AF2101 Intermediate Financial Accounting I Lecture 2 PDF

AF2101 Intermediate Financial Accounting I Lecture 2 Dr Sotirios Kokkinos Part I: Accounting Regulation Necessity for accounting rules Differences in international accounting Accounting harmonization IFRS/IASB IFRS in EU and IFRS vs US GAAP Part II: Published Ac...

AF2101 Intermediate Financial Accounting I Lecture 2 Dr Sotirios Kokkinos Part I: Accounting Regulation Necessity for accounting rules Differences in international accounting Accounting harmonization IFRS/IASB IFRS in EU and IFRS vs US GAAP Part II: Published Accounts Narrative reporting and audited financial statements IAS 1 (presentation of published accounts) Requirements of published accounts Are accounting rules necessary? Some benefits of having (common) accounting rules: ▪Less risk of corporate abuse ▪More uniformity and increased comparability (however, can one size fit all?) ▪Greater stakeholder confidence in the integrity of the accounts → this should lower the cost of funding for businesses Counter-view: Couldn’t market forces act as a regulating force? Is formal regulation necessary? Causes of international differences in accounting Potential causes may include: 1. Differences in legal systems: “Common Law” vs. “Code Law” countries 2. Differences in the main providers of finance to corporations (equity- vs debt-oriented) 3. Taxation rules 4. Accounting profession 1. Common Law vs Code Law Common Law: Provides answer to specific cases, rather than formulating/prescribing specific rules about financial reporting. Code Law: Much more prescriptive/structured. Company law has established rules on how companies need to prepare financial statements. Some examples of Common vs. Code Law countries Source: Table 2.1 – Comparative International Accounting, Nobes & Parker 2. Differences in the providers of finance Where can a company get funding from? ▪Two main sources of funding: ▪Debt (e.g. bank loans, corporate bonds) ▪Equity (e.g. issue new ordinary shares) In certain countries, banks are very important providers of funding and therefore equity funding is not that pronounced. e.g., Germany, France, Italy In other countries, equity funding is very common, e.g. UK, USA. These countries usually have very well-developed equity markets. Evidence: The strength of equity markets Source: Table 2.2 – Comparative International Accounting, Nobes & Parker Link between legal regime and strength of equity markets La Porta et al. (1997) find a statistical link between common law countries and strong equity markets. Common law countries: Stronger legal protection of investors, compared to code law countries.  Link between ownership structure and published information provision ▪Countries in which banks are important providers of finance tend to have small ownership dispersion → banks are also primary shareholders → lower need for published info on company performance. ▪Countries in which there is widespread ownership of companies → greater need for disclosure of quality accounting information. Examples? Germany vs. USA  3. Taxation The degree to which tax regulations determine accounting measurements differs across countries. In some countries, the tax rules are the accounting rules (e.g., in France, Germany). One set of financial statements tax-driven → in that case they might be incentivised to show lower profits to get higher tax deduction. In other countries, the tax rules are separate to the accounting rules (e.g., UK, Australia). Separate accounts are prepared for tax purposes.  4. Accounting profession Difference in the number of accountants across countries Country Population Professional Ratio (in millions) Accountants France 65 18,000 1:3611 UK 62 343,000 1:180 Germany 81 13,000 1:6230 USA 309 303,000 1:1019 Australia 22 155,000 1:142 Source– Comparative International Accounting, Nobes and Parker, 10th Edition, 2008, FT Prentice Hall  Class Activity GROUP A GROUP B Strong Equity Markets ▪Weaker equity Markets Many outside shareholders ▪Core, insider shareholders Separate accounting and tax ▪Tax dominating rules rules Countries: France, UK, Netherlands, Italy, USA, Germany, New Zealand, Austria, Belgium TASK: Group the countries above broadly under Group A or B  How accounting was regulated? Traditionally, each country had its own accounting standards body that produced the local accounting standards GAAP = Generally Accepted Accounting Principles Thus, there would exist different local accounting rules, such as the UK GAAP, German GAAP, US GAAP etc. What issues did this create?  How accounting is regulated? Internationalisation of business Need for harmonisation Integration of financial markets of accounting standards A single set of high-quality global accounting rules IFRS  What do we mean by “harmonisation”? Harmonisation: Does not mean that everything needs to be exactly the same. Rather, it’s the process of increasing the comparability of accounting practices. How? By setting bounds to their degree of variation.  