Department of Management and Law FINANCIAL REPORTING. Lesson 1. Sandro Brunelli, Ph.D. Slide 1-1

Department of Management and Law FINANCIAL REPORTING Lesson 1 Sandro Brunelli, Ph.D. brunelli@economia.uniroma2.it 1-1

1-2 ACTIVITIES OF THE FIRM, FINANCIAL REPORTING AND ACCOUNTING STANDARDS

Firms as business entities What is a Firm? A business entity (also called a firm, enterprise or company) is an organization that produces goods and/or services and it is oriented to the value creation that is sustainable in the long term 1-3

Firms as business entities Shareholders Lenders Firm Government Customers Employees Suppliers 1-4 Definitely a stakeholder is an individual or a group that affects or is affected by the organization. Besides, we have other classifications of stakeholders (internal, external, primary, secondary, strategic, environmental)

Value creation A business entity (also called a firm or an enterprise) is an organization that produces goods and/or services and it is oriented to the value creation 1-5 Value creation is the ultimate measure by which it is judged (by different stakeholders and from different perspectives). To create value, a firm must systematically invest in those projects where the expected value of cash coming in more than compensates for the cash going out. The purpose of the corporation is value creation that is sustainable in the long term. Value creation takes place through the transformation of resources, and the governance system is about who and what really counts in this conversion process (Huse 2007).

Value creation Two types of value creation Economic value creation Social value creation Financial performance indicators 1-6 accountingbased indicators e.g. Return on Total Assets (ROA), Return on Investment (ROI), Return on Equity (ROE) marketbased indicators Market price Earnings per common share (EPS) Price-to-earnings Dividend payout Dividend yield

Legal Structures of Firms The 3 main types of business entities Sole Proprietorship Partnership Corporation Unincorporated business Incorporated business A business that does not possess a separate legal identity from its owner(s) A business that possess a separate legal identity from its owner(s) 1-7 You know these things right??? If it does not so, download on the course website the files named «brief review about the legal structure of the firm» and «circuits and legal forms»

Introduction to Financial Statements Who needs financial information? Internal Users External Users Managers Officers Internal Auditors Sales Managers Budget Officers Controller Shareholders Lenders Governments Labor Unions External Auditors Suppliers Customers 1-8

Introduction to Financial Statements Who needs financial information? Investors in the firm Shareholders are interested in assessing the future performance of firm based on: Published financial statements because of their ability to predict future performance Financial analysts forecasts regarding the future performance of the firm Fundamental/technical analysis Debt security investors Main interest is in ensuring that the solvency of the firm is assured and that the security of the debt is adequate Financial statements are frequently used for this task 1-9

Introduction to Financial Statements Who needs financial information? Business contacts Suppliers use financial statements to assess the financial security of the firm for the same reason that the debt security investors Customers and employees Intermediaries Financial analysts Media Other users Government 1-10

Introduction to Financial Statements From the external transactions between the firm and the stakeholders to the financial statements External transactions between the firm and third parties Recognition (Objective values) 1-11 Measurement (subjective values) Accounting is the language of the business Vice President of IASB Double-entry Accounting Financial statements Balance Sheet Income statement Notes to the financial statements Statement of owner s equity Cash flow statement News from the IAS/IFRS

Introduction to Financial Statements Glossary of accounting terms External Transaction: An external transaction is a transaction that occurs between a business and an external entity. Examples are: 1. The company sells a product to a customer; 2. The owner of the company sends an employee to teach a class to a night school somewhere and then the company gets paid by that other school; 3. The company borrows money from a bank. 4. an accounting transaction is one that involves money exchange. This means that events such as hiring an employee, meeting with a customer, or negotiating the value of a job are not transactions, even if money is mentioned. As long as there is no money exchange, it does not count as a transaction in the accounting sense. As you will see this can generate some problems in evaluating the wealth of a firm! 1-12

1-13 Introduction to Financial Statements Glossary of accounting terms Accounting: is the process of identifying, measuring, recording, and communicating financial information about a company s activities so decision makers can make informed decisions. Accounting information is useful because it helps people answer questions and make better decisions. Double-entry accounting: A double-entry bookkeeping system is a set of rules for recording financial information in a financial accounting system in which every transaction or event changes at least two different nominal ledger accounts. The name derives from the fact that financial information used to be recorded using pen and ink in paper books hence bookkeeping (whereas now it is recorded mainly in computer systems) and that these books were called journals and ledgers (hence nominal ledger, etc.) and that each transaction was entered twice (hence double-entry ), with one side of the transaction being called a debit and the other a credit (e.g. scale).

