2.3 Financial Reporting Standards

** This note is summarized by Hui Wang.

Learning OutcomesThe candidate should be able to:

a. Explain the objective of financial statements and the importance of reporting standards in security analysis and valuation;

b. Explain the role of standard-setting bodies, such as the International Accounting Standards Board and the U.S. Financial Accounting Standards Board, and regulatory authorities such as the International Organization of Securities Commissions, the U.K. Financial Services Authority, and the U.S. Securities and Exchange Commission in establishing and enforcing financial reporting standards;

c. Discuss the ongoing barriers to developing one universally accepted set of financial reporting standards;

d. Describe the International Financial Reporting Standards (IFRS) framework, including the objective of financial statements, their qualitative characteristics, required reporting elements, and the constraints and assumptions in preparing financial statements;

e. Explain the general requirements for financial statements;f. Compare and contrast key concepts of financial reporting standards under IFRS

and alternative reporting systems, and discuss the implications for financial analysis of differing financial reporting systems;

g. Identify the characteristics of a coherent financial reporting framework and barriers to creating a coherent financial reporting network;

h. Discuss the importance of monitoring developments in financial reporting standards and evaluate company disclosures of significant accounting policies.

Financial reporting standard-setting bodies and regulatory authorities

Standard-setting bodies are typically composed of experienced accountants, auditors, users of financial statements, and academics and generally they make the rules.

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 and they have the right to overrule the private sector standard-setting bodies.

International Accounting Standards Board

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IASB was reconstituted in 2001 from IASC (International Accounting Standards Committee) and currently has 14 full-time board members. The four goals of the IASB are:

a. To develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the world’s capital markets and other users make economic decisions;

b. To promote the use and rigorous application of those standards;c. In fulfilling the objectives associated with (a) and (b), to take account of, as appropriate,

the special needs of small and medium-sized entities and emerging economies; andd. To bring about convergence of national accounting standards and International

Accounting Standards and International Financial Reporting Standards to high quality solutions.

International Organization of Securities Commissions

“IOSCO was born in 1983 from the transformation of its ancestor inter-American regional association (created in 1974) into a truly international cooperative body…...Today IOSCO is recognized as the international standard setter for securities markets. The Organization’s wide membership regulates more than 90% of the world’s securities markets and IOSCO is the world’s most important international cooperative forum for securities regulatory agencies. IOSCO members regulate more than one hundred jurisdictions and the Organization’s membership is steadily growing.”The three core objectives of IOSCO on securities regulation are:

Protecting investors; Ensuring that markets are fair, efficient, and transparent; Reducing systematic risk.

Capital markets regulation in Europe

Each individual member state of the EU regulates capital markets in its own jurisdiction. However, in 2001, the European Commission established two committees related to securities regulation:

European Securities Committee (ESC)-is composed of high-level representatives of member states and advises the European Commission on securities policy issues;

Committee of European Securities Regulators (CESR)- an independent advisory body composed of representatives of regulatory authorities of the member states .

Significant securities-related legislation in the United States

Securities Act of 1933 (The 1933 Act) – in the aftermath of the stock market crash of 1929, U.S. Congress enacted the Securities Act of 1933. The 1933 Act requires that any offer or sale of securities using the means and instrumentalities of interstate commerce be registered pursuant to the Act, unless an exemption from registration exists under the law.

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Securities Exchange Act of 1934 (The 1934 Act) – this Act created the SEC and gave the SEC authority over all aspects of the securities industry. Issuers of securities registered under the 1934 Act must file various reports with the SEC. Since 1964 this disclosure requirement has applied not only to companies with securities listed on national securities exchanges but also to companies with more than 500 shareholders and more than $5 million in assets.

Sarbanes-Oxley Act of 2002 – the Sarbanes-Oxley Act was passed in the wake of a myriad of corporate scandals, such as Enron, WorldCom and Tyco covered up or misrepresented a variety of questionable transactions, resulting in huge losses to stakeholders. The major provisions of the act include:

CEOs and CFOs are held responsible for their companies’ financial reports

Executive officers and directors may not solicit or accept loans from their companies

Insider trades are reported more quickly Insider trades are prohibited during pension-fund blackout periods Mandatory disclosure of CEO and CFO compensation and profits Mandatory internal audits and review and certification of those audits by

outside auditors Criminal and civil penalties for securities violations Longer jail sentences and larger fines for executives who intentionally

misstate financial statements Audit firms may no longer provide actuarial, legal, or consulting services

to firms they audit Publicly traded companies must establish internal financial controls and

have those controls audited annually

Some important filings for analysts

(1) Securities Offerings Registration Statement- disclosures about the securities being offered for sale; the relationship of these new securities to the issuer’s other capital securities; the information typically provided in the annual filings; recent audited financial statements; risk factors involved in the business.

