OBJECTIVE OF FINANCIAL REPORTING CHAPTER 3 FINANCIAL REPORTING STANDARDS FINANCIAL REPORTING USE IN SECURITY ANALYSIS AND VALUATION

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1 CHAPTER 3 FINANCIAL REPORTING STANDARDS Presenter s name Presenter s title dd Month yyyy OBJECTIVE OF FINANCIAL REPORTING 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 Copyright 2013 CFA Institute 2 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 entity s future cash flows, and assessing those prospects requires information about an entity s - 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. 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. Copyright 2013 CFA Institute 3 Copyright 2013 CFA Institute 4

2 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). Incook s 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? 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, It sold 60 units, each of which cost $ 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. Copyright 2013 CFA Institute 5 Copyright 2013 CFA Institute 6 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. 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). Copyright 2013 CFA Institute 7 Copyright 2013 CFA Institute 8

3 EXAMPLES OF REGULATORY AUTHORITIES EXAMPLES OF REGULATORY AUTHORITIES (CONTINUED) Country Australia Belgium Brazil China France Germany India Japan Morocco Nigeria Regulatory authority with primary responsibility for securities regulation in the country Australian Securities and Investments Commission Financial Services and Markets Authority Comissão de Valores Mobiliários China Securities Regulatory Commission Autorité des marchés financiers Bundesanstalt für Finanzdienstleistungsaufsicht Securities and Exchange Board of India Financial Services Agency Conseil déontologique des valeurs mobilières Securities and Exchange Commission Nigeria Country Portugal Spain South Africa Turkey United Kingdom United States Uruguay Regulatory authority with primary responsibility for securities regulation in the country Comissão do Mercado de Valores Mobiliários Comisión Nacional del Mercado de Valores Financial Services Board Capital Markets Board of Turkey Financial Services Authority* Securities and Exchange Commission (SEC) Banco Central del Uruguay *FSA to be succeeded by the Financial Conduct Authority and the Prudential Regulation Authority in Copyright 2013 CFA Institute 9 Copyright 2013 CFA Institute 10 INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS (IOSCO) Not a regulatory authority, but an international association of securities regulators formed in 1983 s 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. IFRS USE AROUND THE WORLD Country Status for Listed Companies as of December 2011 Argentina Required for fiscal years beginning on or after 1 January 2012 Australia Required for all private sector reporting entities and as the basis for public sector reporting since 2005 Required for consolidated financial statements of banks and Brazil listed companies from 31 December 2010 and for individual company accounts progressively since January 2008 Required from 1 January 2011 for all listed entities and Canada 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 Indonesia Convergence process ongoing; a decision about a target date for full compliance with IFRS is expected to be made in 2012 Copyright 2013 CFA Institute 11 Copyright 2013 CFA Institute 12

4 IFRS USE AROUND THE WORLD Country Status for Listed Companies as of December 2011 Permitted from 2010 for a number of international companies; Japan 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. 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. Copyright 2013 CFA Institute 13 Copyright 2013 CFA Institute 14 GLOBAL CONVERGENCE OF ACCOUNTING STANDARDS: DIFFERENCES REMAIN 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. 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. Copyright 2013 CFA Institute 15 Copyright 2013 CFA Institute 16

5 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). 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. Copyright 2013 CFA Institute 17 Copyright 2013 CFA Institute 18 IFRS CONCEPTUAL FRAMEWORK 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. Copyright 2013 CFA Institute 19 Copyright 2013 CFA Institute 20

6 IFRS CONCEPTUAL FRAMEWORK: FUNDAMENTAL QUALITATIVE CHARACTERISTICS IFRS CONCEPTUAL FRAMEWORK: ENHANCING 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. 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. - : Reasonably informed users should be able to comprehend the information. Copyright 2013 CFA Institute 21 Copyright 2013 CFA Institute 22 IFRS CONCEPTUAL FRAMEWORK: REPORTING ELEMENTS 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. 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). Copyright 2013 CFA Institute 23 Copyright 2013 CFA Institute 24

7 IFRS CONCEPTUAL FRAMEWORK: CONSTRAINTS AND ASSUMPTIONS FINANCIAL STATEMENTS : The benefits of information should exceed the costs of providing it. s: - 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. 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 Copyright 2013 CFA Institute 25 Copyright 2013 CFA Institute 26 GENERAL FEATURES OF FINANCIAL STATEMENTS Fair presentation Going concern Accrual basis Materiality and aggregation No offsetting Frequency of reporting Comparative information Consistency 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. Copyright 2013 CFA Institute 27 Copyright 2013 CFA Institute 28

8 COHERENT FINANCIAL REPORTING FRAMEWORK DISCLOSURES OF SIGNIFICANT ACCOUNTING POLICIES 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. 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. Copyright 2013 CFA Institute 29 Copyright 2013 CFA Institute 30 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 Company s 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 Company s 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 Company s 2011 Annual Report 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 Company s 2011 Annual Report Copyright 2013 CFA Institute 31 Copyright 2013 CFA Institute 32

9 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 Company s 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 Company s 2011 Annual Report 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 Copyright 2013 CFA Institute 33 Copyright 2013 CFA Institute 34 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 SUMMARY 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, and : benefits of info should exceed costs s Accrual accounting Going concern Copyright 2013 CFA Institute 35 Copyright 2013 CFA Institute 36