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FINANCIAL REPORTING USE IN SECURITY
ANALYSIS AND VALUATION
• Decisions by investors to buy, sell, or hold securities depends on
expectations about returns (dividend yield and price appreciation).
• Expectations about returns depend on prospects for an entity’s future
cash flows, and assessing those prospects requires information about
an entity’s
- resources,
- claims on resources, and
- use of the resources by management and board.
• Financial reports are not designed to show the value of a reporting
entity; they provide information to help users estimate the value of the
reporting entity.
• Financial reports do not and cannot provide all the information needed
by investors and creditors. Other pertinent information must be
obtained from other sources.
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IMPORTANCE OF FINANCIAL REPORTING
STANDARDS IN SECURITY ANALYSIS AND
VALUATION
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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. At
year-end, customers owed Incook $15,000 for cookware that had been
delivered (i.e., $57,000 cash was collected from customers and,
therefore, $15,000 remained outstanding from customers).
Incook’s two owners plan to split the profits 50/50. If no accounting
standards existed, what alternatives might be proposed as reasonable
ways to compute the profits?
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EXAMPLE
• Accounting standards limit the range of allowable approaches.
• Incook would report sales revenues of $72,000; however, that amount
would likely be reduced to reflect an estimate for 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 AND
REGULATORY AUTHORITIES
• Generally,
- Standard-setting bodies set the standards and
- Regulatory authorities recognize and enforce the
standards.
• However, regulators often retain the legal authority to
establish financial reporting standards in their jurisdictions
and can overrule private sector standard-setting bodies.
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EXAMPLES OF STANDARD-SETTING BODIES
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EXAMPLES OF REGULATORY AUTHORITIES
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EXAMPLES OF REGULATORY AUTHORITIES
(CONTINUED)
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INTERNATIONAL ORGANIZATION OF
SECURITIES COMMISSIONS (IOSCO)
• Not a regulatory authority, but an international association of
securities regulators formed in 1983
• Objectives of IOSCO members:
- Develop international standards of market regulation to protect
investors and address systemic risks.
- Exchange information and cooperate in enforcement to enhance
investor 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
Required for all private sector reporting entities and as the
Australia
basis for public sector reporting since 2005
Required for consolidated financial statements of banks and
Brazil listed companies from 31 December 2010 and for individual
company accounts progressively since January 2008
Required from 1 January 2011 for all listed entities and
Canada permitted for private sector entities including not-for-profit
organizations
China Substantially converged national standards
All member states of the EU are required to use IFRS as
European Union
adopted by the EU for listed companies since 2005
India India is converging with IFRS at a date to be confirmed
Convergence process ongoing; a decision about a target date
Indonesia
for 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
Permitted from 2010 for a number of international companies;
Japan decision about mandatory adoption by 2016 expected around
2012
Mexico Required from 2012
Republic of
Required from 2011
Korea
Russia Required from 2012
Required for banking and insurance companies. Full
Saudi Arabia
convergence with IFRS currently under consideration.
South Africa Required for listed entities since 2005
Turkey Required for listed entities since 2005
Allowed for foreign issuers in the U.S. since 2007; target date
United States for substantial convergence with IFRS was 2011 and decision
about possible adoption for U.S. companies expected.
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CONTINUING DEVELOPMENTS IN FINANCIAL
REPORTING STANDARDS
• As illustrated on the preceding slides, although many countries have
adopted 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 and
transactions),
- 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-sectional
analysis.
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GLOBAL CONVERGENCE OF ACCOUNTING
STANDARDS: 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) costing
methodology for inventory, which is permitted under U.S. GAAP.
• In the United States, the Internal Revenue Service (IRS) has
conformity provisions such that certain methods of accounting are
allowed for income tax purposes only if the entity also uses that
method for financial reporting purposes. LIFO is one such method
subject to conformity provisions.
• Thus, without a change in IRS rules, eliminating LIFO from U.S. GAAP
would, in effect, eliminate its use for tax purposes as well.
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GLOBAL CONVERGENCE OF ACCOUNTING
STANDARDS: DIFFERENCES REMAIN
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GLOBAL CONVERGENCE OF ACCOUNTING
STANDARDS: DIFFERENCES REMAIN
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GLOBAL CONVERGENCE OF ACCOUNTING
STANDARDS: DIFFERENCES REMAIN
• Despite convergence efforts, differences remain between U.S. GAAP and
IFRS.
Certain Nonfinancial Liabilities
• The recognition of certain nonfinancial liabilities (e.g., contingencies and
environmental liabilities) is governed by the probability that a liability has been
incurred under both U.S. GAAP and IFRS. However, U.S. GAAP and IFRS
differ in their definitions of what is “probable.”
• For example, the definition of probable for 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 under
U.S. GAAP.
