Financial Reporting

1
Chapter 9
Financial Reporting Evolution ofGlobal
Standards
2
Objectives

• By the end of the chapter, you should be able to
• describe the UK, US and IASB standard setting
  bodies
• critically discuss the arguments for and against
  standards
• describe the reasons for differences in financial
  reporting
• describe the work of international bodies in
  harmonising and standardising financial
  reporting
• explain the impact on financial reporting of
  changing to IFRS
• critically evaluate the progress being made
  towards a single set of global international
  standards

3
Why are FRSs needed?

• Accounting numbers are important when making
  contracts. Eg.
• Management and directors' pay is often related to
  the firm's performance.
• The required performance may not be achieved
  under one method of producing accounting reports,
  but it could be under an alternative method.
• With no restraints on the methods used to produce
  the report, these methods can be changed to suit
  the desired performance requirements.

4
Role of accounting numbers in defining
contractual entitlements temptation to manage
the numbers

• If there is a risk that earnings will not grow at
  a rate attractive to directors THEN there is a
  temptation to take measures not in the interest
  of the shareholders.
• Typical measures include
• Deferring discretionary expenditure, for example
  research, advertising, training expenditure
• Deferring amortisation, for example making
  optimistic sales projections in order to classify
  research as development expenditure which can be
  capitalised and
• Reclassifying deteriorating current assets as
  fixed assets to avoid the need to recognise a
  loss under the lower of cost and net realisable
  value rule applicable to current assets.

5
Role of accounting numbers in defining
contractual entitlements temptation to manage
the numbers
Mandatory standards defining the way in which
accounting numbers are measured and presented in
financial statements would restrict managements
ability to adopt measures such as those listed
above. This affects wealth distribution within
the firm. For example, IF managers cannot delay
the amortisation of development expenditure, THEN
bonuses related to profit will be lower and there
will effectively have been a transfer of wealth
from managers to shareholders.
6
Shareholders are in the dark

• Shareholders are usually unaware that financial
  statements are inaccurate.
• Only aware in restricted circumstances
• When a third party has a vested interest in
  revealing adverse facts following a takeover, or
• When a company falls into the hands of an
  administrator, inspector or liquidator, whose
  duty it is to enquire and report on shortcomings
  in the management of a company.
• The GEC/AEI scandal (p.212) showed that financial
  reports prepared from the same basic information
  could disclosed materially different results
  ranging from a profit forecast of 10 million to
  a loss of 4.5m in this example.

7
GEC takeover of AEI in 1967 reasons for
difference

• Two possible reasons for the difference
• Either the facts have changed or
• The judgements made by the directors have changed
• In this case, it seems there was a change in the
  facts
• a post-acquisition closure of an AEI factory
  explained 5 million of the 14.5 million
  difference between the forecast profit and the
  actual loss
• Also, a change in judgement
• The remaining 9.5 million arose because of
  differences in judgement. For example, the new
  directors took a different view of the value of
  stock and work-in-progress.

8
Public view of the accounting profession
following these cases

• Known that accountancy is not an exact science
• BUT not realised how much latitude there was for
  companies to produce vastly different results
  based on the same transactions
• Given that the auditors were perfectly happy to
  sign that accounts showing either a 10m profit
  or a 4.5m loss were true and fair, the public
  felt the need for action if investors were to
  have any trust in the figures that were being
  published.

9
Arguments in support of standards

• Comparability
• Need to make valid inter-company comparisons of
  performance and trends
• Investors must be supplied with relevant and
  reliable data that have been standardised
• Comparisons are distorted if companies are
  permitted to select accounting policies with the
  intention of disguising changes in performance
  and trends.

10
Arguments in support of standards (Continued)

• Credibility
• Credibility lost if companies selected different
  accounting policies for similar events
• Uniformity essential if reports are to disclose a
  true and fair view
• However, not intended to be a comprehensive code
  of rigid rules
• Not to supersede informed judgement in
  determining what was a true and fair view.

11
Arguments in support of standards (Continued)

• Influence
• The process has stimulated the development of a
  conceptual framework
• For example, the leasing standard considered the
  commercial substance of a transaction rather than
  simply the legal position
• In the 1970s, no clear statement of accounting
  principles other than that accounts should be
  prudent, be consistent, follow accrual accounting
  procedures and be based on the initial assumption
  that the business would remain a going concern
• By 1994, the ASB had produced its exposure drafts
  of Statement of Accounting Principles, which
  appeared in final form in December 1999.

12
Arguments against standards

• Adverse allocative effects
• Could occur if standard setters did not take
  account of the economic consequences flowing from
  the standards they issued. For example,
• Additional costs could be imposed on preparers
• Suboptimal managerial decisions might be taken to
  avoid any reduction in reported earnings.

13
Arguments against standards (Continued)

• Consensus-seeking
• Can lead to the issuing of standards that are
  over-influenced by those with easiest access to
  the standard setters as the subject matter
  becomes more complex, for example capital
  instruments
• ASB attempting to minimise such influences by
  basing its standards on the Statement of
  Principles, but is the Statement of Principles
  too general?

