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Chapter 3 Financial Reporting Standards

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1 Chapter 3 Financial Reporting Standards
Presenter’s name Presenter’s title dd Month yyyy Customization note: Standard-setting bodies and regulatory authorities for presenter’s country Learning Outcomes Describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation. Describe the roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions. Describe the status of global convergence of accounting standards and ongoing barriers to developing one universally accepted set of financial reporting standards. Describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements. Describe general requirements for financial statements under IFRS. Compare key concepts of financial reporting standards under IFRS and U.S. GAAP reporting systems. Identify the characteristics of a coherent financial reporting framework and the barriers to creating such a framework. Explain the implications for financial analysis of differing financial reporting systems and the importance of monitoring developments in financial reporting standards. Analyze company disclosures of significant accounting policies.

2 objective of financial Reporting
Objective 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 LOS. Describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation. Pages 90–92 The financial reports of a company include financial statements and other supplemental disclosures necessary to assess a company’s financial position and periodic financial performance. The objective of general purpose financial reporting is identically worded in international and U.S. standards. The objective is stated in the International Accounting Standards Board (IASB)Conceptual Framework for Financial Reporting 2010 and in the U.S. Financial Accounting Standards Board (FASB) Statement of Financial Accounting Concepts No. 8, Conceptual Framework for Financial Reporting . In September 2010, the IASB adopted the Conceptual Framework for Financial Reporting (2010) in place of the Framework for the Preparation and Presentation of Financial Statements (1989). The Conceptual Framework contains two updated chapters: “The objective of financial reporting” and “Qualitative characteristics of useful financial information.” The remainder of the material in the Conceptual Framework is from the Framework (1989) and will be updated as the project is completed. Also in September 2010, the FASB issued Concepts Statement 8, Conceptual Framework for Financial Reporting, which is identical to the IASB chapters, to replace Concepts Statements 1 and 2. Other aspects of the Conceptual Framework flow logically from the objective. Note that the objective identifies the primary users as “existing and potential investors, lenders, and other creditors.” The Basis for Conclusions states three reasons why the boards concluded that the primary user group should be the “existing and potential investors, lenders, and other creditors” of a reporting entity: This group has the most critical and immediate need for the information in financial reports, and many cannot require the entity to provide the information to them directly. The FASB’s and the IASB’s responsibilities require them to focus on the needs of participants in capital markets. Information that meets the needs of the specified primary users is likely to meet the needs of other stakeholders. Copyright © 2013 CFA Institute

3 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. LOS. Describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation. Pages 90–92 The Conceptual Framework indicates the following: Decisions by existing and potential investors about buying, selling, or holding equity and debt instruments depend on the returns that they expect from an investment in those instruments; for example, dividends, principal and interest payments, or market price increases. Similarly, decisions by existing and potential lenders and other creditors about providing or settling loans and other forms of credit depend on the principal and interest payments or other returns that they expect. Investors’, lenders’, and other creditors’ expectations about returns depend on their assessment of the amount, timing, and uncertainty of (the prospects for) future net cash inflows to the entity. Consequently, existing and potential investors, lenders, and other creditors need information to help them assess the prospects for future net cash inflows to an entity. General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders, and other creditors to estimate the value of the reporting entity. To assess an entity’s prospects for future net cash inflows, existing and potential investors, lenders, and other creditors need information about the resources of the entity, claims against the entity, and how efficiently and effectively the entity’s management and governing board have discharged their responsibilities to use the entity’s resources. Examples of such responsibilities include protecting the entity’s resources from unfavorable effects of economic factors such as price and technological changes and ensuring that the entity complies with applicable laws, regulations, and contractual provisions. Information about management’s discharge of its responsibilities also is useful for decisions by existing investors, lenders, and other creditors who have the right to vote on or otherwise influence management’s actions. General purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders, and other creditors need. Those users need to consider pertinent information from other sources, for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks. Copyright © 2013 CFA Institute

4 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. LOS. Describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation. Pages 90–92 Developing financial reporting standards is complicated because the underlying economic reality is complicated. The financial transactions and financial position that companies aim to represent in their financial reports are also complex. Furthermore, uncertainty about various aspects of transactions often results in the need for accruals and estimates, both of which necessitate judgment. Judgment varies from one preparer to the next. Accordingly, standards are needed to achieve some amount of consistency in these judgments. Even with such standards, there usually will be no single correct answer to the question of how to reflect economic reality in financial reports. Nevertheless, financial reporting standards try to limit the range of acceptable answers to increase consistency in financial reports. Understanding the financial reporting framework—including how and when judgments and estimates can affect the numbers reported—enables an analyst to evaluate the information reported and to use the information appropriately when assessing a company’s financial performance. Clearly, such an understanding is also important in assessing the financial impact of business decisions and in making comparisons among entities. Copyright © 2013 CFA Institute

