Book overview

 Part 1 – Environment of financial reporting

 Part 2 – Basic accounting techniques and the
preparation of annual financial statements
 Part 3 – Interpretation and analysis of
financial statements
 Part 4 – Consolidated financial statements
and issues related to multinational groups
 Part 5 – Advanced financial statement
analysis and accounting values.

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© 2005 Peter Walton and Walter Aerts
 CHAPTER 1
Financial reporting and regulation

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© 2005 Peter Walton and Walter Aerts
 Contents

 Annual financial statements

 Uses of financial statements
 Accounting choices
 Accounting regulation
 International Financial Reporting
Standards

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© 2005 Peter Walton and Walter Aerts
 Financial versus management
accounting
 Financial accounting (FA) -> external
financial reporting
 Management Accounting (MA) ->
financial information useful in internal
decision and management processes
 Starting from the same source data +
FA is frame of reference for MA

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 Annual financial statements

 Income statement
 Balance sheet
 Notes to the accounts
 Cash flow statement
 Statement of changes in equity
 Audit report

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 Uses of financial statements
 Objective of financial statements
 User groups
 Accounting traditions
 Anglo-Saxon accounting
 Continental Europe

 Link with taxation

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 Objective of financial statements

“The objective of financial statements is to

provide information about the financial
position, performance and changes in
financial position of an entity that is
useful to a wide range of users in
making economic decisions.”
IIASB, Framework for the Preparation and Presentation of Financial Statements,
par.12

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© 2005 Peter Walton and Walter Aerts
 Users of financial statements

 Investors
 Employees
 Lenders
 Suppliers
 Customers
 Governments
 Public

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Users of financial statements

Employees

Shareholders Trade creditors

Government Management Customers

Loan providers Public

Potential
Investors

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© 2005 Peter Walton and Walter Aerts
Users – Focus on investors

Employees
Shareholders
Trade creditors
/ Investors

Government Management Customers

Loan providers Public

Potential
Investors

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© 2005 Peter Walton and Walter Aerts
 Accounting traditions

 Anglo-Saxon tradition
 Continental European tradition

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 Anglo-Saxon accounting
 US, UK, Australia, Canada, New
Zealand, etc.
 Financial statements as a function of a
company’s financing
 Market solution to accounting rules
 Powerful accounting profession

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 Continental European accounting
 Financial statement as a product of
government regulating of the economy
 All businesses are subject to accounting
rules, with extra rules for:
 Limited liability companies
 Listed companies

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 Link with Taxation

 Link between measuring performance for

shareholders and measuring profit for tax purposes
 Looser in Anglo-Saxon tradition
 Greater impact on individual accounts (less on consolidated
group accounts)
 Impact of taxation on company accounting also
depends on ownership of the company, which is in
turn an issue frequently linked to size

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© 2005 Peter Walton and Walter Aerts
 Accounting choices
 Accounting is not a set of precise
measurement rules which permit the exact
measurement of company profit and
company value
 Measurement of profit can never be anything
but an estimate
 Accounting measurement is full of choices
 Choices made should be stated clearly in the
annual financial statements

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 Accounting choices – Relevance
versus reliability
 To be useful, accounting information should
be both relevant and reliable
 Information has the quality of relevance
when it influences the economic decisions of
users by helping them evaluate past, present
or future events or confirming or correcting
their past evaluations
 Relevant information is timely
 Relevant information has predictive or feedback
value

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© 2005 Peter Walton and Walter Aerts
 Accounting choices – Relevance
versus reliability (cont.)
 Information has the quality of reliability
when it is free from material error and bias
and can be depended upon by users to
represent faithfully what it purports (or is
expected to) represent
 Accounting choices may imply trade-offs
between relevance and relaibility of
information

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 Accounting regulation

 Accounting regulation will discipline

accounting choices
 Types of regulatory body:
 Government
 Stock exchange
 Private sector body
 Professional accountants
 Specialist industry organizations
 Usually separate rules for banks and
insurance companies.

