1The annual report – and what underlies it
AN ANNUAL REPORT contains two distinct types of information: quantitative – the financial statements; and qualitative – various reports and a management commentary. These are complex documents and often impenetrable – sometimes intentionally so. The increasing volume and detail of legislation, regulation, rules, accounting standards and codes of practice all contribute to this. The annual report tends to be too long and too complex, using mainly financial information that is unhelpful to the average reader. Accountants are acutely aware of these problems.
The main challenge facing the accounting profession is not just to continue to ensure that the balance sheet balances, but also to help companies in the production of an integrated annual report focusing as much on the quality of management’s current and future involvement in the social, environmental, economic and ethical aspects of their business as on the bottom line of the income statement.
Each time there is a major corporate fraud or mismanagement, or a severe economic crisis, there is pressure either for a change in the role, duties and responsibilities of auditors or directors, or for the disclosure of additional or more detailed information. Deloitte Touche Tohmatsu, one of the “Big Four” professional services firms, estimated that in 1996 the average company report contained some 45 pages; today it is over 100 pages. In 2012 two UK-based banks, HSBC and Royal Bank of Scotland (RBS), published annual reports of more than 500 pages. A typical listed company can be expected to publish a 150-page report which takes more than two months to prepare and approve. There is ever-increasing emphasis on the internet as a means of paperless communication.
In December 1983 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Concept (SFAC) 5, “The Recognition and Measurement in Financial Statements of Business Enterprise”, which stated that a full set of financial accounts of a company should consist of statements of:
In 2013 the Financial Reporting Council (FRC) issued three Financial Reporting Standards (FRS), which, in effect, replaced all previous UK reporting standards and UK generally accepted accounting principles (GAAP) for non-listed companies. FRS 102 includes a description of the financial statements to be provided. International Accounting Standard (IAS) 1, “Presentation of Financial Statements”, issued in 1997 and reviewed in 2011, was adopted by the International Accounting Standards Board (IASB) in 2001. This requires companies’ annual reports to contain a:
These four statements will be found in the annual reports of almost all listed companies. There will also be, where appropriate, comparative figures for the previous year. The financial statements produced by US companies follow US GAAP. UK and listed companies will comply with the IASB’s International Financial Reporting Standards (IFRS).
Information on a company’s financial position is mainly derived from the balance sheet and cash flow statement. The three basic accounting elements related to the balance sheet – assets, liabilities and equity – are discussed in Chapter 2. An assessment of company performance will focus on the income statement and the statement of changes in equity. Income and expense, the two basic elements involved in performance measurement from the income statement, are discussed in Chapter 3.
The annual report comprises three elements: narrative reporting, including the strategic report and the directors’ report; governance statements, including those from the chairman and the directors’ remuneration committee, nominations committee and the audit committee; and the financial statements and allied notes. A typical company annual report will contain:
UK companies should now provide a strategic report – previously there were requirements for the publication of an operating and financial review (OFR) or business review (BR). The strategic report is the equivalent to the management discussion and analysis of financial condition and result of operations (MD&A) statement appearing in US company reports. For UK companies the 2006 Companies Act, as amended in 2013, sets out company financial reporting requirements. Everything is covered, from the maintenance of the necessary financial records, application of accounting standards, the presentation of a “true and fair view” and the necessary audit requirements, to the issue and distribution of the annual report. The act allows companies to continue calling the statement of financial position the balance sheet. It also requires a strategic report to be published detailing company objectives, strategies and performance. You will probably find the full strategic report on a company’s website with an edited version included in the annual report. Shareholders who opt not to receive a company’s full annual report will often be sent the strategic review as an alternative source of information.
It is recognised that if the cost of collecting the information is greater than the benefit of providing it, it is not worth it. The report is expected to be timely. If information takes too long to collect, the report may lose its relevance. A listed company will normally publish its annual report within two months of the financial year end.
To read and use an annual report effectively, you need some understanding of the broad theory and the framework of financial accounting. In 1966 the American Accounting Association defined accounting as:
The process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information.
The mechanics of double entry book-keeping do not need to be mastered. It is extremely unusual for a listed company to run into problems with debit and credit. The book-keeping process required to arrive at a statement of financial position that balances – a balance sheet – can be taken for granted. However, some background might be useful.
Double entry book-keeping
Italy claims to have been the first country in Europe to adopt double entry book-keeping. Luca Pacioli has the accolade of being the first to publish on the subject. In 1494 he wrote De Computis et Scripturis. Little is known of him beyond that he was an itinerant mathematics teacher, an unsuccessful gambler and ended up in a monastery. His book included, for the first time, details of the double entry bookkeeping (debits and credits) system being used in Italy.
Under this system, sometimes referred to as “duality”, every transaction has two entries in the books of account. Whatever amount is entered on the right-hand side (credit) of one account, the same amount is entered on the left-hand side (debit) of another account. This guarantees that at the end of the financial year it is possible to produce an income statement (profit and loss account) disclosing the profit or loss for the year and a balance sheet (statement of financial position) with assets (debit balances) equalling liabilities (credit balances). If whatever was entered on the left-hand side was also entered on the right-hand side, the total of the two sides of all the accounts must equal each other. The books must balance. In 1673 France had legislation requiring companies to prepare an annual balance sheet. It was not until the industrial revolution that bookkeeping and financial reporting gained real impetus in Europe.
Who publishes accounts?
Every commercial business must prepare a set of accounts in order to agree its tax liability. The term “entity” is now used to describe any company or other business organisation. Even when the entity is a charity or otherwise tax exempt, accounts must still be prepared to allow those interested in its activities to assess the adequacy and probity of the management of its operations and assets. All public or nationalised enterprises are expected to produce and publish accounts in order to report not only to the state but also to the people. Any company in which the public has been invited to become involved must publish an annual report containing a set of financial statements (accounts). All other companies with limited liability submit accounts to the tax authorities each year and file them, thus making them available for public scrutiny.
Limited liability
Most trading companies have limited liability. This was introduced in the 1860s to provide shareholders with some protection against a company’s creditors. Shareholders (stockholders) providing a company with capital, through the purchase of stocks and shares, cannot be forced to contribute any further money to the company or its creditors. Having paid the $1 or £1 for a share or unit of stock, they need pay no more. Should the company fail they can lose no more than the $1 or £1 invested; their liability is limited to this amount.
The corporate persona
A company is a legal entity separate from its managers and owners and is referred to as an entity in most accounting standards. It can make contracts, sue and be sued as an individual can. Financial statements are prepared as if the company were an individual. For the purposes of law and accounting, it owns assets and incurs liabilities. This is why the shareholders’ stake in a company is shown as a liability. A company’s net worth or equity is the amount the company owes to its shareholders. After having realised all assets and repaid all loans and creditors, the last act of a company, before it ceases to exist, is to pay what remains to the shareholders – the net worth of the company.
