Financial Reporting and Analysis Session 6

Differences in financial statement elements for IASB and FASB

(1) The IASB framework lists income and expenses as the elements related to performance, while the FASB framework uses revenues, expenses, gains, losses, and comprehensive income. (2) FASB defines an asset as a future economic benefit, where IASB defines it as a resource from which a future economic benefit is expected. (3) The word "probable" is used by the FASB to define assets and liabilities. (4) The FASB framework does not allow the values of most assets to be adjusted upward.

unqualified opinion

(also known as a clean opinion) indicates that the auditor believes the statements are free from material omissions and errors.

The IASB has four stated goals:

1. Develop global accounting standards requiring transparency, comparability, and high quality in financial statements. 2. Promote the use of global accounting standards. 3. Account for the needs of emerging markets and small firms when implementing global accounting standards. 4. Achieve convergence between various national accounting standards and global accounting standards.

Describe the flow of information in an accounting system

1. Journal entries record every transaction, showing which accounts are changed and by what amounts. A listing of all the journal entries in order of their dates is called the general journal. 2. The general ledger sorts the entries in the general journal by account. 3. At the end of the accounting period, an initial trial balance is prepared that shows the balances in each account. If any adjusting entries are needed, they will be recorded and reflected in an adjusted trial balance. 4. The account balances from the adjusted trial balance are presented in the financial statements.

financial statement analysis framework

1. State the objective of the analysis. 2. Gather data. 3. Process the data. 4. Analyze and interpret the data. 5. Report the conclusions or recommendations. 6. Update the analysis.

144A

A company can issue securities to certain qualified buyers without registering the securities with the SEC but must notify the SEC that it intends to do so.

Accrual Categories

Accruals fall into four categories: 1. Unearned revenue. 2. Accrued revenue. 3. Prepaid expenses. 4. Accrued expenses. Wages payable are a common example of an accrued expense.

Accruals are best described as requiring an accounting entry:

Accruals require an accounting entry when the earliest event occurs (paying or receiving cash, providing a good or service, or incurring an expense) and one or more offsetting entries as the exchange is completed.

we do you use disclosures of accounting policies for

An analyst should use these disclosures to evaluate what policies are discussed, whether they cover all the relevant data in the financial statements, which policies required management to make estimates, and whether the disclosures and estimates have changed since the prior period.

5 financial statement elements

Assets—the firm's economic resources. Liabilities—creditors' claims on the firm's resources. Owners' equity—paid-in capital (common and preferred stock), retained earnings, and cumulative other comprehensive income. Revenues—sales, investment income, and gains. Expenses—cost of goods sold, selling and administrative expenses, depreciation, interest, taxes, and losses.

qualified opinion

If the statements make any exceptions to the accounting principles. Auditor will explain these exceptions in the audit report.

IAS required financial statements

Balance sheet (statement of financial position). Statement of comprehensive income. Cash flow statement. Statement of changes in owners' equity. Explanatory notes, including a summary of accounting policies.

10-Q

U.S. firms are required to file this form quarterly, with updated financial statements (unlike Form 10-K, these statements do not have to be audited) and disclosures about certain events such as significant legal proceedings or changes in accounting policy. Non-U.S. companies are typically required to file the equivalent Form 6-K semiannually.

8K

Companies must file this form to disclose material events including significant asset acquisitions and disposals, changes in management or corporate governance, or matters related to its accountants, its financial statements, or the markets in which its securities trade.

structure and content of financial statements IAS

Most entities should present a classified balance sheet showing current and noncurrent assets and liabilities. Minimum information is required on the face of each financial statement and in the notes. For example, the face of the balance sheet must show specific items such as cash and cash equivalents, plant, property and equipment, and inventories. Items listed on the face of the comprehensive income statement must include revenue, profit or loss, tax expense, and finance costs, among others. Comparative information for prior periods should be included unless a specific standard states otherwise.

four characteristics that enhance relevance and faithful representation

Comparability. Financial statement presentation should be consistent among firms and across time periods. Verifiability. Independent observers, using the same methods, obtain similar results. Timeliness. Information is available to decision makers before the information is stale. Understandability. Users with a basic knowledge of business and accounting and who make a reasonable effort to study the financial statements should be able to readily understand the information the statements present. Useful information should not be omitted just because it is complicated.

general features of financial statements according to IAS No. 1

Fair presentation. Going concern. Accrual accounting. Consistency. Materiality. Aggregation. No offsetting. Reporting frequency. Comparative information.