5 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? LOS. Describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation. Pages 90–92 Possible alternatives Expense 100% of the office equipment or some portion (depreciation). Expense 100% of the cookware purchased ($70,000) because cash was disbursed or only the 60 sets that were sold (60 × $700 = $42,000). Recognize total sales ($72,000) or only the $57,000 for which the cash was collected. The max income is $20,000 if you recognize $72,000 in sales, the cost of goods sold of $42,000, none of the office equipment, and $10,000 in rent and other expenses. The min income is a loss of $32,000 if you recognize $57,000 in sales, cost of goods sold of $70,000, all $9,000 of the office equipment, and $10,000 in rent and other expenses. Obviously, accounting standards do exist. Sales would be $72,000, possibly reduced for an allowance for uncollectible accounts. The cost of goods sold would be $42,000. And at least part of the office equipment must be expensed (depreciation). Depreciation refers to the allocation of the cost of long-lived assets over their useful life and will be covered in a later reading. The point of the example is that standards serve to limit the range of allowable approaches. Copyright © 2013 CFA Institute

6 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 $42,000. It sold 60 units, each of which cost $700. 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. LOS. Describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation. Pages 90–92 Possible alternatives Expense 100% of the office equipment or some portion (depreciation). Expense 100% of the cookware purchased ($70,000) because cash was disbursed or only the 60 sets that were sold (60 * $700 = $42,000). Recognize total sales ($72,000) or only the $57,000 for which the cash was collected. The max income is $20,000 if you recognize $72,000 in sales, the cost of goods sold of $42,000, none of the office equipment, and $10,000 rent and other expenses. The min income is a loss of $32,000 if you recognize $57,000 in sales, cost of goods sold of $70,000, all $9,000 of the office equipment, and $10,000 rent and other expenses. Obviously, accounting standards do exist. Sales would be $72,000, possibly reduced for an allowance for uncollectible accounts. The cost of goods sold would be $42,000. And at least part of the office equipment must be expensed (depreciation). Depreciation refers to the allocation of the cost of long-lived assets over their useful life and will be covered in a later reading. The point of the example is that standards serve to limit the range of allowable approaches. Copyright © 2013 CFA Institute

7 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. LOS. Describe the roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions. Pages 93–102 Standard-setting bodies, such as the IASB and FASB, are typically private sector, self-regulated organizations with board members who are experienced accountants, auditors, users of financial statements, and academics. Regulatory authorities, such as the Accounting and Corporate Regulatory Authority in Singapore, the Securities and Exchange Commission (SEC) in the United States, the Securities and Exchange Commission of Brazil, and the Financial Service Authority (FSA) in the United Kingdom (a new regulatory authority will succeed the FSA in the United Kingdom as of 2012), are governmental entities that have the legal authority to enforce financial reporting requirements and exert other controls over entities that participate in the capital markets within their jurisdiction. Copyright © 2013 CFA Institute

8 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). LOS. Describe the roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions. Pages 93–102 Standard-setting bodies, such as the IASB and FASB, are typically private sector, self-regulated organizations with board members who are experienced accountants, auditors, users of financial statements, and academics. Other examples The Financial Reporting Council (FRC) sets accounting standards for the United Kingdom and Republic of Ireland (entities not required to apply IFRS) and also influences the work of the IASB. The Accounting Standards Board (AcSB) is an independent body with the authority to develop and establish accounting standards for use by all Canadian entities outside the public sector. The China Accounting Standards Committee (the Committee) under the Ministry of Finance (MOF) is the advisory body for setting Chinese accounting standards. The aim of the Committee is to provide advices [sic] and recommendations on setting and improving Chinese accounting standards. Copyright © 2013 CFA Institute