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© 2005 Peter Walton and Walter Aerts
Government as accounting regulator
 Regulation of accounting designed to
ensure that the markets can operate
free from fraud and misrepresentation
 Accountinglaws
 Commercial codes
 Government regulatory agencies
 Regulation of accounting for tax
collection purposes

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 Stock exchange as accounting
regulator
 Stock exchange regulates the financial
information to be provided by listed
companies
 In some countries this is done by a
government regulator
 US: Securities and Exchange Commission
(SEC) as accounting regulator

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© 2005 Peter Walton and Walter Aerts
 Private sector as accounting
regulator
 Delegation of responsibility of writing detailed
accounting rules to private sector bodies, financed by
contributions from companies, audit industry, etc..
 US: Financial Accounting Standards Board (FASB)
 Global: International Accounting Standards Board (IASB)
 Flexible and rapid rule-making, as opposed to
governmental rule-making
 Technical committees from professional accounting
bodies may function as catalyst

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 International bodies
 International Accounting Standards Board (IASB)
 Accepted as an international source of best practice
 Issues the International Financial Reporting Standards (IFRS)
 International Organization of Securities Commissions
(IOSCO)
 Represents the world’s stock exchange regulators
 Strives for a single, uniform set of accounting standards worldwide
 Intergovernmental Working Group of Experts on
International Standards of Accounting and Reporting
(ISAR)
 Under the auspices of the UN Conference on Trade and
Development (UNCTAD)
 Commissions research reports into current accounting problems
 International Federation of Accountants (IFAC)
 International representative of the accounting profession

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 International Financial Reporting
Standards
 Single set of global accounting and reporting
standards, issued by the IASB
 Increasingly used by many large and
mutinational companies
 Accepted by most security market authorities
 Used as a basis for national accounting
requirements (partially or in full) or as a
benchmark for the development of national
accounting rules

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 International Accounting Standards
Board
 A private sector body
 Operates under the International Accounting
Standards Committee Foundation (IASCF)
 Has no responsibility to any governmental
organization
 Has no enforcement authority
 Develops and issues both main standards
(IAS / IFRS) and interpretations (SIC / IFRIC)

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 Fig. 1.1 The structure of the IASB
IASC Foundation
22 Trustees
Appoint, Oversee, Raise Funds

Board
12 full time and 2 part time
Set technical agenda. Approve standards,
Standards Advisory exposure drafts and Interpretations
Council
30 or more members
International financial reporting
interpretations committee
12 members
Working groups
for major agenda projects Key:
Appoints
Reports to
Advises

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IFRS – Standard-setting due process
 The IASB’s standard-setting procedures have
to ensure that resulting IFRS are of high
quality and are issued only after giving IASB’s
constituencies opportunities to make their
views known at several points in the
standard-setting due process
 An overview of the due process is presented
in figure 1.2

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 Fig. 1.2 Standard-setting due process
of the IASB
National Standard
Setters Others

Research

Discussion Comment Exposure Comment Effective

Standard
paper analysis draft analysis Date

9-15 months 9-15 months 6-18 months

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 IFRS in the world
 Recent decisions of various governments result in the
requirement or permission of the use of IFRS by
more than one hundred countries
 Europe: IAS Regulation of 2002
 Requirement of use of IFRS for consolidated financial
statements of EU qouted companies as from 1 January 2005
 Member state option to extend the application of IFRS to
not-listed companies and to individual financial statements
 Adoption of IFRS (-equivalent) as national accounting
rules in a number of countries (Australia, Singapore,
Hong Kong, …)
 US: convergence process of US accounting rules and
IFRS started in 2002 (“Norwalk Agreement”)

