We Need Better, Not More

As you have learned in your study of this textbook, financial statements contain a wealth of useful information to help investors and creditors assess the amounts, timing, and uncertainty of future cash flows. In addition, the usefulness of accounting reports is enhanced when companies provide note disclosures to help statement readers understand how IFRS was applied to transactions. These additional disclosures help readers understand both the judgments that management made and how those judgments affected the amount reported in the financial statements. Some users, however, feel we need to go even further.

The IASB has heard these demands for improved financial reporting and disclosure and is responding. It organized a Discussion Forum as well as conducted a survey of preparers and users to get input on the effectiveness of reporting and disclosure in financial statements. The survey asked several questions about whether there is a disclosure problem and where in the annual report the problem arises. The survey focused on three potential areas: (1) not enough relevant information, (2) too much irrelevant information, and (3) poor communication of disclosures. The following graphic summarizes the feedback.

As indicated, preparers viewed the disclosure problem as primarily one of information overload; that is, they are being required to provide too much data. Users, on the other hand, complained that some of the information they get is poorly communicated and not that relevant. The message that emerged from the Discussion Forum was similar. Specifically, increases in the volume of financial disclosures has resulted in a perceived reduction in their quality and usefulness. More importantly, there was broad consensus that collective action was required in order for improvements to be made.

As a result, the IASB is taking action in three main areas:

1. Amendments to IAS 1. The IASB will make amendments to IAS 1 (“Presentation of Financial Statements”) to address perceived impediments to preparers exercising their judgment in presenting their financial reports.
2. Materiality. The IASB will seek to develop educational material on materiality with input from an advisory group.
3. Separate project on disclosure. The IASB will consider as part of its research agenda the broader challenges associated with disclosure effectiveness.

Hans Hoogervorst, chairman of the IASB, summarized the IASB's response as follows: “It is undoubtedly true that we and others can improve our [disclosure] requirements. However, material improvements will require behavioural change to ensure that financial statements are regarded as tools of communication rather than compliance. That means addressing the root causes of why preparers may err on the side of caution and ‘kitchen-sink’ their disclosures.” The bottom line: We need better, not necessarily more, disclosure.

Source: “Discussion Forum—Financial Reporting Disclosure,” Feedback Statement (London, U.K.: IASB, May 2013), http://www.ifrs.org/Current-Projects/IASB-Projects/Disclosure-Initiative/Pages/Disclosure-Initiative.aspx. See also “Disclosure Initiative: Proposed Amendments to IAS 1,” Exposure Draft ED/2014/1 (London, U.K.: IASB, March 2014).

FULL DISCLOSURE PRINCIPLE

The IASB Conceptual Framework notes that while some useful information is best provided in the financial statements, some is best provided by other means. For example, net income and cash flows are readily available in financial statements, but investors might do better to look at comparisons to other companies in the same industry, found in news articles or brokerage house reports.

IASB rules directly affect financial statements, notes to the financial statements, and supplementary information. These accounting standards provide guidance on recognition and measurement of amounts reported in the financial statements. However, due to the many judgments involved in applying IFRS, note disclosures provide important information about the application of IFRS. Supplementary information includes items such as disclosures about the risks and uncertainties, resources and obligations not recognized in the statement of financial position (such as mineral reserves), and information about geographical and industry segments. Other types of information found in the annual report, such as management commentary and the letters to shareholders, are not subject to IASB rules. [1] Illustration 24-1 indicates the various types of financial information.

See the Authoritative Literature section (pages 1301–1302).

ILLUSTRATION 24-1
Types of Financial Information

As Chapter 2 indicated, the profession has adopted a full disclosure principle. The full disclosure principle calls for financial reporting of any financial facts significant enough to influence the judgment of an informed reader. In some situations, the benefits of disclosure may be apparent but the costs uncertain. In other instances, the costs may be certain but the benefits of disclosure not as apparent.

For example, the IASB requires companies to provide expanded disclosures about their contractual obligations. In light of the accounting frauds at companies like Parmalat (ITA), the benefits of these expanded disclosures seem fairly obvious to the investing public. While no one has documented the exact costs of disclosure in these situations, they would appear to be relatively small.

On the other hand, the cost of disclosure can be substantial in some cases and the benefits difficult to assess. For example, at one time the financial press reported that if segment reporting were adopted, a company like Fruehauf (USA) would have had to increase its accounting staff 50 percent, from 300 to 450 individuals. In this case, the cost of disclosure can be measured, but the benefits are less well defined.

Some even argue that the reporting requirements are so detailed and substantial that users have a difficult time absorbing the information. These critics charge the profession with engaging in information overload.

Financial disasters at Mahindra Satyam (IND) and Société Générale (FRA) highlight the difficulty of implementing the full disclosure principle. They raise the issue of why investors were not aware of potential problems: Was the information these companies presented not comprehensible? Was it buried? Was it too technical? Was it properly presented and fully disclosed as of the financial statement date, but the situation later deteriorated? Or was it simply not there? In the following sections, we describe the elements of high-quality disclosure that will enable companies to avoid these disclosure pitfalls.

Increase in Reporting Requirements

Disclosure requirements have increased substantially. One survey showed that the size of many companies' annual reports is growing in response to demands for increased transparency. For example, annual report page counts ranged from 92 pages for Wm Morrison Supermarkets plc (GBR) up to a whopping 268 pages in Telefónica's (ESP) annual report. This result is not surprising; as illustrated throughout this textbook, the IASB has issued many pronouncements in the last 10 years that have substantial disclosure provisions.

The reasons for this increase in disclosure requirements are varied. Some of them are:

• Complexity of the business environment. The increasing complexity of business operations magnifies the difficulty of distilling economic events into summarized reports. Areas such as derivatives, leasing, business combinations, pensions, financing arrangements, revenue recognition, and deferred taxes are complex. As a result, companies extensively use notes to the financial statements to explain these transactions and their future effects.

  

• Necessity for timely information. Today, more than ever before, users are demanding information that is current and predictive. For example, users want more complete interim data.
• Accounting as a control and monitoring device. Regulators have recently sought public disclosure of such phenomena as management compensation, off-balance-sheet financing arrangements, and related-party transactions. Many of these newer disclosure requirements enlist accountants and auditors as the agents to assist in controlling and monitoring these concerns.

Differential Disclosure

A trend toward differential disclosure is also occurring.¹. The IASB has developed IFRS for small- and medium-sized entities (SMEs). SMEs are entities that publish general-purpose financial statements for external users but do not issue shares or other securities in a public market. SMEs are estimated to account for over 95 percent of all companies around the world. Many believe a simplified set of standards makes sense for these companies because they do not have the resources to implement full IFRS.

Simplified IFRS for SMEs is designed to meet their needs and capabilities. Compared with full IFRS (and many national accounting standards), simplified IFRS for SMEs is less complex in a number of ways:

• Topics not relevant for SMEs are omitted. Examples are earnings per share, interim financial reporting, and segment reporting.
• Simplified IFRS for SMEs allows fewer accounting policy choices. For example, there is no option to revalue property, equipment, or intangibles.
• Many principles for recognizing and measuring assets, liabilities, revenue, and expenses are simplified. For example, goodwill is amortized (as a result, there is no annual impairment test) and all borrowing and R&D costs are expensed.
• Significantly fewer disclosures are required (roughly 300 versus 3,000).
• To further reduce standard overload, revisions to the IFRS for SMEs will be limited to once every three years.

Thus, the option of using simplified IFRS helps SMEs meet the needs of their financial statement users while balancing the costs and benefits from a preparer perspective. [2]

NOTES TO THE FINANCIAL STATEMENTS

As you know from your study of this textbook, notes are an integral part of the financial statements of a business enterprise. However, readers of financial statements often overlook them because they are highly technical and often appear in small print. Notes are the means of amplifying or explaining the items presented in the main body of the statements. They can explain in qualitative terms information pertinent to specific financial statement items. In addition, they can provide supplementary data of a quantitative nature to expand the information in the financial statements. Notes also can explain restrictions imposed by financial arrangements or basic contractual agreements. Although notes may be technical and difficult to understand, they provide meaningful information for the user of the financial statements.

Accounting Policies

Accounting policies are the specific principles, bases, conventions, rules, and practices applied by a company in preparing and presenting financial statements. IFRS states that information about the accounting policies adopted by a reporting entity is essential for financial statement users in making economic decisions. It recommends that companies should present as an integral part of the financial statements a statement identifying the accounting policies adopted and followed by the reporting entity. Companies should present the disclosure as the first note or in a separate Summary of Significant Accounting Policies section preceding the notes to the financial statements.

The Summary of Significant Accounting Policies answers such questions as: What method of depreciation is used on plant assets? What valuation method is employed on inventories? What amortization policy is followed in regard to intangible assets? How are marketing costs handled for financial reporting purposes? You can see a good example of note disclosure for Marks and Spencer plc (GBR) (which accompany the financial statements presented in Appendix A) at the company's website, www.marksandspencer.com.

Analysts examine carefully the summary of accounting policies to determine whether a company is taking a conservative or a liberal approach to accounting practices. For example, depreciating plant assets over an unusually long period of time is considered liberal. Using weighted-average inventory valuation in a period of inflation is generally viewed as conservative.

In addition to disclosure of significant accounting policies, companies must:

1. Identify the judgments that management made in the process of applying the accounting policies and that have the most significant effect on the amounts recognized in the financial statements, and
2. Disclose information about the assumptions they make about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In respect of those assets and liabilities, the notes shall include details of (a) their nature and (b) their carrying amount as of the end of the reporting period.

These disclosures are many times presented with the accounting policy note or may be provided in a specific policy note. The disclosures should identify the estimates that require management's most difficult, subjective, or complex judgments. [3] An example of this disclosure is presented in Illustration 24-2 for British Airways (GBR).

ILLUSTRATION 24-2
Accounting Estimate and Judgment Disclosure

Collectively, these disclosures help statement readers evaluate the quality of a company's accounting policies in providing information in the financial statements for assessing future cash flows. Companies that fail to adopt high-quality reporting policies may be heavily penalized by the market. For example, when Isoft (GBR) disclosed that it would restate prior-year results due to use of aggressive revenue recognition policies, its share price dropped over 39 percent in one day. Investors viewed Isoft's quality of earnings as low.

Common Notes

We have discussed many of the notes to the financial statements throughout this textbook and will discuss others more fully in this chapter. The more common are as follows.

In earlier chapters, we discussed the disclosures listed above. The following sections of this chapter illustrate four additional disclosures of significance—special transactions or events, subsequent events, segment reporting, and interim reporting.

DISCLOSURE ISSUES

Disclosure of Special Transactions or Events

Related-party transactions, errors, and fraud pose especially sensitive and difficult problems. The accountant/auditor who has responsibility for reporting on these types of transactions must take care to properly balance the rights of the reporting company and the needs of financial statement users.