9 Examples of regulatory authorities
Country Regulatory authority with primary responsibility for securities regulation in the country Australia Australian Securities and Investments Commission Belgium Financial Services and Markets Authority Brazil Comissão de Valores Mobiliários China China Securities Regulatory Commission France Autorité des marchés financiers Germany Bundesanstalt für Finanzdienstleistungsaufsicht India Securities and Exchange Board of India Japan Financial Services Agency Morocco Conseil déontologique des valeurs mobilières Nigeria Securities and Exchange Commission Nigeria LOS. Describe the roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions. Pages 93–102 Regulatory authorities are governmental entities that have the legal authority to enforce financial reporting requirements and exert other controls over entities that participate in the capital markets within their jurisdiction. Regulatory authorities may require that financial reports be prepared in accordance with one specific set of accounting standards or may specify acceptable accounting standards. For example, in Switzerland, as of 2010, companies listed on the main board of the SIX Swiss Exchange had to prepare their financial statements in accordance with either IFRS or U.S. GAAP. Other registrants in Switzerland could use IFRS, U.S. GAAP, or Swiss GAAP FER. The current members of the IOSCO (International Organization of Securities Commissions) executive committee represent the ordinary members from Australia, Belgium, Brazil, China, France, Germany, India, Japan, Morocco, Nigeria, Portugal, Spain, South Africa, Turkey, United Kingdom, United States of America, and Uruguay. Copyright © 2013 CFA Institute

10 Examples of regulatory authorities (continued)
Country Regulatory authority with primary responsibility for securities regulation in the country Portugal Comissão do Mercado de Valores Mobiliários Spain Comisión Nacional del Mercado de Valores South Africa Financial Services Board Turkey Capital Markets Board of Turkey United Kingdom Financial Services Authority* United States Securities and Exchange Commission (SEC) Uruguay Banco Central del Uruguay LOS. Describe the roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions. Pages 93–102 The current members of the IOSCO executive committee represent the ordinary members from Australia, Belgium, Brazil, China, France, Germany, India, Japan, Morocco, Nigeria, Portugal, Spain, South Africa, Turkey, United Kingdom, United States of America, and Uruguay *FSA to be succeeded by the Financial Conduct Authority and the Prudential Regulation Authority in 2013. Copyright © 2013 CFA Institute

11 International Organization of Securities Commissions (IOSCO)
Not a regulatory authority, but an international association of securities regulators formed in 1983 Objectives 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. LOS. Describe the roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions. Pages 93–102 IOSCO was formed in 1983. IOSCO has 115 ordinary members, 12 associate members, and 76 affiliate members. IOSCO is not a regulatory authority but its members regulate a significant portion of the world’s financial capital markets. The objectives of IOSCO’s members are to cooperate in developing, implementing, and promoting adherence to internationally recognized and consistent standards of regulation, oversight, and enforcement to protect investors; maintain fair, efficient, and transparent markets; and seek to address systemic risks; to enhance investor protection and promote investor confidence in the integrity of securities markets through strengthened information exchange and cooperation in enforcement against misconduct and in supervision of markets and market intermediaries; and to exchange information at both global and regional levels on their respective experiences to assist the development of markets, strengthen market infrastructure, and implement appropriate regulation. The current members of the IOSCO executive committee represent the ordinary members from Australia, Belgium, Brazil, China, France, Germany, India, Japan, Morocco, Nigeria, Portugal, Spain, South Africa, Turkey, United Kingdom, United States of America, and Uruguay. Copyright © 2013 CFA Institute

12 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 Brazil Required for consolidated financial statements of banks and listed companies from 31 December 2010 and for individual company accounts progressively since January 2008 Canada Required from 1 January 2011 for all listed entities and permitted for private sector entities including not-for-profit organizations China Substantially converged national standards European Union All member states of the EU are required to use IFRS as 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 LOS. Describe the status of global convergence of accounting standards and ongoing barriers to developing one universally accepted set of financial reporting standards. Pages 102–106 IFRS have been or are in the process of being adopted in many countries. Other countries maintain their own set of standards but are working with the IASB to converge their standards and IFRS. Slides show information on IFRS use in selected countries/regions obtained from IASB website. Data obtained from as of July 2012. The U.S. SEC July 2012 report notes that “very few jurisdictions provide for the use of standards issued by the IASB without measures to ensure the suitability of those standards. Rather, most jurisdictions generally rely on some mechanism to incorporate IFRS into their domestic reporting system. Mechanisms range from converging a jurisdiction’s standards with IFRS without necessarily incorporating IFRS fully into its national framework to various forms of endorsement approaches whereby IFRS are incorporated into the national framework on a standard-by-standard basis, if the newly issued IFRS standard passes some prescribed threshold.” Copyright © 2013 CFA Institute