14
Arguments against standards (Continued)

• Overload
• Too many standards
• Too detailed
• Too general-purpose and fail to recognise the
  differences between large and small entities
• Too many standard setters with differing
  requirements, for example FASB, IASB, ASB,
  national Stock Exchange listing requirements.

15
US GAAP

• The USA has the largest economy in the world
• It is an attractive source of capital for foreign
  companies
• There has been competition for international
  supremacy between US GAAP and IFRSs
• UK and the USA systems of financial reporting
  have much in common, BUT
• There are more rules in the USA than in the UK,
  and
• A greater standardisation and disclosure of
  information.

16
US GAAP (Continued)

• Legislation
• No direct equivalent of the UK Companies Acts in
  the USA
• The main federal regulation of trade in shares
  comprises the Securities Act 1933 and the
  Securities Exchange Act 1934. Neither of these
  includes any detailed provisions for the form and
  content of financial statements
• The Securities and Exchange Commission (SEC) is
  responsible for requiring the publication of
  financial information for the benefit of
  shareholders.

17
Enforcement The Sarbanes-Oxley Act 2002 (SOX)

• SOX
• Is the result of the Enron and Worldcom frauds.
• CEOs of public companies directly responsible
  for accuracy of the financial reports
• Management required to certify the reports
• Criminal offence to take steps to obstruct
  investigations.

18
US GAAP The SEC

• The SEC has the power to dictate the form and
  content of reports
• The largest companies whose shares are listed
  must register with the SEC and comply with its
  regulations
• The SEC monitors the financial reports filed, in
  great detail
• The majority of companies fall outside the SECs
  jurisdiction
• Individual states have the power to introduce
  their own legislation to control businesses and
  even set taxes.

19
US GAAP Standard setting

• FASB
• The Financial Accounting Standards Board (FASB)
  is responsible for setting accounting standards
  in the USA
• Its independence is ensured by limiting the
  voluntary contributions to its funding from the
  various public accounting firms, industry and
  other interested parties
• FASB issues the following documents
• Statements of Financial Accounting Standards,
  which deal with specific issues
• Statements of Concepts, which give general
  information
• Interpretations which clarify existing standards
• Emerging Issues Task Force.

20
US GAAP other mandatory pronouncements
The APB The Accounting Principles Board (APB)
publishes Opinions The AICPA The American
Institute of Certified Public Accountants (AICPA)
publishes Accounting Practice Bulletins and
Opinions APB and AICPA pronouncements should all
be regarded as mandatory.
21
US GAAP What if no bulletins or opinions?

• Refer to the
• FASB Technical Bulletins,
• AICPA Industry Audit and Accounting Guidelines
  cleared by FASB, and
• AICPA Statements of Position.

• Other AICPA interpretations and implementation
  guidelines published by FASB staff may also be
  relevant
• Finally, companies should refer to practices that
  are widely recognised and prevalent, either
  generally or in the industry.

22
SEC

• Power to dictate the form and content of reports
• Monitors financial reports.

23
Reasons for differences in reporting

• The character of the national legal system
• The way in which industry is financed
• The relationship of the tax and reporting systems
• The influence and status of the accounting
  profession
• The extent to which accounting theory is
  developed
• Accidents of history
• Language.

24
Character of the national legal system

• Legal system based on common law
• Importance of equity
• Legal system based on Roman law
• Importance of codification

25
Ways in which industry is financedDifferent
information needs

• Equity investors
• Objective information for stewardship
• Fair information for investment decision-making
• Reliance on external information
• Loan creditors
• Banks principal lenders and shareholders
• Access to internal information
• Published disclosures less relevant.

26
Relationship of the tax and reporting systems

• Reporting and tax separate
• Separate rules for computing profit for tax
• Financial reporting less prescriptive.
• Primacy to taxation rules
• - Allowance only if in the financial accounts
• - Possible misinterpretation when comparing
  different countries
• - Example treatment of depreciation.

27
Influence and status of the accounting profession

• If market-sensitive information has been required
  
• Reliable and relevant information required
• Growth of established profession and audit
  function
• Impact on accounting regulation.
• Where there has been less need for
  market-sensitive information
• - Less need for expertise
• - Less need for financial management.

28
Accidents of history

• Effect of commercial scandals
• In US led to SEC being set up
• In UK led to publishing accounting standards
• Financial reporting less prescriptive
• Pooling resources
• External pressures
• Joining EU and becoming subject to Directives
• Imposed.

29
The European Union

• The European Economic Community established in
  1957 renamed in 1993 the European Union (the
  EU)
• A major aim for financial reports prepared using
  common financial reporting standards
• Accounting Directives Fourth, Seventh and
  Eighth Directives.

30
The Fourth Directive prescribes

• Annual accounts should comprise statements of
  income and financial position with supporting
  notes to the accounts
• A choice of formats, for example vertical or
  horizontal presentation
• The assets and liabilities to be disclosed
• The valuation rules to be followed, for example
  historical cost accounting
• The general principles underlying the valuations.