MD&A

In this section, management discusses a variety of issues, including the nature of the business, past performance, and future outlook. Analysts must be aware that some parts of management's commentary may be unaudited. For publicly held firms in the United States, the SEC requires that MD&A discuss trends and identify significant events and uncertainties that affect the firm's liquidity, capital resources, and results of operations. MD&A must also discuss: -Effects of inflation and changing prices if material. -Impact of off-balance-sheet obligations and contractual obligations such as purchase commitments. -Accounting policies that require significant judgment by management. -Forward-looking expenditures and divestitures. Footnotes to the financial statements are audited.

JRNL entries

Journal entries record every transaction, showing which accounts are changed and by what amounts. A listing of all the journal entries in order of their dates is called the general journal.

double-entry accounting

Keeps accounting equation in balance. Some typical examples of double entry accounting include: Purchase equipment for $10,000 cash. Property, plant, and equipment (an asset) increases by $10,000. Cash (an asset) decreases by $10,000. Borrow $10,000 to purchase equipment. PP&E increases by $10,000. Notes payable (a liability) increases by $10,000. Buy office supplies for $100 cash. Cash decreases by $100. Supply expense increases by $100. An expense reduces retained earnings, so owners' equity decreases by $100. Buy inventory for $8,000 cash and sell it for $10,000 cash. The purchase decreases cash by $8,000 and increases inventory (an asset) by $8,000. The sale increases cash by $10,000 and decreases inventory by $8,000, so assets increase by $2,000. At the same time, sales (a revenue account) increase by $10,000 and "cost of goods sold" (an expense) increases by the $8,000 cost of inventory. The $2,000 difference is an increase in net income and, therefore, in retained earnings and owners' equity (ignoring taxes).

Form S-1

Registration statement filed prior to the sale of new securities to the public. The registration statement includes audited financial statements, risk assessment, underwriter identification, and the estimated amount and use of the offering proceeds.

10-K

Required annual filing that includes information about the business and its management, audited financial statements and disclosures, and disclosures about legal matters involving the firm. Information required in Form 10-K is similar to that which a firm typically provides in its annual report to shareholders. However, a firm's annual report is not a substitute for the required 10-K filing. Equivalent SEC forms for foreign issuers in the U.S. markets are Form 40-F for Canadian companies and Form 20-F for other foreign issuers.

General Ledger

The general ledger sorts the entries in the general journal by account.

Which of the following financial reporting choices is permitted under IFRS but not under U.S. GAAP

Upward revaluation of long-lived assets is permitted under IFRS. Under U.S. GAAP, most assets (other than certain financial instruments) may not be revalued upward. Neither netting deferred tax assets with deferred tax liabilities nor excluding actuarial gains and losses from balance sheet pension items is permitted under IFRS or U.S. GAAP.

Barriers to creating a coherent financial reporting framework

Valuation—Measurement bases for valuation that require little judgment, such as historical cost, may be less relevant than a basis like fair value that requires more judgment. Standard setting—Three approaches to standard setting are a "principles-based" approach that relies on a broad framework, a "rules-based" approach that gives specific guidance about how to classify transactions, and an "objectives-oriented" approach that blends the other two approaches. IFRS is largely a principles-based approach. U.S. GAAP has traditionally been more rules-based, but the common conceptual framework is moving toward an objectives-oriented approach. Measurement—Another trade-off in financial reporting is between properly valuing the elements at one point in time (as on the balance sheet) and properly valuing the changes between points in time (as on the income statement). An "asset/liability" approach, which standard setters have largely used, focuses on balance sheet valuation. A "revenue/expense" approach would tend to place more significance on the income statement.

