an attempt to achieve uniformity Chapter 9 Financial reporting

Slide 6.1

Copyright © 2018, 2016, 2014 Pearson Education, Inc. All Rights Reserved

Part 3

Regulatory framework – an attempt to

achieve uniformity

Chapter 9

Financial reporting – evolution of

global standards

Slide 6.2


The main purpose of this chapter is to describe the

movement towards global standards.

Main purpose

Slide 6.3


Objectives

By the end of the chapter, you should be able to:• critically discuss the arguments for and against

standards;• describe standard setting and enforcement in the UK,

the EU and the US;• discuss the approach taken by the EU with the new

Accounting Directive;• describe and comment on the IASB approach to

financial reporting by small and medium-sized entities (IFRS for SMEs);

• critically discuss the advantages and disadvantages of global standards;

• describe the reasons for differences in financial reporting.

Slide 6.4


Chapter 6 covers

• Need for financial reporting standards

• Need for standards to be mandatory

• Arguments in support of standards

• Arguments against standards

• Standard setting and enforcement under Financial

Reporting Council (FRC)

• The Accounting Council

• The Financial Reporting Review Panel (FRRP)

Slide 6.5


Chapter 6 covers (Continued)

• The International Accounting Standards Board

(IASB)

• Standard setting and enforcement in the EU

• Standard setting and enforcement in the US

• Advantages and disadvantages of global

standards for publicly accountable entities

Slide 6.6


Chapter 6 covers (Continued)

• Reporting requirements for non-publicly accountable

entities

• IFRS for SMES

• Reasons for differences in financial reporting

• Move towards a conceptual framework

Slide 6.7


Role of accounting numbers in defining

contractual entitlements

Contracting parties frequently define the rights between themselves in terms of accounting numbers.

For example, the remuneration of directors and managers might be expressed in terms of a salary plus a bonus based on an agreed performance measure, e.g. Johnson Matthey’s 2016 Annual Report states:

‘The executive directors’ bonus award is based on consolidated underlying profit before tax (PBT) compared with the annual budget’.

Slide 6.8



contractual entitlements – temptation to

manage the numbers

If risk earnings will not grow at a rate attractive to directors

THEN

temptation to take various measures not in the interest of the shareholders.

Think of three Typical measures.

Slide 6.9




manage the numbers (Continued)

Typical measures include:

• Deferring discretionary expenditure, e.g. research, advertising, training expenditure.

• Deferring amortisation, e.g. making optimistic sales projections in order to classify research as development expenditure which can be capitalised.

• Reclassifying deteriorating current assets as fixed assets to avoid the need to recognise a loss under the lower of cost and net realisable value rule applicable to current assets.

Slide 6.10


Mandatory standards change management’s ability to adopt such measures.

This affects wealth distribution within the firm.

For example, IF managers are unable to delay the amortisation of development expenditure, THEN bonuses related to profit will be lower and there will effectively have been a transfer of wealth from managers to shareholders.




Slide 6.11


The effect of changes in mandatory standards on

wealth distribution is a major reason why:(a)

standards are required; and

(b) also why it is difficult to obtain a consensus.

Each party considers the economic consequences,

real or imagined, depending on their personal

position.




Slide 6.12


Why there is a need for mandatory

standards

• Mandatory standards are needed to define the way in which accounting numbers are presented in financial statements.

• Aim is that their measurement and presentation are less subjective.

• Until the 1960s, it was thought that the accountancy profession could obtain uniformity of disclosure by persuasion BUT it is difficult to resist management pressures.

• During the 1960s, confidence in the accountancy profession was lost when internationally known UK-based companies were seen to have published financial data that were materially incorrect.

Slide 6.13


Shareholders are in the dark

• Shareholders are usually unaware that financial statements

are inaccurate.

• Only aware in restricted circumstances

– when a third party has a vested interest in revealing adverse

facts following a takeover; or

– when a company falls into the hands of an administrator,

inspector or liquidator, whose duty it is to enquire and

report on shortcomings in the management of a company.