Private and public companies
A quoted or listed company is one whose shares can be bought and sold on a stock exchange. In the UK this is a public limited company (plc). The term “public” refers to the size of the share capital of the company, so a plc does not necessarily have its shares quoted on the stock exchange. Unquoted limited liability companies have “limited” (ltd) in their name. Most countries provide a distinction between public and private companies. For example, in France it is SARL and SA; Germany AG and GmBH; Italy Spa and Srl; the Netherlands NV and BV; Belgium NV and SPRL; Spain SA and SL. In the US various states have their own requirements, but most commonly “corporation” (Corp or Inc) is used for listed companies.
A quoted company must publish more information than a private company. This is to satisfy legislation and the requirements of the listing stock exchange. A private company cannot offer its shares for sale to the public, so different safeguards and reporting requirements apply compared with those for public or stock exchange listed companies. Private companies can be large organisations. In 2013 in the US there were 100 private companies with annual sales in excess of $4 billion, including Mars ($33 billion), which has “freedom” as one of its five key principles.
Listed companies usually give a preliminary statement of the year’s financial performance within a few weeks of the end of their financial year; formal publication of the annual report follows soon after. For private companies, there can often be a considerable delay after the year end before a set of accounts is made public. This can make relevant analysis and comparisons difficult.
Ownership and management
Shareholders or stockholders of a private company are often directly involved in its management, often with members of the family acting as directors. Shareholders of a public company are much less likely to be directly involved in its management. The management of a public company, its directors and managers, is normally clearly separated from the owners of the company, its shareholders. The directors act as stewards of their shareholders’ investment in the company and each year report the result of their management and the financial position of the company. In the UK “stewardship” was commonly used to describe the directors’ relationship with their shareholders, but problems arose in translating this into other languages. “Accountability” is now the preferred term. At the annual general meeting (AGM) directors present the annual report and accounts to shareholders.
Consolidated accounts
Where one company, the parent company, has a controlling interest in other companies, its subsidiaries, it is necessary to prepare consolidated or group accounts. These incorporate all the activities of all the companies in the group to provide a set of consolidated accounts, including an income statement, statement of financial position and cash flow statement. Since the 1900s, UK and US companies have been required to publish consolidated or group accounts. The Seventh Directive on European harmonisation, revised in 2013, deals with group accounts, and since 1970 they have been mandatory for all EU companies. The objective of a set of consolidated accounts is to ensure that shareholders and others interested in the group of companies have adequate information upon which to assess its operations and financial position. IFRS 3 and IAS 27 deal with business combinations and consolidated financial statements.
In addition to the consolidated statement of financial position, UK groups must provide one for the parent company, though this is often relegated to the notes accompanying the annual report. There is no requirement to provide an income statement. The presentation of a parent statement of financial position is not required in the US.
Non-controlling interest
Where a subsidiary is not 100% owned, the non-controlling interest (NCI), outside or minority interest (MI) – the proportion of the subsidiary owned by those other than the parent company – is shown separately in the financial statements. Inevitably, some problems may arise in identifying ownership and control when there are pyramid structures of shareholdings.
All intra-group trading is eliminated to avoid double counting of profits, so only revenue from dealing with customers outside the group of companies is recognised in the income statement. However, non-controlling interests must be credited with their proportion of any profits flowing from intra-group trading. What remains belongs to the parent company.
Details of subsidiaries
With a group of companies, the annual report should provide full details of all subsidiaries. The name, business, geographic location and the proportion of voting or other shares owned by the parent company should be disclosed. If, during the year, a subsidiary has been sold or otherwise disposed of, details should be reported as part of the notes to the accounts on discontinued operations. Any gain or loss on disposal will also be disclosed separately.
Other influences on the annual report
EU Directives
In the UK and the US it is the accounting profession that oversees the development and implementation of accounting rules. In most of continental Europe a country’s government takes on this role. In 1957 the Treaty of Rome set out the objectives for what has become the European Union (EU). Directives are issued which member countries are expected to incorporate into their own legislation. The Fourth Directive (1978) dealt with accounting principles, financial statements and allied information and imposed a standard format for the income statement and balance sheet. It also contained the true and fair view requirement in the preparation of the annual report. The Seventh Directive (1983) dealt with public quoted companies and the presentation of consolidated or group accounts, including the treatment of goodwill. This was adopted in the 1989 Companies Act in the UK. In 2013 the two Directives were consolidated. Since 2005 all EU listed companies have had to use IFRS as the basis for their financial reporting.
Stock exchange listing requirements
In the US the Securities and Exchange Commission (SEC) imposes reporting and disclosure requirements on all listed (quoted) companies, including the filing of 10-K reports (see below). In 2012 the Financial Conduct Authority (FCA) took over this responsibility in the UK.
The stock exchange also reinforces the application of accounting standards by requiring companies to provide a compliance statement and an explanation of any material deviations. The overall objective is to ensure that investors have appropriate information for their buy-hold-sell decisions. China has two stock exchanges, Shanghai (established in 1891) and Shenzhen. In 2005 the first Chinese company was listed on London’s Alternative Investment Market (AIM).
Every company listed on a stock exchange must comply with its listing requirements. This may call for revision of the presentation and content of the financial statements. In 1993 Daimler-Benz complied with US GAAP when it became the first German company to be listed in New York. Today the adoption of IFRS provides an acceptable basis for a stock-exchange listing.
Companies with assets over $75m must file a 10-K report within 60 days of the year end. The SEC (www.sec.gov) provides a good introduction to the content of a 10-K report, How to Read a 10-K. The 10-K often contains more information and financial data than the traditional annual report – with no pictures or graphics to distract the reader – and is presented in a standardised format. In it are the audited financial statements together with a detailed overview of the business and its financial condition. Item 6, “Selected Financial Data”, provides five-year financial information, linking with the more detailed three-year data in Item 8.
There is also a general description of the development of the business noting any material changes in the manner in which it is run. Item 7, “Management Discussion and Analysis of Financial Condition and Results of Operations”, includes a discussion of management’s view of the key risks the facing the business. There will also be a detailed segment analysis by product and/or geographical area, including the naming of any customer accounting for more than 10% of revenues.
The objectives of the annual report
The annual report was designed primarily to satisfy the information needs of existing and possible future shareholders. The financial reports are intended to assist and support their decision-making and to provide the basis for assessing the directors’ management of their investment in the company. Financial statements are not only a historical review; they also aim to assist users to predict the timing, nature and risks of future cash flows.
The annual report is an important document, containing not only the statutory financial statements, tables, notes and management reports but also anything else that the company may wish to disclose. It is the formal report by directors to their shareholders of their performance during the year and the financial position of the company at the year end. It also has an important public relations role.