(2) Forms 10-K, 20-F, and 40-F- filing on a annual basis, disclosing historical summary of financial date, management’s discussion and analysis (MD&A) of the company’s financial condition and results of operations, and audited financial statements. Form 10-K is for U.S. registrants, Form 40-F is for certain Canadian registrants, and Form 20-F is for all other non-U.S. registrants.

(3) Proxy Statement/ Form DEF-14A- the material accompanying solicitation of a proxy from stockholders. The proxy statement lists the items to be voted on including nominees for directorships, the auditing firm recommended by directors, the salaries of top officers and directors, and resolutions submitted by management and stockholders. Proxy statement are required by the SEC.

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(4) Forms 10-Q and 6-K- interim filings that include unaudited financial statements, an MD&A for the interim period and disclosures of nonrecurring events.

(5) Form 8-K- filed with SEC when a company is going through major events as acquisitions or disposals of corporate assets, changes in securities and trading markets, matters related to accountants and financial statements, corporate governance and management changes, and Regulation FD disclosures.

(6) Form-144- filed with the SEC as notice of the proposed sale of restricted securities or securities held by an affiliate of the issuer in reliance on Rule 144.

(7) Forms 3, 4, and 5-filed by director or officer of a registered as well as beneficial owners of greater than 10% of a class of registered equity securities to report beneficial ownership of securities.

(8) Form 11-K- filed annually to report employee stock purchase, savings, and similar plans.

The Norwalk Agreement

In the Norwalk Agreement, both the IASB and FASB pledged to make best efforts to:(1) Make their existing financial reporting standards fully compatible as soon as

practicable;(2) Coordinate their future work programs to ensure that, once achieved,

compatibility is maintained.

IFRS framework for the preparation and presentation of financial statements

(1) Objective of financial statements- to provide a fair presentation of financial position, financial performance and cash flows of an entity for potential users (include investors, creditors, suppliers, customers, employees, lenders, government agencies, the public, and analyst)

(2) Qualitative Characteristics of financial statements

Qualitative Characteristics MeaningUnderstandability Readily understandable by users with a

basic knowledge of business, economic activities, and accounting, and a willingness to study the information with reasonable diligence.

Relevance Will influences economic decisions of users

Reliability Free from material error and bias:

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Faithful representation Substance over form Neutrality Prudence

Comparability Presented in a consistent manner over time and in a consistent manner between entities to ensure users to make significant comparisons

(3) Underlying assumptions in financial statements Accrual basis- under accrual basis accounting, income is reported in the

fiscal period it is earned, regardless of when cash is received, and expenses are deducted in the fiscal period they are incurred, whether they are paid or not.

Going concern- a company will continue to operate indefinitely, and will not go out of business and liquidate its assets. For this to happen, the company must be able to generate and/ or raise enough resources to stay operational.

Measurement of financial statement elements

Asset LiabilityHistorical cost Acquisition price of an asset

less discounts plus all normal incidental costs necessary to bring the asset into existing use and location.

The amount of proceeds received in exchange for the obligation.

Current cost The amount of money that would have to be paid to buy identical or an equivalent asset today.

Undiscounted amount of cash or cash equivalents that would be required to settle the obligation today.

Realizable value Amount of money that could currently be obtained by the disposal of the asset.

Undiscounted amount of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business

Present value Present discounted value of the future net cash inflows that the asset is expected to generate

Present discounted value of the future nest cash outflows that are expected to be required to settle the liabilities

Fair value The amount agreed upon between knowledgeable, willing parties in an arm’s length transaction

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Required financial statements

According to IAS No. 1, a complete set of financial statements includes: A balance sheet An income statement A statement of changes in equity showing either:

all changes in equity, orchanges in equity other than those arising from transactions with equity holders acting in their capacity as equity holders

A cash flow statement Notes comprising a summary of significant accounting policies and other

explanatory notes.

