1 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, Chapter 6 Constructing Financial Statements: IFRS and the Framework of Accounting

Overview – Chapter 6 IFRS and the Framework Statement of Comprehensive Income Statement of Financial Position Statement of Cash Flows Accruals accounting & depreciation Special accounting treatments Theoretical perspective on financial statements 2 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

International Financial Reporting Standards (IFRS) International Accounting Standards Board: – to develop a single set of high quality, understandable, enforceable and globally accepted international financial reporting standards; – to promote the use and rigorous application of those standards; – to take account of the financial reporting needs of emerging economies and small and medium-sized entities; and – to bring about convergence of national accounting standards and IFRSs to high quality solutions 3 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Regulation of reporting In the UK, the Financial Reporting Council (FRC) is the independent regulator responsible for promoting high-quality corporate governance and reporting to foster investment. The FRC promotes high standards of corporate governance through the UK Corporate Governance Code, sets standards for corporate reporting, and monitors and enforces accounting and auditing standards 4 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Framework for the Preparation and Presentation of Financial Statements A complete set of financial statements includes a: – Statement of Financial Position (previously Balance Sheet); – Income Statement and/or Statement of Comprehensive Income; – Statement of Changes in Equity (i.e. changes in shareholders’ funds); – Statement of Cash Flows (previously Cash Flow Statement); – Explanatory Policies and Explanatory Notes. 5 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Framework The objectives of financial statements; The qualitative characteristics that determine decision usefulness; The definition, recognition and measurement of the elements from which financial statements are constructed; Concepts of capital maintenance 6 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Users of financial statements investors; employees; lenders; suppliers and trade creditors; customers; government and their agencies; public. Note: managers are not included in this list 7 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Objectives of financial statements to provide information about the financial position, performance and changes in financial position (i.e. cash flow) of an entity that is useful to a wide range of users in making economic decisions (i.e. ‘decision usefulness’). The financial statements show the results of the stewardship or accountability of management for the resources entrusted to them by shareholders. 8 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Qualitative characteristics of financial statements Understandability Relevance Reliability Comparability 9 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Elements of financial statements The elements related to the measurement of financial position in the Statement of Financial Position are assets, liabilities and equity. The elements related to the measurement of performance in the Statement of Comprehensive Income are income and expenses. Measurement: historic cost, current cost, realizable value, present value 10 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Companies Act, 2006 (UK) Requires the financial statements to represent a ‘true and fair view’ of the state of affairs of the company and its profits, and Requires directors to state whether the financial statements have been prepared in accordance with international accounting standards and to explain any significant departures from those standards. 11 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Income and expenses Income is the value of sales of goods or services produced by the business. Expenses are all the costs incurred in buying, making or providing those goods or services and all the marketing and selling, production, logistics, human resource, IT, financing, administration and management costs involved in operating the business 12 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Income statement (Profit and loss account) Gross profit = sales – cost of sales Cost of sales – The cost of providing a service; or – The cost of buying goods sold by a retailer; or – The cost of raw materials and production costs for a manufacturer Operating profit = Gross profit – Expenses – PBIT or EBIT 13 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Statement of Comprehensive Income Companies have two options in reporting comprehensive income: – a single Statement of Comprehensive Income; or – two statements, one an Income Statement, and the second showing the components of other comprehensive income:. foreign currency translation adjustments on investments in overseas subsidiaries; actuarial gains and losses arising from a defined benefit pension plan for employees; revaluations of property, plant and equipment; and changes in the fair value of financial assets. 14 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Statement of Changes in Equity the profit from the Income Statement, other comprehensive income and the payment of dividends out of profits. Various other movements in shareholders’ funds, including the issue of new shares, and the purchase of a company’s own shares 15 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Statement of Financial Position (Balance Sheet) Assets, liabilities and equity at the end of a financial period. Non-current assets: tangible and intangible Current assets: bank, receivables, inventory Non-current liabilities Current liabilities: overdraft, payables 16 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Statement of Financial Position (Balance Sheet) 17 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