A listed company may have many thousands of shareholders, and, though only a few hundred are likely to turn up for the AGM where the accounts are formally presented to shareholders, all will receive a copy or, more likely, have access to an electronic copy on the internet. Anyone else interested in the company may also request a copy. Producing the annual report, which is often supported by audio-visual materials and internet access, is therefore a significant cost; a listed company typically spends between $500,000 and $1m on this publication.
In 2010 the IASB approved The Conceptual Framework for Financial Reporting (The Framework), replacing the one issued in 1989, which defined the prime objective of financial reporting as being:
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.
These decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.
A company’s annual report is also expected to provide information on the following:
The UK Companies Act requires listed companies to place their annual accounts on their website “as soon as reasonably practicable”. The simplest way to obtain an annual report is to visit a company’s website. All listed companies have one, usually with a separate “investor relations” section which includes financial information. There are also agencies offering to provide either hard-copy or downloaded annual reports. In the UK the Financial Times (annual report service) offers a user-friendly service at www.ft.com/annual reports.
Annual reports are filed by government agencies. All SEC listed companies in the US file their financial reports and other required information using Edgar (www.sec.gov/edgar.shtml) – a website that provides free access to all such information with the valuable ability to import the data directly into a spreadsheet (see Chapter 10).
In the UK, Companies House (www.companieshouse.gov.uk) collects company statutory accounts and associated information. A company’s annual filing can be downloaded for a nominal £1 fee. In 2013 some 3.1m accounts were on file with more than 76% of companies providing information electronically. Companies House has launched the Free Accounts Data Product to assist public access to company information. Though not yet as user-friendly as Edgar, it will eventually offer a similar service.
Who uses annual reports?
The Framework says that financial reports are “prepared for users who have a reasonable knowledge of business and economic activity and who review and analyse the information diligently”. Seven major users of the annual report can be identified. Companies are expected to provide information on their financial performance and position, the generation and use of cash, and financial adaptability in order to satisfy the information requirements of each user group.
Investors and their advisers
Probably the best concise explanation of the function of the annual report is found in the 2013 FRC Guidance on the Strategic Report:
The purpose of the annual report is to provide shareholders with relevant information that is useful for making resource allocation decisions and assessing management’s stewardship.
Investors – shareholders or stockholders – are the principal target for annual reporting. The annual report is expected to provide them with a basis for assessing the current performance and position of their company as well as giving them some insight into its future prospects. It should also contain information on the strategy being adopted by the company to achieve its objectives including a description of its business model and its governance.
Shareholders range from individuals owning a few shares to institutions owning a large number, and it is a mistake to assume that the requirements of the two groups for information about the company are the same. Meeting the requirements of financial advisers, security analysts and shareholders in a single publication is a difficult task.
Although they own the company, shareholders do not have access to its internal management information systems. They have to rely on published reports to discover how their investment has been managed by directors during the previous year. Shares are normally acquired and retained for future income and capital growth. The annual report provides the basis for assessing past trends, but shareholders will be more interested in the level of dividends and capital growth they are likely to see in the future. In assessing this they will look at a range of measuring sticks covered in Part 2, including dividend cover, rate of return and debt/equity ratios.
The people who advise shareholders, those who earn a living on the strength of their analyses and forecasts of company performance, will look at a wider range of measures and focus closely on indicators of the potential risk of investing in the company. They are generally most interested in the likely future of the company.
Shareholders and power
The majority of shareholders in a typical listed company may make up to 60–80% of the total number of shareholders but own less than 10% of the issued shares. The bulk of the shares – and therefore effective control of the company – is almost always in the hands of a group of institutional shareholders, usually a few hundred. These will include insurance companies, trust and pension funds, banks, private equity funds and other financial institutions. In the UK individuals hold just over 10% of shares. Foreign investors now own close to 50% of UK and US equities.
It is not necessary to own 50% of the shares to control a company. In practice, holding 20% or more of a public company’s shares provides a high degree of control over its actions. Typically, the term “controlling shareholder” is used to refer to a holding of more than 20% of a company’s shares. US GAAP uses 20% equity ownership to define a “significant interest” (see Chapter 2). Details of anyone, excluding directors, owning more than 3% of a company’s equity shares will be found in the annual report, and any transactions with a controlling shareholder will be described.
When a group of institutional shareholders get together to tackle a company they wield formidable power that cannot be ignored by even the most autocratic CEO or chairman. These are the shareholders that the directors must listen to and try to satisfy. They have a significant interest in the company. They are usually well informed and highly competent in financial analysis, and so are generally in a better position to know what is going on than small shareholders.
Lenders
Lenders – providers of long-term and short-term finance to a company – include not only banks, other institutions and wealthy individuals but also suppliers offering goods and services to a company on credit terms. They have strong incentives to assess the company’s performance. They need to be assured that the company can meet the interest payments due on borrowed funds and that the loans they have advanced will be repaid when due. They are therefore likely to focus on profit and cash flow generating capability, and measures of liquidity, solvency and gearing (see Chapters 8 and 9). In assessing this, a company’s creditors often rely on professional credit-rating agencies. There are three major agencies – Fitch, Standard & Poor’s and Moody’s – offering company and country ratings.
Credit ratings for a company can run from AAA (the highest rating) through BBB (adequate) to BB (speculative) to CCC (currently vulnerable) ending with C (bankrupt). A few months before Enron’s collapse, Standard and Poor’s gave the company’s debt an AAA rating. Part of the fallout from the 2008 global financial crisis has been a further denting of credit agencies’ reputations. In 2008 the International Organization of Securities Commissions (IOSCO) published a voluntary code of practice for credit-rating agencies. Gradually the agencies are winning back confidence – companies maintain a careful watch on their rating.
Suppliers
Suppliers need to satisfy themselves that if they provide goods or services on credit to a company they will receive payment. If the company is a major customer, it is important to gain some indication as to its long-term prospects and survival.
Employees and unions
Employees and their advisers or representatives turn to the annual report to help them assess a company’s ability to continue to offer employment and the wages it can afford to pay. Employees who do not turn immediately to the pages detailing the directors’ remuneration usually show greatest interest in information concerning the particular part of the business – the division, factory, section or department – in which they work. Evidence suggests they have less direct interest in, or sympathy for, the company as a whole.
Generally, employees have difficulty reading an annual report, which can create problems for corporate communication. Companies are therefore increasingly providing employees with a separate report, briefing, or audio-visual presentation that provides a clear summary of important matters.
Government and the taxman
Annual reports and the information filed with them may be used by the government for statistical analysis. Regulators will have an interest in the annual reports of companies under their control. Company and personal taxation are often based on the statement of accounting profit given in annual reports. However, in most countries a company’s tax liability is not fixed on the basis of the annual report but on a separate set of accounts and calculations produced for tax purposes and agreed with the tax authority. One exception to this is Germany, where a company’s tax liability is fixed on the basis of the published accounts, and Massgeblichkeitsprinzip (the principle of congruency and bindingness) is the basis for net income definition. As a result, German companies can be expected to favour understating profits in the income statement, and understating assets and overstating liabilities in their financial statements.