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 Table 1.2 Financial reporting in the
European Union – Main developments
1978 4th Company Law Directive (Individual financial statements)
1983 7th Company Law Directive (Consolidated financial statements)
1995 Decision on new accounting strategy (adhering to IAS instead of
further development of specific European accounting rules)
2000 Announcement of plan to require IAS for consolidated financial
statements of listed companies by 2005
2001 Fair Value Directive (requiring/allowing for fair value measurement of
specific balance sheet items (mainly financial instruments))
2002 IAS Regulation (Application of IFRS by 2005 - see Table 1.3)
2003 Modernization Directive (reflecting IFRS developments in the 4 th and
7th Directive)
2005/2007 IFRS mandatory for listed companies in European Union

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 Table 1.3 Effects of the IAS
Regulation (EU)

Individual financial Group/ Consolidated

statements financial statements
Listed companies Member state option IFRS mandatory from
2005/2007
Not-listed companies Member state option Member state option

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Table 1.1 List of IASB rules as of September
2005
Conceptual Framework
CF Framework for the Preparation and Presentation of Financial Statements
Main standards
IAS 1 Presentation of Financial Statements
IAS 2 Inventories
IAS 7 Cash Flow Statements
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
IAS 10 Events after the Balance Sheet Date
IAS 11 Constructions Contracts
IAS 12 Income Taxes
IAS 14 Segment Reporting
IAS 16 Property, Plant and Equipment
IAS 17 Leases
IAS 18 Revenue
IAS 19 Employee Benefits
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance
IAS 21 The Effects of Changes in Foreign Exchange Rates
IAS 23 Borrowing Costs
IAS 24 Related Party Disclosures

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Table 1.1 List of IASB rules as of September 2005 (cont.)
Main standards (continued)
IAS 26 Accounting and Reporting by Retirement Benefit Plans
IAS 27 Consolidated and Separate Financial Statements
IAS 28 Investments in Associates
IAS 29 Financial Reporting in Hyperinflationary Economies
IAS 30 Disclosure in the Financial Statements of Banks and Similar Financial Institutions
IAS 32 Financial Instruments: Disclosure and Presentation
IAS 33 Earnings per Share
IAS 34 Interim Financial Reporting
IAS 36 Impairment of Assets
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
IAS 38 Intangible Assets
IAS 39 Financial Instruments: Recognition and Measurement
IAS 40 Investment Property
IAS 41 Agriculture

IFRS 1 First-time Adoption of International Financial Reporting Standards

IFRS 2 Share-based Payment
IFRS 3 Business Combinations
IFRS 4 Insurance Contracts
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
IFRS 6 Exploration for and Evaluation of Mineral Resources
IFRS 7 Financial Instruments: Disclosures
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Table 1.1 List of IASB rules as of September 2005 -
Interpretations
Interpretations
SIC 7 Introduction of the Euro (IAS 21)
SIC 10 Government Assistance – No Specific Relation to Operating Activities (IAS 20)
SIC 12 Consolidation – Special Purpose Entities (IAS 27)
SIC 13 Jointly Controlled Entities – Non-Monetary Contributions By Venturers (IAS 31)
SIC 15 Operating Leases – Incentives (IAS 17)
SIC 21 Income Taxes – Recovery of Revalued Non-Depreciable Assets (IAS 12)
SIC 25 Income Taxes – Changes in the Tax Status of an Enterprise or its Shareholders IAS (12)
SIC 27 Evaluating the Substance of Transactions involving the Legal Form of a Lease
SIC 29 Disclosure – Service Concession Arrangements
SIC 31 Revenue – Barter Transactions Involving Services
SIC 32 Intangible Assets – Web Site Costs

IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities

IFRIC 2 Members’ Shares in Co-operative Entities and Similar Instruments
IFRIC 3 Emission Rights (withdrawn by the Board in June 2005)
IFRIC 4 Determining Whether an Arrangement contains a Lease
Rights to Interests arising from Decommissioning, Restoration and Environmental
IFRIC 5
Rehabilitation Funds

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