13 IFRS USE around the world
Country Status for Listed Companies as of December 2011 Japan Permitted from 2010 for a number of international companies; decision about mandatory adoption by 2016 expected around 2012 Mexico Required from 2012 Republic of Korea Required from 2011 Russia Saudi Arabia Required for banking and insurance companies. Full convergence with IFRS currently under consideration.  South Africa Required for listed entities since 2005 Turkey United States Allowed for foreign issuers in the U.S. since 2007; target date for substantial convergence with IFRS was 2011 and decision about possible adoption for U.S. companies expected. LOS. Describe the status of global convergence of accounting standards and ongoing barriers to developing one universally accepted set of financial reporting standards. Pages 102–106 IFRS have been or are in the process of being adopted in many countries. Other countries maintain their own set of standards but are working with the IASB to converge their standards and IFRS. Slides show information on IFRS use in selected countries/regions obtained from IASB website. Data obtained from as of July 2012. In the United States, the SEC has not (as of 16 July 2012) announced a decision about adoption of IFRS for U.S. companies. Copyright © 2013 CFA Institute

14 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. LOS. Explain the implications for financial analysis of differing financial reporting systems and the importance of monitoring developments in financial reporting standards. Pages 122–123 As illustrated by the preceding slides, many countries have adopted IFRS, but not all countries have done so. The United States is a notable example. Accounting standards (both IFRS and home-country GAAP) are not fixed in stone. Standards 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. For example, in comparing a company using IFRS with a company using U.S. GAAP, what differences could create a lack of comparability? Furthermore, given the continual evolution of financial reporting standards, it is important for the analyst to monitor developments in standards. Copyright © 2013 CFA Institute

15 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. LOS. Describe the status of global convergence of accounting standards and ongoing barriers to developing one universally accepted set of financial reporting standards. LOS. Compare key concepts of financial reporting standards under IFRS and U.S. GAAP reporting systems. LOS. Explain the implications for financial analysis of differing financial reporting systems and the importance of monitoring developments in financial reporting standards. Pages 102–106, 120–123 Since committing to the Norwalk Agreement after their joint meeting in September 2002, the FASB and IASB have been working toward the goal of a single set of high-quality, globally accepted accounting standards. Although the boards have made significant progress related to a number of projects, differences remain. These slides discuss four of the significant differences between U.S. GAAP and IFRS listed in the 13 July 2012 SEC final Staff report, “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers.” 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. The Staff’s research indicates that this difference could have a significant impact on the operating results and income taxes payable of certain U.S. issuers. With respect to income taxes, the Internal Revenue Service (IRS) has conformity provisions such that certain methods of accounting are allowed for tax purposes only if the entity also uses that method for financial reporting purposes—LIFO is one such method subject to conformity provisions. Thus, absent a change in IRS rules, eliminating LIFO from U.S. GAAP would, in effect, eliminate its use for tax purposes as well. Several stakeholders have commented on this difference and the potential significant tax impact that eliminating LIFO would have on U.S. issuers. The Staff believes that this difference is more of an issue of tax policy rather than of financial reporting, but the effect remains an element of the Staff’s overall consideration of the incorporation of IFRS. Copyright © 2013 CFA Institute

16 global convergence of accounting standards: Differences remain
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. LOS. Describe the status of global convergence of accounting standards and ongoing barriers to developing one universally accepted set of financial reporting standards. LOS. Compare key concepts of financial reporting standards under IFRS and U.S. GAAP reporting systems. Pages 102–106, 117–118 Significant differences between U.S. GAAP and IFRS listed in the 13 July 2012 SEC final staff report, “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers.” 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 must make an accounting policy election by asset class to continue with a cost model or revalue the assets within each class to fair market value (less any subsequent accumulated amortization or depreciation). U.S. GAAP precludes use of a revaluation model. Under IFRS, an entity can also make an election to adopt either the fair value model or the cost model to account for investment properties. U.S. GAAP generally only allows for the cost model, unless the entity meets certain criteria. (Investment properties are recorded at fair value under U.S. GAAP in the following instances: (1) The entity determined that it is an investment company in accordance with ASC Topic 946; (2) the entity is controlled by a pension plan that is required to measure its investments at fair value; or (3) the entity follows industry practices that have developed over time, allowing fair value measurement for real estate investments without regard to investment company attributes or pension plan ownership.) Copyright © 2013 CFA Institute

17 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). LOS. Describe the status of global convergence of accounting standards and ongoing barriers to developing one universally accepted set of financial reporting standards. LOS. Compare key concepts of financial reporting standards under IFRS and U.S. GAAP reporting systems. Pages 102–106, 117–118 Impairment Impairment models for property, plant, and equipment (PP&E), inventory, and intangible assets, the impairment methodology for recognizing and measuring an impairment loss differs between U.S. GAAP and IFRS. The IFRS models allow for reversals of impairments up to a certain amount if there is an indication that an impairment loss has decreased whereas the U.S. GAAP models preclude reversals of impairments. This distinction could result in differences in the timing and extent of recognized impairment losses. U.S. issuers could experience greater income statement volatility if the IFRS models were incorporated (flowing from recoveries of values previously written down). Copyright © 2013 CFA Institute