Customers
Customers of a company will use its annual report to look for reassurance that it will be in business long enough to fulfil its side of any contracts it has with them. This can be particularly important in the case of, say, a large construction project or the installation of a complex management information system spanning several years, or the provision of a product or service where future continuity of delivery and quality is essential. The failure of a major supplier could have serious cost implications for the customer.
The public
The general public can also be expected to show interest in a company’s annual report. They may be interested in the company’s products or services, local investment and activities, or be considering taking employment with it.
Underlying the annual report
Before reading an annual report, it is sensible to have some appreciation of the basis upon which it has been prepared. Traditionally financial accountants, particularly auditors, were trained to be:
These six Cs are still evident in the preparation and presentation of the annual report. Financial accounting and reporting are governed by what are referred to as assumptions, concepts, principles, conventions, elements and rules. These have evolved over many years. They have been moulded by experience and linked together to provide the framework for the construction of a set of financial statements. They are applicable to every country and company. The underlying assumptions in the preparation of an annual report are as follows.
Money quantification
If it is impossible to reliably place a monetary value on a transaction or an event, it cannot be recorded in the books of account. A rule of thumb for accountants is “if you can’t measure it, ignore it”. This is one reason accountants have such difficulties with intangibles (goodwill, brand names) or the qualitative aspects of a business. For example, the cost of a board of directors can be quantified to two decimal places and appear in the annual report each year. However, the question of what the directors are worth to the company is, at least for the accountant, impossible to answer and so they never appear in the balance sheet, as either an asset or a liability.
Accountants can be cautious in the treatment of intangibles or when quantifying difficult aspects of business costs and expenses. However, if it proves necessary for a measuring rod to be placed against anything, an accountant will prove well up to the task. For example, a company’s employees could be quantified for inclusion in the balance sheet using human-asset accounting, and there is increasing pressure to quantify and report on the environmental aspects of a business.
Each year financial statements are prepared on the assumption that they will form part of a continuing flow of such accounts. For all companies it can be assumed that the financial statements have been prepared on the going-concern basis. Directors consider that their company will continue trading for at least the next 12 months. In other words, it is a going concern. UK Listing Rules and the UK Corporate Governance Code require the annual report to contain a statement from the directors, checked by the auditors, that they consider their company to be a going concern.
Accrual
Merely looking at cash movements during the year and year-end cash balances will not provide a useful basis for assessing either performance or position. The income statement shows the revenue generated during the year and matches it with the costs and expenses incurred in producing it. Income and expenses are included in the income statement at the time the transaction or event took place. This is usually when an invoice is raised, not when the cash relating to the transaction is received or paid. An item is recognised – brought into the accounts – when it occurs, not when cash is received or paid. This is accrual accounting.
The accrual basis of accounting matches income and expenses for the financial year in the income statement without reference to their cash impact. The difference between the timing of the transaction and its translation into a cash movement is shown either as an accrual (money to be paid in a future time period) or a prepayment (money paid in advance for future benefit). This approach provides a much better basis for performance and position analysis and is the basis for all corporate reporting.
Recognition
Accounting standards refer to “recognition”, meaning that an item has been entered in a company’s financial records, the income statement or the balance sheet. Until an event or transaction has actually taken place it should not be taken into account (or recognised) in arriving at the profit or loss for the year. A major customer may, at the end of a company’s financial year, promise a large order. This is good news for the company. It will be recorded in the management information and control systems, and plans may be made to adjust the order book and production schedules. However, until a formal and legally binding agreement is made and executed, nothing has occurred as far as the financial accounting system is concerned. No revenue can be brought into this year’s account. The transaction has not yet taken place and so is quite correctly ignored in the financial statements. Profit is made or realised only when the transaction is completed. For example, a sale is recognised only when the transaction is completed by ownership of the goods passing to the customer.
An asset is recognised in the balance sheet only when its cost or value can be accurately measured and it is expected to provide future economic benefits to the company. A liability must be capable of measurement and an outflow of economic benefits will occur on its settlement.
Asset values may increase as a result of inflation or market changes. This is beneficial for the company but it cannot claim that it has made a profit. Unless the asset is sold, any increase in value must be retained in the balance sheet as part of the shareholders’ equity. A profit can be recognised in the income statement only when the asset is sold.
The elements of financial statements
In 1985 FASB issued SFAC 6, which listed the ten elements relating to corporate financial statements. These still represent the building blocks used in the preparation and presentation of the annual report:
It is easy to consider the term “comprehensive income” as a relatively recent addition to financial reporting terminology. As the FASB’s list above shows, this is not the case.
Generally accepted accounting principles
Over a number of years the accounting profession developed rules and guidelines of best practice, but it was not until the 1930s that these began to be written down and codified. Every country has developed a set of generally accepted accounting principles (GAAP), consisting of a mixture of legislation, stock exchange rules, accounting standards, conventions, concepts and practice. The aim of GAAP is to ensure that the preparation and presentation of financial statements conform to the current best accounting practice. A good source of information on different countries’ GAAP is the Institute of Chartered Accountants in England and Wales (ICAEW) library (www.icaew.com/en/library).
The important words are “generally accepted” and “principles”. GAAP do not comprise an unchanging set of written rules; they provide the skeleton upon which the financial statements must be fleshed out. As circumstances and theory and practice change so do GAAP. The People’s Republic of China is developing its own GAAP. But most countries are now using IFRS and their individual GAAP have less relevance.
Who sets the standards for the UK and US?
Accounting standards in the US began to be developed in 1936 when, encouraged by the SEC, the American Institute of Certified Public Accountants (AICPA) set up the Committee of Accounting Procedures (CAP). In 1973 the FASB (www.fasb.org) replaced the CAP as the source of US financial accounting standards (FAS). The SEC supports these standards for adoption by all listed companies.
The FASB has the task of establishing and communicating US GAAP. Until 2009, US GAAP incorporated the FASB standards, technical bulletins, Emerging Issues Task Force (EITF) statements and interpretation guides. There were also AICPA research bulletins, interpretations and statements of position, and the Accounting Principles Board (APB) opinions. In 2009 the FASB initiated a major restructuring of reporting standards with the Accounting Standards Codification (ASC) “to integrate and synthesize existing US GAAP and offer an online database” – the Codification Research System (CRS). In 2013 the US GAAP Financial Reporting Taxonomy (UGT), based on computer-readable Extensible Business Reporting Language (XBRL) tags (see Chapter 10), was issued. The FASB now provides listed companies in the US with a comprehensive online source of guidance for their financial reporting – the only source of US GAAP.