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IFRS CONCEPTUAL FRAMEWORK
Reporting Elements
Qualitative Characteristics
Objective
To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity
o Reporting
Constraint Ele
Cost (cost/benefit considerations)
Underlying Assumption
Accrual Basis
Going Concern
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IFRS CONCEPTUAL FRAMEWORK:
OBJECTIVE OF FINANCIAL REPORTING
• At the core of the Conceptual Reporting Elements
Framework is the objective to
provide financial information that Qualitative Characteristics
is useful to current and potential
Objective
providers of resources in making To Provide Financial Information
Useful in Making Decisions about
decisions. Providing Resources to the Entity
objective. o
o
o
Expenses
Capital Maintenance Adjustments
Past Cash Flows
o
o
Liabilities
Equity
o Reporting
Constraint Ele
Cost (cost/benefit considerations)
Underlying Assumption
Accrual Basis
Going Concern
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IFRS CONCEPTUAL FRAMEWORK:
FUNDAMENTAL QUALITATIVE CHARACTERISTICS
Financial Position
represents an economic o
o
o
Income
Expenses
Capital Maintenance Adjustments
o
o
o
Assets
Liabilities
Equity
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IFRS CONCEPTUAL FRAMEWORK:
ENHANCING QUALITATIVE CHARACTERISTICS
• Four enhancing qualitative
Reporting Elements
characteristics that make financial
information useful:
Qualitative Characteristics
- Comparability: Companies record
Objective
and report information in a similar To Provide Financial Information
Useful in Making Decisions about
manner. Providing Resources to the Entity
Relevance*
- Verifiability: Independent people Faithful Representation
Comparability, Verifiability,
Timeliness,
Understandability
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IFRS CONCEPTUAL FRAMEWORK:
REPORTING ELEMENTS
• Elements directly related to the
Reporting Elements
measurement of financial position:
- Assets: Resources controlled by Qualitative Characteristics
the enterprise as a result of past
Objective
events and from which future
To Provide Financial Information
economic benefits are expected to Useful in Making Decisions about
Providing Resources to the Entity
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IFRS CONCEPTUAL FRAMEWORK:
REPORTING ELEMENTS
• Elements directly related to the
Reporting Elements
measurement of performance:
- Income: Increases in economic Qualitative Characteristics
benefits in the form of inflows or
Objective
enhancements of assets or
To Provide Financial Information
decreases of liabilities that result Useful in Making Decisions about
Providing Resources to the Entity
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IFRS CONCEPTUAL FRAMEWORK:
CONSTRAINTS AND ASSUMPTIONS
• Constraint: The benefits of Reporting Elements
information should exceed the
costs of providing it. Qualitative Characteristics
• Underlying Assumptions: Objective
To Provide Financial Information
- Accrual Basis: Financial Useful in Making Decisions about
Providing Resources to the Entity
movements occur.
o Reporting
Constraint Ele
Cost (cost/benefit considerations)
- Going Concern: Assumption
that the company will continue Underlying Assumption
Accrual Basis
in business for the foreseeable Going Concern
future. *Materiality is an aspect of relevance.
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FINANCIAL STATEMENTS
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GENERAL FEATURES OF FINANCIAL
STATEMENTS
• Fair presentation
• Going concern
• Accrual basis
• Materiality and aggregation
• No offsetting
• Frequency of reporting
• Comparative information
• Consistency
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STRUCTURE AND CONTENT REQUIREMENTS
FOR FINANCIAL STATEMENTS (IAS NO. 1)
• Classified statement of financial position: Balance sheet required to
distinguish between current and noncurrent assets and between
current and noncurrent liabilities unless a presentation based on
liquidity provides more relevant and reliable information (e.g., in the
case of a bank or similar financial institution).
• Minimum information on the face of the financial statements: Minimum
line item disclosures on the face of, or in the notes to, the financial
statements are specified.
• Minimum information in the notes (or on the face of financial
statements): Disclosures about information to be presented in the
financial statements are specified.
• Comparative information: For all amounts reported in a financial
statement, comparative information for the previous period is required.
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COHERENT FINANCIAL REPORTING
FRAMEWORK
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DISCLOSURES OF SIGNIFICANT ACCOUNTING
POLICIES
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MD&A DISCLOSURES OF SIGNIFICANT
ACCOUNTING POLICIES: EXAMPLE 1
“In certain instances, accounting principles generally accepted in the United
States of America allow for the selection of alternative accounting methods. The
Company’s 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 such
costs, primarily related to warehousing and outbound freight, in the
Consolidated Statements of Income as a component of Selling, general and
administrative expenses. Accordingly, the Company’s 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 Company’s 2011 Annual Report
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FOOTNOTE DISCLOSURE OF SIGNIFICANT
ACCOUNTING POLICIES: EXAMPLE 1 (CONTINUED)
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FOOTNOTE DISCLOSURE OF SIGNIFICANT
ACCOUNTING POLICIES: EXAMPLE 1 (CONTINUED)
Use of Estimates
“The preparation 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 and
expenses 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 Company’s
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 Company’s 2011 Annual Report
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FOOTNOTE DISCLOSURES OF ACCOUNTING
PRINCIPLES 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 ultimate
parent 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 ACCOUNTING
PRINCIPLES 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-based payment plans...”
Excerpt from footnotes of Henkel 2011 Annual Report
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FINANCIAL REPORTING FRAMEWORK IN PAKISTAN
• Under the Pakistani Companies Ordinance (1984), the Securities and Exchange
Commission of Pakistan notifies the accounting standards that are applied by entities in
Pakistan.
• Pakistan has adopted most but not all International Financial Reporting Standards (IFRSs)
for mandatory application by listed companies, banks and other financial institutions and
Economically Significant Entities (ESE), even when these are not listed.
• IFRSs are usually adopted as issued by the International Accounting Standards Board
(IASB) and generally include 'any further revisions thereof', however, some differences are
worth noting:
• IFRS 1 was not adopted as Pakistan has not adopted all IFRSs.
• Application of the requirements of IFRIC 4 and 12 has been waived for all companies. (A
voluntary application is possible.)
• IAS 39 is currently applied in the 2009 version of the standard.
• IFRS 10, IFRS 11, and the revised versions of IAS 27 and IAS 28 have been adopted
recently, but in doing so their mandatory effective date was set at 1 January 2015. (Earlier
adoption is encouraged.)
• IFRS 12 and IFRS 13 have been adopted with an effective date of 1 January 2015.
• Adoption of IFRS 9 is currently under consideration.
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FINANCIAL REPORTING FRAMEWORK IN PAKISTAN
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SUMMARY
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