DEF 14A

When a company prepares a proxy statement for its shareholders prior to the annual meeting or other shareholder vote, it also files the statement with the SEC as Form DEF-14A.

Can management manipulate earnings?

Yes. Because adjustments and assumptions within the financial statements are to some extent at the discretion of management, the possibility exists that management can try to manipulate or misrepresent the company's financial performance. A clean auditor's report does not ensure that management is unable to manipulate earnings, and a qualified opinion expresses reservations about the appropriateness of accounting policies. An analyst doesn't have access to the detailed information that flows through a company's accounting system, but only sees its end product, the financial statements.

liabilities

are creditor claims on the company's resources. Examples of liabilities include: Accounts payable and trade payables. Financial liabilities such as short-term notes payable. Unearned revenue. Items that will show up on future income statements as revenues. Income taxes payable. The taxes accrued during the past year but not yet paid. Long-term debt such as bonds payable. Deferred tax liabilities.

Assets

are the firm's economic resources. Examples of assets include: Cash and cash equivalents. Liquid securities with maturities of 90 days or less are considered cash equivalents. Accounts receivable. Accounts receivable often have an "allowance for bad debt expense" or "allowance for doubtful accounts" as a contra account. Inventory. Financial assets such as marketable securities. Prepaid expenses. Items that will be expenses on future income statements. Property, plant, and equipment. Includes a contra-asset account for accumulated depreciation. Investment in affiliates accounted for using the equity method. Deferred tax assets. Intangible assets. Economic resources of the firm that do not have a physical form, such as patents, trademarks, licenses, and goodwill. Except for goodwill, these values may be reduced by "accumulated amortization."

Internal controls

are the processes by which the company ensures that it presents accurate financial statements. Internal controls are the responsibility of management. For publicly traded firms in the United States, the auditor must express an opinion on the firm's internal controls. The auditor can provide this opinion separately or as the fourth element of the standard opinion.

expanded accounting equation

assets = liabilities + contributed capital + ending retained earnings or assets = liabilities + contributed capital + beginning retained earnings + revenue - expenses - dividends

basic accounting equation

assets = liabilities + owners' equity

disclaimer of opinion

auditor cannot make an opinion (scope limitation)

standard auditor's report

contains three parts and states that: Whereas the financial statements are prepared by management and are its responsibility, the auditor has performed an independent review. Generally accepted auditing standards were followed, thus providing reasonable assurance that the financial statements contain no material errors. The auditor is satisfied that the statements were prepared in accordance with accepted accounting principles and that the principles chosen and estimates made are reasonable. The auditor's report must also contain additional explanation when accounting methods have not been used consistently between periods.

Convergence

developing one universally accepted set of accounting standards. One barrier to convergence is simply that different standard-setting bodies and the regulatory authorities of different countries can and do disagree on the best treatment of a particular item or issue. Other barriers result from the political pressures that regulatory bodies face from business groups and others who will be affected by changes in reporting standards.

Forms 3,4 and 5

involve the beneficial ownership of securities by a company's officers and directors. Analysts can use these filings to learn about purchases and sales of company securities by corporate insiders.

Objective of Financial reporting per IASB

is to provide information about the firm to current and potential investors and creditors that is useful for making their decisions about investing in or lending to the firm. The conceptual framework is used in the development of accounting standards. Given the variety and complexity of possible transactions and the estimates and assumptions a firm must make when presenting its performance, financial statements could potentially take any form if reporting standards did not exist. Thus, financial reporting standards are needed to provide consistency by narrowing the range of acceptable responses.

financial statement analysis

is to use the information in a company's financial statements, along with other relevant information, to make economic decisions. Examples of such decisions include whether to invest in the company's securities or recommend them to investors and whether to extend trade or bank credit to the company. Analysts use financial statement data to evaluate a company's past performance and current financial position in order to form opinions about the company's ability to earn profits and generate cash flow in the future.

