IFSA 3

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CHAPTER 3

FINANCIAL REPORTING STANDARDS

Presenters namePresenters titledd Month yyyy

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OBJECTIVE OF FINANCIAL REPORTING

Objective of general purpose financial reporting

- To provide financial information about the reporting entity that isuseful to existing and potential investors, lenders, and othercreditors in making decisions about providing resources to the entity.Those decisions involve buying, selling, or holding equity and debt

instruments and providing or settling loans and other forms of credit.

Investors

- Buy, sell, or hold

Lenders and other creditors

- Lend or not- Amount and terms

Copyright 2013 CFA Institute 2

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FINANCIAL REPORTING USE IN SECURITYANALYSIS AND VALUATION

Decisions by investors to buy, sell, or hold securities depends onexpectations about returns (dividend yield and price appreciation).

Expectations about returns depend on prospects for an entitysfuturecash flows, and assessing those prospects requires information aboutan entitys

- resources,- claims on resources, and

- use of the resources by management and board.

Financial reports are not designed to show the value of a reportingentity; they provide information to help users estimate the value of thereporting entity.

Financial reports do not and cannot provide all the information neededby investors and creditors. Other pertinent information must beobtained from other sources.


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IMPORTANCE OF FINANCIAL REPORTINGSTANDARDS IN SECURITY ANALYSIS AND

VALUATION

Complexity involved in setting standards reflects the complexity of theunderlying economic reality.

Complexity and uncertainty create the need for judgment by preparers.

Judgment can vary among preparers, so standards are needed toachieve consistency.

Even though standards limit the range of acceptable approaches,preparers still must make judgments and use estimates.

By understanding how and when standards require judgments and

estimates that can affect reported numbers, an analyst can make betteruse of the information.


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EXAMPLE

During an accounting period, Incook Inc., a hypothetical company that

imports gourmet cookware sets, had the following transactions:

Acquired office equipment for $9,000 in cash

Paid rent and other miscellaneous business expenses of $10,000

Purchased 100 sets of cookware at a cost of $700 each and paid

100% on delivery Sold 60 sets to customers for $1,200 each ($72,000 total). In order to

make the sales, Incook had to offer credit terms to many customers. Atyear-end, customers owed Incook $15,000 for cookware that had beendelivered (i.e., $57,000 cash was collected from customers and,

therefore, $15,000 remained outstanding from customers).Incookstwo owners plan to split the profits 50/50. If no accountingstandards existed, what alternatives might be proposed as reasonableways to compute the profits?


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EXAMPLEAccounting standards limit the range of allowable approaches.

Incook would report sales revenues of $72,000; however, that amountwould likely be reduced to reflect an estimatefor uncollectible

accounts.

Incook would report cost of goods sold of $42,000.

- It sold 60 units, each of which cost $700.- If the per-unit costs were different, cost of goods sold would require

the choice of inventory cost method.

Incook would report some amount of expense for at least part of the

office equipment. The amount of the expense would depend on- Estimated useful life of the equipment,

- Estimated salvage value of the equipment at the end of its life, and

- Choice of depreciation method.


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STANDARD-SETTING BODIES ANDREGULATORY AUTHORITIES

Generally,

- Standard-setting bodies set the standards and

- Regulatory authorities recognize and enforce thestandards.

However, regulators often retain the legal authority toestablish financial reporting standards in their jurisdictionsand can overrule private sector standard-setting bodies.


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EXAMPLES OF STANDARD-SETTING BODIES

The International Accounting Standards Board (IASB) setsIFRS (International Financial Reporting Standards).

The U.S. Financial Accounting Standards Board (FASB)sets U.S. GAAP (generally accepted accounting

principles).


