVES After studying this chapter you should be able to:
• compare the meanings of international financial reporting before and since IFRS Standards
• compare the roles of financial reporting in different types of business entity
• explain the objectives of financial reporting standards and financial reporting regulation
• explain how IFRS Standards are intended to facilitate global capital markets
• describe the main functions of general purpose financial reporting
• with reference to these functions, describe the major types of users of published financial information and discuss the implications of their different needs
• discuss two major challenges for the IASB.
1.1 INTRODUCTION
This chapter will first compare the meaning of international financial reporting before International Financial Reporting Standards (IFRS Standards) with what it means today. It will then define financial reporting and discuss what financial reporting is meant to achieve in different types of entity and what financial reporting standards are meant to achieve within a jurisdiction as well as globally. Then it will consider the general purpose objective of financial reporting, its users and their various information needs. Finally, this chapter will discuss the main challenges for international general purpose financial reporting and IFRS Standards.
1.2 INTERNATIONAL FINANCIAL REPORTING BEFORE AND SINCE IFRS STANDARDS
International financial reporting used to involve two areas of study: first, comparative accounting systems, institutions and practices; and second, the accounting for international transactions and multinational enterprises (Radebaugh and Gray, 2002: 15). The first topic will be discussed in Chapter 2 and the second topic in Part Three of this book and in particular in the chapter on foreign currency translation.
International financial reporting was and still is practised by companies wishing to raise money at capital markets in other countries. There were no international accounting standards until 1973 when the International Accounting Standards Committee (IASC) started to develop its International Accounting Standards (IAS Standards). Even then, companies would adopt IAS Standards on a voluntary basis because they had not been formally adopted in any jurisdiction. Multinational corporations had to follow the accounting standards in the countries of the stock exchanges where they were listed. If they were listed at stock exchanges in five different countries, that often meant they had to prepare financial statements in accordance with five different sets of accounting standards. In some cases, they would have to provide a reconciliation of the financial statements in their home country with the standards of the country where they were seeking to be listed.
Companies seeking to raise capital from international investors usually did one of five things in response to the problem of different accounting standards across different countries:
1 Do nothing. For example, a French company might do nothing and hope that international investors would make efforts to understand their financial statements.
2 Provide translations in another language, usually English (convenience translations).
3 Provide translations in the language as well as the currency of the country from which investment was sought (convenience statements). For example, a French company would translate its financial statements from French into English and translate the amounts into French francs (French currency prior to the adoption of the euro) into US dollars.
4 Provide partial restatements. For example, a French company would reconcile the net income in its income statement with a net income amount using US accounting standards and do the same for the whole balance sheet or selected items in the balance sheet.
5 Prepare secondary financial statements. In this case, the French company would prepare an additional set of financial statements in accordance with US accounting standards. See Mueller et al., 1994: 56.
As you can imagine, this was an inefficient and costly way of doing things, and it also caused much confusion for users of those financial statements.
From the mid-1980s, more and more countries started to deregulate their financial and capital markets. In the UK, the ‘Big Bang’ was the day the London Stock Exchange rules changed on 27 October 1986. In the US, deregulation happened in stages between 1980 and 1999 when the regulations that were put in place after the stock market crash of 1929 were abolished. Other countries followed suit. Japan’s ‘Big Bang’, modelled on that of the UK, happened between 1996 and 2001. Helped by developments in information technology, financial and capital markets became more globally interconnected. Having a single set of internationally accepted financial accounting standards started to make a lot of sense.
From 2001, the year in which the IASC was reorganized into the International Accounting Standards Board (the Board), international financial reporting has increasingly come to mean financial reporting based on the Board’s IFRS Standards. In effect, the Board cornered the market for international financial reporting standards to the extent that there is no competition for IFRS Standards as the accepted set of international accounting standards. Hence, in this book, the term ‘international financial reporting’ will usually indicate financial reporting in accordance with IFRS Standards. Where this is not the case, you will be able to understand this by looking at the context in which the term is used.