Proxy statement

issued to shareholders when there are matters that require a shareholder vote. These statements, which are also filed with the SEC and available from EDGAR, are a good source of information about the election of (and qualifications of) board members, compensation, management qualifications, and the issuance of stock options.

characteristics of a coherent financial reporting framework

one that fits together logically. Such a framework should be transparent, comprehensive, and consistent. Transparency—Full disclosure and fair presentation reveal the underlying economics of the company to the financial statement user. Comprehensiveness—All types of transactions that have financial implications should be part of the framework, including new types of transactions that emerge. Consistency—Similar transactions should be accounted for in similar ways across companies, geographic areas, and time periods.

Expenses

outflows of economic resources and include: Cost of goods sold. Selling, general, and administrative expenses. These include such expenses as advertising, management salaries, rent, and utilities. Depreciation and amortization. To reflect the "using up" of tangible and intangible assets. Tax expense. Interest expense. Losses. Decreases in assets from transactions incidental to the firm's day-to-day activities.

Owners' equity

owners' residual claim on a firm's resources, which is the amount by which assets exceed liabilities. Owners' equity includes: Capital. Par value of common stock. Additional paid-in capital. Proceeds from common stock sales in excess of par value. (Share repurchases that the company has made are represented in the contra account treasury stock.) Retained earnings. Cumulative net income that has not been distributed as dividends. Other comprehensive income. Changes resulting from foreign currency translation, minimum pension liability adjustments, or unrealized gains and losses on investments.

Standard-setting bodies

professional organizations of accountants and auditors that establish financial reporting standards. Regulatory authorities are government agencies that have the legal authority to enforce compliance with financial reporting standards. Regulatory authorities, such as the Securities and Exchange Commission (SEC) in the U.S. and the Financial Services Authority (FSA) in the United Kingdom, are established by national governments. Most national authorities belong to the International Organization of Securities Commissions (IOSCO).

financial reporting

refers to the way companies show their financial performance to investors, creditors, and other interested parties by preparing and presenting financial statements. According to the IASB Conceptual Framework for Financial Reporting 2010: "The objective of general purpose 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. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit."

two fundamental characteristics that make financial information useful

relevance and faithful representation. -Relevance. Financial statements are relevant if the information in them can influence users' economic decisions or affect users' evaluations of past events or forecasts of future events. To be relevant, information should have predictive value, confirmatory value (confirm prior expectations), or both. Materiality is an aspect of relevance. -Faithful representation. Information that is faithfully representative is complete, neutral (absence of bias), and free from error.

statement of comprehensive income

reports all changes in equity except for shareholder transactions (e.g., issuing stock, repurchasing stock, and paying dividends).

income statement

reports on the financial performance of the firm over a period of time. The elements of the income statement include revenues, expenses, and gains and losses. Revenues are inflows from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. Expenses are outflows from delivering or producing goods or services that constitute the entity's ongoing major or central operations. Other income includes gains that may or may not arise in the ordinary course of business.

Statement of Cash flows

reports the company's cash receipts and payments. These cash flows are classified as follows: Operating cash flows include the cash effects of transactions that involve the normal business of the firm. Investing cash flows are those resulting from the acquisition or sale of property, plant, and equipment; of a subsidiary or segment; of securities; and of investments in other firms. Financing cash flows are those resulting from issuance or retirement of the firm's debt and equity securities and include dividends paid to stockholders.

revenue

represents inflows of economic resources and includes: Sales. Revenue from the firm's day-to-day activities. Gains. Increases in assets from transactions incidental to the firm's day-to-day activities. Investment income such as interest and dividend income.

reconciliation statement

shows what its financial results would have been under an alternative reporting system. For example, firms that list their shares in the United States but do not use U.S. GAAP or IFRS are required to reconcile their financial statements with U.S. GAAP. For IFRS firms listing their shares in the United States, reconciliation is no longer required.

adverse opinion

the statements are not presented fairly or are materially nonconforming with accounting standards.

contra account

used for entries that offset some part of the value of another account. For example, equipment is typically valued on the balance sheet at acquisition (historical) cost, and the estimated decrease in its value over time is recorded in a contra account titled "accumulated depreciation."