Related-party transactions arise when a company engages in transactions in which one of the parties has the ability to significantly influence the policies of the other. They may also occur when a non-transacting party has the ability to influence the policies of the two transacting parties.² Competitive, free-market dealings may not exist in related-party transactions, and so an “arm's-length” basis cannot be assumed. Transactions such as borrowing or lending money at abnormally low or high interest rates, real estate sales at amounts that differ significantly from appraised value, exchanges of non-monetary assets, and transactions involving companies that have no economic substance (“shell corporations”) suggest that related parties may be involved.

In order to make adequate disclosure, companies should report the economic substance, rather than the legal form, of these transactions. IFRS requires the following minimum disclosures of material related-party transactions. [5]

1. The nature of the related-party relationship;
2. The amount of the transactions and the amount of outstanding balances, including commitments, the nature of consideration, and details of any guarantees given or received;
3. Provisions for doubtful debts related to the amount of outstanding balances; and
4. The expense recognized during the period in respect of bad or doubtful debts due from related parties.

Illustration 24-3, from the annual report of Volvo Group (SWE), shows disclosure of related-party transactions.

ILLUSTRATION 24-3
Disclosure of Related-Party Transactions

Many companies are involved in related-party transactions. However, another type of special event, errors and fraud (sometimes referred to as irregularities), is the exception rather than the rule. Accounting errors are unintentional mistakes, whereas fraud (misappropriation of assets and fraudulent financial reporting) involves intentional distortions of financial statements.³ As indicated earlier, companies should correct the financial statements when they discover errors. The same treatment should be given fraud. The discovery of fraud, however, gives rise to a different set of procedures and responsibilities for the accountant/auditor.

Disclosure plays a very important role in these types of transactions because the events are many times more qualitative than quantitative and involve more subjective than objective evaluation. Users of the financial statements need some indication of the existence and nature of these transactions, through disclosures, modifications in the auditor's report, or reports of changes in auditors.

Events after the Reporting Period (Subsequent Events)

Notes to the financial statements should explain any significant financial events that took place after the formal statement of financial position date, but before the statements are authorized for issuance (hereafter referred to as the authorization date). These events are referred to as events after the reporting date or subsequent events. Illustration 24-4 shows a time diagram of the subsequent events period.

ILLUSTRATION 24-4
Time Periods for Subsequent Events

A period of several weeks or sometimes months may elapse after the end of the fiscal year but before the management or the board of directors authorizes issuance of the financial statements.⁴ Various activities involved in closing the books for the period and issuing the statements all take time: taking and pricing the inventory, reconciling subsidiary ledgers with controlling accounts, preparing necessary adjusting entries, ensuring that all transactions for the period have been entered, obtaining an audit of the financial statements by independent certified public accountants, and printing the annual report. During the period between the statement of financial position date and its authorization date, important transactions or other events may occur that materially affect the company's financial position or operating situation.

Many who read a statement of financial position believe the financial condition is constant, and they project it into the future. However, readers must be told if the company has experienced a significant change—e.g., sold one of its plants, acquired a subsidiary, suffered unusual losses, settled significant litigation, or experienced any other important event in the post-statement of financial position period. Without an explanation in a note, the reader might be misled and draw inappropriate conclusions.

Two types of events or transactions occurring after the statement of financial position date may have a material effect on the financial statements or may need disclosure so that readers interpret these statements accurately:

1. Events that provide additional evidence about conditions that existed at the statement of financial position date, including the estimates inherent in the process of preparing financial statements. These events are referred to as adjusted subsequent events and require adjustments to the financial statements. All information available prior to the authorization date of the financial statements helps investors and creditors evaluate estimates previously made. To ignore these subsequent events is to pass up an opportunity to improve the accuracy of the financial statements. This first type of event encompasses information that an accountant would have recorded in the accounts had the information been known at the statement of financial position date.

   For example, if a loss on an account receivable results from a customer's bankruptcy subsequent to the statement of financial position date, the company adjusts the financial statements before their issuance. The bankruptcy stems from the customer's poor financial health existing at the statement of financial position date.

   The same criterion applies to settlements of litigation. The company must adjust the financial statements if the events that gave rise to the litigation, such as personal injury or patent infringement, took place prior to the statement of financial position date.

2. Events that provide evidence about conditions that did not exist at the statement of financial position date but arise subsequent to that date. These events are referred as non-adjusted subsequent events and do not require adjustment of the financial statements. To illustrate, a loss resulting from a customer's fire or flood after the statement of financial position date does not reflect conditions existing at that date. Thus, adjustment of the financial statements is not necessary. A company should not recognize subsequent events that provide evidence about conditions that did not exist at the date of the statement of financial position but that arose after the statement of financial position date.

The following are examples of non-adjusted subsequent events:

• A major business combination after the reporting period or disposing of a major subsidiary.
• Announcing a plan to discontinue an operation or commencing the implementation of a major restructuring.
• Major purchases of assets, other disposals of assets, or expropriation of major assets by government.
• The destruction of a major production plant or inventories by a fire or natural disaster after the reporting period.
• Major ordinary share transactions and potential ordinary share transactions after the reporting period.
• Abnormally large changes after the reporting period in asset prices, foreign exchange rates, or taxes.
• Entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees after the statement date. [7]⁵

Some non-adjusted subsequent events may have to be disclosed to keep the financial statements from being misleading. For such events, a company discloses the nature of the event and an estimate of its financial effect.

Illustration 24-5 presents an example of subsequent events disclosure, excerpted from the annual report of Tieto (FIN).

ILLUSTRATION 24-5
Disclosure of Subsequent Events

Many subsequent events or developments do not require adjustment of or disclosure in the financial statements. Typically, these are non-accounting events or conditions that management normally communicates by other means. These events include legislation, product changes, management changes, strikes, unionization, marketing agreements, and loss of important customers.

Reporting for Diversified (Conglomerate) Companies

In certain business climates, companies have a tendency to diversify their operations. Take the case of Siemens AG (DEU), whose products include energy technologies, consumer products, and financial services. When businesses are so diversified, investors and investment analysts want more information about the details behind conglomerate financial statements. Particularly, they want income statement, statement of financial position, and cash flow information on the individual segments that compose the total income figure.

Much information is hidden in the aggregated totals. With only the consolidated figures, the analyst cannot tell the extent to which the differing product lines contribute to the company's profitability, risk, and growth potential. For example, in Illustration 24-6, the office equipment segment looks like a risky venture. Segmented reporting would provide useful information about the two business segments and would be useful for making an informed investment decision regarding the whole company.

ILLUSTRATION 24-6
Segmented Income Statement

A classic situation that demonstrates the need for segmented data involved Caterpillar, Inc. (USA). Market regulators cited Caterpillar because it failed to tell investors that nearly a quarter of its income in one year came from a Brazilian unit and was non-recurring in nature. The company knew that different economic policies in the next year would probably greatly affect earnings of the Brazilian unit. But Caterpillar presented its financial results on a consolidated basis, not disclosing the Brazilian operations. Caterpillar's failure to include information about Brazil left investors with an incomplete picture of the company's financial results and denied investors the opportunity to see the company “through the eyes of management.”

Companies have always been somewhat hesitant to disclose segmented data for various reasons:

1. Without a thorough knowledge of the business and an understanding of such important factors as the competitive environment and capital investment requirements, the investor may find the segmented information meaningless or may even draw improper conclusions about the reported earnings of the segments.
2. Additional disclosure may be helpful to competitors, labor unions, suppliers, and certain government regulatory agencies, and thus harm the reporting company.
3. Additional disclosure may discourage management from taking intelligent business risks because segments reporting losses or unsatisfactory earnings may cause shareholder dissatisfaction with management.
4. The wide variation among companies in the choice of segments, cost allocation, and other accounting problems limits the usefulness of segmented information.
5. The investor is investing in the company as a whole and not in the particular segments, and it should not matter how any single segment is performing if the overall performance is satisfactory.
6. Certain technical problems, such as classification of segments and allocation of segment revenues and costs (especially “common costs”), are formidable.

On the other hand, the advocates of segmented disclosures offer these reasons in support of the practice:

1. Investors need segmented information to make an intelligent investment decision regarding a diversified company.
   1. (a) Sales and earnings of individual segments enable investors to evaluate the differences between segments in growth rate, risk, and profitability, and to forecast consolidated profits.
   2. (b) Segmented reports help investors evaluate the company's investment worth by disclosing the nature of a company's businesses and the relative size of the components.
2. The absence of segmented reporting by a diversified company may put its unsegmented, single product-line competitors at a competitive disadvantage because the conglomerate may obscure information that its competitors must disclose.

The advocates of segmented disclosures appear to have a much stronger case. Many users indicate that segmented data are the most useful financial information provided, aside from the basic financial statements. As a result, the IASB has issued extensive reporting guidelines in this area.

Objective of Reporting Segmented Information

The objective of reporting segmented financial data is to provide information about the different types of business activities in which an enterprise engages and the different economic environments in which it operates. Meeting this objective will help users of financial statements do the following.

1. (a) Better understand the enterprise's performance.
2. (b) Better assess its prospects for future net cash flows.
3. (c) Make more informed judgments about the enterprise as a whole.

Basic Principles

Financial statements can be disaggregated in several ways. For example, they can be disaggregated by products or services, by geography, by legal entity, or by type of customer. However, it is not feasible to provide all of that information in every set of financial statements. IFRS requires that general-purpose financial statements include selected information on a single basis of segmentation. Thus, a company can meet the segmented reporting objective by providing financial statements segmented based on how the company's operations are managed. The method chosen is referred to as the management approach. [8] The management approach reflects how management segments the company for making operating decisions. The segments are evident from the components of the company's organization structure. These components are called operating segments.

Identifying Operating Segments

An operating segment is a component of an enterprise:

1. (a) That engages in business activities from which it earns revenues and incurs expenses.
2. (b) Whose operating results are regularly reviewed by the company's chief operating decision-maker to assess segment performance and allocate resources to the segment.
3. (c) For which discrete financial information is available that is generated by or based on the internal financial reporting system.

Companies may aggregate information about two or more operating segments only if the segments have the same basic characteristics in each of the following areas.

1. (a) The nature of the products and services provided.
2. (b) The nature of the production process.
3. (c) The type or class of customer.
4. (d) The methods of product or service distribution.
5. (e) If applicable, the nature of the regulatory environment.

After the company decides on the possible segments for disclosure, it makes a quantitative materiality test. This test determines whether the segment is significant enough to warrant actual disclosure. An operating segment is deemed significant and therefore a reportable segment if it satisfies one or more of the following quantitative thresholds.

1. Its revenue (including both sales to external customers and intersegment sales or transfers) is 10 percent or more of the combined revenue of all the company's operating segments.
2. The absolute amount of its profit or loss is 10 percent or more of the greater, in absolute amount, of (a) the combined operating profit of all operating segments that did not incur a loss, or (b) the combined loss of all operating segments that did report a loss.
3. Its identifiable assets are 10 percent or more of the combined assets of all operating segments.

In applying these tests, the company must consider two additional factors. First, segment data must explain a significant portion of the company's business. Specifically, the segmented results must equal or exceed 75 percent of the combined sales to unaffiliated customers for the entire company. This test prevents a company from providing limited information on only a few segments and lumping all the rest into one category.

