CHAPTER 2
Financial Reporting Standards

Learning Outcomes

After completing this chapter, you will be able to do the following:

• describe the objective of financial reporting and the importance of financial reporting standards in security analysis and valuation;
• describe the roles of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards;
• describe the International Accounting Standards Board’s conceptual framework, including qualitative characteristics of financial reports, constraints on financial reports, and required reporting elements;
• describe general requirements for financial statements under International Financial Reporting Standards (IFRS);
• describe implications for financial analysis of alternative financial reporting systems and the importance of monitoring developments in financial reporting standards.

Summary Overview

An awareness of financial reporting and underlying financial reporting standards can assist in security valuation and other financial analysis. This chapter describes the conceptual objectives of financial reporting standards, the parties involved in standard-setting processes, and the implication for analysts in monitoring developments in reporting standards.

Some key points of the chapter are summarized below:

• The objective of financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.
• Financial reporting requires policy choices and estimates. These choices and estimates require judgment, which can vary from one preparer to the next. Accordingly, standards are needed to ensure increased consistency in these judgments.
• Private-sector standard-setting bodies and regulatory authorities play significant but different roles in the standard-setting process. In general, standard-setting bodies make the rules, and regulatory authorities enforce the rules. However, regulators typically retain legal authority to establish financial reporting standards in their jurisdiction.
• The IFRS framework sets forth the concepts that underlie the preparation and presentation of financial statements for external users.
• The objective of fair presentation of useful information is the center of the IASB’s Conceptual Framework. The qualitative characteristics of useful information include fundamental and enhancing characteristics. Information must exhibit the fundamental characteristics of relevance and faithful representation to be useful. The enhancing characteristics identified are comparability, verifiability, timeliness, and understandability.
• IFRS Financial Statements: IAS No. 1 prescribes that a complete set of financial statements includes a statement of financial position (balance sheet), a statement of comprehensive income (either two statements—one for net income and one for comprehensive income—or a single statement combining both net income and comprehensive income), a statement of changes in equity, a cash flow statement, and notes. The notes include a summary of significant accounting policies and other explanatory information.
• Financial statements need to reflect certain basic features: fair presentation, going concern, accrual basis, materiality and aggregation, and no offsetting.
• Financial statements must be prepared at least annually, must include comparative information from the previous period, and must be consistent.
• Financial statements must follow certain presentation requirements including a classified statement of financial position (balance sheet) and minimum information on both the face of the financial statements and in the notes.
• A significant number of the world’s listed companies report under either IFRS or US GAAP.
• In many cases, a user of financial statements will lack the information necessary to make specific adjustments required to achieve comparability between companies that use IFRS and companies that use US GAAP. Instead, an analyst must maintain general caution in interpreting comparative financial measures produced under different accounting standards and monitor significant developments in financial reporting standards.
• Analysts can remain aware of ongoing developments in financial reporting by monitoring new products or types of transactions; actions of standard setters, regulators, and other groups; and company disclosures regarding critical accounting policies and estimates.

Problems

1. Which of the following is most likely not an objective of financial statements?
   1. To provide information about the performance of an entity.
   2. To provide information about the financial position of an entity.
   3. To provide information about the users of an entity’s financial statements.
2. International financial reporting standards are currently developed by which entity?
   1. The IFRS Foundation.
   2. The International Accounting Standards Board.
   3. The International Organization of Securities Commissions.
3. US generally accepted accounting principles are currently developed by which entity?
   1. The Securities and Exchange Commission.
   2. The Financial Accounting Standards Board.
   3. The Public Company Accounting Oversight Board.
4. A core objective of the International Organization of Securities Commissions is to:
   1. eliminate systemic risk.
   2. protect users of financial statements.
   3. ensure that markets are fair, efficient, and transparent.
5. According to the Conceptual Framework for Financial Reporting, which of the following is not an enhancing qualitative characteristic of information in financial statements?
   1. Accuracy.
   2. Timeliness.
   3. Comparability.
6. Which of the following is not a constraint on the financial statements according to the Conceptual Framework?
   1. Understandability.
   2. Benefit versus cost.
   3. Balancing of qualitative characteristics.
7. The assumption that an entity will continue to operate for the foreseeable future is called:
   1. accrual basis.
   2. comparability.
   3. going concern.
8. The assumption that the effects of transactions and other events are recognized when they occur, not when the cash flows occur, is called:
   1. relevance.
   2. accrual basis.
   3. going concern.
9. Neutrality of information in the financial statements most closely contributes to which qualitative characteristic?
   1. Relevance.
   2. Understandability.
   3. Faithful representation.
10. Valuing assets at the amount of cash or equivalents paid or the fair value of the consideration given to acquire them at the time of acquisition most closely describes which measurement of financial statement elements?
    1. Current cost.
    2. Historical cost.
    3. Realizable value.
11. The valuation technique under which assets are recorded at the amount that would be received in an orderly disposal is:
    1. current cost.
    2. present value.
    3. realizable value.
12. Which of the following is not a required financial statement according to IAS No. 1?
    1. Statement of financial position.
    2. Statement of changes in income.
    3. Statement of comprehensive income.
13. Which of the following elements of financial statements is most closely related to measurement of performance?
    1. Assets.
    2. Expenses.
    3. Liabilities.
14. Which of the following elements of financial statements is most closely related to measurement of financial position?
    1. Equity.
    2. Income.
    3. Expenses.
15. Which of the following disclosures regarding new accounting standards provides the most meaningful information to an analyst?
    1. The impact of adoption is discussed.
    2. The standard will have no material impact.
    3. Management is still evaluating the impact.