18 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. LOS. Describe the status of global convergence of accounting standards and ongoing barriers to developing one universally accepted set of financial reporting standards. LOS. Compare key concepts of financial reporting standards under IFRS and U.S. GAAP reporting systems. Pages 102–106, 117–118 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, for contingencies, IFRS defines probable as “more likely than not to occur.” By contrast, U.S. GAAP defines it as “the future event or events are likely to occur.” No numbers are mentioned in the standards themselves, but in practice, “likely” is considered to be a higher threshold (say, >70%) than “more likely than not” (say, >50%), meaning U.S. GAAP has a higher recognition threshold than does IFRS. The effect of this difference is that, a liability often will be recognized earlier under IFRS than under U.S. GAAP. In addition, under U.S. GAAP, an obligation for a cost associated with exit or disposal activities generally is recognized in the period in which the liability is incurred. By contrast, costs may be accrued under IFRS at an earlier date—for example, when a restructuring is announced or commences. The lower threshold under IFRS for certain nonfinancial liabilities could lead companies to record provisions earlier under IFRS than they would have under U.S. GAAP. Copyright © 2013 CFA Institute

19 Ifrs conceptual framework
LOS. Describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements. Pages 106–112 Copyright © 2013 CFA Institute

20 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. LOS. Describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements. Pages 106–112 At the core of the Conceptual Framework (2010) 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

21 IFRS conceptual framework: fundamental 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. LOS. Describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements. Pages 106–112 Flowing from the central objective of providing information that is useful to providers of resources, the Conceptual Framework elaborates on what constitutes usefulness. It identifies two fundamental qualitative characteristics that make financial information useful: relevance and faithful representation. Relevance: Information is relevant if it would potentially affect or make a difference in users’ decisions. The information can have predictive value (useful in making forecasts), confirmatory value (useful to evaluate past decisions or forecasts), or both. In other words, relevant information helps users of financial information to evaluate past, present, and future events or to confirm or correct their past evaluations in a decision-making context. Information is considered to be material if omission or misstatement of the information could influence users’ decisions. Materiality is a function of the nature and/or magnitude of the information. Faithful Representation: Information that faithfully represents an economic phenomenon that it purports to represent is ideally complete, neutral, and free from error. Complete means that all information necessary to understand the phenomenon is depicted. Neutral means that information is selected and presented without bias. In other words, the information is not presented in such a manner as to bias the users’ decisions. Free from error means that there are no errors of commission or omission in the description of the economic phenomenon and that an appropriate process to arrive at the reported information was selected and adhered to without error. Faithful representation maximizes the qualities of complete, neutral, and free from error to the extent possible. Relevance and faithful representation are the fundamental, most critical characteristics of useful financial information. Copyright © 2013 CFA Institute

22 IFRS conceptual framework: enhancing qualitative characteristics
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. Understandability: Reasonably informed users should be able to comprehend the information. LOS. Describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements. Pages 106–112 Relevance and faithful representation are the fundamental, most critical characteristics of useful financial information. In addition to these two fundamental characteristics, the Conceptual Framework (2010) identifies four characteristics that enhance the usefulness of relevant and faithfully represented financial information. These enhancing qualitative characteristics are comparability, verifiability, timeliness, and understandability. Comparability: Comparability allows users “to identify and understand similarities and differences of items.” Information presented in a consistent manner over time and across entities enables users to make comparisons more easily than information with variations in how similar economic phenomena are represented. Verifiability: Verifiability means that different knowledgeable and independent observers would agree that the information presented faithfully represents the economic phenomena it purports to represent. Timeliness: Timely information is available to decision makers prior to their making a decision. Understandability: Clear and concise presentation of information enhances understandability. The Conceptual Framework (2010) specifies that the information is prepared for and should be understandable by users who have a reasonable knowledge of business and economic activities and who are willing to study the information with diligence. However, some complex economic phenomena cannot be presented in an easily understandable form. Information that is useful should not be excluded simply because it is difficult to understand. It may be necessary for users to seek assistance to understand information about complex economic phenomena. Financial information exhibiting these qualitative characteristics—fundamental and enhancing—should be useful for making economic decisions. Copyright © 2013 CFA Institute

