Financial Reporting PDF

Session 1 F. Reporting FINANCIAL REPORTING SESSION 1 Original by professor Álvaro García Soto at IE Business School. Original version: May 2011. Last revised: September 2023 ©2023 IE Business School. Total or partial publication of this document without the express, written consent of IE is prohib...

Session 1 F. Reporting FINANCIAL REPORTING SESSION 1 Original by professor Álvaro García Soto at IE Business School. Original version: May 2011. Last revised: September 2023 ©2023 IE Business School. Total or partial publication of this document without the express, written consent of IE is prohibited. 1 Agenda Session 1 F. Reporting ✓The Accounting system ✓The Financial Statements ✓The GAAP ✓Management responsibility and auditing ✓Accounting Strategy and Financial Disclosure 2 Session 1 F. Reporting 3 The Accounting System Session 1 F. Reporting 4 The Accounting System Session 1 F. Reporting 5 The Accounting System Session 1 F. Reporting 6 The Accounting System Session 1 F. Reporting 7 The Accounting System Session 1 F. Reporting Measurement Principles IFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle. • Historical cost principle (or cost principle): dictates that companies record assets at their cost. This is true not only at the time the asset is purchased, but also over the time the asset is held. • Fair value principle: states that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). 8 The Accounting System Session 1 F. Reporting Qualities of useful information The IASB conceptual framework states that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. Useful information should possess two fundamental qualities: Relevance Faithful representation 9 The Accounting System Session 1 F. Reporting Qualities of useful information 10  The Accounting System Session 1 F. Reporting Assumptions They provide a foundation for the accounting process Monetary unit Economic entity Time period Going concern 11  The Accounting System Session 1 F. Reporting Assumptions 12  The Accounting System Session 1 F. Reporting Assumptions 13  Session 1 F. Reporting The Financial Statements The Financial Statements Session 1 F. Reporting General purpose: to provide information about the financial position, performance and cash flows of a firm that is useful to a wide range of users in making economic decisions The Financial Statements Session 1 F. Reporting Information in the Financial Statements What is the accumulated wealth of the company at the end of a particular period? Balance Sheet (BS) How much wealth was generated by the company over a particular period? Income Statement (IS) What cash movements took place over a particular period? Cash Flow Statement (CFS) 16  The Financial Statements Session 1 F. Reporting BALANCE SHEET/STATEMENT OF FINANCIAL POSITION – reports the amount of assets, liabilities, and shareholders/stockholders’ equity of an accounting entity at a specific date INCOME STATEMENT – reports the revenues less the expenses and resulting net income or net loss for a specific period of time STATEMENT OF SHAREHOLDERS’ / STOCKHOLDERS’ EQUITY / RETAINED EARNINGS STATEMENTS – reports the changes in each of the company’s shareholders’ / stockholders’ equity accounts, including the change in the retained earnings balance caused by net income and dividends during a specific period of time STATEMENT OF CASH FLOWS – reports inflows (receipts) and outflows (payments) of cash for a specific period of time in the categories of operating, investing, and financing COMPREHENSIVE INCOME STATEMENT – presents other comprehensive income items that are not included in the determination of net income 17  The Financial Statements Session 1 F. Reporting 18  The Financial Statements Session 1 F. Reporting 19  The Financial Statements Session 1 F. Reporting The Balance Sheet / Statement of Financial Position Elements Assets Cash Short-Term Investment Accounts Receivable Notes Receivable Inventory (to be sold) Supplies Prepaid Expenses Long-Term Investments Equipment Buildings Land Intangibles Liabilities Accounts Payable Accrued Expenses Notes Payable Interest Payable Taxes Payable Unearned Revenue Loans/Bonds Payable Shareholders’/Stockholders’ Equity Common Stock/Share Capital 20  Retained Earnings Session 1 F. Reporting 21  The Financial Statements Session 1 F. Reporting The Accounting Equation A = L + SE Assets Economic Resources Liabilities Shareholders’ / Stockholders’ Equity Sources of Financing for Economic Resources Liabilities: From Creditors Equity: From Shareholders/Stockholders 22  Session 1 F. Reporting 23  The Financial Statements Session 1 F. Reporting The Income Statement Elements Revenues Sales Revenue Fee Revenue Interest Revenue Rent Revenue Expenses Cost of Goods Sold Wages Expense Rent Expense Interest Expense Depreciation Expense Advertising Expense Insurance Expense Repair Expense Income Tax Expense 24  Session 1 F. Reporting 25  The Financial Statements Session 1 F. Reporting The Statement of Cash Flows Elements Cash Flows from Operating Activities Cash Flows from Investing Activities Cash Flows from Financing Activities /- Note that each of the three cash flow sources can be positive (net cash inflow) or negative (net cash outflow). 