Second, the profession recognizes that reporting too many segments may overwhelm users with detailed information. The IASB decided that 10 is a reasonable upper limit for the number of segments that a company must disclose. [9]

To illustrate these requirements, assume a company has identified six possible reporting segments, as shown in Illustration 24-7 (euros in thousands).

ILLUSTRATION 24-7
Data for Different Possible Reporting Segments

The company would apply the respective tests as follows.

The reporting segments are therefore A, C, D, and E, assuming that these four segments have enough sales to meet the 75 percent of combined sales test. The 75 percent test is computed as follows.

Measurement Principles

The accounting principles that companies use for segment disclosure need not be the same as the principles they use to prepare the consolidated statements. This flexibility may at first appear inconsistent. But, preparing segment information in accordance with IFRS would be difficult because some IFRS are not expected to apply at a segment level. Examples are accounting for the cost of company-wide employee benefit plans and accounting for income taxes in a company that files a consolidated tax return with segments in different tax jurisdictions.

The IASB does not require allocations of joint, common, or company-wide costs solely for external reporting purposes. Common costs are those incurred for the benefit of more than one segment and whose interrelated nature prevents a completely objective division of costs among segments. For example, the company president's salary is difficult to allocate to various segments. Allocations of common costs are inherently arbitrary and may not be meaningful. There is a presumption that if companies allocate common costs to segments, these allocations are either directly attributable or reasonably allocable to the segments.

Segmented Information Reported

The IASB requires that an enterprise report the following.

1. General information about its operating segments. This includes factors that management considers most significant in determining the company's operating segments and the types of products and services from which each operating segment derives its revenues.
2. Segment profit and loss and related information. Specifically, companies must report the following information about each operating segment if the amounts are included in determining segment profit or loss.
   1. (a) Revenues from transactions with external customers.
   2. (b) Revenues from transactions with other operating segments of the same enterprise.
   3. (c) Interest revenue.
   4. (d) Interest expense.
   5. (e) Depreciation and amortization expense.
   6. (f) Unusual items.
   7. (g) Equity in the net income of investees accounted for by the equity method.
   8. (h) Income tax expense or benefit.
   9. (i) Significant non-cash items other than depreciation, depletion, and amortization expense.
3. Segment assets and liabilities. A company must report each operating segment's total assets and liabilities.
4. Reconciliations. A company must provide a reconciliation of the total of the segments' revenues to total revenues, a reconciliation of the total of the operating segments' profits and losses to its income before income taxes, and a reconciliation of the total of the operating segments' assets and liabilities to total assets and liabilities.
5. Information about products and services and geographic areas. For each operating segment not based on geography, the company must report (unless it is impracticable): (1) revenues from external customers, (2) long-lived assets, and (3) expenditures during the period for long-lived assets. This information, if material, must be reported (a) in the enterprise's country of domicile and (b) in each other country.
6. Major customers. If 10 percent or more of company revenue is derived from a single customer, the company must disclose the total amount of revenue from each such customer by segment.

Illustration of Disaggregated Information

Illustration 24-8 shows the segment disclosure for Statoil (NOR).

ILLUSTRATION 24-8
Segment Disclosure

Interim Reports

Another source of information for the investor is interim reports. As noted earlier, interim reports cover periods of less than one year. The securities exchanges, market regulators, and the accounting profession have an active interest in the presentation of interim information.

Because of the short-term nature of the information in these reports, there is considerable controversy as to the general approach companies should employ. One group, which favors the discrete approach, believes that companies should treat each interim period as a separate accounting period. Using that treatment, companies would follow the principles for deferrals and accruals used for annual reports. In this view, companies should report accounting transactions as they occur, and expense recognition should not change with the period of time covered.

Another group, which favors the integral approach, believes that the interim report is an integral part of the annual report and that deferrals and accruals should take into consideration what will happen for the entire year. In this approach, companies should assign estimated expenses to parts of a year on the basis of sales volume or some other activity base. In general, IFRS requires companies to follow the discrete approach. [10]

Interim Reporting Requirements

Generally, companies should use the same accounting policies for interim reports and for annual reports. They should recognize revenues in interim periods on the same basis as they are for annual periods. For example, if Cedars Corp. uses the percentage-of-completion method as the basis for recognizing revenue on an annual basis, then it should use the percentage-of-completion method for interim reports as well. Also, Cedars should treat costs directly associated with revenues (product costs, such as materials, labor and related fringe benefits, and manufacturing overhead) in the same manner for interim reports as for annual reports.

Companies should use the same inventory pricing methods (FIFO, average-cost, etc.) for interim reports and for annual reports. However, companies may use the gross profit method for interim inventory pricing. But, they must disclose the method and adjustments to reconcile with annual inventory.

Discrete Approach. Following the discrete approach, companies record in interim reports revenues and expenses according to the revenue and expense recognition principles. This includes costs and expenses other than product costs (often referred to as period costs). No accruals or deferrals in anticipation of future events during the year should be reported. For example, the cost of a planned major periodic maintenance or overhaul for a company like Airbus (FRA) or other seasonal expenditure that is expected to occur late in the year is not anticipated for interim reporting purposes. The mere intention or necessity to incur expenditure related to the future is not sufficient to give rise to an obligation.

Or, a company like Carrefour (FRA) may budget certain costs expected to be incurred irregularly during the financial year, such as advertising and employee training costs. Those costs generally are discretionary even though they are planned and tend to recur from year to year. However, recognizing an obligation at the end of an interim financial reporting period for such costs that have not yet been incurred generally is not consistent with the definition of a liability.

While year-to-date measurements may involve changes in estimates of amounts reported in prior interim periods of the current financial year, the principles for recognizing assets, liabilities, income, and expenses for interim periods are the same as in annual financial statements. For example, Wm Morrison Supermarkets plc (GBR) records losses from inventory write-downs, restructurings, or impairments in an interim period similar to how it would treat these items in the annual financial statements (when incurred). However, if an estimate from a prior interim period changes in a subsequent interim period of that year, the original estimate is adjusted in the subsequent interim period.

Interim Disclosures. IFRS does not require a complete set of financial statements at the interim reporting date. Rather, companies may comply with the requirements by providing condensed financial statements and selected explanatory notes. Because users of interim financial reports also have access to the most recent annual financial report, companies only need provide explanation of significant events and transactions since the end of the last annual reporting period. Companies should report the following interim data at a minimum.

1. 1. Statement that the same accounting policies and methods of computation are followed in the interim financial statements as compared with the most recent annual financial statements or, if those policies or methods have been changed, a description of the nature and effect of the change.
2. 2. Explanatory comments about the seasonality or cyclicality of interim operations.
3. 3. The nature and amount of items affecting assets, liabilities, equity, net income, or cash flows that are unusual because of their nature, size, or incidence.
4. 4. The nature and amount of changes in accounting policies and estimates of amounts previously reported.
5. 5. Issuances, repurchases, and repayments of debt and equity securities.
6. 6. Dividends paid (aggregate or per share) separately for ordinary shares and other shares.
7. 7. Segment information, as required by IFRS 8, “Operating Segments.”
8. 8. Changes in contingent liabilities or contingent assets since the end of the last annual reporting period.
9. 9. Effect of changes in the composition of the company during the interim period, such as business combinations, obtaining or losing control of subsidiaries and long-term investments, restructurings, and discontinued operations.
10. 10. Other material events subsequent to the end of the interim period that have not been reflected in the financial statements for the interim period.

If a complete set of financial statements is provided in the interim report, companies comply with the provisions of IAS 1, “Presentation of Financial Statements.”

Unique Problems of Interim Reporting

IFRS reflects a preference for the discrete approach. However, within this broad guideline, a number of unique reporting problems develop related to the following items.

Income Taxes. Not every dollar of corporate taxable income may be taxed at the same rate if the tax rate is progressive. This aspect of business income taxes poses a problem in preparing interim financial statements. Should the company use the annualized approach, which is to annualize income to date and accrue the proportionate income tax for the period to date? Or should it follow the marginal principle approach, which is to apply the lower rate of tax to the first amount of income earned? At one time, companies generally followed the latter approach and accrued the tax applicable to each additional dollar of income.

IFRS requires use of the annualized approach. Income tax expense is recognized in each interim period based on the best estimate of the weighted-average annual income tax rate expected for the full financial year. This approach is consistent with applying the same principles in interim reports as applied to annual report; that is, income taxes are assessed on an annual basis. However, amounts accrued for income tax expense in one interim period may have to be adjusted in a subsequent interim period of that financial year if the estimate of the annual income tax rate changes. [11]⁶

Seasonality. Seasonality occurs when most of a company's sales occur in one short period of the year, while certain costs are fairly evenly spread throughout the year. For example, the natural gas industry has its heavy sales in the winter months. In contrast, the beverage industry has its heavy sales in the summer months.

The problem of seasonality is related to the expense recognition principle in accounting. Generally, expenses are associated with the revenues they create. In a seasonal business, wide fluctuations in profits occur because off-season sales do not absorb the company's fixed costs (for example, manufacturing, selling, and administrative costs that tend to remain fairly constant regardless of sales or production).

To illustrate why seasonality is a problem, assume the following information.

ILLUSTRATION 24-9
Data for Seasonality Example

Sales for four quarters and the year (projected and actual) were as follows.

ILLUSTRATION 24-10
Sales Data for Seasonality Example

Under the present accounting framework, the income statements for the quarters might be as shown in Illustration 24-11.

ILLUSTRATION 24-11
Interim Net Income for Seasonal Business—Discrete Approach

An investor who uses the first quarter's results might be misled. If the first quarter's earnings are $4,500, should this figure be multiplied by four to predict annual earnings of $18,000? Or, if first-quarter sales of $20,000 are 20 percent of the predicted sales for the year, would the net income for the year be $22,500 ($4,500 × 5)? Both figures are obviously wrong. And, after the second quarter's results occur, the investor may become even more confused.

The problem with the conventional approach is that the fixed non-manufacturing costs are not charged in proportion to sales. Some enterprises have adopted a way of avoiding this problem by making all fixed non-manufacturing costs follow the sales pattern, as shown in Illustration 24-12.

ILLUSTRATION 24-12
Interim Net Income for Seasonal Business—Integral Approach

This approach solves some of the problems of interim reporting: Sales in the first quarter are 20 percent of total sales for the year, and net income in the first quarter is 20 percent of total income. In this case, as in the previous example, the investor cannot rely on multiplying any given quarter by four but can use comparative data or rely on some estimate of sales in relation to income for a given period.

The greater the degree of seasonality experienced by a company, the greater the possibility of distortion. Because there are no definitive guidelines for handling such items as the fixed non-manufacturing costs, variability in income can be substantial. To alleviate this problem, IFRS requires companies subject to material seasonal variations to disclose the seasonal nature of their business and consider supplementing their interim reports with information for 12-month periods ended at the interim date for the current and preceding years.

The two illustrations highlight the difference between the discrete and integral approaches. Illustration 24-11 (page 1269) represents the discrete approach, in which the fixed non-manufacturing expenses are expensed as incurred. Illustration 24-12 (page 1269) shows the integral approach, in which expenses are charged to expense on the basis of some measure of activity.