23 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. LOS. Describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements. Pages 106–112 Three elements of financial statements are directly related to the measurement of financial position: assets, liabilities, and equity. 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. Assets are what a company owns (e.g., inventory and equipment). 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. Liabilities are what a company owes (e.g., bank borrowings). Equity (for public companies, also known as “shareholders’ equity” or “stockholders’ equity”): Assets less liabilities. Equity is the residual interest in the assets after subtracting the liabilities. Copyright © 2013 CFA Institute

24 IFRS conceptual framework: reporting elements
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). LOS. Describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements. Pages 106–112 The elements of financial statements directly related to the measurement of performance (profit and related measures) are income and expenses. 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). Income includes both revenues and gains. Revenues represent income from the ordinary activities of the enterprise (e.g., the sale of products). Gains may result from ordinary activities or other activities (the sale of surplus equipment). 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). Expenses include losses, as well as those items normally thought of as expenses, such as the cost of goods sold or wages. Copyright © 2013 CFA Institute

25 IFRS conceptual framework: constraints and assumptions
Constraint: The benefits of information should exceed the costs of providing it. Underlying Assumptions: 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. LOS. Describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements. Pages 106–112 Constraint A pervasive constraint on useful financial reporting is the cost of providing and using this information. Optimally, benefits derived from information should exceed the costs of providing and using it. The aim is a balance between costs and benefits. Assumptions underlying financial statements determine how financial statement elements are recognized and measured. The use of accrual accounting assumes that financial statements should reflect transactions in the period when they actually occur, not necessarily when cash movements occur. For example, accrual accounting specifies that a company report revenues when they are earned (when the performance obligations have been satisfied), regardless of whether the company received cash before delivering the product, after delivering the product, or at the time of delivery. Refer to the earlier Incook, Inc. example. Accrual accounting assumption requires the company to recognize revenue in the period it was earned. Going concern refers to the assumption that the company will continue in business for the foreseeable future. To illustrate, consider the value of a company’s inventory if it is assumed that the inventory can be sold over a normal period of time versus the value of that same inventory if it is assumed that the inventory must all be sold in a day (or a week). Companies with the intent to liquidate or materially curtail operations would require different information for a fair presentation. In reporting the financial position of a company that is assumed to be a going concern, it may be appropriate to list assets at some measure of a current value based on normal market conditions. However, if a company is expected to cease operations and be liquidated, it may be more appropriate to list such assets at an appropriate liquidation value—namely, a value that would be obtained in a forced sale. Copyright © 2013 CFA Institute

26 Financial statements 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 LOS. Describe general requirements for financial statements under IFRS. Pages 112–116 The Conceptual Framework provides a basis for establishing standards and the elements of financial statements, but it does not address the contents of the financial statements Under IAS No. 1, a complete set of financial statements includes a statement of financial position (balance sheet); a statement of comprehensive income (a single statement of comprehensive income or two statements, an income statement and a statement of comprehensive income that begins with profit or loss from the income statement); a statement of changes in equity, separately showing changes in equity resulting from profit or loss, each item of other comprehensive income, and transactions with owners in their capacity as owners (examples of transactions with owners acting in their capacity as owners include sales of equity securities to investors, distributions of earnings to investors, and repurchases of equity securities from investors); a statement of cash flows; and notes comprising a summary of significant accounting policies and other explanatory notes that disclose information required by IFRS and not presented elsewhere and that provide information relevant to an understanding of the financial statements. Entities are encouraged to furnish other related financial and nonfinancial information in addition to that required. Financial statements need to present fairly the financial position, financial performance, and cash flows of an entity. Copyright © 2013 CFA Institute

27 general features of financial statements
Fair presentation Going concern Accrual basis Materiality and aggregation No offsetting Frequency of reporting Comparative information Consistency LOS. Describe general requirements for financial statements under IFRS. Pages 112–116 IAS No. 1 specifies a number of general features underlying the preparation of financial statements. These features clearly reflect the Conceptual Framework (2010). Fair presentation: The application of IFRS is presumed to result in financial statements that achieve a fair presentation. The IAS describes fair presentation as follows: “Fair presentation requires the faithful representation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework”. (IAS No. 1, Presentation of Financial Statements, paragraph 15). Going concern: Financial statements are prepared on a going concern basis unless management either intends to liquidate the entity or to cease trading or has no realistic alternative but to do so. If not presented on a going concern basis, the fact and rationale should be disclosed. Accrual basis: Financial statements (except for cash flow information) are to be prepared using the accrual basis of accounting. Materiality and aggregation: Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Each material class of similar items is presented separately. Dissimilar items are presented separately unless they are immaterial. No offsetting: Assets and liabilities, and income and expenses, are not offset unless required or permitted by IFRS. Frequency of reporting: Financial statements must be prepared at least annually. Comparative information: Financial statements must include comparative information from the previous period. The comparative information of prior periods is disclosed for all amounts reported in the financial statements, unless IFRS requires or permits otherwise. Consistency: The presentation and classification of items in the financial statements are usually retained from one period to the next. Copyright © 2013 CFA Institute