The ICAEW (www.icaew.com) began to issue Recommendations on Accounting Principles for the UK in 1942. In 1970 the Accounting Standards Committee (ASC) was set up, and its first Statement of Standard Accounting Practice (SSAP) issued in 1971. Between 1971 and 1990 24 SSAPs were issued. In 1990 the Financial Reporting Council (FRC – www.frc.org.uk) was established with its subsidiary, the Accounting Standards Board (ASB), replacing the ASC as the UK accounting and auditing standards setter, and was recognised under the 1985 Companies Act for this purpose. In January 2014 the FRC restated its mission as being “to promote high-quality corporate governance and reporting”. The FRC co-operates with the IASB on the development of international financial reporting standards.
The FRC was reorganised in 2012. It now sets UK accounting standards – Financial Reporting Standards (FRS) – and is recognised by UK company law. It has two main committees. The Codes and Standards Committee provides advice on the maintenance of an effective framework of UK codes and standards and on corporate governance issues; it also co-operates with the various international accounting standards setters. The Conduct Committee monitors companies to ensure they comply with the 2006 Companies Act and FRS in their reporting. There are currently 30 FRS in issue. The aim is to promote and police high-quality corporate reporting. Companies may be required to amend their accounts if they do not satisfy the FRC. Financial Reporting Standards for Smaller Entities (FRSSE) are also issued.
FRS 102
The FRC recognised that there was little sense in having two separate sets of accounting standards: UK GAAP and IFRS. In March 2013 it published FRS 102, “The Financial Reporting Standard applicable in the UK and Republic of Ireland”, updating and consolidating UK accounting standards. It is intended to ensure that a company’s financial statements provide a true and fair view and became effective from 2014.
FRS 102 goes a long way towards bringing UK GAAP and IFRS into line. The fact that it is only some 300 pages long, compared with nearly 3,000 pages of UK GAAP, is impressive. It provides a much needed reference work for the preparation of financial statements. It will be revised as necessary every three years.
FRS 100 gives an overview of the financial reporting framework and FRS 101 deals with reduced disclosure by qualifying entities. From 2014 listed companies may choose to adopt FRS 101 and 102 in their reporting or continue with IFRS guidance.
International accounting standards
In 1973 the professional accounting bodies of Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the UK and the US formed the International Accounting Standards Committee (IASC). Over its lifetime it issued 41 International Accounting Standards (IAS – see list below).
In 2000 the SEC, the IOSCO and the EU endorsed the use of international accounting standards in company financial reporting. In 2001 the International Financial Reporting Standards Foundation was established and the International Accounting Standards Board (IASB) replaced the IASC as the international standard-setting body. The IASB is an independent private institution that issues international financial reporting standards (IFRS – see list below). The IFRS Foundation’s objective is “to develop a single set of high-quality, understandable, enforceable and globally accepted International Financial Reporting Standards (IFRS) through its standard-setting body, the International Accounting Standards Board (IASB)”.
The original objective of the IASB was to bring about the international convergence and harmonisation of corporate reporting through the adoption of a set of global standards. In 2006 the chairman of the IASB stated:
A common financial language, applied consistently, will enable investors to compare the financial results of companies operating in different jurisdictions more easily and provide more opportunity for investment and diversification. The removal of a major investment risk – the concern that the nuances of different national accounting regimes have not been fully understood – should reduce the cost of capital and open new opportunities for diversification and improved investment returns.
The IASB is supported by a technical advisory body, the Accounting Standards Advisory Forum (ASAF), which aims to improve global co-operation between standard setters and to advise the IASB as it develops IFRS. The International Financial Reporting Issues Committee (IFRIC) – previously named the Standing Interpretations Committee (SIC) – assists with the practical interpretation of IFRS. The EU and more than 100 countries apply IFRS.
The IASB website (www.iasb.org) contains detailed information on IFRS. Deloitte offers a useful website (www.iasplus.com) as does KPMG (www.KPMG.com/global). It is worth having a look at any of the large accounting firms’ websites to see what is available and which you find easiest to work with.
Adopting IFRS
National GAAP still exist in Europe, but the EU has endorsed IFRS for listed companies – more than 7,000 now use these. US companies still look to the FASB for reporting guidance and some 15,000 listed companies apply US GAAP. In 2002 the IASB and the FASB signed the Norwalk Agreement to work together to improve financial reporting standards and eventually to achieve convergence – aligning US accounting standards with IFRS. The aim is to provide a basis for the provision of a “cohesive financial picture” of a company.
In 2013 the ASAF was set up to assist the IASB in its collaboration with FASB in the production of a set of globally accepted financial reporting standards. The word “convergence” is no longer used; the emphasis has shifted to the development of global standards.
From November 2007 foreign companies have been exempt from reconciling their accounts with US GAAP as long as they have complied with IFRS. This has considerably eased the complexity and cost of listing for these companies.
International Accounting Standards (IAS)
IAS 1 |
Presentation of Financial Statements |
IAS 2 |
Inventories |
IAS 7 |
Cash Flow Statements |
IAS 8 |
Accounting Policies |
IAS 10 |
Events after the Balance Sheet Date |
IAS 11 |
Construction Contracts |
IAS 12 |
Income Taxes |
IAS 16 |
Property, Plant and Equipment |
IAS 17 |
Accounting for Leases |
IAS 18 |
Revenue |
IAS 19 |
Employee Benefits |
IAS 20 |
Accounting for Government Grants |
IAS 21 |
The Effects of Changes in Foreign Exchange Rates |
IAS 23 |
Borrowing Costs |
IAS 24 |
Related-Party Disclosures |
IAS 26 |
Accounting and Reporting by Retirement Benefit Plans |
IAS 27 |
Consolidated and Separate Financial Statements |
IAS 28 |
Accounting for Investment in Associates |
IAS 29 |
Financial Reporting in Hyperinflationary Economies |
IAS 31 |
Financial Reporting of Interests in Joint Ventures |
IAS 32 |
Financial Instruments |
IAS 33 |
Earnings Per Share |
IAS 34 |
Interim Financial Reporting |
IAS 36 |
Impairment of Assets |
IAS 37 |
Provisions, Contingent Liabilities, and Contingent Assets |
IAS 38 |
Intangible Assets |
IAS 39 |
Financial Instruments: Recognition and Measurement |
IAS 40 |
Investment Property |
IAS 41 |
Agriculture |
International Financial Reporting Standards (IFRS)
IFRS 1 |
First-Time Adoption of IFRS |
IFRS 2 |
Share-Based Payment |
IFRS 3 |
Business Combinations |
IFRS 4 |
Insurance Contracts |
IFRS 5 |
Non-current Assets Held for Sale and Discontinued Operations |
IFRS 6 |
Exploration for and Evaluation of Mineral Resources |
IFRS 7 |
Financial Instruments: Disclosures |
IFRS 8 |
Operating Segments |
IFRS 9 |
Financial Instruments |
IFRS 10 |
Consolidated Financial Statements |
IFRS 11 |
Joint Arrangements |
IFRS 12 |
Disclosure of Interest in other Entities |
IFRS 13 |
Fair Value Measurement |
IFRS 14 |
Regulatory Deferral Accounts |
IFRS 15 |
Revenue from Contracts with Customers |
The accounting standards setters are to be congratulated. Wading through a terrifying mix of linguistics and semantics, accounting theory and practice, national and professional body pressures, with big business and political “assistance” always available, they have managed to produce a usable framework for future international developments. A former chairman of the IASC made the case for accounting standards: “In a rapidly globalising world, it only makes sense that the same economic transactions are accounted for in the same manner.”