Introduction to Financial Statements Business Activities 1-14

Introduction to Financial Statements External transactions between the firm and third parties Recognition (Objective values) Double-entry Accounting The company's activities (transactions between the firm and third parties) can be represented by three circuits Production Received Financing Given Financing Owners (Equity) Creditors (Debts) 1-15

1-16 The circuits are also useful because they allow linking the operations, in particular acquisition of the input and selling of the output, to the economic values (revenues, cost and equity) and financial values (cash, trade receivable, trade payable). Thus they investigate the link be-tween accounting (i.e. performance) and operations. P.153, Fob Notes, E. Di Carlo.

Introduction to Financial Statements Circuit of production Customers Suppliers Cash in Cash out Trend of the cash Trend of the production Sell of products Acquisition of factors of production Obtaining products (goods or services) [ Productive ] combination 1-17 (Acts of internal management)

Introduction to Financial Statements Circuit of production with trade receivables and trade payables Customers Suppliers Trend of the cash and of the similar securities + Cash + Trade receivable - Trade payable - Cash + Trade payable - Trade receivable Trend of the production Sell of products Revenue Obtaining products (goods or services) [ Productive ] combination Acquisition of factors of production Cost 1-18 (Acts of internal management)

1-19 From the accounting point of view, every transaction generates a double effect: the monetary effect (cash in and cash out) and the richness effect (costs and revenues). In particular when the firm acquires the input, cash out and costs are recorded, while cash in and revenues are recorded when the firm sells the products. The costs can be seen as a sacrifice of the owner s wealth, while the revenues is a recovery of the owner s wealth

Introduction to Financial Statements Glossary of accounting terms Trade payable: is a liability to supplier, in other words it is the money owed by a business to suppliers for purchases or services rendered. More commonly referred to as accounts payable. Trade receivable: is a credit to customers, in other words it is the money owed to a business by its clients (customers). More commonly referred to as accounts receivable. 1-20

Introduction to Financial Statements Glossary of accounting terms Cost: is the value of money that has been used up to buy something, and hence is not available for use anymore. In other words it is the amount of money expended to acquire something.!cost Expense Revenue: is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In general usage, revenue is income received by an organization in the form of cash or cash equivalents. E.g., sales revenue or revenues is income received from selling goods or services over a period of time; tax revenue is income that a government receives from taxpayers. 1-21

Introduction to Financial Statements Circuits of received financing Equity Debts Individual (Sole proprietorship) Partners (Partnership and corporation) Contributions in cash Contributions in kind (i.e. real estate, buildings, patents, copyright ) 1-22

Introduction to Financial Statements Glossary of accounting terms Equity: is the capital paid into or invested in the business by the shareholders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock/share: is the generic term for common equity securities. Shares represent a fraction of ownership in a business. A business may declare different types (classes) of shares, each having distinctive ownership rules, privileges, or share values (e.g., common stock, preferred stock, convertible preferred stock). Debt: is an obligation owed by one party (the debtor) to a second party, the creditor referring to assets granted by the creditor to the debtor. A debt is created when a creditor (lender) agrees to lend a sum of assets to a debtor. 1-23

Introduction to Financial Statements Circuit of received financing from lenders Capital Market (bond market, bank loan) Cash in Cash out Trend of the cash Trend of received financing Borrow loans from lenders (payable) Repay loans to lenders + (Financial expenses) (nominal amounts negotiated) (Costs of the transaction) Payable: Sum of money that ought to be paid, as agreed or required. 1-24

Introduction to Financial Statements Circuit of received financing from the owners Capital Market (stock market) Cash in Cash out Trend of the cash Trade of received financing Issue of Stocks Repayment of stocks + Net income/- Net loss 1-25

Introduction to Financial Statements Circuit of grant loans Capital Markets Cash in Cash out Trend of the cash (nominal amounts negotiated) (income from the operation) 1-26 Repayment of financing receivables (+ Financial revenues) Issue of financing receivables Trend of the given financing Receivables: are claims that are expected to be collected in cash.

