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CHAPTER 3

FINANCIAL REPORTING STANDARDS


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Presenters title
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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 entitys future
cash flows, and assessing those prospects requires information about
an entitys
- 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).
Incooks 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

Comisso de Valores Mobilirios

China

China Securities Regulatory Commission

France

Autorit des marchs financiers

Germany

Bundesanstalt fr Finanzdienstleistungsaufsicht

India

Securities and Exchange Board of India

Japan

Financial Services Agency

Morocco

Conseil dontologique des valeurs mobilires

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

Comisso do Mercado de Valores Mobilirios

Spain

Comisin 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
Australia

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
basis for public sector reporting since 2005

Brazil

Required for consolidated financial statements of banks and


listed companies from 31 December 2010 and for individual
company accounts progressively since January 2008

Canada

Required from 1 January 2011 for all listed entities and


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

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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.
All other aspects of the
framework flow from that central
objective.

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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.

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IFRS CONCEPTUAL FRAMEWORK:


ENHANCING QUALITATIVE CHARACTERISTICS
Four enhancing qualitative
characteristics that make financial
information useful:
- Comparability: Companies record
and report information in a similar
manner.
- 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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IFRS CONCEPTUAL FRAMEWORK:


REPORTING ELEMENTS
Elements directly related to the
measurement of financial position:
- 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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IFRS CONCEPTUAL FRAMEWORK:


REPORTING ELEMENTS
Elements directly related to the
measurement of performance:
- 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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IFRS CONCEPTUAL FRAMEWORK:


CONSTRAINTS AND ASSUMPTIONS
Constraint: The benefits of
information should exceed the
costs of providing it.
Underlying Assumptions:
- Accrual Basis: Financial
statements should reflect
transactions in the period when
they actually occur, not
necessarily when cash
movements occur.
- Going Concern: Assumption
that the company will continue
in business for the foreseeable
future.
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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 Companys
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
Companys 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 Companys 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 Companys 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 Companys
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 Companys 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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