The accounting equation Net Assets = Total assets – Total Liabilities = Equity Total Assets (or capital employed) = Total Liabilities + Equity 18 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Accruals basis of accounting Cash v. accruals accounting Matching principle Prepayments Accruals Provisions Depreciation 19 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Prepayments & accruals Prepayments 12 month insurance € cash outflow At year end (31 st March) Expense (¼) €3000 Prepayment (¾) €9000 Accrual Quarterly electricity (Mar. – May) Based on previous year €2400/qtr At year end Mar unpaid – no cash flow Accrual (⅓) €800 Expense € © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Provisions Estimates of possible liabilities that may arise, but where there is uncertainty as to timing or the amount of money. Some are shown as liabilities (e.g. warranty claims), others are shown as deductions from assets: – Doubtful debts – Inventory – Depreciation 21 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Depreciation Asset cost €100,000 Life 4 years Resale value €20,000 Depreciation: 100,000 – 20,000 4 = €20,000 p.a. Cash outflow €100,000 Income Statement: Expense €20,000 Statement of Financial Position: Asset (net): Cost100,000 Less depreciation 20,000 €80, © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Specific accounting treatments Sales taxes Research and development – research is recognized as an expense; – expenditure on development may be recognized as an asset provided specific criteria can be satisfied (income generation) Goodwill Leased equipment – Operating leases: rental expense – Finance leases: treated as if the asset is owned 23 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Accounting for Goodwill Business bought for €1,000,000 Fair value of tangible assets €700,000 Goodwill €300,000 (intangible asset) Amortized over 10 years Income Statement expense each year €30,000 Statement of Financial Position: Goodwill €300,000 Less provision for amortization 30,000 €270,000 Note need for annual impairment test! 24 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Statement of Cash Flows Cash flows from operations (profit adjusted by non- cash expenses and movements in working capital); Cash flows from investing (purchase and sale of non- current assets); Cash flows from financing (borrowings and repayment of debt; new share issues and purchase of a company’s own shares); 25 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Cash flow from operations Cash flow from operations differs from the operating profit because of – depreciation, which as a non-cash expense is added back to profit (since operating profit is the result after depreciation is deducted); – increases (or decreases) in working capital (e.g. changes in Receivables, Inventory, Prepayments, Payables and Accruals), which reduce (or increase) available cash. 26 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Cash flows from investing and financing The major items are: – capital expenditure or the disposal of non-current assets (cash flows from investing); – borrowings and repayments of debt; and – changes in shareholders’ equity (cash flows from financing) all of which affect cash flow, but not profit. 27 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Alternative forms of Statement of Cash Flows Direct method, disclosing major classes of gross cash flows receipts and payments; and Indirect method, whereby profit or loss is adjusted for the effect of non-cash transactions 28 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Statement of Cash Flows (Indirect method) 29 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Differences between the financial statements Income Statement: the profit (or loss) of a business for a financial year, using the accruals method Statement of Financial Position: the assets, liabilities and equity on the last day of the financial year Statement of Cash Flows: the movements in and out of the company’s bank account (or cash equivalents) during a financial year. 30 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Theoretical perspective on financial statements Shareholder value – Separation of ownership from control Agency theory – Contracting between principal and agent to ensure goal congruence – Sharing rule: rewards – Moral hazard & adverse selection: agent’s effort – Information asymmetry Problems with agency theory: – Single principal? – Rational self-interest? – Single period? – Disregard of power, trust, etc. 31 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Critical perspective Almost continual introduction of new and amended standards, making comparisons over longer time periods difficult. Standards that fail to consider practical implementation issues. ‘International’ standards that do not yet incorporate the USA. Lobbying which may influence the development of standards The unclear relationship between the requirement for a ‘true and fair’ view and compliance with accounting standards. The potential for standards to lead to more creative accounting through a focus on presentation rather than the underlying business reality. Standards having a narrow accounting focus rather than being inclusive of non-financial performance and broader accountability issues such as social and environmental accountability 32 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Key points The principles in IFRS and the Framework The main financial statements: – Statement of Comprehensive Income – Statement of Financial Position – Statement of Cash Flows Differences between each financial statement Accruals, prepayments, depreciation and goodwill Theoretical perspective on financial statements 33 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,