1.3 FINANCIAL ACCOUNTING AND REPORTING IN DIFFERENT TYPES OF BUSINESS ENTITY
Accounting has been defined in many ways. However, the way the IASB thinks about accounting was informed by an often quoted definition of accounting given in A Statement of Basic Accounting Theory by the American Accounting Association (AAA). It reads ‘accounting is the process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information’ (AAA, 1966: 1). This definition emphasizes the use of accounting information as a basis for decision making. Alternatively, one could think of the purpose of accounting as providing accountability for the way the accounting entity has achieved or failed to achieve its objectives during the past.
As you will be aware, accounting can be divided into management accounting and financial accounting. Management accounting produces information designed for the management user, i.e. for internal decision making. Senior management, by definition, can obtain whatever information it needs from within the organization. Financial accounting produces information in the form of financial reports designed to be useful to all parties with an interest in the reporting entity. External users have to rely on negotiation or regulation in order to obtain information. As we shall see, there are many different types of external user and they may all require different types of financial accounting information. It could be very costly for business entities to prepare separate financial reports for each type of interested party.
ACTIVITY 1.1
From the above paragraphs, you have learned that from a financial accounting perspective, managers are the internal users of a company’s accounting information and that all other interested parties are considered external users of accounting information. Do you agree with this categorization? What about the company’s shareholders or its employees?
Activity feedback
It may seem strange that the company’s shareholders (its owners) are considered external to the reporting entity. However, the characteristics of listed public limited companies create an arm’s length relationship between
the company and its shareholders. These characteristics include a separate legal personality, limited liability of its shareholders and the fact that the shareholders can sell their shares at will to other prospective shareholders. Similarly, employees work for the company on an arm’s length basis. Although they are responsible for specific tasks or outcomes, they do not have the overall responsibility for the financial performance and financial position of the company and usually will not have access to the same information that the senior managers have. They are dependent on the same general purpose reports as shareholders and other external parties for most of the financial information about the reporting entity.
Financial accounting serves the purpose of determining the financial position (Assets = Liabilities + Equity, as shown by the balance sheet at a certain date) and the financial performance (Profit or loss for the period = Income − Expense, as shown by the income statement) of the business entity. For sole traders and basic partnerships, this enables the owner(s) to file their tax returns, apply for bank loans or other types of loan, and calculate how much of the profit can be withdrawn without jeopardizing the capital base of the business. If the business is managed by a hired professional manager, the financial statements also enable the owner to monitor the performance of the manager, determine the size of the manager’s bonus, if any, and determine the extent to which the owner is happy with the financial performance and financial position of the entity. Apart from serving these purposes, there is no legal requirement for sole traders and basic partnerships to produce periodic financial statements.
Financial reporting is the periodic reporting of an entity’s financial position, financial performance and other financial information. In this book, we discuss financial reporting in respect of companies. Corporate financial reporting is one of the tools of corporate governance. In short, corporate governance is the system by which companies are directed and controlled. Corporate governance will be discussed in Chapter 9. Within the corporate governance system, financial reporting is the means by which the directors of a company provide accountability to its shareholders for the financial performance and financial position of the company. The regulations that require companies to produce and disclose general purpose financial reporting information are meant to mitigate, to some extent, the information asymmetry which exists between the reporting entity’s senior management and the reporting entity’s shareholders, investors and other external stakeholders. This book is primarily concerned with general purpose financial reporting.
In this book, we are not concerned with financial accounting and reporting for notfor-profit entities. We are solely concerned with financial accounting and reporting for business entities. Furthermore, this book has been written assuming that you know how to do double-entry bookkeeping and basic financial accounting. In other words, the assumption is that you are able to produce a basic income statement and balance sheet from summary information for business entities such as a sole trader, a basic partnership and a single entity company.
In all jurisdictions, companies are formed under some kind of law (Companies Act, Company Law, Commercial Code, etc.) that requires the company’s senior management
to produce financial statements periodically for the benefit of its shareholders. Unlimited companies do not offer shareholders the protection of limited liability, which makes the shareholders of unlimited companies similar to the owners of partnerships. The creditors of an unlimited company have a claim on the personal wealth of the unlimited company’s shareholders. Unlimited companies are legally obliged to prepare financial statements so their shareholders can monitor the performance of the company’s senior management and discharge the managers of their stewardship responsibilities over the past period. Based on this information they can determine the size of the managers’ remuneration and determine the dividend to be paid out to the shareholders. Corporation tax payable is calculated using the company’s financial performance as a starting point.