Continuing Controversy. While IFRS has developed some rules for interim reporting, additional issues remain. For example, there is continuing debate on the independent auditor's involvement in interim reports. Many auditors are reluctant to express an opinion on interim financial information, arguing that the data are too tentative and subjective. On the other hand, more people are advocating some examination of interim reports. Generally, auditors perform a review of interim financial information. Such a review, which is much more limited in its procedures than the annual audit, provides some assurance that the interim information appears to be in accord with IFRS.⁷

Analysts and investors want financial information as soon as possible, before it is old news. We may not be far from a continuous database system in which corporate financial records can be accessed online. Investors might be able to access a company's financial records whenever they wish and put the information in the format they need. Thus, they could learn about sales slippage, cost increases, or earnings changes as they happen, rather than waiting until after the quarter has ended.

A steady stream of information from the company to the investor could be very positive because it might alleviate management's continual concern with short-run interim numbers. Today, many contend that management is too oriented to the short-term. The truth of this statement is echoed by the words of the president of a large company who decided to retire early: “I wanted to look forward to a year made up of four seasons rather than four quarters.”

AUDITOR'S AND MANAGEMENT'S REPORTS

Auditor's Report

Another important source of information that is often overlooked is the auditor's report. An auditor is an accounting professional who conducts an independent examination of a company's accounting data.

If satisfied that the financial statements present the financial position, results of operations, and cash flows fairly in accordance with IFRS, the auditor expresses an unmodified opinion. An example is shown in Illustration 24-13.⁸

ILLUSTRATION 24-13
Auditor's Report

In preparing the report, the auditor follows these reporting standards.

1. 1. The report states whether the financial statements are in accordance with the financial reporting framework (IFRS) and describes the responsibilities of the directors and auditors with respect to the financial statements.
2. 2. The report identifies those circumstances in which the company has not consistently observed such policies in the current period in relation to the preceding period.
3. 3. Users are to regard the informative disclosures in the financial statements as reasonably adequate unless the report states otherwise.
4. 4. The report contains either an expression of opinion regarding the financial statements taken as a whole or an assertion to the effect that an opinion cannot be expressed. When the auditor cannot express an overall opinion, the report should state the reasons. In all cases where an auditor's name is associated with financial statements, the report should contain a clear-cut indication of the character of the auditor's examination, if any, and the degree of responsibility being taken.

In most cases, the auditor issues a standard unmodified or clean opinion, as shown in Illustration 24-13. That is, the auditor expresses the opinion that the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity in conformity with accepted accounting principles.

Certain circumstances, although they do not affect the auditor's unmodified opinion, may require the auditor to add an explanatory paragraph to the audit report. Some of the more important circumstances are as follows.

1. 1. Going concern. The auditor must evaluate whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time, taking into consideration all available information about the future. (Generally, the future is at least, but not limited to, 12 months from the end of the reporting period.) If substantial doubt exists about the company continuing as a going concern, the auditor adds to the report an explanatory note describing the potential problem.
2. 2. Lack of consistency. If a company has changed accounting policies or the method of their application in a way that has a material effect on the comparability of its financial statements, the auditor should refer to the change in an explanatory paragraph of the report. Such an explanatory paragraph should identify the nature of the change and refer readers to the note in the financial statements that discusses the change in detail. The auditor's concurrence with a change is implicit unless the auditor takes exception to the change in expressing an opinion as to fair presentation in conformity with accepted accounting principles (IFRS).
3. 3. Emphasis of a matter. The auditor may wish to emphasize a matter regarding the financial statements but nevertheless intends to express an unqualified opinion. For example, the auditor may wish to emphasize that the entity is a component of a larger business enterprise or that it has had significant transactions with related parties. The auditor presents such explanatory information in a separate paragraph of the report.

In some situations, however, the auditor expresses a modified opinion. A modified opinion can be either (1) a qualified opinion, (2) an adverse opinion, or (3) a disclaimed opinion.

A qualified opinion contains an exception to the standard opinion. Ordinarily, the exception is not of sufficient magnitude to invalidate the statements as a whole; if it were, an adverse opinion would be rendered. The usual circumstances in which the auditor may deviate from the standard unqualified report on financial statements are as follows.

1. 1. The scope of the examination is limited or affected by conditions or restrictions.
2. 2. The statements do not fairly present financial position or results of operations because of:
   1. (a) Lack of conformity with accepted accounting principles and standards.
   2. (b) Inadequate disclosure.

If confronted with one of the situations noted above, the auditor must offer a qualified opinion. A qualified opinion states that, except for the effects of the matter to which the qualification relates, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows in conformity with accepted accounting principles.

Illustration 24-14 shows an example of an auditor's report with a modified opinion—in this case, a qualified opinion of Helio Company (USA). The auditor modified the opinion because the company used an accounting policy at variance with accepted accounting principles.

ILLUSTRATION 24-14
Auditor's Report with Qualified Opinion

An adverse opinion is required in any report in which the exceptions to fair presentation are so material that in the independent auditor's judgment, a qualified opinion is not justified. In such a case, the financial statements taken as a whole are not presented in accordance with IFRS. Adverse opinions are rare because most companies change their accounting to conform with IFRS. Market regulators will not permit a company listed on an exchange to have an adverse opinion.

A disclaimer of an opinion is appropriate when the auditor has gathered so little information on the financial statements that no opinion can be expressed.

The audit report should provide useful information to the investor. One investment banker noted, “Probably the first item to check is the auditor's opinion to see whether or not it is a clean one—'in conformity with accepted accounting principles'—or is qualified in regard to differences between the auditor and company management in the accounting treatment of some major item, or in the outcome of some major litigation.”

Management's Reports

Management Commentary

Management commentary helps in the interpretation of the financial position, financial performance, and cash flows of a company. For example, a company like Delhaize Group (BEL) may present, outside the financial statements, a financial review by management that describes and explains the main features of the company's financial performance and financial position, and the principal uncertainties it faces. Such a report may include a review of:

• The main factors and influences determining financial performance, including changes in the environment in which the entity operates, the entity's response to those changes and their effect, and the company's policy for investment to maintain and enhance financial performance, including its dividend policy;
• The company's sources of funding and its targeted ratio of liabilities to equity; and
• The company's resources not recognized in the statement of financial position in accordance with IFRS.

Such commentary also provides an opportunity to understand management's objectives and its strategies for achieving those objectives. Users of financial reports, in their capacity as capital providers, routinely use the type of information provided in management commentary as a tool for evaluating an entity's prospects and its general risks, as well as the success of management's strategies for achieving its stated objectives.

For many companies, management commentary is already an important element of their communication with the capital markets, supplementing as well as complementing the financial statements. Management commentary encompasses reporting that is described in various jurisdictions as management's discussion and analysis (MD&A), operating and financial review (OFR), or management's report.

Illustration 24-15 presents an excerpt from the MD&A section of Lectra's (FRA) annual report.

ILLUSTRATION 24-15
Management's Discussion and Analysis

Some companies use the management commentary section of the annual report to disclose company efforts in the area of sustainability. An excerpt from the annual report of Marks and Spencer plc (GBR) is presented in Illustration 24-16.

ILLUSTRATION 24-16
Sustainability Reporting

Additional reporting on sustainability is important because it indicates the company's social responsibility and can provide insights about potential obligations that are reported in the financial statements.

While there are no formal IFRS requirements for management commentary, the IASB has initiated a project that offers a non-binding framework and limited guidance on its application, which could be adapted to the legal and economic circumstances of individual jurisdictions. While the proposal is focused on publicly traded entities, to the extent that the framework is deemed applicable, it may be a useful tool for non-exchange traded entities, for example, privately held and state-owned enterprises.⁹

Management's Responsibilities for Financial Statements

Management is responsible for preparing the financial statements and establishing and maintaining an effective system of internal controls. The auditor provides an independent assessment of whether the financial statements are prepared in accordance with IFRS (see the audit opinion in Illustration 24-13 on page 1271). An example of the type of disclosure that public companies are now making is shown in Illustration 24-17.

ILLUSTRATION 24-17
Report on Management's Responsibilities

CURRENT REPORTING ISSUES

Reporting on Financial Forecasts and Projections

In recent years, the investing public's demand for more and better information has focused on disclosure of corporate expectations for the future.¹⁰ These disclosures take one of two forms:¹¹.

• Financial forecasts. A financial forecast is a set of prospective financial statements that present, to the best of the responsible party's knowledge and belief, a company's expected financial position, results of operations, and cash flows. The responsible party bases a financial forecast on conditions it expects to exist and the course of action it expects to take.
• Financial projections. Financial projections are prospective financial statements that present, to the best of the responsible party's knowledge and belief, given one or more hypothetical assumptions, an entity's expected financial position, results of operations, and cash flows. The responsible party bases a financial projection on conditions it expects would exist and the course of action it expects would be taken, given one or more hypothetical assumptions.

The difference between a financial forecast and a financial projection is clear-cut: A forecast provides information on what is expected to happen, whereas a projection provides information on what might take place but is not necessarily expected to happen.

Whether companies should be required to provide financial forecasts is the subject of intensive discussion with journalists, corporate executives, market regulators, financial analysts, accountants, and others. Predictably, there are strong arguments on either side. Listed below are some of the arguments.

Arguments for requiring published forecasts:

1. 1. Investment decisions are based on future expectations. Therefore, information about the future facilitates better decisions.
2. 2. Companies already circulate forecasts informally. This situation should be regulated to ensure that the forecasts are available to all investors.
3. 3. Circumstances now change so rapidly that historical information is no longer adequate for prediction.

Arguments against requiring published forecasts:

1. 1. No one can foretell the future. Therefore, forecasts will inevitably be wrong. Worse, they may mislead if they convey an impression of precision about the future.
2. 2. Companies may strive only to meet their published forecasts, thereby failing to produce results that are in the shareholders' best interest.
3. 3. If forecasts prove inaccurate, there will be recriminations and probably legal actions.¹²
4. 4. Disclosure of forecasts will be detrimental to organizations because forecasts will inform competitors (foreign and domestic), as well as investors.

Auditing standards establish guidelines for the preparation and presentation of financial forecasts and projections.¹³ They require accountants to provide (1) a summary of significant assumptions used in the forecast or projection and (2) guidelines for minimum presentation.

To encourage management to disclose prospective financial information, some market regulators have established a safe harbor rule. It provides protection to a company that presents an erroneous forecast, as long as the company prepared the forecast on a reasonable basis and disclosed it in good faith.¹⁴ However, many companies note that the safe harbor rule does not work in practice, since it does not cover oral statements, nor has it kept them from investor lawsuits.

Questions of Liability

What happens if a company does not meet its forecasts? Can the company and the auditor be sued? If a company, for example, projects an earnings increase of 15 percent and achieves only 5 percent, should shareholders be permitted to have some judicial recourse against the company?

One court case involving Monsanto Chemical Corporation (USA) set a precedent. In this case, Monsanto predicted that sales would increase 8 to 9 percent and that earnings would rise 4 to 5 percent. In the last part of the year, the demand for Monsanto's products dropped as a result of a business turndown. Instead of increasing, the company's earnings declined. Investors sued the company because the projected earnings figure was erroneous, but a judge dismissed the suit because the forecasts were the best estimates of qualified people whose intents were honest.