PREVIEW OF CHAPTER 1 1-27 Intermediate Accounting IFRS 2nd Edition Kieso, Weygandt, and Warfield

1 Financial Reporting and Accounting Standards LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Describe the growing importance of global financial markets and its relation to financial reporting. 2. Identify the major financial statements and other means of financial reporting. 3. Explain how accounting assists in the efficient use of scarce resources. 5. Identify the objective of financial reporting. 6. Identify the major policy-setting bodies and their role in the standard-setting process. 7. Explain the meaning of IFRS. 8. Describe the challenges facing financial reporting. 4. Explain the need for high-quality standards. 1-28

GLOBAL MARKETS World markets are becoming increasingly intertwined. Top 20 Global Companies In Terms of Sales ILLUSTRATION 1-1 1-29 LO 1

GLOBAL MARKETS Significant number of foreign companies are found on national exchanges. ILLUSTRATION 1-2 International Exchange Statistics 1-30 LO 1

1 Financial Reporting and Accounting Standards LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Describe the growing importance of global financial markets and its relation to financial reporting. 2. Identify the major financial statements and other means of financial reporting. 3. Explain how accounting assists in the efficient use of scarce resources. 5. Identify the objective of financial reporting. 6. Identify the major policy-setting bodies and their role in the standard-setting process. 7. Explain the meaning of IFRS. 8. Describe the challenges facing financial reporting. 1-31 4. Explain the need for high-quality standards.

GLOBAL MARKETS Financial Accounting, Financial Statements and Financial Reporting Financial accounting is the process that culminate with the preparation and presentation of financial reports for both internal and external uses. The characteristics of accounting are: 1. the identification, measurement, and communication of financial information about 2. economic entities to 3. interested parties. 1-32 LO 2

General View of Financial statements: Brief Comments The financial statements are a picture of the company in financial terms. Each financial statement relates to a specific date or covers a particular period. 1-33

1-34 Information Disclosed on Financial Statements Question 1. How well did the company perform(or operate) during the period? 2. Why did the company s equity change during the period? 3. What is the company s financial position at the end of the period? 4. How much cash did the company generate and spend during the period? Revenues Expenses Answer Net profit (Net loss) Beg. retained earnings + Net income (or Net loss) - Cash dividends Ending retained earnings Assets = Liabilities + Owners equity Operating cash flows ± Investing cash flows ± Financing cash flows Increase or decrease in cash Financial Statement Income statement Statement of Retained earnings Balance Sheet (statement of financial position) Statement of Cash flows

I General View of Financial statements: a Comparison Income Statement Statement of Owner s Equity Ending Balance Sheet Statement of Cash Flows Point in time Period of time Point in time 1-35

GLOBAL MARKETS Economic Entity Financial Statements Additional Information Financial Information Accounting? Identify and Measure and Communicate 1-36 Statement of Financial Position Income Statement or Statement of Comprehensive Income Statement of Cash Flows Statement of Changes in Equity Note Disclosures President s letter Reports filed with governmental agencies News releases Forecasts Environmental impact statements CSR Accomplishments Tax Return LO 2

GLOBAL MARKETS Accounting and Capital Allocation Resources are limited. Efficient use of resources often determines whether a business thrives. ILLUSTRATION 1-3 Capital Allocation Process 1-38 LO 3

GLOBAL MARKETS High Quality Standards Globalization demands a single set of high-quality international accounting standards. Some elements: 1. Single set of high-quality accounting standards established by a single standard-setting body. 2. Consistency in application and interpretation. 3. Common disclosures. 4. Common high-quality auditing standards and practices. 5. Common approach to regulatory review and enforcement. 6. Education and training of market participants. (Continued) 1-40 LO 4

GLOBAL MARKETS High Quality Standards Globalization demands a single set of high-quality international accounting standards. Some elements: 7. Common delivery systems (e.g., extensible Business Reporting Language XBRL). 8. Common approach to corporate governance and legal frameworks around the world. 1-41 LO 4

The need to develop standards December 10, 2012: A car seller receives 100 000 from Mr B. who has ordered a new car that is 400 000 worth. December 20, 2012: Mr B. receives his new car. He does not pay anything to the car seller. January 6, 2013: The car seller receives 300 000 from Mr B. When should the proceeds of this sale be recognized in the car seller revenues? When should it affect its profits? 1-42