Most companies are limited companies. This means that the liability of the shareholders for the business entity’s liabilities is limited to the amount that they have invested. A limited company’s creditors do not have a claim on the wealth of the company’s shareholders. There are private limited companies and public limited companies. Most limited companies are private limited companies. In the UK, private limited companies have the suffix ‘Limited’ or ‘Ltd’ as part of their name. The equivalents in certain other European countries are given in Table 1.1. A private limited company can only issue its shares privately. If the shareholders of a private limited company wish to sell their shares, they must do so in a private sale, following the rules set out in the company’s constitution. In the UK, such a constitution is called the Articles of Association. In private limited companies, shareholders are often required to obtain permission from the other shareholders to transfer their shares to a new shareholder. Private limited companies do not have to disclose publicly as much information as public limited companies. Financial reporting in private limited companies primarily fulfils the stewardship objectives outlined above, although financial reports are also used to apply for loans and enable the assessment of the entity’s credit worthiness.
TABLE 1.1
UK
Examples of the terms for public limited company and private limited company in certain countries
Public limited company (plc)Private limited company (Ltd)
Belgium and the NetherlandsNaamloze Vennootschap (NV)Besloten Vennootschap (BV)
France
Société Anonyme (SA)
Société à Responsabilité Limitée (SARL)
Germany Aktiengesellschaft (AG)Gesellschaft mit beschränkter Haftung (GmbH)
Italy
Japan
Spain
Società Anónima (SA)
Yugen kaisha
Società per Azioni
Kabushiki kaisha
Sociedad Anónima (SA)Sociedad de Responsabilidad Limitada (SL)
Public limited companies issue their shares to the general public. In the UK, public limited companies must have the suffix ‘public limited company’ or the abbreviations ‘plc’, ‘PLC’ or ‘Plc’. See Table 1.1. for the equivalents in other countries. A minority of public limited companies are listed public limited companies, where they have their shares listed on a stock exchange. A stock exchange is a market for trading in the issued shares of public limited companies and also other types of debt and equity securities. In order to qualify to have its securities listed and traded on a stock exchange, the company has to fulfil strict financial reporting and other requirements issued by the stock exchange.
These are usually embedded in the laws of a jurisdiction (or country). Such requirements are intended to protect current shareholders and potential investors. Although financial reporting still fulfils its traditional accountability and stewardship functions, financial reporting is also meant to aid current and potential investors to make decisions about whether to hold, buy or sell the shares or other securities in the company.
Multinational corporations or transnational corporations are not so easy to define. They operate in multiple countries because this offers proximity in terms of markets and natural resources or because of low wages, highly skilled workers, or tax benefits. In terms of financials, they will generate sales, pay expenses, own assets and incur liabilities in multiple countries. Popular at the beginning of the twentieth century, the use of holding companies has again been increasing since 2000. A holding company is a company that is formed for the sole purpose of owning the shares of other companies in order to form a corporate group. This enables a company to register its headquarters in a country where the tax regime is most advantageous for the group. It also enables the owners of the holding company to control a group of companies while minimizing the risk to the companies within the group.
1.4 THE OBJECTIVES OF CORPORATE FINANCIAL REPORTING STANDARDS AND REGULATION
Financial reporting standards require the information to be of a reliable quality and presented in a reliable format. This allows investors and other users of financial statement information to compare the financial performance and financial position of a company across time or with other companies in the same industry or across industries. However, accounting standards and accounting systems develop in response to the environment in which they operate. As Mueller et al. (1994) observed in the 1990s:
In a number of countries (such as the United States), financial accounting information is directed primarily towards the needs of investors and creditors, and ‘decision-usefulness’ is the overriding criterion for judging its quality. However, in other countries, financial reporting has a different focus and performs other roles. For example, in some countries, financial accounting is designed primarily to ensure that the proper amount of income tax is collected by the national government. This is the case in most South American countries. In other countries, financial accounting is designed to help accomplish macroeconomic policies, such as achieving a predetermined rate of growth in the nation’s economy.