26  Session 1 F. Reporting 27  The Financial Statements Session 1 F. Reporting The Statement of Shareholders’ / Stockholders’ Equity or Retained Earnings Statement Elements Share capital / Common Stock Retained Earnings Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings 28  Session 1 F. Reporting 29  The Financial Statements Session 1 F. Reporting Relationships among the statements Income Statement Net income is computed first and is needed to determine the ending balance in retained earnings. Retained Earnings Statement The ending balance in retained earnings is needed in preparing the statement of financial position. BS/Statement of Financial Position The cash shown on the statement of financial position is needed in preparing the statement of cash flows. Statement of Cash Flows 30  The Financial Statements Session 1 F. Reporting The Notes Did you notice a sentence at the bottom of each financial statement? All financial statements should be accompanied by notes which provide the reader with supplemental information about the financial condition and results of operations of the company. 31  Session 1 F. Reporting 32  The Financial Statements Session 1 F. Reporting 33  Session 1 F. Reporting The GAAP 34  The GAAP Session 1 F. Reporting Our accounting system has a long and distinguished history. An Italian monk and mathematician, Fray Luca Pacioli, published the first elements of doubleentry bookkeeping in 1494.* Prior to 1933, the management teams of most companies were largely free to choose their own financial reporting practices. * Summa de arithmetica, geometria, proportioni et proportionalita (Summary of arithmetic, geometry, proportions and proportionality) 35  The GAAP Session 1 F. Reporting In order to assure high-quality financial reporting, accountants present financial statements in conformity with accounting standards issued by standard-setting bodies. Generally Accepted Accounting Principles (GAAP) 36  The GAAP Session 1 F. Reporting 37  The GAAP Session 1 F. Reporting Two sets of standards accepted for international use: ▪ U.S. GAAP, issued by the FASB http://www.fasb.org/home ▪ International Financial Reporting Standards (IFRS), issued by the IASB http://www.ifrs.org/ Different jurisdictions Different rules US GAAP (FASB – SEC) IFRS & IAS (IASB) – National bodies - Governments 38  The GAAP Session 1 F. Reporting Securities Act of 1933 Securities and Exchange Act of 1934 The Securities and Exchange Commission (SEC) has been given broad powers to determine measurement rules for financial statements in the USA 39  The GAAP Session 1 F. Reporting The SEC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP Currently, the Financial Accounting Standards Board (FASB) is recognized as the body to formulate US GAAP which are applied by most companies in the U.S.A. 40  The GAAP Session 1 F. Reporting IASB (International Accounting Standards Board): ▪ Private institution; ▪ Issuer of IFRS (former IAS); ▪ Interpretations IFRICs (International Financial Reporting Interpretations Committee) and SICs (Standards Interpretations Committee) 41  The GAAP Session 1 F. Reporting 42  http://www.ifrs.org/Pages/default.aspx The GAAP Session 1 F. Reporting Global Convergence of Accounting Standards Since 2002, there has been substantial movement toward the adoption of International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). They are used in more than 130 countries Examples of jurisdictions requiring the use of IFRS : • European Union (2005, 2008) • Israel, Turkey & S Africa (2008) • Australia and New Zealand (2005), Canada (2009-11) • Brazil (2010), Chile (2009), Mexico & Perú (2012), Colombia (2016) • UAE, Saudi Arabia (2008), Hong Kong, Malaysia &South Korea (2016) In the United States, the SEC allows foreign companies whose stock is traded in the U.S.A. to use IFRS. Japanese companies also can use IFRS. You can find the use of IFRS by jurisdiction via the following link: https://www.iasplus.com/en/resources/ifrs-topics/use-of-ifrs 43  The GAAP Session 1 F. Reporting Differences in Accounting Methods 44  Session 1 F. Reporting Management responsibility & auditing 45  Management responsibility and auditing Session 1 F. Reporting Companies incur the cost of preparing the financial statements and bear the following economic consequences of their publication . . . ✓ Effects on the selling price of stock. ✓ Effects on the amount of bonuses received by managers and other employees. ✓ Loss of competitive information to other companies. 