• Two scandals that disturbed the public at the time,

GEC/AEI and Pergamon press, were both made public in

the restricted circumstances referred to above, when

financial reports prepared from the same basic information

disclosed a materially different picture.

Slide 6.14


GEC takeover of AEI in 1967 – AEI story

• The pre-takeover accounts prepared by the old

AEI directors differed materially from the

post-takeover accounts prepared by the new AEI

directors.

• AEI profit forecast for 1967 as determined by the

old AEI directors.

• AEI Ltd produced a profit forecast of £10 million

in November 1967 and recommended its

shareholders to reject the GEC bid.

Slide 6.15


GEC takeover of AEI in 1967 – AEI story

(Continued)

• The forecast had the blessing of the auditors, in as

much as they said that it had been prepared

– on a fair and reasonable basis

– in a manner, consistent with the principles followed

in preparing the annual accounts.

• The investing public would normally have been

quite satisfied with the forecast figure and the

process by which it was produced.

• AEI would not subsequently have produced other

information to show that the picture was materially

different from that forecast.

Slide 6.16


GEC takeover of AEI in 1967 – GEC story

• GEC was successful with its bid.

• GEC’s directors had control over the preparation of

the AEI accounts for 1967.

• AEI profit for 1967 was determined by the new AEI

directors.

• The accounts of AEI were produced for 1967

showing a loss of £4.5 million.

• From the same basic information used by AEI

when producing its profit forecast.

Slide 6.17


GEC takeover of AEI in 1967 – reasons for

difference

• Two possible reasons for the difference:

– Either the facts have changed; or

– The judgements made by the directors have changed.

• In this case, it seems there was a change in the facts

– To the extent of a post-acquisition closure of an AEI

factory; this explained £5 million of the £14.5 million

difference between the forecast profit and the actual

loss.

• Also, a change in judgement

– The remaining £9.5 million arose because of differences

in judgement. For example, the new directors took a

different view of the value of stock and work-in-progress.

Slide 6.18


Public view of the accounting profession

following these cases

• Known that accountancy is not an exact science.

• BUT not realised how much latitude there was for

companies to produce vastly different results

based on the same transactions.

• Given that the auditors were perfectly happy to

sign that accounts showing either a £10 million

profit or a £4.5 million loss were true and fair, the

public felt the need for action if investors were to

have any trust in the figures that were being

published.

Slide 6.19


Profession’s response

• Each firm of accountants tended to rely on precedents

within its own firm in deciding what was true and fair.

• Fine until the public becomes aware that profits

depend on the particular firm or partner who happens

to be responsible for the audit.

• The auditors were also under pressure to agree to

practices that the directors wanted because there

were no professional mandatory standards.

• An embarrassed profession announced in 1969, via

the ICAEW, that there was a pressing need for the

introduction of Statements of Standard Accounting

Practice to supplement the legislation.

Slide 6.20


Arguments in support of standards

Comparability

• Need to make valid inter-company comparisons of

performance and trends.

• Investors must be supplied with relevant and reliable

data that have been standardised.

• Comparisons are distorted if companies are permitted

to select accounting policies with the intention of

disguising changes in performance and trends.

Slide 6.21


Credibility

• Credibility lost if companies selected different

accounting policies for similar events.

• Uniformity essential if reports are to disclose a

true and fair view.

• However, not intended to be a comprehensive

code of rigid rules.

• Not to supersede informed judgement in

determining what was a true and fair view.


(Continued)

Slide 6.22


Influence

• The process has stimulated the development of a conceptual framework.

• For example, the leasing standard considered the commercial substance of a transaction rather than simply the legal position.

• In the 1970s, no clear statement of accounting principles other than that accounts should be prudent, be consistent, follow accrual accounting procedures and be based on the initial assumption that the business would remain a going concern.

• By 1994, the ASB had produced its exposure drafts of Statement of Accounting Principles, which appeared in final form in December 1999.