(Mueller et al., 1994: 1–2)
Since the 1990s, global capital markets have grown in size and reach, the influence of US accounting thought has become stronger, and decision-usefulness is also the criterion adopted by the IASB. Although the differences indicated in the quotation above have become less pronounced, Chapter 2 will show that they can still be observed.
For a long time, investment in stocks, shares and debentures (bonds) was the prerogative of wealthy individuals. The general view was that these people knew what they were doing or were able to afford to buy the best advice. Therefore, if these people wanted to speculate with their wealth, there was no need for the government to protect their interests in case things went wrong. However, the ‘democratization’ of shareholding meant that more and more people who were not rich could invest in the stocks and shares of public limited companies. Shareholder ownership of specific companies became dispersed across many investors rather than concentrated in the hands of a few. The problem was that because of
their limited liability, shareholders with well-diversified stock portfolios had little incentive to monitor actively all of the companies included in their portfolios. If they were unhappy with the dividends or returns, they would simply sell their shares and invest in another company. In the US, Berle and Means (1968/2009) observed that corporate managers increasingly ran companies for their own benefit rather than for their shareholders. Financial reporting and auditing requirements were quite basic, because corporate governance was considered a matter between the company and its owners. The stock market crash of 1929 in the US caused an economic depression that spread across the world. In the US, the crash led to the Securities and Exchange Acts of 1933 and 1934, which ultimately resulted in the development of financial reporting standards in the US.
Since then, as more and more countries have embraced capital markets as the way to allocate financial capital to companies, the main functions of financial accounting and reporting standards and financial reporting regulation came to be as follows:
• To establish a minimum standard for the quality, quantity and presentation of useful financial information in order to reduce the information asymmetry between managers (company directors) and investors in equity and debt securities and other users of financial statement information, so as to improve their resource-allocation decisions.
• To improve transparency and access to information in order to create a more level playing field for investors. Otherwise, those investors with less access to information and information-processing capabilities may withdraw from the capital market altogether because they tend to lose out to those investors with better access to information and the ability to buy investment advice from analysts with better information-processing capabilities. The idea is to prevent capital markets from breaking down due to a lack of the general public’s confidence, thereby depriving the national economy of the benefits of allocation of capital through capital markets (Lev, 1988: 7).
For capital markets to function well, they need many different types of investor.
ACTIVITY 1.2
Above we considered the possibility that capital markets will break down due to unequal access to financial information. What would happen if all investors had equal access to information and equal informationprocessing abilities?
Activity feedback
If all investors had equal access to information and equal information-processing capabilities, the market
for information might become efficient. However, Grossman and Stiglitz (1980: 404–405) showed that, in theory, informationally efficient capital markets will also break down. In this case the capital markets will break down because investors lack the incentives to spend resources on gaining an information advantage and hence to trade on this advantage and to invest.
1.5 IFRS STANDARDS ADOPTED TO FACILITATE INTEGRATED CAPITAL MARKETS
In May 1999, the European Commission agreed on the Financial Services Action Plan. One of the objectives of this Plan was to create a single, large capital market within the EU. To facilitate the creation of a more integrated and efficient European common market, including a common capital market, the European Commission proposed in
2000 that all listed companies should use one set of accounting standards for financial reporting purposes. International Accounting Standards (IAS Standards) issued by the IASC were chosen to be that set of accounting standards. In 2002, Regulation (EC) No. 1606/2002 then required the application of IAS/IFRS Standards as endorsed by the EU for all companies listed on stock exchanges in EU member countries from 2005. Although the IASB has always stated in its Constitution to be committed to serving the public interest, it was not clear what this meant. In April 2015, the IFRS® Foundation issued a Mission Statement. In short, it states that ‘Our mission is to develop International Financial Reporting Standards (IFRS) that bring transparency, accountability and efficiency to financial markets around the world. Our work serves the public interest by fostering trust, growth and long-term financial stability in the global economy’ (IFRS Foundation, 2015).
ACTIVITY 1.3
From the above paragraphs, we may conclude that IFRS Standards are meant to achieve more integrated and efficient global financial and capital markets. In what ways might IFRS Standards foster trust, growth and long-term financial stability in the global economy? Is this likely to benefit the general public? You may wish to look at the IFRS Foundation’s Mission Statement on the Internet.