In 1989 the IASC published the Framework for the Preparation and Presentation of Financial Statements (the Framework) to provide the basis for company reports and the principles upon which future accounting standards would be based. It was not an accounting standard but was intended to be the base reference point for all IFRS. This relieved individual accounting standards of the burden of restating definitions, principles or assumptions. The Framework, for the first time, provided definitions of asset, liability, income and expense. The underlying assumptions and qualitative characteristics of financial statements were also dealt with. In 2001 the Framework was adopted by the IASB to form the basis for its work in developing IFRS.
In 2004, following on from the 1989 Framework, the IASB and the FASB jointly began work on a conceptual framework for financial reporting. The first stages were published in September 2010 when the FASB issued SFAC 8, “The Objective of General Purpose Financial Reporting and Qualitative Characteristics of Useful Financial Information” replacing SFAC 1 and 2. The IASB published the same document as The Conceptual Framework for Financial Reporting 2010.
Progress on the joint FASB and IASB activity then slowed down and in 2012 the IASB decided to continue working alone. In 2013 a discussion paper of over 200 pages was published to provide the basis for the revision and amendment of the Framework, hopefully to be completed by the end of 2015. This was followed in January 2014 with a Review of the Conceptual Framework for Financial Reporting.
The FASB has been rules-based, producing detailed standards to be followed exactly by companies. Each time a standard was revised to overcome a specific problem it was not long before companies developed new means of avoiding its impact. The IASB has been more principles-based, with standards indicating the way to provide financial information rather than specific instructions. Paul Boyle of the FRC summed it up: “If you have a precise rule it also makes it possible to design something that is precisely just outside the rule.”
The Framework provides the basic concepts that underlie the preparation of financial statements and allows standards to be principles-based rather than a set of detailed rules. There are pros and cons to both approaches. The collapse of Enron showed the shortcomings of the FASB approach, and the IASB’s non-specific standards may make international comparisons difficult. Also the lack of precise guidelines can place auditors under considerable pressure. Neither approach is foolproof: and combining the two is taking time.
Fundamental qualitative characteristics
In the Framework, the IASB and the FASB identified two fundamental qualitative characteristics of financial information: relevance and faithful representation. If the financial information provided by a company is to be useful to investors, lenders and other creditors, it must incorporate these two characteristics.
Relevance and materiality
The information contained in the annual report must be relevant to users’ needs. A company may show an asset in the balance sheet at a cost-based valuation. Cost is easy to find and reliable. However, the current market value of the asset – its fair value – is probably more relevant to those using the financial statements of the company. SFAC 8 and the IASB Framework see relevance and faithful representation as being the fundamental qualitative characteristics of a financial report. Relevance is defined as: “Relevant financial information is capable of making a difference in the decisions made by users.”
Materiality is seen as one factor contributing to relevance. Only items of sufficient importance to influence the decisions the users of financial statements might take need to be disclosed. The intention is to ensure that all appropriate information is made available to such users. Materiality is not quantified by the IASB but left to the company to decide. This is a further example of principles-based rather than rules-based accounting standards:
Information is material if omitting it or misstating it could influence the decisions that users make on the basis of the financial information about a specific reporting entity.
The 10% rule offers a rough guide to materiality in terms of size. For example, in segmental reporting, if a classification of sales revenue represents more than 10% of total revenues, it should be reported separately. IAS 1 makes clear that all material items, or classes of items (aggregation), should be shown separately in the financial statements. It also provides limitations to the “offsetting” (netting) of revenue and expenses or assets and liabilities, this being allowed only in limited cases.
Faithful representation
In the UK both the 1947 and the 1985 Companies Act make reference to the true and fair view requirement of financial reporting. The term was adopted in the EU’s Fourth Directive but is not to be found in US GAAP. A definition of true and fair has never been provided in either UK legislation or EU Directive, but for some 50 years it remained the prime objective of company reporting. It was assumed that everyone knew what it meant.
In 2008 the FRC took a legal opinion that confirmed the overriding importance of the true and fair view in financial statements. Now, if a recently qualified accountant were asked to define the objective of an annual report, the reply would almost certainly include reference to “faithful representation” rather than a “true and fair view”. FRS 102 explains that fair presentation or faithful representation is beginning to replace true and fair view.
The IASB and the FASB use the term “faithful representation” as the overriding objective of financial reporting. The application of US GAAP or IFRS, with additional disclosure when necessary, is presumed to result in a set of financial statements that achieve a faithful representation. This requires that the information contained in the financial statements should be accurate, timely, error free, unbiased and complete, and should clearly reflect the substance rather than the form of transactions and events.
It has long been agreed that financial statements should always adopt substance over form – “it’s not what I say but what I mean”. Merely to follow the legal form may not fully explain the commercial or business implications of what has occurred. It is more important for the basics of a transaction or event to be understood. FRS 102 and the 2006 Companies Act require that a company’s financial statements should clearly reflect the economic reality of any material transaction or event that has taken place during the year. This is an essential contributor to faithful representation: “Transactions and other events should be accounted for and presented in accordance with their substance and not merely their legal form.”
The annual report has a variety of users each with differing interests. It may be used as a basis for buying or selling a company’s shares or even the company itself, or granting credit to, purchasing a product from, taking a job with, or lending money to a company. Because it is impossible in a single set of financial statements to meet all the requirements of all users, it is best for accountants to be cautious in presenting the figures. The 1989 Framework included “prudence” as a qualitative characteristic of financial reports.
To help avoid overoptimistic definitions of profit in the income statement or asset valuation in the balance sheet, accountants developed the rule of prudence, caution, or conservatism. Profit or asset values should never knowingly be overstated. For financial accounting and reporting this was condensed to:
The Framework made clear that prudence should never give rise to hidden reserves or excessive provisions – creative accounting. However, prudence in preparing and presenting the figures appearing in financial statements was seen as important. For example:
The Framework does not include prudence as a separate characteristic of financial information. The argument is that using prudence to reflect conservative estimates of asset values is applying a bias and conflicts with neutrality:
Understating assets or overstating liabilities in one period frequently leads to overstating financial performance in later periods – a result that cannot be described as prudent or neutral.
Faithful representation requires the information to be complete, neutral and free from error.
Enhancing qualitative characteristics
The Framework defines the four enhancing qualitative characteristics necessary for preparation of a relevant and faithfully presented financial report.