(Continued)

Slide 6.23


Arguments against standards

Adverse allocative effects

• Could occur if standard setters did not take account

of the economic consequences flowing from the

standards they issued. For example:

– additional costs could be imposed on preparers;

– suboptimal managerial decisions might be taken to avoid

any reduction in reported earnings.

Slide 6.24


Consensus-seeking

• Can lead to the issuing of standards that are over-

influenced by those with easiest access to the

standard setters as the subject matter becomes more

complex, e.g. capital instruments.

• ASB attempting to minimise such influences by

basing its standards on the Statement of Principles,

but is the Statement of Principles too general?

Arguments against standards (Continued)

Slide 6.25


Overload

• Too many standards

• Too detailed

• Too general-purpose and fail to recognise the

differences between large and small entities

• Too many standard setters with differing

requirements, e.g. FASB, IASB, ASB, national Stock

Exchange listing requirements.

Arguments against standards (Continued)

Slide 6.26


FRC was set up in 1990, operating through:

• ASB – the Accounting Standards Board

• FRRP – the Financial Reporting Review Panel.

Financial Reporting Council (FRC)

Slide 6.27


FRC’s organisation chart

Figure 6.1 FRC structure from 2012

Slide 6.28


Criticism of the FRRP for being reactive

Investor pressure for a more proactive stance

• Following Enron, investors want proactive FRRP.

Proactive stance – European initiative

• The Committee of European Securities Regulators

(CESR) in 2002 issued Statement of Principles:

Definition and Methods of Enforcement of Accounting

Standards in Europe

• Proposed a proactive approach

• Risk-based approach to selecting companies for

investigation.

Slide 6.29


Proactive stance – UK initiative

• The Coordinating Group on Accounting and Auditing

Issues recommended in its Final Report in 2003 that

the FRRP should press ahead urgently with

developing a proactive element to its work.

Criticism of the FRRP for being reactive

(Continued)

Slide 6.30


The FRRP response to the new

requirement for a proactive approach

The Panel proposed that there should be:

• a stepped implementation with a minimum of 300

accounts being reviewed from 2004;

• the development of a risk-based approach to the

selection of published accounts.

Reviews should comprise an initial desk-check of

selected risk areas or whole sets of accounts

followed, where appropriate, with correspondence

to chairpersons.

Slide 6.31


Areas of future focus

In 2015 it reported under Areas of Future Focus that:

• We are currently in a relatively mature corporate reporting

environment, where UK Boards are.

• Generally familiar with the requirements of IFRS and can

apply them appropriately in most circumstances.

• We spend an increasing proportion of our time

– evaluating the significant accounting judgements that Boards

make; and

– the quality of their conclusions, as we know that these areas

are important to investors.

• These significant judgements involve the consideration of

materiality.

Slide 6.32


Areas of future focus (Continued)

• Boards should consider both the quantitative

and qualitative aspects of materiality when

making judgements.

• We may challenge these conclusions if:

we believe the Board may be using a quantitative

materiality argument to achieve a particular

accounting treatment, to justify giving insufficient

prominence to relevant information; or

to avoid the transparency surrounding an error

correction.

Slide 6.33


Review of accounts by the FRC

In 2015, the FRC reported that it had reviewed 252

sets of accounts.

Slide 6.34


FRC targeted in 2015

The ten areas of corporate reporting most frequently raised

with companies

• Strategic Reports

• Accounting policies

• Critical judgements

• Clear and Concise reporting

• Business combinations

• Exceptional and similar items

• Revenue

• Pensions

• Taxation

• Cash flow statements.

Slide 6.35


New Accounting Directive

Pre 2013:

Each EU country had adopted into their national laws

• the Fourth Directive

• the Seventh Directive, and

• the Eighth Directive

in the UK it is the Companies Act 2006

2013:

These directives were subsumed into a new Accounting

Directive.

Slide 6.36


The Fourth Directive had prescribed

• Annual accounts should comprise statements of

income and financial position with supporting

notes to the accounts.