28 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. LOS. Describe general requirements for financial statements under IFRS. Pages 112–116 IAS No. 1 also specifies structure and content of financial statements. These requirements include the following: Classified statement of financial position (balance sheet): IAS No. 1 requires the balance sheet 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: IAS No. 1 specifies the minimum line item disclosures on the face of, or in the notes to, the financial statements. For example, companies are specifically required to disclose the amount of their plant, property, and equipment as a line item on the face of the balance sheet. The specific requirements are listed in Exhibit 3-4 (p.115). Minimum information in the notes (or on the face of financial statements): IAS No. 1 specifies disclosures about information to be presented in the financial statements. This information must be provided in a systematic manner and cross-referenced from the face of the financial statements to the notes. The required information is summarized in Exhibit 3-5 (p. 116). Comparative information: For all amounts reported in a financial statement, comparative information should be provided for the previous period unless another standard requires or permits otherwise. Such comparative information allows users to better understand reported amounts. Copyright © 2013 CFA Institute

29 coherent financial reporting framework
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. LOS. Identify the characteristics of a coherent financial reporting framework and the barriers to creating such a framework. Pages 118–120 Any effective financial reporting system needs to be a coherent one (i.e., a framework in which all the pieces fit together according to an underlying logic). Such frameworks have several characteristics: Transparency: A framework should enhance the transparency of a company’s financial statements. Transparency means that users should be able to see the underlying economics of the business reflected clearly in the company’s financial statements. Full disclosure and fair presentation create transparency. Comprehensiveness: To be comprehensive, a framework should encompass the full spectrum of transactions that have financial consequences. This spectrum includes not only transactions currently occurring, but also new types of transactions as they are developed. So, an effective financial reporting framework is based on principles that are universal enough to provide guidance for recording both existing and newly developed transactions. Consistency: An effective framework should ensure reasonable consistency across companies and time periods. In other words, similar transactions should be measured and presented in a similar manner regardless of industry, company size, geography, or other characteristics. Balanced against this need for consistency, however, is the need for sufficient flexibility to allow companies sufficient discretion to report results in accordance with underlying economic activity. Although effective frameworks all share the characteristics of transparency, comprehensiveness, and consistency, there are some conflicts that create inherent limitations in any financial reporting standards framework. Specifically, it is difficult to completely satisfy all these characteristics concurrently, so any framework represents an attempt to balance the relative importance of these characteristics. Three areas of conflict include valuation, standard-setting approach, and measurement: Valuation: Various bases for measuring the value of assets and liabilities exist, such as historical cost, current cost, fair value, realizable value, and present value. Historical cost valuation, under which an asset’s value is its initial cost, requires minimal judgment. In contrast, other valuation approaches, such as fair value, require considerable judgment but can provide more relevant information. Standard-Setting Approach: Financial reporting standards can be established based on (1) principles, (2) rules, or (3) a combination of principles and rules (sometimes referred to as “objectives oriented”). A principles-based approach provides a broad financial reporting framework with little specific guidance on how to report a particular element or transaction. Such principles-based approaches require the preparers of financial reports and auditors to exercise considerable judgment in financial reporting. In contrast, a rules-based approach establishes specific rules for each element or transaction. Rules-based approaches are characterized by a list of yes-or-no rules, specific numerical tests for classifying certain transactions (known as “bright line tests”), exceptions, and alternative treatments. Some suggest that rules are created in response to preparers’ needs for specific guidance in implementing principles, so even standards that begin purely as principles evolve into a combination of principles and rules. The third alternative, an objectives-oriented approach, combines the other two approaches by including both a framework of principles and appropriate levels of implementation guidance. The common conceptual framework is likely to be more objectives oriented. Measurement: The balance sheet presents elements at a point in time, whereas the income statement reflects changes during a period of time. Because these statements are related, standards regarding one of the statements have an effect on the other statement. Financial reporting standards can be established taking an asset/liability approach, which gives preference to proper valuation of the balance sheet, or a revenue/expense approach that focuses more on the income statement. This conflict can result in one statement being reported in a theoretically sound manner, but the other statement reflecting less relevant information. In recent years, standard setters have predominantly used an asset/liability approach. Copyright © 2013 CFA Institute