As indicated earlier, safe harbor rules are intended to protect companies that provide good-faith projections. However, much concern exists as to how market regulators and the courts will interpret such terms as “good faith” and “reasonable assumptions” when erroneous forecasts mislead users of this information.

Internet Financial Reporting

Most companies now use the power and reach of the Internet to provide more useful information to financial statement readers. All large companies have Internet sites, and a large proportion of companies' websites contain links to their financial statements and other disclosures. The popularity of such reporting is not surprising as companies can reduce the costs of printing and disseminating paper reports with the use of Internet reporting.

Does Internet financial reporting improve the usefulness of a company's financial reports? Yes, in several ways. First, dissemination of reports via the Web allows firms to communicate more easily and quickly with users than do traditional paper reports. In addition, Internet reporting allows users to take advantage of tools such as search engines and hyperlinks to quickly find information about the firm and, sometimes, to download the information for analysis, perhaps in computer spreadsheets. Finally, Internet reporting can help make financial reports more relevant by allowing companies to report expanded disaggregated data and more timely data than is possible through paper-based reporting. For example, some companies voluntarily report weekly sales data and segment operating data on their websites.

Given the widespread use of the Internet by investors and creditors, it is not surprising that organizations are developing new technologies and standards to further enable Internet financial reporting. An example is the increasing use of Extensible Business Reporting Language (XBRL). XBRL is a computer language adapted from the code of the Internet. It “tags” accounting data to correspond to financial reporting items that are reported in the statement of financial position, income statement, and the cash flow statement. Once tagged, any company's XBRL data can be easily processed using spreadsheets and other computer programs. In fact, XBRL is a global language with common tags across countries. As more companies prepare their financial reports using XBRL, users will be able to easily search a company's reports, extract and analyze data, and perform financial comparisons within industries and across countries.¹⁵

Fraudulent Financial Reporting

Economic crime is on the rise around the world. A recent global survey of over 3,000 executives from 54 countries documented the types of economic crimes, as shown in Illustration 24-18.¹⁶

ILLUSTRATION 24-18
Types of Economic Crime

As indicated, a wide range of economic crimes are reported. Unfortunately, for the top three areas, the trend is not good. As shown in Illustration 24-19, there has been a steady upward trend of economic crime.

ILLUSTRATION 24-19
Trends in Reported Frauds

Important and troubling, note that accounting frauds have also increased since 2011.

Fraudulent financial reporting is defined as “intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements.”¹⁷ Fraudulent reporting can involve gross and deliberate distortion of corporate records (such as inventory count tags), or misapplication of accounting policies (failure to disclose material transactions). The frauds reported above and recent events involving such well-known companies as Parmalat (ITA), Mahindra Satyam (IND), and Société Générale (FRA) indicate that more must be done to address this issue.

Causes of Fraudulent Financial Reporting

Fraudulent financial reporting usually occurs because of conditions in a company's internal or external environment. Influences in the internal environment relate to poor internal control systems, management's poor attitude toward ethics, or perhaps a company's liquidity or profitability. Those in the external environment may relate to industry conditions, overall business environment, or legal and regulatory considerations.

General incentives for fraudulent financial reporting vary. Common ones are the desire to obtain a higher share price, avoid default on a loan covenant, or make a personal gain of some type (additional compensation, promotion). Situational pressures on the company or an individual manager also may lead to fraudulent financial reporting. Examples of these situational pressures include the following.

• Sudden decreases in revenue or market share for a single company or an entire industry.
• Unrealistic budget pressures may occur when headquarters arbitrarily determines profit objectives (particularly for short-term results) and budgets without taking actual conditions into account.
• Financial pressure resulting from bonus plans that depend on short-term economic performance. This pressure is particularly acute when the bonus is a significant component of the individual's total compensation.

Opportunities for fraudulent financial reporting are present in circumstances when the fraud is easy to commit and when detection is difficult. Frequently, these opportunities arise from:

1. 1. The absence of a board of directors or audit committee that vigilantly oversees the financial reporting process.
2. 2. Weak or non-existent internal accounting controls. This situation can occur, for example, when a company's revenue system is overloaded as a result of a rapid expansion of sales, an acquisition of a new division, or the entry into a new, unfamiliar line of business.
3. 3. Unusual or complex transactions such as the consolidation of two companies, the divestiture or closing of a specific operation, and the purchase and sale of derivative instruments.
4. 4. Accounting estimates requiring significant subjective judgment by company management, such as the allowance for loan losses and the estimated liability for warranty expense.
5. 5. Ineffective internal audit staffs resulting from inadequate staff size and severely limited audit scope.

A weak corporate ethical climate contributes to these situations. Opportunities for fraudulent financial reporting also increase dramatically when the accounting policies followed in reporting transactions are non-existent, evolving, or subject to varying interpretations.¹⁸

As discussed earlier, auditing regulators have issued numerous auditing standards in response to concerns of the accounting profession, the media, and the public.¹⁹ For example, the recent standard on fraudulent financial reporting “raises the bar” on the performance of financial statement audits by explicitly requiring auditors to assess the risk of material financial misstatement due to fraud.²⁰

Criteria for Making Accounting and Reporting Choices

Throughout this textbook, we have stressed the need to provide information that is useful to predict the amounts, timing, and uncertainty of future cash flows. To achieve this objective, companies must make judicious choices between alternative accounting concepts, methods, and means of disclosure. You are probably surprised by the large number of choices that exist among acceptable alternatives.

You should recognize, however, as indicated in Chapter 1, that accounting is greatly influenced by its environment. It does not exist in a vacuum. Therefore, it is unrealistic to assume that the profession can entirely eliminate alternative presentations of certain transactions and events. Nevertheless, we are hopeful that the profession, by adhering to the Conceptual Framework, will be able to focus on the needs of financial statement users and eliminate diversity where appropriate. The IASB's focus on principles-based standards are directed at these very issues. It seeks to develop guidance that will result in accounting and financial reporting that reflects the economic substance of the transactions, not the desired financial result of management. The profession must continue its efforts to develop a sound foundation upon which to build financial standards and practice. As Aristotle said, “The correct beginning is more than half the whole.”

KEY TERMS

accounting policies, 1254

adjusted subsequent events, 1260

adverse opinion, 1273

auditor, 1270

auditor's report, 1270

common costs, 1265

differential disclosure, 1253

disclaimer of an opinion, 1273

discrete approach, 1266

errors, 1259

events after the reporting date, 1259

financial forecast, 1277

financial projection, 1278

fraud, 1259

fraudulent financial reporting, 1281

full disclosure principle, 1252

integral approach, 1266

interim reports, 1266

management approach, 1263

management commentary, 1274

modified opinion, 1272

non-adjusted subsequent events, 1260

notes to the financial statements, 1256

operating segment, 1263

qualified opinion, 1273

related-party transactions, 1258

safe harbor rule, 1278

seasonality, 1268

subsequent events, 1259

unmodified or clean opinion, 1272

XBRL, 1280

Review the full disclosure principle and describe implementation problems. The full disclosure principle calls for financial reporting of any financial facts significant enough to influence the judgment of an informed reader. Implementing the full disclosure principle is difficult because the cost of disclosure can be substantial and the benefits difficult to assess. Disclosure requirements have increased because of (1) the growing complexity of the business environment, (2) the necessity for timely information, and (3) the use of accounting as a control and monitoring device.

Explain the use of notes in financial statement preparation. Notes are the accountant's means of amplifying or explaining the items presented in the main body of the statements. Notes can explain in qualitative terms information pertinent to specific financial statement items and can provide supplementary data of a quantitative nature. Common note disclosures relate to such items as accounting policies; inventories; property, plant, and equipment; creditor claims; contingencies and commitments; and subsequent events.

Discuss the disclosure requirements for related-party transactions, subsequent events, and major business segments. In related-party transactions, one party has the ability to significantly influence the actions of the other. As a result, IFRS requires disclosure of the relationship, a description of the transactions including amounts, provisions for doubtful debts, and expenses recognized. For events after the reporting date, a company should disclose any transactions that materially affect its financial position or operating situation. Finally, aggregated figures hide much information about the composition of these consolidated figures. There is no way to tell from the consolidated data the extent to which the differing product lines contribute to the company's profitability, risk, and growth potential. As a result, the profession requires segment information in certain situations.

Describe the accounting problems associated with interim reporting. Interim reports cover periods of less than one year. Two viewpoints exist regarding interim reports. The discrete approach holds that each interim period should be treated as a separate accounting period. The integral approach is that the interim report is an integral part of the annual report and that deferrals and accruals should take into consideration what will happen for the entire year. IFRS requires use of the discrete approach.

Companies should use the same accounting policies for interim reports that they use for annual reports. A number of unique reporting problems develop related to the following items: (1) income taxes and (2) seasonality.

Identify the major disclosures in the auditor's report. The auditor expresses an unmodified or clean opinion if satisfied that the financial statements present the financial position, results of operations, and cash flows fairly in accordance with IFRS. A qualified opinion contains an exception to the standard opinion; ordinarily, the exception is not of sufficient magnitude to invalidate the statements as a whole.

An adverse opinion is required when the exceptions to fair presentation are so material that a qualified opinion is not justified. A disclaimer of an opinion is appropriate when the auditor has so little information on the financial statements that no opinion can be expressed.

Understand management's responsibilities for financials. Management commentary complements information reported in the financial statements. This commentary frequently discusses financial aspects of an enterprise's business, such as liquidity, capital resources, results of operations, important risks, and sustainability. Management's responsibility for the financial statements is often indicated in a letter to shareholders in the annual report.

Identify issues related to financial forecasts and projections. Companies are permitted (not required) to include profit forecasts in their reports. To encourage management to disclose such information, market regulators have issued a safe harbor rule. The rule provides protection to a company that presents an erroneous forecast, as long as it prepared the projection on a reasonable basis and disclosed it in good faith. However, the safe harbor rule has not worked well in practice.

Describe the profession's response to fraudulent financial reporting. Fraudulent financial reporting is intentional or reckless conduct, whether through act or omission, that results in materially misleading financial statements. Fraudulent financial reporting usually occurs because of poor internal control, management's poor attitude toward ethics, poor performance, and so on.

APPENDIX 24A BASIC FINANCIAL STATEMENT ANALYSIS

What would be important to you in studying a company's financial statements? The answer depends on your particular interest—whether you are a creditor, shareholder, potential investor, manager, government agency, or labor leader. For example, short-term creditors such as banks are primarily interested in the ability of the firm to pay its currently maturing obligations. In that case, you would examine the current assets and their relation to short-term liabilities to evaluate the short-run solvency of the firm.

Bondholders, on the other hand, look more to long-term indicators, such as the enterprise's capital structure, past and projected earnings, and changes in financial position. Shareholders, present or prospective, also are interested in many of the features considered by a long-term creditor. As a shareholder, you would focus on the earnings picture because changes in it greatly affect the market price of your investment. You also would be concerned with the financial position of the company because it affects indirectly the stability of earnings.