• A choice of formats, e.g. vertical or horizontal

presentation.

• The assets and liabilities to be disclosed.

• The valuation rules to be followed, e.g. historical

cost accounting.

• The general principles underlying the valuations.

Slide 6.37


The Seventh Directive had required

• The consolidation of subsidiary undertakings

across national borders, that is worldwide.

• Uniform accounting policies to be followed by all

members of the group.

• Eliminating inter-company profit and cancelling

inter-company debt.

Slide 6.38


The Eighth Directive had required

• Independent audit committees to have one

financial expert as a member.

• Audit partners to be rotated every seven years.

• The group auditor bears full responsibility for the

audit report.

Slide 6.39


US GAAP

• The USA has the largest economy in the world.

• It is an attractive source of capital for foreign

companies.

• There has been apparent competition for international

supremacy between US GAAP and IFRSs.

• So, appropriate to consider the US regulatory

environment.

• UK and the USA systems of financial reporting have

much in common, BUT

– there are more rules in the USA than in the UK; and

– a greater standardisation and disclosure of information.

Slide 6.40


Legislation

• No direct equivalent of the UK Companies Acts in the

USA.

• The main federal regulation of trade in shares

comprises the Securities Act 1933 and the Securities

Exchange Act 1934. Neither of these includes any

detailed provisions for the form and content of

financial statements.

• The Securities and Exchange Commission (SEC) is

responsible for requiring the publication of financial

information for the benefit of shareholders.

US GAAP (Continued)

Slide 6.41


SOX

• CEO’s of public companies directly responsible for

accuracy of the financial reports.

• Management required to certify the reports.

• Criminal offence to take steps to obstruct

investigations.

Enforcement – The Sarbanes–Oxley Act

2002 (SOX)

Slide 6.42


US GAAP – standard setting

FASB

• The Financial Accounting Standards Board (FASB) is

responsible for setting accounting standards in the USA.

• Its independence is ensured by limiting the voluntary

contributions to its funding from the various public

accounting firms, industry and other interested parties.

• FASB issues the following documents:

– Statements of Financial Accounting Standards, which deal

with specific issues.

– Statements of Concepts, which give general information.

– Interpretations, which clarify existing standards.

– Emerging Issues Task Force.

Slide 6.43


US GAAP – The SEC

• The SEC has the power to dictate the form and content of reports

– The largest companies whose shares are listed must register with the SEC and comply with its regulations.

– The SEC monitors the financial reports filed, in great detail.

• The majority of companies fall outside the SEC’s jurisdiction

– Individual states have the power to introduce their own legislation to control businesses and even set taxes.

Slide 6.44


Progress towards adoption by the USA of

international standards

• There has been continuous collaboration since the Norwalk Agreement in 2002 towards the time when

– the US will cease to require companies using IFRS to lodge reconciliation statements; and

– when it will mandate the use of IFRS by US companies.

• The process

– started with the Norwalk agreement;

– followed by the IASB carrying out a Convergence programme; and

– finally joint standards being issued.

Slide 6.45


In 2002, the Financial Accounting Standards Board (FASB)

and the IASB committed to the development of high-quality,

compatible accounting standards that could be used for

both domestic and cross-border financial reporting.

The aim was to:

(i) make their existing financial reporting standards fully

compatible by undertaking a short-term project aimed at

removing a variety of individual differences between US

GAAP and International Financial Reporting Standards;

(ii) remove other differences between IFRSs and US GAAP

through coordination of their future work programmes by

undertaking discrete, substantial projects on which both

Boards would work concurrently.

The Norwalk agreement

Slide 6.46


• IASB and FASB aimed to remove minor differences by changing their standards. For example,

– the IASB was to change IAS 11 construction contracts, IAS 12 income taxes, IAS 14 segment reporting, IAS 28 joint ventures; and

– the FASB was to change inventory costs, earnings per share and research and development costs.