30 Disclosures of significant accounting policies
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. LOS. Analyze company disclosures of significant accounting policies. Pages 126–127 Under both IFRS and U.S. GAAP, companies are required to disclose their accounting policies and estimates in the notes to the financial statements. Companies also discuss in the management commentary (or the management’s discussion and analysis, MD&A) those policies that management deems most important. Although many of the policies are discussed in both the management commentary and the notes to the financial statement, there is typically a distinction between the two discussions. The management commentary generally relates to aspects of the accounting policies deemed important by management to understand the financial statements, particularly changes. The MD&A disclosure relates to those policies that require significant judgments and estimates, whereas the notes discuss all accounting policies, irrespective of whether judgment was required. Copyright © 2013 CFA Institute

31 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 LOS. Analyze company disclosures of significant accounting policies. Pages 126–127 This excerpt from the MD&A in Colgate Palmolive Company’s 2011 Annual Report illustrates disclosure of a critical accounting policy that impacts profitability analysis. The disclosure states that Colgate includes shipping and handling costs in its selling, general, and administrative expenses (SG&A) and thus the company’s gross profit margin is not comparable with the gross profit margin of companies that include SG&A in cost of goods sold. Recall that gross profit margin = gross profit divided by sales Recall that gross profit = sales minus cost of goods sold. This disclosure appears in the company’s MD&A. The next slide shows the disclosure about shipping and handling costs that Colgate made in the footnotes to its financial statements. Copyright © 2013 CFA Institute

32 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 LOS. Analyze company disclosures of significant accounting policies. Pages 126–127 This excerpt from the footnotes to the financial statements in Colgate Palmolive Company’s 2011 Annual Report illustrates disclosure of an accounting policy. The previous slide showed Colgate’s disclosure stating that it include shipping and handling costs in its SG&A and thus the company’s gross profit margin is not comparable with the gross profit margin of companies that include SG&A in cost of goods sold. An analyst can use this numerical disclosure to adjust Colgate’s reported cost of goods sold, if desired. Copyright © 2013 CFA Institute

33 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.” LOS. Analyze company disclosures of significant accounting policies. Pages 126–127 This excerpt from the footnotes to the financial statements in Colgate Palmolive Company’s 2011 Annual Report illustrates general disclosure about the use of estimates in preparing financial statements. Excerpt from footnotes in Colgate Palmolive Company’s 2011 Annual Report Copyright © 2013 CFA Institute

34 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 LOS. Analyze company disclosures of significant accounting policies. Pages 126–127 This excerpt from the footnotes to the financial statements in Henkel’s 2011 Annual Report illustrates the general information typically found in the footnotes explaining the accounting standards applied and the scope of consolidation. The first disclosure shown states that the company uses IFRS as adopted by the EU. Note that IAS 1, Financial Statements, Paragraph 16 states: “An entity whose financial statements comply with IFRSs shall make an explicit and unreserved statement of such compliance in the notes. An entity shall not describe financial statements as complying with IFRSs unless they comply with all the requirements of IFRSs.” The second item shown indicates how the scope of consolidation has changed for Henkel: 4 new companies included, 11 companies excluded, and 7 mergers. The disclosure indicates that the changes in scope of consolidation has not had a material impact on “the main items of the consolidated financial statements.” Copyright © 2013 CFA Institute

35 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 LOS. Analyze company disclosures of significant accounting policies. Pages 126–127 This excerpt from the footnotes to the financial statements in Henkel’s 2011 Annual Report illustrates a disclosure about the use of estimates and assumptions. It is similar to the footnoted disclosure by Colgate. Deletions in the paragraph are to the specific footnote and page numbers and are made so that the slide is easier to read. Complete text of the paragraph: “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. Changes in accounting estimates are recognized in the period in which the change takes place where such change exclusively affects that period. A change is recognized in the period in which it occurs and in later periods where such change affects both the reporting period and subsequent periods. 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 (Note 30 on pages 140 to 142), intangible assets (Note 1 on pages 111 to 114), pension obligations (Note 15 on pages 120 to 124), financial instruments (Note 21 on pages 128 to 138) and share-based payment plans (Note 32 on pages 143 to 145).” Copyright © 2013 CFA Institute

36 summary Objective 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, Timeliness, and Understandability Constraint: benefits of info should exceed costs Underlying Assumptions Accrual accounting Going concern Copyright © 2013 CFA Institute


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