Financial Reporting and Analysis. In this reading
we will talk about the objective of Financial Reporting.
We will then discuss the distinction between Standard-Setting
Bodies and Regulatory authorities. In section 4,
we will talk about the International Financial
Reporting Standards framework or IFRS. We will
also discuss the general requirements for Financial
Statements. In Section 5, we will compare IFRS with
Alternate Reporting Systems such as US GAAP, and
then in section 6, we will discuss the importance
of Monitoring Developments in Financial Reporting
Standards. First a few introductory remarks, financial
reporting standards provide principles for preparing
financial reports and determine the types and amounts
of information that must be provided. So essentially
when accountants create financial reports, they
create those reports based on published financial
reporting standards and this way when financial
analysts are studying the financial reports they
know what standards the reports are based on. There are several financial
reporting standards, but the two major ones are
IFRS and US GAAP. Most of the world uses IFRS, but
in the United States US GAAP is used. The differences
between IFRS and US GAAP used to be significant,
but over time these differences are becoming fewer
and fewer. This reading focuses on the context within
which the standards are created. The objective
of financial reporting is to provide financial
information that is useful to users in making decisions
about providing resources to the reporting entity.
Now we as financial analysts are classical users of
financial reports. A given company, which has the
reporting entity will publish financial reports
and we will study those financial reports before
deciding whether to provide any capital to the company,
if we are equity analyst we will be determining whether
equity capital should be provided. If we are bond
analyst or fixed-income analyst, we will study the
reports to determine whether we should be lending
money to this company. The other aspect of financial
reporting is to influence management actions that
affect or influence the use of the entity's economic
resource. In preparing financial reports companies
must meet or follow financial reporting standards. These financial reporting standards
facilitate comparison across companies, and over time
for a particular company. When we compare different
companies that is called cross-sectional analysis,
and when we look at the performance of a given company
over time that is called time series analysis. Accounting
standards must be flexible enough to recognize
that differences exist in the underlying economics
between businesses. So for example, the banking
business is very different from the manufacturing
business and accounting standards must have the
flexibility to be able to accommodate these differences.
Consider two companies that buy similar equipment
for long-term use; one company expenses and the other
capitalizes. What is the challenge that this might
create and how do financial reporting standards
address such challenges? If you are a financial
analyst you are comparing these two companies from
economic perspective. They are both doing a similar
transaction so they are both buying equipment and
let's say that this equipment is very similar, but
company is A expenses and what this means is, the company
shows the entire cost, let's say the cost is 2 million,
so the company shows the entire cost in the income
statement. So in the year where the equipment was
purchased the income is going to be very low because
the entire hit is taken when the purchase happens.
But company B capitalizes, what that means is company
B creates a asset and then depreciates this asset over say
10 years. What you can see from this very simple example,
is that even though the two companies are performing
the same transaction from an economic perspective,
but by treating them differently from accounting
perspective, they will end up with very different
financial reports and the life of a analyst then
becomes complicated because even with this simple
scenario, he will have to identify the differences
and then be able to make adjustments before he compares
the financial reports. When companies are performing
similar economic transactions those transactions
should be reported in a similar or comparable manner.
Now, let's look at the other element which is flexibility.
Say one company will make extensive use of the equipment
while the other will not. How do financial reporting
standards allow for such a difference? I already
mentioned that Company B plans to use the equipment
over 10 years. Let's say company A will use the
same equipment much more rigorously and the useful
life of the equipment over here with company A is only
3 years. Ideally, financial reporting standards should
give both companies the flexibility to deal with
the economic situation, and if you think about it,
financial reporting standards to allow companies
to define the economic life or the depreciation
life here of the equipment. company A could define a
depreciation life of 3 years and depreciate over
the 3-year period whereas Company B could define a 10-
year life and appreciate over 10 years. So notice
that Accounting Standards do provide flexibility.
Standard-Setting Bodies and Regulatory Authorities.
Standard-Setting Bodies are private sector, self-regulated
organizations. They have board members who are
typically experienced accountant, auditors, analysts
and academics. The two major standard-setting bodies
in the world are FASB which is in the United States,
Financial Accounting Standards Board, and IASB,
which is the International Accounting Standards
Board. They set standards, but do not have the authority
to enforce the standards. Regulatory authorities are government entities.
They are country-specific, SEC is the Regulatory Authority
in the United States, FSA is the Regulatory Authority
in the UK. They have the authority to enforce financial
reporting requirements. So note that since they
are Regulatory Authority they are operating within
the jurisdiction of a given country so they
can enforce requirements. They can overrule private sector standard-setting bodies
and establish standards in the jurisdiction. So
if you have a given country like Germany, even though
Germany follows IFRS, which is published by IASB,
but the Regulatory Authority in Germany can make
minor adjustments to the reporting standards for
their own country. The regulatory authorities regulate capital markets in general.
So the point here is, while they enforce financial reporting
standards they often have a larger mandate which
includes the regulation of capital markets. International
Organization of Securities Commissions or IOSCO.
IOSCO is not a regulatory authority but the members
(such as the SEC) regulate a significant portion of
the world's financial markets. This organization
has established objectives and principles to guide
securities on capital market regulation. So you
can think of IOSCO as an umbrella organization, simplistically,
you can think of it as a United Nations of the regulatory
organizations. So the core objectives that are published
or that are promoted by IOSCO are to protect investors, ensure
fairness, efficiency and transparency, reduce systemic
risk. In other words, rather than every individual
regulatory authority coming up with best practices
what these regulatory authorities have done is
formed this overall organization, called IOSCO,
which publishes the best practices in the form of
objectives and principles which can then be adopted
by each regulatory authority. The major principles
are the following; there should be full, accurate, and
timely disclosure of financial results and risk.
Financial statements should be of a high and internationally
acceptable quality. Let us look at a simple example,
which of the following is least likely to be required
by the SEC for a company which is filing for registration.
Note that you need to learn the material from the
previous slide very well. Clearly the SEC which is
a regulatory authority will require audited financial
statements as noted on the previous slide and assessment
of risks is also going to be required. Since the question
is least likely the correct answer is C or projected
future cash flows. These are very subjective and
while an analyst needs to come up with projected
future cash flows to assess whether or not to buy
a particular security or whether or not to buy a bond
issued by a company, but from a regulatory perspective
it is not necessary. Companies share their future projected
cash flows.