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EXAMPLES OF REGULATORY AUTHORITIES

Country Regulatory authority with primary responsibility forsecurities regulation in the country

Australia Australian Securities and Investments Commission

Belgium Financial Services and Markets Authority

Brazil Comisso de Valores Mobilirios

China China Securities Regulatory Commission

France Autorit des marchs financiers

Germany Bundesanstalt fr Finanzdienstleistungsaufsicht

India Securities and Exchange Board of India

Japan Financial Services Agency

Morocco Conseil dontologique des valeurs mobilires

Nigeria Securities and Exchange Commission Nigeria


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EXAMPLES OF REGULATORY AUTHORITIES(CONTINUED)

Country Regulatory authority with primary responsibility for

securities regulation in the country

Portugal Comisso do Mercado de Valores Mobilirios

Spain Comisin Nacional del Mercado de Valores

South Africa Financial Services Board

Turkey Capital Markets Board of Turkey

United Kingdom Financial Services Authority*

United States Securities and Exchange Commission (SEC)

Uruguay Banco Central del Uruguay


*FSA to be succeeded by the Financial Conduct Authority and the PrudentialRegulation Authority in 2013.

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INTERNATIONAL ORGANIZATION OFSECURITIES COMMISSIONS (IOSCO)

Not a regulatory authority, but an international association ofsecurities regulators formed in 1983

Objectives of IOSCO members:

- Develop international standards of market regulation to protectinvestors and address systemic risks.

- Exchange information and cooperate in enforcement to enhanceinvestor protection and promote investor confidence.

- Exchange information to assist in development of markets,infrastructure, and regulation.


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IFRS USE AROUND THE WORLD


Country Status for Listed Companies as of December 2011

Argentina

Required for fiscal years beginning on or after 1 January 2012

AustraliaRequired for all private sector reporting entities and as thebasis for public sector reporting since 2005

BrazilRequired for consolidated financial statements of banks andlisted companies from 31 December 2010 and for individualcompany accounts progressively since January 2008

CanadaRequired from 1 January 2011 for all listed entities andpermitted for private sector entities including not-for-profitorganizations

China Substantially converged national standards

European Union

All member states of the EU are required to use IFRS as

adopted by the EU for listed companies since 2005

India India is converging with IFRS at a date to be confirmed

IndonesiaConvergence process ongoing; a decision about a target datefor full compliance with IFRS is expected to be made in 2012

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IFRS USE AROUND THE WORLD


Country Status for Listed Companies as of December 2011

Japan Permitted from 2010 for a number of international companies;decision about mandatory adoption by 2016 expected around2012

Mexico Required from 2012

Republic of

KoreaRequired from 2011

Russia Required from 2012

Saudi ArabiaRequired for banking and insurance companies. Fullconvergence with IFRS currently under consideration.

South Africa Required for listed entities since 2005Turkey Required for listed entities since 2005

United States

Allowed for foreign issuers in the U.S. since 2007; target datefor substantial convergence with IFRS was 2011 and decisionabout possible adoption for U.S. companies expected.

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CONTINUING DEVELOPMENTS IN FINANCIALREPORTING STANDARDS

As illustrated on the preceding slides, although many countries haveadopted IFRS, not all countries have done so.

Financial reporting standards (both IFRS and home-country GAAP)continue to evolve for various reasons, including

- Changes in economic activity (new types of products andtransactions),

- Improvements to existing standards, and

- Convergence between international and home-country standards.

An analyst needs to understand whether and how differences in

financial reporting standards affect comparability in cross-sectionalanalysis.


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GLOBAL CONVERGENCE OF ACCOUNTINGSTANDARDS: DIFFERENCES REMAIN

Different reporting systems are used in different countries. For example, despite convergence efforts, differences remain between

U.S. GAAP and IFRS.

Inventory

IFRS does not allow for the use of the LIFO (last in, first out) costingmethodology for inventory, which is permitted under U.S. GAAP.

In the United States, the Internal Revenue Service (IRS) hasconformity provisions such that certain methods of accounting areallowed for income tax purposes only if the entity also uses that

method for financial reporting purposes. LIFO is one such methodsubject to conformity provisions.

Thus, without a change in IRS rules, eliminating LIFO from U.S. GAAPwould, in effect, eliminate its use for tax purposes as well.


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Despite convergence efforts, differences remain between U.S. GAAPand IFRS.