Comparability
A major dilemma for accountants is that accounting problems rarely have a single solution; usually there are several perfectly acceptable alternatives. This has given rise to the apocryphal story of a chief executive who is said to have advertised for an accountant with only one arm as he was tired of being told “on the one hand … but then on the other hand …”.
The treatment of items in the preparation of a financial report is expected to be consistent, and thereby comparable, from year to year. A company could massage its profits for the year simply by changing its accounting policy: for example, by adjusting the inventory valuation or depreciation method. What may appear to be in the best interests of the company one year may not be in the next. If companies were allowed each year to change their methods of asset valuation and depreciation charging or the treatment of costs and expenses, it would be impossible to compare previous years’ financial statements with the current ones. These financial statements would be of little value in comparing the performance and financial position of a company over a number of years and with that of other companies. Without consistency in presentation there can be no comparability.
Unless there is a statement to the contrary, it can be assumed that the underlying accounting policies for the preparation of this year’s financial statements are the same as for the previous year. As far as possible, from one year to the next, there should be consistency of terminology, calculation and presentation of all items included in the financial statements to allow comparisons to be made.
Companies can of course correctly decide to change an accounting policy in order to improve the quality of information being provided. When this occurs the notes in the annual report should clearly state the nature of the change and the reasons for it. SFAC 8 provides the guidelines for changing an accounting policy.
Verifiability
For users of a financial report to have confidence in its content they must be sure that the information it contains is capable of independent verification. Two equally competent users of a financial report should reach similar conclusions, though not necessarily complete agreement, as to whether or not they have been given a faithful representation upon which to base their analysis.
Timeliness
If the information is to provide any real benefit to users it must be available in time for them to incorporate it in their decision-making.
The Framework sees the typical user of an annual report as having “a reasonable knowledge of business and economic activities”, and who “reviews and analyses the information diligently”. The annual report should be prepared with a view to being readable by the average user – small-print notes can meet the needs of experts.
Cost constraints in financial reporting
It will never be possible to fulfil all users’ information requirements in a single annual report. Weighing cost against benefit will always be important. It is recognised that information has an associated cost – and this is the overriding constraint in information provision. If the cost of gathering or presenting the information is greater than the benefits of its availability, it is not worth the effort.
Statement of accounting policies
When reading the financial statements in an annual report it can be assumed that all the appropriate assumptions and qualitative characteristics have been applied. The overriding requirement for financial statements, and the objective of accounting standards, is to give a faithful representation. IAS 1 requires companies to explain the measurement basis used in preparing the financial statements and also to disclose anything else relevant to understanding them. IAS 8 states that “the specific principles, bases, conventions, rules and practices applied to an entity in preparing and presenting financial statements” should be described in the accounting policies statement.
For each major item companies are expected to comply with GAAP and with all applicable accounting standards. A statement of compliance is normally found within the accounting policies statement. Where there is no applicable standard, management is expected to use appropriate judgment in the selection of the accounting policy to apply in its presentation and to disclose this.
A statement of accounting policies will normally include:
It can be assumed that a company’s accounting policies will be applied consistently from year to year. A company can change an accounting policy if this is required by a new standard, or the change will improve the relevance or reliability of the information being presented. Any changes in accounting policies will be set out in the annual report. When a company makes any such change, you should read the auditor’s report to see if it gives the company a clean bill of health. If the auditors believe that some aspect of the financial statements does not comply with legislation, accounting standards or GAAP, they have a duty to make this clear in their report to shareholders.
Auditors
Every listed company must employ an independent professional auditor. Auditing developed in the 19th century to protect shareholders’ interests. Auditors are professional accountants who check the accounting records and all other relevant sources of data and information, and report that the financial statements give a true and fair view or faithful presentation, and have been properly prepared in accordance with all relevant legislation, IFRS and appropriate GAAP – the financial reporting framework.
Auditors are independent of management. They are employed by the shareholders, not the directors of the company. They report directly to shareholders at the AGM. In the UK, the main professional body is the ICAEW, and in the US it is the AICPA.
All countries have many firms of auditors dealing with small and medium-sized companies, but for listed companies, particularly if they are multinational, there are only a few suitable auditing firms. These are capable of offering full professional services anywhere in the world. They are as multinational as any company they may deal with and their names are well known. The largest, “the Big Four”, and their 2013 fee income are:
Size is important. A small firm of auditors, threatened with losing the business of a major company, might find the prospect made it more amenable to management’s wishes. A large firm might not like losing the account any more than a small one, but it would not miss the income to the same degree. Bernard Madoff’s $50 billion hedge fund relied on being audited by a three-person firm: a 78-year-old retiree and two assistants. This fact alone should have set alarm bells ringing well before the fraud was discovered at the end of 2008.
However, experience of corporate misadventure through the 1990s and the 2008 global financial crisis cast doubt on the effectiveness of large auditing firms as a safeguard to shareholders. One particular problem in the 1990s was that, in general, for every $1 charged to a company for audit fees, professional firms seemed to generate more than $1 of non-audit-related income. Can complete independence be guaranteed if the auditing firm is reliant on consultancy or other fees from the same company?
Sarbanes-Oxley Act
In 1996 Alan Greenspan, then chairman of the US Federal Reserve, warned investors against “irrational exuberance”, and in 2002 he warned them of “infectious greed”. At the start of the new millennium there were a number of financial reporting frauds, the most infamous being Enron, a US energy and commodities company. In October 2001 Enron declared that as a result of “accounting errors”, it was reducing after-tax net income by $544m and stockholders’ equity by $1.2 billion. A further restatement was offered in November with bankruptcy coming in December. In one year, Arthur Andersen, then one of the largest international audit firms, received $25m for audit-related activities from Enron and $27m for consultancy work. In June 1999 Rite Aid, a US drugstore chain, where the SEC found “widespread accounting fraud schemes” resulting in an overstatement of profits between 1997 and 1999 of some $1 billion, paid its auditors $1.5m in consultancy contracts.
In 2002 186 large US companies filed for bankruptcy, with WorldCom owing over $100 billion. And, not to be outdone, in 2003 Italy contributed Parmalat, a multinational dairy and food company, to the list of giant companies failing in questionable circumstances in Europe’s largest ever bankruptcy. In 2002 the Public Company Accounting Reform and Investor Protection Act, referred to as the Sarbanes-Oxley Act (SOX), was passed. Self-regulation ended for the auditing profession. The Dodd-Frank Act of 2010 set up the Financial Stability Oversight Council (FSOC), which has the task of promoting financial stability for banks and other financial institutions.
The SOX created the Public Company Accounting Oversight Board (PCAOB) to protect investors and ensure full, transparent corporate reporting and the application of the highest auditing standards. To achieve this audit reports are expected to be “informative, accurate and independent”. With the support of the SEC, the PCAOB sets the standards for auditing (AS) and auditors, and oversees the Generally Accepted Auditing Standards (GAAS). Firms are banned from undertaking non-audit work for companies they audit. The PCAOB is working towards the improvement of both auditing standards and the content of the auditor’s report.