The managers of a company are concerned about the composition of its capital structure and about the changes and trends in earnings. This financial information has a direct influence on the type, amount, and cost of external financing that the company can obtain. In addition, the company managers find financial information useful on a day-to-day operating basis in such areas as capital budgeting, breakeven analysis, variance analysis, gross margin analysis, and for internal control purposes.

PERSPECTIVE ON FINANCIAL STATEMENT ANALYSIS

Readers of financial statements can gather information by examining relationships between items on the statements and identifying trends in these relationships. The relationships are expressed numerically in ratios and percentages, and trends are identified through comparative analysis.

A problem with learning how to analyze statements is that the means may become an end in itself. Analysts could identify and calculate thousands of possible relationships and trends. But knowing only how to calculate ratios and trends without understanding how such information can be used accomplishes little. Therefore, a logical approach to financial statement analysis is necessary, consisting of the following steps.

1. 1. Know the questions for which you want to find answers. As indicated earlier, various groups have different types of interest in a company.
2. 2. Know the questions that particular ratios and comparisons are able to help answer. These will be discussed in this appendix.
3. 3. Match 1 and 2 above. By such a matching, the statement analysis will have a logical direction and purpose.

Several caveats must be mentioned. Financial statements report on the past. Thus, analysis of these data is an examination of the past. When using such information in a decision-making (future-oriented) process, analysts assume that the past is a reasonable basis for predicting the future. This is usually a reasonable approach, but its limitations should be recognized.

Also, ratio and trend analyses will help identify a company's present strengths and weaknesses. They may serve as “red flags” indicating problem areas. In many cases, however, such analyses will not reveal why things are as they are. Finding answers about “why” usually requires an in-depth analysis and an awareness of many factors about a company that are not reported in the financial statements.

Another caveat is that a single ratio by itself is not likely to be very useful. For example, analysts may generally view a current ratio of 2 to 1 (current assets are twice current liabilities) as satisfactory. However, if the industry average is 3 to 1, such a conclusion may be invalid. Even given this industry average, you may conclude that the particular company is doing well if you know the previous year's ratio was 1.5 to 1. Consequently, to derive meaning from ratios, analysts need some standard against which to compare them. Such a standard may come from industry averages, past years' amounts, a particular competitor, or planned levels.

Finally, awareness of the limitations of accounting numbers used in an analysis is important. We will discuss some of these limitations and their consequences later in this appendix.

RATIO ANALYSIS

In analyzing financial statement data, analysts use various devices to bring out the comparative and relative significance of the financial information presented. These devices include ratio analysis, comparative analysis, percentage analysis, and examination of related data. No one device is more useful than another. Every situation is different, and analysts often obtain the needed answers only upon close examination of the interrelationships among all the data provided. Ratio analysis is the starting point. Ratios can be classified as follows.

We have integrated discussions and illustrations about the computation and use of these financial ratios throughout this textbook. Illustration 24A-1 summarizes all of the ratios presented in the textbook and identifies the specific chapters that presented that material.

ILLUSTRATION 24A-1
Summary of Financial Ratios

You can find additional coverage of these ratios, accompanied by assignment material, at the book's companion website, at www.wiley.com/college/kieso. This supplemental coverage takes the form of a comprehensive case adapted from the annual report of a large international chemical company that we have disguised under the name of Anetek Chemical Corporation.

Limitations of Ratio Analysis

The reader of financial statements must understand the basic limitations associated with ratio analysis. As analytical tools, ratios are attractive because they are simple and convenient. But too frequently decision-makers base their decisions on only these simple computations. The ratios are only as good as the data upon which they are based and the information with which they are compared.

One important limitation of ratios is that they generally are based on historical cost, which can lead to distortions in measuring performance. Inaccurate assessments of the enterprise's financial condition and performance can result from failing to incorporate fair value information.

Also, investors must remember that where estimated items (such as depreciation and amortization) are significant, income ratios lose some of their credibility. For example, income recognized before the termination of a company's life is an approximation. In analyzing the income statement, users should be aware of the uncertainty surrounding the computation of net income. As one analyst aptly noted, “The physicist has long since conceded that the location of an electron is best expressed by a probability curve. Surely an abstraction like earnings per share is even more subject to the rules of probability and risk.”²²

Probably the greatest limitation of ratio analysis is the difficult problem of achieving comparability among firms in a given industry. Achieving comparability requires that the analyst (1) identify basic differences in companies' accounting policies and procedures, and (2) adjust the balances to achieve comparability. Basic differences in accounting usually involve one of the following areas.

1. 1. Inventory valuation (FIFO, average-cost).
2. 2. Depreciation methods, particularly the use of straight-line versus accelerated depreciation.
3. 3. Capitalization versus expensing of certain costs.
4. 4. Capitalization of leases versus non-capitalization.
5. 5. Investments in ordinary shares carried under the equity method versus fair value.
6. 6. Differing treatments of postretirement benefit costs.
7. 7. Questionable practices of defining discontinued operations, impairments, and unusual items.

The use of these different alternatives can make a significant difference in the ratios computed. For example, at one time Anheuser-Busch (now AB InBev (BEL)) (USA) noted that if it had used a different inventory method, inventories would have increased approximately $33,000,000. Such an increase would have a substantive impact on the current ratio. Several studies have analyzed the impact of different accounting methods on financial statement analysis. The differences in income that can develop are staggering in some cases. Investors must be aware of the potential pitfalls if they are to be able to make the proper adjustments.²³

Finally, analysts should recognize that a substantial amount of important information is not included in a company's financial statements. Events such as industry changes, management changes, competitors' actions, technological developments, government actions, and union activities are often critical to a company's successful operation. These events occur continuously, and information about them must come from careful analysis of financial reports in the media and other sources. Indeed, many argue in what is known as the efficient-market hypothesis that financial statements contain “no surprises” to those engaged in market activities. They contend that the effect of these events is known in the marketplace—and the price of the company's shares adjusts accordingly—well before the issuance of such reports.

COMPARATIVE ANALYSIS

Comparative analysis presents the same information for two or more different dates or periods, so that like items may be compared. Ratio analysis provides only a single snapshot, for one given point or period in time. In a comparative analysis, an investment analyst can concentrate on a given item and determine whether it appears to be growing or diminishing year by year and the proportion of such change to related items. Generally, companies present comparative financial statements. They typically include two years of statement of financial position information and three years of income statement information.

In addition, many companies include in their annual reports five- or 10-year summaries of pertinent data that permit readers to examine and analyze trends. As indicated in IFRS, “the presentation of comparative financial statements in annual and other reports enhances the usefulness of such reports and brings out more clearly the nature and trends of current changes affecting the enterprise.” Illustration 24A-2 (page 1292) presents a five-year condensed statement, with additional supporting data, of Anetek Chemical Corporation.

ILLUSTRATION 24A-2
Condensed Comparative Financial Information

PERCENTAGE (COMMON-SIZE) ANALYSIS

Analysts also use percentage analysis to help them evaluate and compare companies. Percentage analysis consists of reducing a series of related amounts to a series of percentages of a given base. For example, analysts frequently express all items in an income statement as a percentage of sales or sometimes as a percentage of cost of goods sold. They may analyze a statement of financial position on the basis of total assets. Percentage analysis facilitates comparison and is helpful in evaluating the relative size of items or the relative change in items. A conversion of absolute dollar amounts to percentages may also facilitate comparison between companies of different size.

Illustration 24A-3 shows a comparative analysis of the expense section of Anetek Chemical for the last two years.

ILLUSTRATION 24A-3
Horizontal Percentage Analysis

This approach, normally called horizontal analysis, indicates the proportionate change over a period of time. It is especially useful in evaluating trends because absolute changes are often deceiving.

Another comparative approach, called vertical analysis, is the proportional expression of each financial statement item in a given period to a base figure. For example, Anetek Chemical's income statement using this approach appears in Illustration 24A-4.

ILLUSTRATION 24A-4
Vertical Percentage Analysis

Vertical analysis is frequently called common-size analysis because it reduces all of the statement items to a “common size.” That is, all of the elements within each statement are expressed in percentages of some common number and always add up to 100 percent. Common-size (percentage) analysis reveals the composition of each of the financial statements.

In the analysis of the statement of financial position, common-size analysis answers such questions as: What percentage of the capital structure is equity, current liabilities, and long-term debt? What is the mix of assets (percentage-wise) with which the company has chosen to conduct business? What percentage of current assets is in inventory, receivables, and so forth?

Common-size analysis of the income statement typically relates each item to sales. It is instructive to know what proportion of each sales dollar is absorbed by various costs and expenses incurred by the enterprise.

Analysts may use common-size statements to compare one company's statements from different years, to detect trends not evident from comparing absolute amounts. Also, common-size statements provide intercompany comparisons regardless of size because they recast financial statements into a comparable common-size format.

KEY TERMS

accounts receivable turnover, 1289

acid-test ratio, 1289

activity ratios, 1289

asset turnover, 1289

book value per share, 1290

cash debt coverage, 1290

common-size analysis, 1293

comparative analysis, 1291

coverage ratios, 1289

current cash debt coverage, 1289

current ratio, 1289

debt to assets ratio, 1290

earnings per share, 1290

horizontal analysis, 1293

inventory turnover, 1289

liquidity ratios, 1289

payout ratio, 1290

percentage analysis, 1292

profitability ratios, 1289

profit margin on sales, 1289

quick ratio, 1289

return on assets, 1289

return on ordinary share capital—equity, 1289

times interest earned, 1290

vertical analysis, 1293

Understand the approach to financial statement analysis. Basic financial statement analysis involves examining relationships between items on the statements (ratio and percentage analysis) and identifying trends in these relationships (comparative analysis). Analysis is used to predict the future, but ratio analysis is limited because the data are from the past. Also, ratio analysis identifies present strengths and weaknesses of a company, but it may not reveal why they are as they are. Although single ratios are helpful, they are not conclusive. For maximum usefulness, analysts must compare them with industry averages, past years, planned amounts, and the like.

Identify major analytic ratios and describe their calculation. Ratios are classified as liquidity ratios, activity ratios, profitability ratios, and coverage ratios. (1) Liquidity ratio analysis measures the short-run ability of a company to pay its currently maturing obligations. (2) Activity ratio analysis measures how effectively a company is using its assets. (3) Profitability ratio analysis measures the degree of success or failure of a company to generate revenues adequate to cover its costs of operation and provide a return to the owners. (4) Coverage ratio analysis measures the degree of protection afforded long-term creditors and investors.

Explain the limitations of ratio analysis. Ratios are based on historical cost, which can lead to distortions in measuring performance. Also, where estimated items are significant, income ratios lose some of their credibility. In addition, comparability problems exist because companies use different accounting policies and procedures. Finally, analysts must recognize that a substantial amount of important information is not included in a company's financial statements.

Describe techniques of comparative analysis. Companies present comparative data, which generally includes two years of statement of financial position information and three years of income statement information. In addition, many companies include in their annual reports five- to 10-year summaries of pertinent data that permit the reader to analyze trends.