31
The Seventh Directive requires

• The consolidation of subsidiary undertakings
  across national borders, that is worldwide
• Uniform accounting policies to be followed by all
  members of the group
• Eliminating inter-company profit and cancelling
  inter-company debt.

32
The Eighth Directive requires

• Independent audit committees to have one
  financial expert as a member
• Audit partners to be rotated every seven years
• The group auditor bears full responsibility for
  the audit report.

33
The wider reach of IFRS

• Transition to IFRSs occurring in EU and Asian
  Pacific Region, but different national editions
  of IFRSs appearing
• China - all listed companies in China must
  comply with IFRS
• The Australian Accounting Standards Board (AASB)
  has issued Australian equivalents (AIFRS) that
  are fully compliant with IFRS, but are not
  identical to IFRS
• This means that Australian companies accounts
  will be compliant with IFRS, but foreign
  companies following IFRS will not necessarily be
  compliant with AIFRS.

34
The wider reach of IFRS (Continued)

• In New Zealand IFRSs are issued as national
  equivalents which introduce specific additional
  requirements considered appropriate to the New
  Zealand environment
• Singapore seems to have adopted IFRS verbatim in
  its local standards, but with some important
  differences

35
The Impact of changing to IFRS

• In some instances the changes have a dramatic
  effect on headline figures (e.g. the Dutch
  company, Wessanen, reported an increase of over
  400 in its net income figure when the Dutch GAAP
  accounts were restated under IFRS)
• In other cases, there may be some large
  adjustments to individual balances, but the net
  effect may be less obvious. The European hotel
  group, Accor, reported a reduction in total
  assets of only 1 when its 2004 balance sheet was
  restated from French GAAP to IFRS, but within
  this, other receivables and accruals had fallen
  by 294m, a reduction of over 30 of the
  previously reported balance.
• Total assets 29,400 - 294 29,106 (1 fall)
• Other recs. 980 - 294 686 (30
  fall)

36
The impact of changing to IFRS (Continued)

• In most countries, earnings and balance sheet
  values will be more volatile than in the past
• In certain countries, there will be major changes
  in specific components of equity in the year of
  transition as particular assets or liabilities
  may be recognised differently
• In UK, many companies provisions for deferred
  tax liabilities increased on revalued properties
• Australian companies have made large adjustments
  to their balance sheets through the
  de-recognition of intangible assets

37
The impact of changing to IFRS (Continued)

• Accounting for financial instruments has proved
  particularly challenging
• In the short term, changes in reported figures
  can have important consequences for companies
  contractual obligations (e.g. they may not be
  able to maintain the level of liquidity required
  by their loan agreements) and their ability to
  pay dividends
• There may be motivational issues to consider
  where staff bonuses have traditionally been based
  on reported accounting profit.

38
Progress towards adoption by the USA of
International standards

• There has been continuous collaboration since
  the Norwalk Agreement in 2002 towards the time
  when
• The US will cease to require companies using IFRS
  to lodge reconciliation statements, and
• When it will mandate the use of IFRS by US
  companies.
• The process
• Started with the Norwalk agreement
• Followed by the IASB carrying out a Convergence
  programme and
• Finally joint standards being issued.

39
The Norwalk agreement
In 2002, the Financial Accounting Standards Board
(FASB) and the IASB committed to the development
of high-quality, compatible accounting standards
that could be used for both domestic and
cross-border financial reporting. The aim was
to (i) Make their existing financial reporting
standards fully compatible by undertaking a
short-term project aimed at removing a variety
of individual differences between US GAAP and
International Financial Reporting Standards and
(ii) Remove other differences between IFRSs and
US GAAP through coordination of their future work
programmes by undertaking discrete, substantial
projects on which both Boards would work
concurrently.
40
The short-term project

• IASB and FASB aimed to remove minor differences
  by changing their standards. For example,
• The IASB was to change IAS 11 Construction
  Contracts, IAS 12 Income taxes, IAS 14 Segment
  Reporting, IAS 28 Joint Ventures and
• The FASB was to change Inventory costs, Earnings
  per share and Research and Development costs
• By 2008 a number of projects were completed. For
  example,
• The FASB adopted the IFRS approach to accounting
  for research and development assets acquired in a
  business combination (SFAS 141R) and
• The IASB revised its standard on borrowing costs
  (IAS 23 revised) and segment reporting (IFRS 8).

41
Review questions

• 1. Why is it necessary for financial reporting to
  be subject to (a) mandatory control and (b)
  statutory control?
• The most favoured way to reduce information
  overload was to have the company filter the
  available information set based on users
  specifications of their needs. Discuss how this
  can be achieved given that users have differing
  needs.

42
Review questions (Continued)

• How is it possible to make shareholders aware of
  the significance of the exercise of judgement by
  directors which can turn profits of 6 million
  into losses of 2 million?