Activity feedback
The Mission Statement (IFRS Foundation, 2015) says that IFRS Standards bring transparency by enhancing the international comparability and quality of financial information. This will then enable international investors and other global market participants to make better informed economic decisions. Furthermore, IFRS Standards strengthen accountability by reducing the information asymmetry between the providers of equity
and debt capital and the directors of the companies in which they have invested their money. As a source of globally comparable information, IFRS Standards are also useful to regulators around the world. IFRS Standards contribute to economic efficiency by helping investors to identify opportunities and risks across the world, thus improving global capital allocation. For businesses, the use of a single, trusted accounting language lowers the cost of capital and reduces international reporting costs.
The Board and IFRS Foundation think that improved global capital allocation, which is in the interests of global investors and global companies, is also in the interests of the international general public. This may be true to the extent that the benefits of a growing global economy are shared internationally and among the general public in different countries. But are they? Maybe in the long term?
1.6 THE MAIN FUNCTIONS OF GENERAL PURPOSE FINANCIAL REPORTING
Why does this book focus on general purpose financial reporting? Does this mean that all external users require the same information for the same general purpose? Not really. Specific financial reporting could be aimed at specific user groups, but this would mean that companies would have to prepare several different reports each tailored to the needs of a different user group. This could be quite costly for the company, in particular the costs involved in preparing many reports and, also, the costs associated with the risk of disclosing proprietary information (information that would endanger the competitive position of the company). Sometimes it happens that an external party such as a large lender can demand specific information in order to assess the risk and return of a substantial loan to the company. In the past, the Financial Accounting Standards Board (FASB) and the IASB, like many other national private and public standard setters, decided they should set general purpose
financial reporting standards to serve those external parties who do not have this type of negotiating power.
So, what is the general purpose that financial reporting is meant to serve? According to the Board’s 2010 Conceptual Framework:
The objective of general purpose 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. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit.
(IASB, 2010: OB2)
The Board’s view on the general purpose of financial statements is also known as the decision-usefulness objective.
In truth, there are different views on the usefulness of general purpose financial reporting. Accountability refers to the action of providing information in order to account for one’s actions and decisions to those to whom one is accountable. Accountability also refers to bearing responsibility for those actions and decisions as well as for their intended outcomes and unintended consequences. Historically, corporate financial reporting has been a tool that enables the senior management of a company to provide accountability to the owners of the company for how the managers have performed their stewardship responsibilities.
Traditionally, the stewardship function of general purpose financial reporting was twofold. First, the financial statements enabled the senior management of a company (the stewards or agents) to provide accountability for how they have used the company’s assets and liabilities during the year to achieve the company’s objectives. Second, the financial statements enabled the company’s owners (the shareholders) to judge if they were satisfied with the financial performance of the company and the proposed dividends. If they were satisfied, they would approve the financial statements, the dividends and the remuneration for senior management, thereby discharging the managers from their stewardship responsibilities over that period. If the shareholders were not satisfied with the reporting, clarifications from senior management might be needed. If the shareholders were not happy with the entity’s financial performance, they could decide to change the company’s senior management or their remuneration.
During the 1980s and 1990s, company legislation was changed in some countries (e.g. Japan) so that the shareholders were no longer required to approve the financial statements. They would still approve the dividends and decide on the fate of the company’s senior management. However, in an age of portfolio investment and regular rebalancing of their investment portfolio based on an assessment of the market risk of the company’s shares or other securities, shareholders increasingly ‘voted with their feet’ (i.e. sold their shares) rather than at the annual general meeting (AGM). In many internationally listed companies, the monitoring function of the shareholders came to be more abstract and less meaningful. This caused a second interpretation of stewardship to develop. In this interpretation, the stewardship function of financial reporting is subsumed under the decision-usefulness function of financial reporting.
The decision-usefulness function of general purpose financial reporting was conceptualized in the 1960s in the US, which had the most advanced capital markets and securities markets at the time. The decision-usefulness function is to provide information to help prospective shareholders and other investors, lenders and creditors in a market setting to make decisions about providing resources to