Describe techniques of percentage analysis. Percentage analysis consists of reducing a series of related amounts to a series of percentages of a given base. Analysts use two approaches. Horizontal analysis indicates the proportionate change in financial statement items over a period of time; such analysis is most helpful in evaluating trends. Vertical analysis (common-size analysis) is a proportional expression of each item on the financial statements in a given period to a base amount. It analyzes the composition of each of the financial statements from different years (a) to detect trends not evident from the comparison of absolute amounts and (b) to make intercompany comparisons of different-sized enterprises.

APPENDIX 24B FIRST-TIME ADOPTION OF IFRS

As discussed in Chapter 1, IFRS is growing in acceptance around the world. For example, recent statistics indicate 40 percent of the Global Fortune 500 companies use IFRS. And the chair of the IASB predicts that IFRS adoption will grow from more than 115 countries to nearly 150 countries in the near future.

When countries accept IFRS for use as accepted accounting policies, companies need guidance to ensure that their first IFRS financial statements contain high-quality information. Specifically, IFRS 1 requires that information in a company's first IFRS statements (1) be transparent, (2) provide a suitable starting point, and (3) have a cost that does not exceed the benefits. [12]

The overriding principle in converting from national GAAP (e.g., U.S., Chinese, or Russian) to IFRS (the conversion process) is full retrospective application of all IFRS. Retrospective application—recasting prior financial statements on the basis of IFRS—provides financial statement users with comparable information. However, the IASB recognizes that full retrospective application may be difficult in some situations, particularly when information related to past periods is not readily available. In response, the IASB has established guidelines to ensure that financial statement users have high-quality comparable information while balancing the costs and benefits of providing comparable data.

GENERAL GUIDELINES

The objective of the conversion process is to present a set of IFRS financial statements as if the company always reported on IFRS. To achieve this objective, a company must:

1. Identify the timing for its first IFRS statements.
2. Prepare an opening statement of financial position at the date of transition to IFRS.
3. Select accounting policies that comply with IFRS and apply these policies retrospectively.
4. Consider whether to apply any optional exemptions and apply mandatory exceptions.
5. Make extensive disclosure to explain the transition to IFRS.

Relevant Dates

Once a company decides to convert to IFRS, it must decide on the transition date and the reporting date. The transition date is the beginning of the earliest period for which full comparative IFRS information is presented. The reporting date is the closing statement of financial position date for the first IFRS financial statements.

To illustrate, assume that FirstChoice Company plans to provide its first IFRS statements for the year ended December 31, 2016. FirstChoice decides to present comparative information for one year only. Therefore, its date of transition to IFRS is January 1, 2015, and its reporting date is December 31, 2016. The timeline for first-time adoption is presented in Illustration 24B-1.

ILLUSTRATION 24B-1
First-Time Adoption Timeline

Illustration 24B-1 shows the following.

1. The opening IFRS statement of financial position for FirstChoice on January 1, 2015, serves as the starting point (date of transition) for the company's accounting under IFRS.
2. The first full IFRS statements are shown for FirstChoice for December 31, 2016. In other words, a minimum of two years of IFRS statements must be presented before a conversion to IFRS occurs. As a result, FirstChoice must prepare at least one year of comparative financial statements (for 2015) using IFRS.
3. FirstChoice presents financial statements in accordance with its national GAAP annually to December 31, 2015.

Following this conversion process, FirstChoice provides users of the financial statements with comparable IFRS statements for 2015 and 2016.

IMPLEMENTATION STEPS

Opening IFRS Statement of Financial Position

As indicated, to start the conversion process, companies first prepare an opening IFRS statement of financial position. This process involves the following steps.

1. 1. Include all assets and liabilities that IFRS requires.
2. 2. Exclude any assets and liabilities that IFRS does not permit.
3. 3. Classify all assets, liabilities, and equity in accordance with IFRS.
4. 4. Measure all assets and liabilities according to IFRS. [13]

Completing this process requires knowledge of both the prior GAAP used and IFRS (which you have obtained by your study of this textbook). To illustrate, the following facts for NewWorld Company are presented in Illustration 24B-2.

ILLUSTRATION 24B-2
Policy Changes—Opening Statement of Financial Position

Adjustments as a result of applying IFRS for the first time are generally recorded in retained earnings. NewWorld makes the following entries on January 1, 2015, to adjust the accounts to IFRS treatment.

In each of these situations, NewWorld adjusts retained earnings for the differences between IFRS and national GAAP to ensure that the opening statement of financial position is reported in accordance with IFRS.

After recording these adjustments, NewWorld prepares its opening IFRS statement of financial position. The January 1, 2015, statement of financial position is the starting point (the date of transition). Subsequently, in 2015 and 2016, NewWorld prepares IFRS financial statements internally. At December 31, 2016, it will formally adopt IFRS.²⁴

Exemptions from Retrospective Treatment

In some cases, adjustments relating to prior periods cannot be reasonably determined. In other cases, it is “impracticable” to provide comparable information because the cost of generating the information exceeds the benefits. The IASB therefore targeted exemptions from the general retrospective treatment where it appeared appropriate. Two types of exemptions are provided—required and elective.

Required Exemptions

The Board identified three areas in which companies are prohibited from retrospective application in first-time adoption of IFRS:

1. 1. Estimates.
2. 2. Hedge accounting.
3. 3. Non-controlling interests.

These required exemptions are imposed because implementation of retrospective application in these areas generally requires companies to obtain information that may not be readily available. In these cases, companies may have to re-create information about past transactions with the benefit of hindsight. [15] For example, retrospective application with respect to non-controlling interests requires information about conditions and estimates made at the time of a business combination—an often difficult task. In addition, this exception provides relief for companies that otherwise might have to determine the allocation of transactions between owners and non-controlling interests in periods prior to the transition period.

Elective Exemptions

In addition to the required exemptions for retrospective treatment, the IASB identified specific additional areas in which companies may elect exemption from retrospective treatment. These exemptions provide companies some relief from full retrospective application. This simplifies the preparation of the first-time IFRS statements. Areas addressed in the textbook are presented in Illustration 24B-3.²⁵

ILLUSTRATION 24B-3
Elective Exemption from Retrospective Treatment

Optional exemption from retrospective treatment is understandable for certain situations. The accounting for the areas identified above generally requires a number of estimates and assumptions at initial recognition and in subsequent accounting. Depending on the accounting under previous GAAP, the information necessary for retrospective application may not be available, or may be obtained only at a high cost. We discuss two examples.²⁶

Exemption Example: Compound Securities. As discussed in Chapter 16, IFRS requires splitting the debt and equity components of convertible debt, using the “with and without” approach. The subsequent accounting for the debt element reflects effective-interest amortization on the estimated debt component. However, if the liability component is no longer outstanding at the date of first-time adoption, retrospective application involves separating two portions of equity. The first portion is in retained earnings and represents the cumulative interest accredited on the liability component. The other portion represents the original equity component. Since the company would not have records on the debt once it is no longer outstanding, it would be costly to re-create that information for retrospective application. As a result, a first-time adopter need not separate these two portions if the liability component is no longer outstanding at the date of transition to IFRS.

Exemption Example: Fair Value or Revaluation as Deemed Cost. Companies can elect to measure property, plant, and equipment at fair value at the transition date and use that fair value as their deemed cost in accounting for those assets subsequent to the adoption of IFRS. This exemption may also be applied to intangible assets in certain situations. By using the exemption, companies avoid re-creating depreciation records for property, plant, and equipment, which is a costly exercise for many companies. In fact, in providing this exemption, the IASB noted that reconstructed cost data might be less relevant to users, and less reliable, than current fair value data. The Board therefore concluded that it would allow companies to use fair value as deemed cost. A company that applies the fair value as deemed cost exemption is not required to revalue the assets subsequent to first-time adoption. [18]²⁷

Presentation and Disclosure

Upon first-time adoption of IFRS, a company must present at least one year of comparative information under IFRS. [19] To comply with IAS 1, an entity's first IFRS financial statements shall include at least three statements of financial position, two statements of comprehensive income, two separate income statements (if presented), two statements of cash flows, and two statements of changes in equity and related notes, including comparative information. Companies must explain how the transition from previous GAAP to IFRS affected its reported financial position, financial performance, and cash flows.

A company's first IFRS financial statements shall include reconciliations of:

• Its equity reported in accordance with previous GAAP to its equity in accordance with IFRS at the transition date.
• Its total comprehensive income in accordance with IFRS to total comprehensive income in accordance with previous GAAP for the same period. The reconciliation should be prepared for latest period in the company's most recent annual financial statements under the previous GAAP. [20]

For example, Jones plc first adopted IFRS in 2016, with a date of transition to IFRS January 1, 2015. Its last financial statements in accordance with previous GAAP were for the year ended December 31, 2015. An example of Jones plc's reconciliations for first-time adoption is provided in Illustration 24B-4 for the non-current assets section of the statement of financial position.

ILLUSTRATION 24B-4
Reconciliation of Equity for 2015

Through this reconciliation, statement users are provided information to evaluate the impact of the adoption of IFRS on the statement of financial position. In practice, it may be helpful to include cross-references to accounting policies and supporting analyses that give further explanation of the adjustments shown in the reconciliations.

The reconciliation for total comprehensive income for Jones with respect to the gross profit section of the income statement is presented in Illustration 24B-5.

ILLUSTRATION 24B-5
Reconciliation of Total Comprehensive Income for 2015

SUMMARY

When companies adopt IFRS, they must ensure that financial statement users receive high-quality information in order to compare financial statements prepared under IFRS and previous GAAP. IFRS guidelines are designed to ensure that upon first-time adoption, financial statements are comparable and that the costs and benefits of first-time adoption are effectively managed.

KEY TERMS

deemed cost, 1298

opening IFRS statement of financial position, 1296

reporting date, 1295

transition date, 1295

Describe the guidelines for first-time adoption of IFRS. Upon first-time adoption of IFRS, a company must prepare and present an opening IFRS statement of financial position at the date of transition to IFRS. This is the starting point for its accounting in accordance with IFRS. The general rule for first-time adoption of IFRS is retrospective application. That is, recast prior financial statements on the basis of IFRS and using the same accounting policies in its opening IFRS statement of financial position and throughout all periods presented in its first IFRS financial statements. Those accounting policies shall comply with each IFRS effective at the end of its first IFRS reporting period. Companies provide at least one year of comparative statements prepared in accordance with IFRS.

Describe the implementation steps for preparing the opening IFRS statement of financial position. Companies must first prepare the opening IFRS statement of financial position by (1) including all assets and liabilities that IFRS requires; (2) excluding any assets and liabilities that IFRS does not permit; (3) classifying all assets, liabilities, and equity in accordance with IFRS; and (4) measuring all assets and liabilities according to IFRS. Companies must make entries through retrospective application. After recording these adjustments, an opening IFRS statement of financial position is prepared, which will reflect application of the same policies that will be applied in the first IFRS financial statements.

Describe the exemptions to retrospective application in first-time adoption of IFRS. Given the range of changes that might be required for first-time adoption, the IASB considered the cost-benefit of retrospective application and developed targeted exemptions from retrospective treatment when the amount of the adjustment relating to prior periods cannot be reasonably determined and when it is “impracticable” to provide comparable information. These exemptions are classified as required (in which a company is prohibited from retrospective application) and optional.