Measurement of Certain Asset Classes(optionality permitted underIFRS)

Under IFRS, certain assets (e.g., capitalized acquired intangibles andproperty, plant, and equipment) are initially recognized at cost. Forsubsequent measurement, entities have a choice:

- to continue with a cost model or

- To revalue the assets within each class to fair market value (less anysubsequent accumulated amortization or depreciation).

U.S. GAAP does not permit use of a revaluation model.


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Despite convergence efforts, differences remain between U.S. GAAPand IFRS.

Impairment(property, plant, and equipment; inventory; and intangibleassets)

The IFRS models allow for reversals of impairments up to a certainamount if there is an indication that an impairment loss has decreased

U.S. GAAP does not allow reversals of impairments.

The SEC staff believes that the distinction could result in differences in

the timing and extent of recognized impairment losses. Therefore, U.S. issuers could experience greater income statement

volatility if the IFRS models were incorporated (flowing from recoveriesof values previously written down).


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Despite convergence efforts, differences remain between U.S. GAAP andIFRS.

Certain Nonfinancial Liabilities

The recognition of certain nonfinancial liabilities (e.g., contingencies andenvironmental liabilities) is governed by the probability that a liability has been

incurred under both U.S. GAAP and IFRS. However, U.S. GAAP and IFRSdiffer in their definitions of what is probable.

For example, the definition of probablefor contingencies is

- For IFRS, more likely than not to occur.

- For U.S. GAAP, the future event or events are likely to occur.

Likely is considered to be a higher threshold than more likely than not,

meaning U.S. GAAP has a higher recognition threshold than does IFRS.

Therefore, a liability will often be recognized earlier under IFRS than underU.S. GAAP.


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IFRS CONCEPTUAL FRAMEWORK


FinancialPositiono Assetso Liabilities

o Equity

Performanceo Incomeo Expenseso Capital Maintenance Adjustmentso Past Cash Flows

Reporting Elements

Relevance*

Faithful Representation

Comparability, Verifiability,

Timeliness,Understandabilit

Qualitative Characteristics

To Provide Financial InformationUseful in Making Decisions aboutProviding Resources to the Entity

Objective

Constraint Cost (cost/benefit considerations)

Underlying Assumption Accrual Basis

Going Concern

*Materiality is an aspect of relevance.

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IFRS CONCEPTUAL FRAMEWORK:OBJECTIVE OF FINANCIAL REPORTING

At the core of the ConceptualFramework is the objective toprovide financial information thatis useful to current and potentialproviders of resources in making

decisions.All other aspects of the

framework flow from that centralobjective.



o Equity

Performanceo Incomeo Expenseso Capital Maintenance Adjustments

o Past Cash Flows

Reporting Elements

Relevance*





To Provide Financial InformationUseful in Making Decisions about

Providing Resources to the Entity

Objective



Going Concern

Materiality is an aspect of relevance.

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IFRS CONCEPTUAL FRAMEWORK:FUNDAMENTAL QUALITATIVE CHARACTERISTICS

Two fundamentalqualitativecharacteristics that makefinancial information useful:- Relevance:Information that

could potentially make a

difference in users decisions.- Faithful Representation:Information that faithfullyrepresents an economicphenomenon that it purportsto represent. It is ideally- complete,- neutral, and- free from error.



o Equity


o Past Cash Flows

Reporting Elements

Relevance*







Objective



Going Concern


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IFRS CONCEPTUAL FRAMEWORK:ENHANCING QUALITATIVE CHARACTERISTICS

Four enhancingqualitativecharacteristics that make financial

information useful:

- Comparability: Companies record

and report information in a similar

manner.

- Verifiability: Independent people

using the same methods arrive at

similar conclusions.

- Timeliness: Information is available

before it loses its relevance.

- Understandability: Reasonably

informed users should be able to

comprehend the information.



o Equity


o Past Cash Flows

Reporting Elements

Relevance*







Objective



Going Concern


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IFRS CONCEPTUAL FRAMEWORK:REPORTING ELEMENTS

Elements directly related to themeasurement of financial position:

- Assets: Resources controlled bythe enterprise as a result of pastevents and from which futureeconomic benefits are expected toflow to the enterprise.