46  Management responsibility and auditing Session 1 F. Reporting Ethical Conduct 47  Management responsibility and auditing Session 1 F. Reporting Ensuring the Accuracy of Financial Statements To ensure the accuracy of the company’s financial information, management: • Maintains a system of controls • Hires external independent or external auditors • Forms a committee of the Board of Directors to review these other two safeguards. 48  Management responsibility and auditing Session 1 F. Reporting External Audit An audit is an examination of the financial reports to ensure that they represent what they claim and conform with GAAP 49  Overall, I believe these financial statements are fairly stated Management responsibility and auditing Session 1 F. Reporting 50  Management responsibility and auditing Session 1 F. Reporting Ethics, reputation and legal liability 51  Session 1 F. Reporting Accounting Strategy & Financial Disclosure 52  Accounting Strategy and Financial Disclosure Session 1 F. Reporting 53  Source: The World Bank & UNODC Accounting Strategy and Financial Disclosure Session 1 F. Reporting • Parent Company stand alone Financial Statements or/and Consolidated Financial Statements ▪ Where to get this information? ▪ Be aware of Financial Statements Annexes. • Financial Statements (Conceptual Framework): ▪ The Balance Sheet ▪ The Income Statement ▪ Cash Flow Statement ▪ The statement of owners’ or stockholders’ equity. • Auditor’s Report: Limiting their responsibility: Has The company performed an auditor change? 54  Accounting Strategy and Financial Disclosure Session 1 F. Reporting • Notes to Financial Statements: cross references to Financial Statements. • How are reflected in Financial Statements relevant issues published? • Collaboration of Accounting and Financial Analysis Department with the different Company Areas: Legal & Compliance Department, Tax Department, Finance Department, Management Control, Controller office, Marketing and Sales, Operations, Procurement and Logistics. • Implication (coherence) of financial risk coverage policy in Financial Statements. • Consequences of potential or actual tax/financial inspections. 55  Accounting Strategy and Financial Disclosure Session 1 F. Reporting • Accounting Rules: ▪ Identify key accounting policies: Analyze policies and estimates the firm uses to measure its critical factors and risks ▪ How the firm’s accounting policies compare to the norms in the industry? • Comparative Information: two/three years for Balance Sheet & two/three years for Income & Cash Flow Statement • Financial KPI’s for decision making: “non gaap measures”: ▪ Gross Margin ▪ EBITDA (Earnings Before Interests Taxes Depreciation & Amortization). ▪ Net Financial Debt 56  Accounting Strategy and Financial Disclosure Session 1 F. Reporting Economic Entity Financial Information Accounting Identifies Measures & Communicates Financial Statements Additional Information Balance Sheet President’s letter Income Statement Prospectuses, Statement of Cash Flows SEC Reporting Statement of Owners’ or Stockholders’ Equity Note Disclosures GAAP 57  News and Press releases Forecasts Environmental Reports Non-GAAP measures Not GAAP Accounting Strategy and Financial Disclosure Session 1 F. Reporting Quality of Financial Disclosures: ▪ Do disclosures show the firm’s business strategy and its economic consequences? ▪ Do the financial statements explain the key accounting policies and assumptions? ▪ Does the company explain its current performance? ▪ When accounting rules restrict the firm from measuring its key success factors, does the firm provide adequate additional disclosure to help outsiders how these factors are managed? ▪ Quality of segment disclosure ▪ How good is the Investor Relations program/team? ▪ Do managers face strong incentives to use accounting discretion to manage earnings? Debt covenants, bonus targets, stock options plans, reducing tax payments? ▪ Realistic estimations in the past? Is there a justification? 58  Accounting Strategy and Financial Disclosure Session 1 F. Reporting • Some companies sacrifice value creation to get short term targets. • Moderate and constant growth is much more valued by the market than strong & volatile growth, surprises affect negatively to share value of quoted companies • Lack of transparency may “under price” shares Trade-off between offering additional information or compulsory disclosures: Good because….. Bad because…. Once you offer additional information you can not cease on it. But sometimes, it may not be easy to get the same information Legal risks Information for competitors Additional information may reduce risk in terms of understanding Reduce costs for analysts Sign of “quality” 59  Session 1 F. Reporting 60 