Describe the presentation and disclosure requirements for first-time adoption of IFRS. Upon first-time adoption of IFRS, a company presents at least one year of comparative information under IFRS. A company's first IFRS financial statements shall include at least three statements of financial position, two statements of comprehensive income, two separate income statements (if presented), two statements of cash flows, and two statements of changes in equity and related notes, including comparative information. Companies also must explain how the transition from previous GAAP to IFRS affected its reported financial position, financial performance, and cash flows. A company's first IFRS financial statements shall include reconciliations of its equity and total comprehensive income in accordance with previous GAAP to its equity and comprehensive income in accordance with IFRS.

Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.

1. 1. What are the major advantages of notes to the financial statements? What types of items are usually reported in notes?
2. 2. What is the full disclosure principle in accounting? Why has disclosure increased substantially in the last 10 years?
3. 3. The IASB requires a reconciliation between the effective tax rate and the government's statutory rate. Of what benefit is such a disclosure requirement?
4. 4. What type of disclosure or accounting do you believe is necessary for the following items?
   1. (a) Because of a general increase in the number of labor disputes and strikes, both within and outside the industry, there is an increased likelihood that a company will suffer a costly strike in the near future.
   2. (b) A company reports a loss on a discontinued operation (net of tax) correctly on the income statement. No other mention is made of this item in the annual report.
   3. (c) A company expects to recover a substantial amount in connection with a pending refund claim for a prior year's taxes. Although the claim is being contested, counsel for the company has confirmed the client's expectation of recovery.
5. 5. The following information was described in a note of Canon Packing Co.

   “During August, Holland Products Corporation purchased 311,003 ordinary shares of the Company, which constitutes approximately 35% of the shares outstanding. Holland has since obtained representation on the Board of Directors.”

   “An affiliate of Holland Products Corporation acts as a food broker for Canon Packing in the greater Amsterdam marketing area. The commissions for such services after August amounted to approximately €20,000.” Why is this information disclosed?

6. 6. What are the major types of subsequent events? Indicate how each of the following “subsequent events” would be reported.
   1. (a) Collection of a note written off in a prior period.
   2. (b) Issuance of a large preference share offering.
   3. (c) Acquisition of a company in a different industry.
   4. (d) Destruction of a major plant in a flood.
   5. (e) Death of the company's chief executive officer (CEO).
   6. (f) Additional wage costs associated with settlement of a 4-week strike.
   7. (g) Settlement of an income tax case at considerably more tax than anticipated at year-end.
   8. (h) Change in the product mix from consumer goods to industrial goods.
7. 7. What are diversified companies? What accounting problems are related to diversified companies?
8. 8. What quantitative materiality test is applied to determine whether a segment is significant enough to warrant separate disclosure?
9. 9. Identify the segment information that is required to be disclosed by IFRS.
10. 10. What is an operating segment, and when can information about two operating segments be aggregated?
11. 11. The controller for Lafayette Inc. recently commented, “If I have to disclose our segments individually, the only people who will gain are our competitors and the only people that will lose are our present shareholders.” Evaluate this comment.
12. 12. What are interim reports? Why is a complete set of financial statements often not provided with interim data?
13. 13. What are the accounting problems related to the presentation of interim data?
14. 14. Dierdorf Inc., a closely held corporation, has decided to go public. The controller, Ed Floyd, is concerned with presenting interim data when an inventory write-down is recorded. What problems are encountered with inventories when quarterly data are presented?
15. 15. What approaches have been suggested to overcome the seasonality problem related to interim reporting?
16. 16. An article in the financial press entitled “Important Information in Annual Reports This Year” noted that annual reports include a management commentary section. What would this section contain?
17. 17. “The financial statements of a company are management's, not the accountant's.” Discuss the implications of this statement.
18. 18. Olga Conrad, a financial writer, noted recently, “There are substantial arguments for including earnings projections in annual reports and the like. The most compelling is that it would give anyone interested something now available to only a relatively select few—like large shareholders, creditors, and attentive bartenders.” Identify some arguments against providing earnings projections.
19. 19. The following comment appeared in the financial press: “Inadequate financial disclosure, particularly with respect to how management views the future and its role in the marketplace, has always been a stone in the shoe. After all, if you don't know how a company views the future, how can you judge the worth of its corporate strategy?” What are some arguments for reporting earnings forecasts?
20. 20. What is the difference between an auditor's unmodified opinion or “clean” opinion and a modified one?
21. 21. Jane Ellerby and Sam Callison are discussing the recent fraud that occurred at LowRental Leasing, Inc. The fraud involved the improper reporting of revenue to ensure that the company would have income in excess of $1 million. What is fraudulent financial reporting, and how does it differ from an embezzlement of company funds?
22. 22. Briefly describe some of the similarities and differences between disclosure rules under U.S. GAAP and IFRS.
23. 23. Bill Novak is working on an audit of a U.S. GAAP client. In his review of the client's interim reports, he notes that the reports are prepared on an integral basis. That is, each interim report is viewed as a part of the annual period. Is this acceptable under U.S. GAAP? If so, explain how that treatment could affect comparisons to an IFRS company.
24. *24. “The significance of financial statement data is not in the amount alone.” Discuss the meaning of this statement.
25. *25. A close friend of yours, who is a history major and who has not had any college courses or any experience in business, is receiving the financial statements from companies in which he has minor investments (acquired for him by his now-deceased father). He asks you what he needs to know to interpret and to evaluate the financial statement data that he is receiving. What would you tell him?
26. *26. Distinguish between ratio analysis and percentage analysis relative to the interpretation of financial statements. What is the value of these two types of analyses?
27. *27. In calculating inventory turnover, why is cost of goods sold used as the numerator? As the inventory turnover increases, what increasing risk does the business assume?
28. *28. What is the relationship of the asset turnover to the return on assets?
29. *29. Explain the meaning of the following terms: (a) common-size analysis, (b) vertical analysis, (c) horizontal analysis, and (d) percentage analysis.
30. *30. Briefly explain the need for a standard on first-time adoption of IFRS.
31. *31. How is the date of transition and the date of reporting determined in first-time adoption of IFRS?
32. *32. What are the characteristics of high-quality information in a company's first IFRS financial statements?
33. *33. What are the steps to be completed in preparing the opening IFRS statement of financial position?
34. *34. What is the rationale for exemptions to retrospective application at first-time adoption of IFRS?
35. *35. Briefly describe the required exemptions to retrospective application at first-time adoption of IFRS.
36. *36. What are three elective exemptions to retrospective application at first-time adoption of IFRS?
37. *37. Briefly describe the deemed cost exemption to retrospective application at first-time adoption of IFRS.
38. *38. If a company elects the deemed cost exemption, must it continue to use revaluation accounting subsequent to first-time adoption? Explain.
39. *39. Briefly describe the presentation and disclosure requirements for first-time adoption of IFRS.

*E24-7 (Opening Statement of Financial Position) Goodman Company is preparing to adopt IFRS. In preparing its opening statement of financial position on January 1, 2015, Goodman identified the following accounting policy differences between IFRS and its previous GAAP.

*E24-8 (Opening Statement of Financial Position, Disclosure) Lombardo Group is preparing to adopt IFRS. It is preparing its opening statement of financial position on January 1, 2015. Lombardo identified the following accounting policy differences between IFRS and its previous GAAP.

*P24-3 (Ratio Computations and Additional Analysis) Bradburn Corporation was formed 5 years ago through a public subscription of ordinary shares. Daniel Brown, who owns 15% of the ordinary shares, was one of the organizers of Bradburn and is its current president. The company has been successful but it currently is experiencing a shortage of funds. On June 10, Daniel Brown approached the Hibernia Bank, asking for a 24-month extension on two £35,000 notes, which are due on June 30, 2015, and September 30, 2015. Another note of £6,000 is due on March 31, 2016, but he expects no difficulty in paying this note on its due date. Brown explained that Bradburn's cash flow problems are due primarily to the company's desire to finance a £300,000 plant expansion over the next 2 fiscal years through internally generated funds.

*P24-5 (Dividend Policy Analysis) Matheny Inc. went public 3 years ago. The board of directors will be meeting shortly after the end of the year to decide on a dividend policy. In the past, growth has been financed primarily through the retention of earnings. A share or a cash dividend has never been declared. Presented below is a brief financial summary of Matheny Inc. operations (euros in thousands).

CA24-4 (Subsequent Events) At December 31, 2014, Coburn Corp. has assets of £10,000,000, liabilities of £6,000,000, share capital of £2,000,000 (representing 2,000,000 ordinary shares at £1 par), and retained earnings of £2,000,000. Net sales for the year 2014 were £18,000,000, and net income was £800,000. You are making a review of subsequent events on February 13, 2015, and you find the following.

CA24-5 (Segment Reporting) You are compiling the consolidated financial statements for Winsor Corporation International (WCI). The corporation's accountant, Anthony Reese, has provided you with the segment information shown below.

CA24-7 (Treatment of Various Interim Reporting Situations) The following are six independent cases on how accounting facts might be reported on an individual company's interim financial reports.

CA24-8 (Financial Forecasts) An article in Barron's noted the following.

CA24-9 (Disclosure of Estimates) Nancy Tercek, the financial vice president, and Margaret Lilly, the controller, of Romine Manufacturing Company are reviewing the financial ratios of the company for the years 2015 and 2016. The financial vice president notes that the profit margin on sales has increased from 6% to 12%, a hefty gain for the 2-year period. Tercek is in the process of issuing a media release that emphasizes the efficiency of Romine Manufacturing in controlling costs. Margaret Lilly knows that the difference in ratios is due primarily to an earlier company decision to reduce the estimates of warranty and bad debt expense for 2016. The controller, not sure of her supervisor's motives, hesitates to suggest to Tercek that the company's improvement is unrelated to efficiency in controlling costs. To complicate matters, the media release is scheduled in a few days.

CA24-10 (Reporting of Subsequent Events) In June 2015, the board of directors for McElroy Enterprises Inc. authorized the sale of £10,000,000 of corporate bonds. Jennifer Grayson, treasurer for McElroy Enterprises Inc., is concerned about the date when the bonds are issued. The company really needs the cash, but she is worried that if the bonds are issued before the company's year-end (December 31, 2015) the additional liability will have an adverse effect on a number of important ratios. In July, she explains to company president, William McElroy, that if they delay issuing the bonds until after December 31, the bonds will not affect the ratios until December 31, 2016. They will have to report the issuance as a subsequent event which requires only footnote disclosure. Grayson expects that with expected improved financial performance in 2016 ratios should be better.

*CA24-11 (Effect of Transactions on Financial Statements and Ratios) The transactions listed on page 1317 relate to Wainwright Inc. You are to assume that on the date on which each of the transactions occurred, the corporation's accounts showed only ordinary shares ($100 par) outstanding, a current ratio of 2.7:1, and a substantial net income for the year to date (before giving effect to the transaction concerned). On that date, the book value per share was $151.53.