- Liabilities: Present obligations ofan enterprise arising from pastevents, the settlement of which isexpected to result in an outflow of

resources embodying economicbenefits.

- Equity: Residual interest in theassets after subtracting theliabilities.



o Equity


o Past Cash Flows

Reporting Elements

Relevance*







Objective



Going Concern


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IFRS CONCEPTUAL FRAMEWORK:REPORTING ELEMENTS

Elements directly related to themeasurement of performance:

- Income: Increases in economicbenefits in the form of inflows orenhancements of assets ordecreases of liabilities that resultin an increase in equity (other thanincreases resulting fromcontributions by owners).

- Expenses:Decreases in economicbenefits in the form of outflows or

depletions of assets or increasesin liabilities that result in decreasesin equity (other than decreasesbecause of distributions toowners).



o Equity


o Past Cash Flows

Reporting Elements

Relevance*







Objective



Going Concern


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IFRS CONCEPTUAL FRAMEWORK:CONSTRAINTS AND ASSUMPTIONS

Constraint: The benefits ofinformation should exceed thecosts of providing it.

Underlying Assumptions:

-Accrual Basis: Financialstatements should reflecttransactions in the period whenthey actually occur, notnecessarily when cashmovements occur.

- Going Concern: Assumptionthat the company will continuein business for the foreseeablefuture.



o Equity


o Past Cash Flows

Reporting Elements

Relevance*







Objective



Going Concern


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FINANCIAL STATEMENTS


A complete set of financial statements includes Statement of financial position

Statement of comprehensive income

Statement of changes in equity

Statement of cash flows

Notes

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GENERAL FEATURES OF FINANCIALSTATEMENTS


Fair presentation

Going concern

Accrual basis

Materiality and aggregation

No offsetting

Frequency of reporting

Comparative information

Consistency

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STRUCTURE AND CONTENT REQUIREMENTSFOR FINANCIAL STATEMENTS (IAS NO. 1)


Classified statement of financial position:Balance sheet required todistinguish between current and noncurrent assets and betweencurrent and noncurrent liabilities unless a presentation based onliquidity provides more relevant and reliable information (e.g., in thecase of a bank or similar financial institution).

Minimum information on the face of the financial statements: Minimumline item disclosures on the face of, or in the notes to, the financialstatements are specified.

Minimum information in the notes (or on the face of financialstatements): Disclosures about information to be presented in the

financial statements are specified.

Comparative information: For all amounts reported in a financialstatement, comparative information for the previous period is required.

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COHERENT FINANCIAL REPORTINGFRAMEWORK

Characteristics of a coherentfinancial reportingframework

Transparent

Comprehensive

Consistent

Barriers to creating such aframework

Valuation: alternativemeasurement approaches

Standard-SettingApproach:balancebetween principles andrules.

Measurement: alternativeemphasis on balancesheet versus incomestatement.


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DISCLOSURES OF SIGNIFICANT ACCOUNTINGPOLICIES

Companies are required to disclose their accountingpolicies and estimates in the notes to the financialstatements.

Companies also discuss in the management commentary

(MD&A) those policies that management deems mostimportant. Many of the policies are discussed in both the

management commentary and the notes to the financialstatement.

Companies also disclose information about changes.


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MD&A DISCLOSURES OF SIGNIFICANTACCOUNTING POLICIES: EXAMPLE 1

In certain instances, accounting principles generally accepted in the UnitedStates of America allow for the selection of alternative accounting methods. The

Companys significant policies that involve the selection of alternative methods

are accounting for shipping and handling costs and inventories.

Shipping and handling costs may be reported as either a component of cost of

sales or selling, general and administrative expenses. The Company reports suchcosts, primarily related to warehousing and outbound freight, in the

Consolidated Statements of Income as a component of Selling, general and

administrative expenses. Accordingly, the Companys gross profit margin is not

comparable with the gross profit margin of those companies that include

shipping and handling charges in cost of sales. If such costs had been included

in cost of sales, gross profit margin as a percent of sales would have decreased

by 750 bps, from 57.3% to 49.8% in 2011 and decreased by 730 bps in 2010

and 2009, with no impact on reported earnings.