Fundamental principles underlying the preparation of financial statements

A company may state in the note to its financial statements that it is in compliance with IFRS only when it is in compliance with all requirements of IFRS.Fundamental principles specified by IAS in preparing of financial statements include:

Fair presentation Going concern Accrual basis Consistency Materiality

Presentation requirement

Under IAS No. 1, the basic presentation principles include:

Aggregation- each material class similar items is presented separately No offsetting- assets and liabilities, income and expenses are not offset unless

required or permitted by an IFRS. Classified balance sheet Minimum information on the face of the financial statements- there is requirement

about the minimum line item disclosures on the face of financial statements or in the notes to them

Minimum information in the notes Comparative information- comparative information on all items reported in a

financial statement should be provided for the previous period unless another standard requires or permits otherwise

U.S. GAAP

Generally accepted accounting principles (GAAP) is a collection of methods used to process, prepare, and present public accounting information. It defines the sources of accounting principles and a framework for selecting the right principle.

Summary of Differences between IFRS and U.S. GAAP FrameworksU.S. GAAP (FASB) Framework

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Purpose of the framework The FASB framework is similar to the IASB framework in its purpose to assist in developing and revising standards, but it resides at a lower level in the hierarchy- a very important difference. Under IFRS, management is expressly required to consider the framework if there is no standard or interpretation for that issue. The FASB framework does not have a similar provision.

Objectives of financial statements There is general agreement on the objectives of financial statements: both frameworks have a broad focus to provide relevant information to a wide range of users. The principal difference is that the U.S. GAAP framework provides separate objectives for business entities versus nonbusiness entities rather than one objective as in the IASB framework.

Underlying assumptions Although the U.S. GAAP framework recognizes the importance of the accrual and going concern assumptions, these are not given as much prominence as in the IASB framework. In particular, the going concern assumption is not well developed in the FASB framework.

Qualitative characteristics The U.S. GAAP framework identifies the same qualitative characteristics but also establishes a hierarchy of those characteristics. Relevance and reliability are considered primary qualities, whereas comparability is deemed to be a secondary quality under the FASB framework. The fourth qualitative characteristic, understandability, is treated as a use-specific quality in the U.S. GAAP framework and is seen as a link between the characteristics of framework indicates that it cannot base its decisions on the specific circumstances of individual users.

Constraints There is similar discussion of the constraints in both frameworks.

Financial statement elements (definition, recognition, and measurement)

Performance elements. The FASB framework includes three elements relating to financial performance in addition to revenue and expenses:

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gains, losses, and comprehensive income. Comprehensive income is a more encompassing concept than net income, as it includes all changes in equity during a period except those resulting from investments by and distributions to owners.

Financial position elements. The FASB framework defined\s an asset as “a future economic benefit” rather than the “resource” from which future economic benefits are expected to flow to the entity as in the IASB framework. It also includes the term “probable” to define the assets and liabilities elements.

Recognition of elements. The FASB framework does not discuss the term “probable” in its recognition criteria, whereas the IASB framework requires that it is probable that any future economic benefit flow to/ from the entity. The FASB framework also has a separate recognition criterion of relevance.

Measurement of elements. Measurement attributes (historical cost, current cost, settlement value, current market value, and present value) are broadly consistent, and both frameworks lack fully developed measurement concepts. Furthermore, the FASB framework prohibits revaluations except for certain categories of financial instruments, which have to be carried at fair value.

-from CFA® Curriculum

Characteristics of an effective financial reporting framework

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Transparency- users should be able to see the underlying business operations through a company’s financial statements. Full disclosure and fair presentation entail transparency.

Comprehensiveness- the information contain in financial statements should be universal enough to provide guidance for recording both existing and newly developed transactions.

Consistency- financial statements should ensure reasonable consistency across companies and time periods.

Barriers to a single coherent framework

Valuation- different cost measures require different degree of judgment and give different values of identical assets or liabilities.

Standard- setting approach- financial reporting standards can be either principles-based (meaning it provides a broad financial reporting framework with little specific guidance on how to report a particular element or transaction) or rules-based (meaning that it establishes specific rules for each element or transaction)

IFRS has been referred to as a “principles-based approach.” The FASB, which has been criticized for having a rules-based approach in the past, has explicitly stated that it is moving to adopt a more objectives-oriented approach to standard setting.

Measurement-the conflict between taking an “asset/liability” approach and taking an “revenue/expense” approach can result in either balance sheet or income statement being reported in a theoretically sound manner, while the other statement reflecting less relevant information.

Monitoring developments in financial reporting standards

There are three areas that worth analysts’ attention: New products or transactions Actions of standard setters and other groups representing users of financial

statements Company disclosures regarding critical accounting policies and estimates

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Exercise Problems: (provided by Stalla PassMaster for CFA Exams.)

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EXPLANATIONQ1.

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