Reasons in favour of accounting harmonisation (Advantages) ▪Better for investors: greater transparency / comparability for investment purposes ▪Better for companies: Reduction in cost of capital if accounting becomes more transparent & reliable ▪Advantages for companies willing to list in foreign exchanges and cost savings for multinationals ▪Easier mobility for accounting employees Example: GlaxoSmithKline’s reconciliations of Earnings to US GAAP What are the IFRS? IFRS: International Financial Reporting Standards The IFRS is a set of high quality, principles-based, financial reporting standards issued by the IASB. They deal with key issues such as: What information should be disclosed How information should be presented How assets should be valued How profit should be measured  Examples of IFRSs The IFRS consists of a list of individual IASs and IFRSs. For example: Presentation of F/S: IAS 1 Consolidation: IFRS 3, IAS 27, IAS 28, IFRS 10, IFRS 11, IFRS 12 Tangible Assets: IAS 16 and IAS 40 Intangible Assets: IAS 38 Inventories: IAS 2 Leases: IAS 17, IFRS 16 Financial Instruments: IAS 32, IFRS 7, IFRS 9 Provisions: IAS 37 Employee benefits: IAS 19, IFRS 2, IAS 26 For a comprehensive list of IFRSs, visit: http://www.iasplus.com/standard/standard.htm The International Accounting Standards Board (IASB) An independent standard setting body, based in London It produces, promotes and publishes the IFRS IASB’s IFRS Setting Process Agenda, project planning This process results in IFRS Exposure for comment of discussion paper and exposure taking several draft (professional accounting bodies, Big4, investment years before they bodies, academics) got introduced Revision and Publication of IFRS Follow up process after publication about practical issues of implementation  Adoption of IFRS in the EU IFRS in the European Union (EU): ▪Since 2005, EU-endorsed IFRS have been adopted by all EU member states ▪Who has to comply: All listed companies in the EU (for their consolidated financial statements) ▪EU member states can decide whether to extend the use of IFRS to unlisted companies & to unconsolidated statements, by making this compulsory or optional.  IFRS Implementation Around the World (2005) IFRS or fixed date for implementation U.S. GAAP and/or convergence intended Convergence plans No/unknown convergence plans 23  IFRS Implementation Around the World (2010) IFRS or fixed date for implementation U.S. GAAP and/or convergence intended Convergence plans No/unknown convergence plans 24  Differing IFRS practices in the EU Despite the EU adoption of IFRS, differing IFRS practices still exist among the consolidated F/S of listed companies in the EU. Some examples of differences: 1. Differing IFRS implementation dates 2. IFRS offers options with regards to various accounting treatments 3. Subjectivity in measurement estimations 4. Imperfect Enforcement of IFRS  IFRS vs. US GAAP: High-level differences IFRS US GAAP (principles-based) (rules-based) Focus more on providing the conceptual basis for accountants Rules include specific criteria, to follow rather than a list of thresholds, examples, scope detailed rules restrictions, exceptions.  IFRS vs. US GAAP: High-level differences (cont.) ▪US GAAP contains far more detailed accounting regulation than IFRS. ▪Under US GAAP, public companies must make the world’s most extensive disclosures when presenting their financial statements. ▪US GAAP contains fewer explicit options than IFRS.  Activity in class Use the following links to download the annual report of Apple Inc. (US GAAP) and the annual report of Tesco PLC (IFRS). What main differences do you notice? https://s2.q4cdn.com/470004039/files/doc_financials/2022/q4/_10 -K-2022-(As-Filed).pdf https://www.tescoplc.com/media/an0cp1co/tesco-annual-report- 2022.pdf Part II: Published accounts What do you see? Annual reports  The annual report The annual report is the means by which the directors are accountable for their stewardship of the assets and their handling of the company’s affairs for the past year. What, do you think, is the main reason we need annual reports? It consists of: Narrative material (some of which is regulated) Audited financial data  Can you spot similarities/differences? Most of it unregulated… allowing subjectivity!!!  The annual report The annual report is the means by which the directors are accountable for their stewardship of the assets and their handling of the company’s affairs for the past year. What, do you think, is the main reason we need annual reports? It consists of: Narrative material (some of which is regulated) Audited financial data  Narrative reporting At a glance (highlights) Chairman’s statement, Chief Executive’s review, strategy and board overview Directors’ report (business review) (split into sections)* Remuneration report* Corporate Governance Report * Statement of directors’ responsibilities* Auditors’ report* * Content regulated Narrative reporting - Director’s report  Required items in this section: ▪ Principal activities ▪ Statement about employee involvement ▪ Business review ▪ Number of employees with disabilities ▪ Future developments ▪ Donations to charities /political parties ▪ R&D activities ▪ Purchase of own shares ▪ Post balance sheet ▪ Information about directors events ▪ Policy on creditor payment ▪ Value of land and buildings  Audited financial statements IAS 1 deals with the presentation of account According to IAS 1, a complete set of financial statements comprises: 1. A statement of Financial Position (SoFP or B/S) 2. A statement of Comprehensive Income (SoCI) 3. A statement of Changes in Equity (SoCE) 4. A statement of Cash Flows (SoCF) 5. Notes (comprising a summary of significant accounting policies and other explanatory information) IAS 1 requires: ✓ compliance with fundamental accounting principles ✓ consistency in policies IAS 1 – Presentation of Financial Statements  1.The Statement of Financial Position The minimum information that must be presented on the face of the BALANCE SHEET: ✓Trade and other payables ✓Provisions ✓ Property, plant & equipment ✓Financial liabilities (ppe) ✓Liabilities and assets for ✓ Investment property current tax ✓ Intangible assets ✓Deferred tax liabilities and ✓ Financial assets assets ✓ Investments accounted for using the equity method ✓Non-controlling interests (within