National Standard Setters Italy???? 1-43

Legal system Western Legal systems 1-44

1-45 Corporate financing classification

1 Financial Reporting and Accounting Standards LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Describe the growing importance of global financial markets and its relation to financial reporting. 2. Identify the major financial statements and other means of financial reporting. 3. Explain how accounting assists in the efficient use of scarce resources. 4. Explain the need for high-quality standards. 5. Identify the objective of financial reporting. 6. Identify the major policy-setting bodies and their role in the standard-setting process. 7. Explain the meaning of IFRS. 8. Describe the challenges facing financial reporting. 1-46

OBJECTIVE OF FINANCIAL ACCOUNTING Objective: Provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. 1-47 LO 5

OBJECTIVE OF FINANCIAL ACCOUNTING General-Purpose Financial Statements Provide financial reporting information to a wide variety of users. Provide the most useful information possible at the least cost. Equity Investors and Creditors Investors and creditors are the primary user group. 1-48 LO 5

OBJECTIVE OF FINANCIAL ACCOUNTING Entity Perspective Companies viewed as separate and distinct from their owners (shareholders). Decision-Usefulness Investors are interested in assessing 1. the company s ability to generate net cash inflows and 2. management s ability to protect and enhance the capital providers investments. 1-49 LO 5

1 Financial Reporting and Accounting Standards LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Describe the growing importance of global financial markets and its relation to financial reporting. 2. Identify the major financial statements and other means of financial reporting. 3. Explain how accounting assists in the efficient use of scarce resources. 4. Explain the need for high-quality standards. 5. Identify the objective of financial reporting. 6. Identify the major policy-setting bodies and their role in the standardsetting process. 7. Explain the meaning of IFRS. 8. Describe the challenges facing financial reporting. 1-50

STANDARD-SETTING ORGANIZATIONS Main international standard-setting organization: International Accounting Standards Board (IASB) Issues International Financial Reporting Standards (IFRS). Standards used on most foreign exchanges. IFRS used in over 115 countries. Organizations that have a role in international standardsetting are the International Organization of Securities Commissions (IOSCO) and the IASB. 1-51 LO 6

STANDARD-SETTING ORGANIZATIONS International Organization of Securities Commissions (IOSCO) Does not set accounting standards. Dedicated to ensuring that global markets can operate in an efficient and effective basis. Supports the use of IFRS as the single set of international standards in cross-border offerings and listings. http://www.iosco.org/ 1-52 LO 6

HOW IS IT GOING? 1-53 How much progress has been made toward the goal of one single set of global accounting standards? To answer this question, the IASB conducted a major survey on IFRS adoption. The survey indicates that there is almost universal support (95 percent) for IFRS as the single set of global accounting standards. This includes those jurisdictions that have yet to make a decision on adopting IFRS, such as the United States. More than 80 percent of the jurisdictions report IFRS adoption for all (or in five cases, almost all) public companies. Most of the remaining 11 non-adopters have made significant progress toward IFRS adoption. Those jurisdictions that have adopted IFRS have made very few modifications to the standards. More than 40 percent of the IFRS adopters do so automatically, without an endorsement process. Where modifications have occurred, they are regarded as temporary arrangements to assist in the migration from national accounting standards to IFRS. (Continued) Source: Adapted from Hans Hoogervorst, Breaking the Boilerplate, IFRS Foundation Conference (June 13, 2013). LO 6

HOW IS IT GOING? How much progress has been made toward the goal of one single set of global accounting standards? To answer this question, the IASB conducted a major survey on IFRS adoption. The survey indicates that there is almost universal support (95 percent) for IFRS as the single set of global accounting standards. This includes those jurisdictions that have yet to make a decision on adopting IFRS, such as the United States. A few large and important economies have not yet (fully) adopted IFRS. In such countries, more progress is being made than many people are aware of. Japan already permits the use of full IFRS and has recently widened the scope of companies that are allowed to adopt it. In the United States, non-u.s. companies are allowed to use IFRS for listings on their exchanges. Today, more than 450 foreign private issuers are reporting using IFRS in U.S. regulatory filings, which represents trillions of dollars in market capitalization. 1-54 Source: Adapted from Hans Hoogervorst, Breaking the Boilerplate, IFRS Foundation Conference (June 13, 2013). LO 6

STANDARD-SETTING ORGANIZATIONS International Accounting Standards Board (IASB) Composed of four organizations IFRS Foundation International Accounting Standards Board (IASB) IFRS Advisory Council IFRS Interpretations Committee 1-55 LO 6

International Accounting Standards Board ILLUSTRATION 1-4 International Standard-Setting Structure 1-56 LO 6