Excerpt from MD&A in Colgate Palmolive Companys 2011 Annual Report


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FOOTNOTE DISCLOSURE OF SIGNIFICANTACCOUNTING POLICIES: EXAMPLE 1 (CONTINUED)

Shipping and Handling CostsShipping and handling costs are classified as Selling, general and

administrative expenses and were $1,250, $1,142 and $1,116 for

the years ended December 31, 2011, 2010 and 2009, respectively.

Excerpt from footnotes in Colgate Palmolive Companys 2011 Annual Report


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FOOTNOTE DISCLOSURE OF SIGNIFICANTACCOUNTING POLICIES: EXAMPLE 1 (CONTINUED)

Use of EstimatesThepreparation of financial statements in accordance with accounting

principles generally accepted in the United States of America requires

management to use judgment and make estimates that affect the reported

amounts of assets and liabilities and disclosure of contingent gains and losses at

the date of the financial statements and the reported amounts of revenues andexpenses during the reporting period. The level of uncertainty in estimates and

assumptions increases with the length of time until the underlying transactions

are completed. As such, the most significant uncertainty in the Companys

assumptions and estimates involved in preparing the financial statements

includes pension and other retiree benefit cost assumptions, stock-based

compensation, asset impairment, uncertain tax positions, tax valuation

allowances and legal and other contingency reserves. Actual results could

ultimately differ from those estimates.


Excerpt from footnotes in Colgate Palmolive Companys 2011 Annual Report

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FOOTNOTE DISCLOSURES OF ACCOUNTINGPRINCIPLES AND METHODS: EXAMPLE 2

General Information. The consolidated financial statements of Henkel AG &Co. KGaA as of December 31, 2011 have been prepared in accordance with

International Financial Reporting Standards (IFRS) as adopted by the European

Union and in compliance with Section 315a of the German Commercial Code

[HGB].

Scope of consolidation. In addition to Henkel AG & Co. KGaA as the ultimateparent company, the consolidated financial statements at December 31, 2011

include seven German and 170 non-German companies in which Henkel AG &

Co. KGaA has a dominating influence over financial and operating policy, based

on the concept of control..... Compared to December 31, 2010, four new

companies have been included in the scope of consolidation and eleven

companies have left the scope of consolidation. Seven mergers also took place.

The changes in the scope of consolidation have not had any material effect on

the main items of the consolidated financial statements.Excerpt from footnotes of Henkel 2011 Annual Report


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FOOTNOTE DISCLOSURES OF ACCOUNTINGPRINCIPLES AND METHODS: EXAMPLE 2

Accounting estimates, assumptions and discretionary judgments

Preparation of the consolidated financial statements is based on a

number of accounting estimates and assumptions. These have an impact

on the reported amounts of assets, liabilities and contingent liabilities at

the reporting date and the disclosure of income and expenses for the

reporting period. The actual amounts may differ from these estimates.The accounting estimates and their underlying assumptions are

continually reviewed....The judgments of the Management Board

regarding the application of those IFRSs which have a significant impact

on the consolidated financial statements are presented in the explanatory

notes on taxes on income intangible assets..., pension obligations, financial instruments and

share-basedpayment plans...Excerpt from footnotes of Henkel 2011 Annual Report


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SUMMARY

Objective of financial reporting is to provide financial information aboutthe reporting entity that is useful to existing and potential investors,lenders, and other creditors in making decisions about providingresources to the entity.

Fundamentalqualitative characteristics that make financial information

useful include Relevance and Faithful representation (complete, neutral, free from error)

Enhancingqualitative characteristics that make financial informationuseful include Comparability,Verifiability,Timeliness, andUnderstandability

Constraint: benefits of info should exceed costs Underlying Assumptions

Accrual accounting Going concern

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