equity) ✓ Inventories ✓Issued share capital and ✓ Trade and other receivables reserves attributable to equity holders of the parent ✓ Cash & cash equivalents  IAS 1 – Presentation of Financial Statements IAS 1 does NOT prescribe the order and presentation of the balance sheet! For example: ▪Total Assets = Total equity & liabilities ▪Assets – Liabilities = Net Assets = Equity ▪Not a strict requirement, but suggested if relevant: ▪Splitting assets & liabilities into current & non-current ▪Present assets & liabilities broadly in order of liquidity-reverse liquidity (i.e., least liquid to the most liquid)  2. Statement of Comprehensive Income (SoCI) Purpose: to present all income and expense recognised in the period. Difference between I/S and SoCI ❖I/S is part of the SoCI ❖I/S reports only gains and losses that have been realised. ❖SoCI includes also other gains/losses (other comprehensive income) that have NOT necessarily been realised.  2. Statement of Comprehensive Income (SoCI) Choice of presentations: Single Statement (i.e., SoCI) OR a Double Statement that essentially splits the required information into: ✓(1) profit and loss (i.e., the I/S) and ✓(2) a statement that starts with profit or loss and then adds other comprehensive income.  2. Statement of Comprehensive Income (SoCI) IAS 1 also allows a choice of two formats for detailing income and expenditure: ✓Format 1: Vertical with costs analysed according to function, e.g., Cost of sales, distribution costs and administrative expenses ✓Format 2: Vertical with costs analysed according to nature, e.g., whether they relate to raw materials, employee benefits expenses, operating expenses and depreciation *We will be studying Format 1 only.  SoCI Format 1: costs analysed by function In order to arrive at its Operating Profit, a company needs to classify all of its operating expenses into 1 of 4 categories: 1. Cost of Sales (production costs) 2. Distribution and Selling Costs 3. Administrative expenses 4. Other operating expenses (or income)  The 3 other categories of operating expenses Distribution & Selling Administration expenses costs Administrative staff salaries Warehousing Premises Promotion Professional fees e.g. audit Selling Trade receivable write- Transport downs Other operating expense (income) Payments for licences Income from 3rd party use of PPE not used currently in production Income from employees (e.g., canteen)  Activity: Classify the operating expense 1. Head office salaries 2. Salaries of staff involved in the production 3. Warehouse insurance 4. Advertising costs 5. Accounting fees 6. Bad debts 7. Subcontracting costs related to production  3. Statement of Changes in Equity (SoCE) shows the changes of equity within the financial year The Statement of Changes in Equity will show the following items on the face of the statement:  Comprehensive income  for each component of equity, the effect of changes in accounting policies and corrections of errors recognised (IAS 8)  Capital transactions with the owners (e.g., new equity issuance, dividends, share buybacks, increases from bonus, rights or new cash issues)  Example – Statement of Changes in Equity Sainsbury’s Annual Report 2013 48  4. Statement of Cash Flows (SoCF) IAS 7 deals with SoCF “the provision of information about the historical changes in cash and cash equivalents by means of a cash flow statement which classifies cash flow during the period from operating, investing and financing activities” Cash - Cash in hand and money available on demand – bank deposits Cash equivalents – short term highly liquid investments readily convertible to known amounts of cash and subject to an insignificant risk of changes in value3  5. Notes to the Financial Statements 50 The notes section contains notes!: ✓Setting out Accounting policies ✓Giving greater detail of the make up of B/S items e.g., Inventory, non-current asset make-up ✓Giving additional information to assist the prediction of future cash flows e.g., Capital commitments, future commitments, contingent liabilities ✓Other information of interest to other stakeholders e.g., Staff costs and numbers  Recap question: Why do investors around the world trust IFRS? Explain few benefits which IFRS provide to the world economy. IFRS bring transparency by enhancing the international comparability and quality 51 of financial information, enabling investors and other market participants to make informed economic decisions. IFRS strengthen accountability by reducing the information gap between the providers of capital and the people to whom they have entrusted their money. IFRS Standards provide information that is needed to hold management to account. As a source of globally comparable information, IFRS Standards are also of vital importance to regulators around the world. IFRS contribute to economic efficiency by helping investors to identify opportunities and risks across the world, thus improving capital allocation. For businesses, the use of a single, trusted accounting language lowers the cost of capital and reduces international reporting costs.  Recap question: Why do investors around the world trust IFRS? Explain few benefits which IFRS provide to the world economy. 52 Some documented benefits might include: a lower cost of capital for some companies and increased investment in jurisdictions adopting IFRS Standards. Some companies also report benefits from being able to use IFRS in their internal reporting, improving their ability to compare operating units in different jurisdictions, reducing the number of different reporting systems and having the flexibility to move staff with IFRS experience around their organisation.