International Accounting Standards Board Due Process The IASB due process has the following elements: 1. Independent standard-setting board; 2. Thorough and systematic process for developing standards; 3. Engagement with investors, regulators, business leaders, and the global accountancy profession at every stage of the process; and 1-57 4. Collaborative efforts with the worldwide standard-setting community. LO 6

International Accounting Standards Board ILLUSTRATION 1-5 International Standard-Setting Structure 1-58 LO 6

International Accounting Standards Board Types of Pronouncements International Financial Reporting Standards. Conceptual Framework for Financial Reporting. International Financial Reporting Standards Interpretations. 1-59 LO 6

STANDARD-SETTING ORGANIZATIONS Hierarchy of IFRS Companies first look to: 1. International Financial Reporting Standards; International Financial Reporting Standards, International Accounting Standards (issued by the predecessor to the IASB), and IFRS interpretations originated by the IFRS Interpretations Committee (and its predecessor, the IAS Interpretations Committee); 2. The Conceptual Framework for Financial Reporting; and 3. Pronouncements of other standard-setting bodies that use a similar conceptual framework (e.g., U.S. GAAP). 1-60 LO 7

FINANCIAL REPORTING CHALLENGES IFRS in a Political Environment ILLUSTRATION 1-6 User Groups that Influence the Formulation of Accounting Standards 1-62 LO 8

FINANCIAL REPORTING CHALLENGES The Expectations Gap What the public thinks accountants should do vs. what accountants think they can do. Significant Financial Reporting Issues Non-financial measurements Forward-looking information Soft assets Timeliness 1-63 LO 8

FINANCIAL REPORTING CHALLENGES Ethics in the Environment of Financial Accounting Companies that concentrate on maximizing the bottom line, facing the challenges of competition, and stressing short-term results place accountants in an environment of conflict and pressure. IFRS do not always provide an answer. Technical competence is not enough when encountering ethical decisions. 1-64 LO 8

FINANCIAL REPORTING CHALLENGES International Convergence Examples of how convergence is occurring: 1. China s goal is to eliminate differences between its standards and IFRS. 2. Japan now permits the use of IFRS for domestic companies. 3. The IASB and the FASB have spent the last 12 years working to converge their standards. 4. Malaysia helped amend the accounting for agricultural assets. 5. Italy provided advice and counsel on the accounting for business combinations under common control. 1-65 LO 8

1-66 Some US, IFRS and UK accounting terms

1-67 Some US, IFRS and UK accounting terms

THE U.S. STANDARD-SETTING ENVIRONMENT Organizations responsible for developing financial accounting standards (GAAP) in the United States: 1. Securities and Exchange Commission (SEC). http://www.sec.gov/ 2. Financial Accounting Standards Board (FASB). http://www.fasb.org/ 1-68

QUESTION TIME Question General-purpose financial statements are prepared primarily for: a. internal users. b. external users. c. auditors. d. government regulators. 1-69 LO 5

QUESTION TIME Question IFRS stands for: a. International Federation of Reporting Services. b. Independent Financial Reporting Standards. c. International Financial Reporting Standards. d. Integrated Financial Reporting Services. 1-70 LO 6

QUESTION TIME Question The major key players on the international side are the: a. IASB and IFRS Advisory Council. b. IOSCO and the U.S. SEC. c. London Stock Exchange and International Securities Exchange. d. IASB and IOSCO. 1-71 LO 6

QUESTION TIME Question Accounting standard-setters use the following process in establishing international standards: a. Research, exposure draft, discussion paper, standard. b. Discussion paper, research, exposure draft, standard. c. Research, preliminary views, discussion paper, standard. d. Research, discussion paper, exposure draft, standard. 1-72 LO 6

QUESTION TIME Question 1-73 IFRS is comprised of: a. International Financial Reporting Standards and FASB financial reporting standards. b. International Financial Reporting Standards, International Accounting Standards, and International Accounting Standards Interpretations. c. International Accounting Standards and International Accounting Standards Interpretations. d. FASB financial reporting standards and International Accounting Standards. LO 7

QUESTION TIME Question The expectations gap is: a. what financial information management provides and what users want. b. what the public thinks accountants should do and what accountants think they can do. c. what the governmental agencies want from standardsetting and what the standard-setters provide. d. what the users of financial statements want from the government and what is provided. 1-74 LO 8