• By 2008 a number of projects were completed. For example,

– the FASB adopted the IFRS approach to accounting for research and development assets acquired in a business combination (SFAS 141R); and

– the IASB revised its standard on borrowing costs (IAS 23 revised) and segment reporting (IFRS 8).

The short-term project

Slide 6.47


Small companies – statutory requirements

• A small company satisfies two or more of the following conditions:

– Turnover does not exceed £6.5 million.

– Assets do not exceed £3.26 million.

– Average number of employees does not exceed 50.

• Provision for small companies to file abbreviated accounts

– The company is excused from filing a profit and loss account.

– The directors’ report and balance sheet need only be an abbreviated version disclosing major asset and liability headings.

– Privacy is protected by excusing disclosure of directors’ emoluments.

Slide 6.48


FRSSE replaced in UK

The FRSSE was withdrawn from 1 January 2016

and replaced by either:

•FRS 105 The Financial Reporting Standard for

the Micro-entities Regime, or

•Section 1A of FRS 102 The Financial Reporting

Standard.

Slide 6.49


Small companies – IASB position

• In 2009, the IASB issued the IFRS for SMEs.

Public accountability criterion

• Move from size tests to a definition based on qualitative factors such as public accountability.

• SME if it does not have public accountability.

Public accountability test

• Public accountability implied if:

– outside stakeholders have a high degree of either investment, commercial or social interest; and

– the majority of stakeholders have no alternative to the external financial report for financial information.

Slide 6.50


Reasons for differences in reporting

• The character of the national legal system.

• The way in which industry is financed.

• The relationship of the tax and reporting systems.

• The influence and status of the accounting

profession.

• The extent to which accounting theory is

developed.

• Accidents of history.

• Language.

Slide 6.51


Character of the national legal system

• Legal system based on common law

– Importance of equity.

• Legal system based on Roman law

– Importance of codification.

Slide 6.52


Ways in which industry is financed

Figure 6.3 Domestic equity market capitalisation/gross domestic product

Slide 6.53


Ways in which industry is financed

(Continued)

Different information needs.

• Equity investors

– Objective information for stewardship

– Fair information for investment decision-making

– Reliance on external information.

• Loan creditors

– Banks principal lenders and shareholders

– Access to internal information

– Published disclosures less relevant.

Slide 6.54


Relationship of the tax and reporting

systems

• Reporting and tax separate

– Separate rules for computing profit for tax

– Financial reporting less prescriptive.

Slide 6.55


• Primacy to taxation rules

– Allowance only if in the financial accounts

– Possible misinterpretation when comparing

different countries

– Example: treatment of depreciation.

Relationship of the tax and reporting

systems (Continued)

Slide 6.56


Influence and status of the accounting

profession

• If market-sensitive information has been required

– Reliable and relevant information required

– Growth of established profession and audit function

– Impact on accounting regulation.

Slide 6.57


• Where there has been less need for market-

sensitive information

– Less need for expertise

– Less need for financial management.

Influence and status of the accounting

profession (Continued)

Slide 6.58


Accounting theory

• Theory has impacted practice.

• Theory has been developed by the profession as

with the Netherlands influence on current cost

inflation accounting.

• Theory has been developed by academics, as in

the UK, with the influence on current purchasing

power.

Slide 6.59


Accidents of history

• Effect of commercial scandals

– In US led to SEC being set up

– In UK led to publishing accounting standards

– Financial reporting less prescriptive.

• Pooling resources

• External pressures

– Joining EU and becoming subject to Directives

– Imposed.

Slide 6.60


Review questions

1. Why is it necessary for financial reporting to be

subject to (a) mandatory control and (b)

statutory control?

4. ‘The most favoured way to reduce information

overload was to have the company filter the

available information set based on users’

specifications of their needs’. Discuss how this

can be achieved given that users have differing

needs.

Slide 6.61


6. How is it possible to make shareholders aware

of the significance of the exercise of judgement

by directors which can turn profits of £6 million

into losses of £2 million?

Review questions (Continued)

Documents

an attempt to achieve uniformity Chapter 9 Financial reporting