In the UK the FRC contributes to the development and application of auditing standards through the Auditing Practices Board (APB). In 2012 it published The Auditor’s Report on Financial Statements to support the move towards expanding the auditor’s report to include more positive information to assist the understanding of a company’s financial statements.
Most countries have a set of auditing standards that are mandatory for members of the auditing and assurance profession. The Auditing Standards Board (ASB) has this role in the US and the FRC provides standards and guidance for UK auditors.
The purpose of an audit is to provide an expert and independent view of a company’s financial statements. It is primarily designed for the shareholders. The auditor’s report normally describes the respective responsibilities of management and the auditor for the preparation and presentation of the financial statements, and the basis upon which the audit was conducted, and ends with a formal opinion. The auditor’s opinion is the item of prime interest in an audit report – do the financial statements give a true and fair view? Does the auditor give the company a clean bill of health or is there any cause for concern?
If appropriate there will also be discussion of any key (IAASB) or critical (PCAOB) audit matters (KAM or CAM) representing the significant issues arising during the audit. The audit report should confirm that the financial statements have been prepared properly in accordance with an appropriate financial reporting framework – IFRS, GAAP – and any relevant legislation. There should also be some information on the approach taken by the auditor in completing the audit. ISA 700 requires auditors to describe any material risks they saw as having an impact on their audit strategy.
ISA 700, “Forming an Opinion and Reporting on Financial Statements”, is the primary guide for auditor reporting standards in the UK. Auditors learn a considerable amount about the company they are auditing. It would obviously be beneficial if this information were shared with users of the financial statements. Since 2014 the UK audit report has become a more valuable document. Auditors are encouraged to prepare an “Auditor’s Commentary”. This should explain the work they carried out and describe the key points they discovered that have a bearing on the understanding of the financial statements.
The auditor’s report will include an opinion on the accounts. In the US the audit report is likely to include the following: “In our opinion the financial statements present fairly, in all material matters, the financial position of the company, and the result of its operations and its cash flows for the year in conformity with US GAAP.” A typical UK report will contain: “In our opinion, the financial statements give a true and fair view of [or present fairly, in all material aspects] the financial position of the company … and the results of operations and its cash flows for the year in accordance with IFRS or GAAP.” The report will also comment on the appropriateness of management’s use of the going-concern assumption in preparing the financial statements.
For a UK listed company the audit can be expected to take, on average, some 60 days to complete. The annual report will include details of the auditor’s fees for the statutory audit and any non-audit fees. The statutory audit fees for a large multinational company can range from $5m to $50m. In 2012 the top four UK banking groups all paid more than £20m for their audit, with Barclays heading the list at £35m. Royal Dutch Shell paid £28m, GlaxoSmithKline £14m, Diageo £6m and Marks & Spencer £2m.
In 2014, to comply with the UK Corporate Governance Code, PricewaterhouseCoopers, which had been Marks & Spencer’s auditor since 1926, handed over to Deloitte. Its final audit report provides a good example of the new format.
With the changes made to ISA 700 it is worth reading the auditor’s report. Auditors have welcomed the opportunity to share their knowledge of a company’s operations and explain what work they have carried out. The auditor’s report may contain some useful information to assist your understanding of the company and in the framing of your analysis of the financial statements.
Qualified report
Always read the auditor’s report. It is extremely important. An independent professional accountancy firm has studied the preparation and presentation of the company’s financial statements and provided an opinion as to the level of confidence you can place in them. When auditors feel it necessary to make public any concerns they have this should influence any view taken of the company, its management and its future. If auditors are not satisfied with any aspect of the information provided to them or in the preparation and presentation of the financial statements, they have a duty to draw this to shareholders’ attention. They qualify their report.
The auditors will detail the area of concern and indicate how this may influence the standing of the company. A qualified report on the application of an accounting standard or a change in accounting policy may reflect nothing more than a basic disagreement on principle between auditor and management and is not necessarily a serious problem. However, an auditor might state, for example: “This indicates the existence of a material uncertainty, which may cast significant doubt on the company’s ability to continue as a going concern.”
This is about as bad as it can get, and makes the auditor’s report the most important page in the annual report. In effect, the auditor is saying, there is a likelihood that this company will fail.
The last resort of an auditor is to resign. In 2008 the third largest travel operator in the UK, XL Leisure Group, failed, leaving thousands of people stranded abroad, and many thousands more lost their pre-booked and paid-for holidays. In 2006 the auditors had resigned from the audit of one of the main XL subsidiaries after deciding there were “material errors” in the financial statements and warned that as a result these did not “give a true and fair view of the profit and state of affairs of the company”.
Auditors and fraud
It is a common misapprehension that the auditor’s main role is to search for fraud. The detection of fraud is the responsibility of management and others involved in the governance of the company. An 1896 legal case in the UK provided a useful definition of the auditor as “a watchdog not a bloodhound”. That a company has a clean audit report does not guarantee that there has been no fraud or, indeed, that the company will not fail the day after the annual report is published. In 2006 the Association of Certified Fraud Examiners (ACFE) published research suggesting that only 10% of fraud was initially detected by auditors, whereas 40% was disclosed by whistleblowers. Traditionally, auditors were employed only to ensure the presentation of a set of financial statements that provided a true and fair view.
The IAASB recommends that auditors should maintain a healthy level of scepticism as they endeavour to “identify and assess the risks of material misstatement of the financial statements due to fraud”. In the US auditors have responsibility for designing and completing an audit that gives “reasonable assurance that the financial statements are free from material misstatement either by fraud or error”.
Auditors must satisfy themselves that the company’s internal control systems are adequate. It was a combination of less-than-effective auditing and sloppy internal management control that led to the demise of Barings Bank in 1995.
Directors are required to make clear that they have complete confidence in their internal control systems, and that they consider the financial statements free from fraud and material misstatement. Auditors also make sure that the information contained in the directors’ report is consistent with the financial statements.
From the end of 2014 it is likely that companies will have to change auditors at least every ten years. This will help avoid auditors becoming too cosy with their clients. In Italy auditors must change every nine years. When Deloitte took over the audit of Parmalat the company’s financial problems were soon recognised, leading to Europe’s biggest corporate bankruptcy.
Bannerman and liability limitation
Bannerman Johnstone Maclay was the auditor of a company that failed in 1998 owing some £13m to RBS. In 2002 RBS sued the auditor, claiming that the financial accounts had misstated the true position of the company. This proved to be an important case (referred to as Bannerman) defining the duties and liabilities of auditors. The auditor claimed there was no duty of care to third parties, but lost the case. The judge ruled that as the auditor had not made it clear it was denying any duty of care to third parties using the audit report, it could be assumed that this duty was accepted. The absence of any disclaimer was the key. An appeal in 2005 was dismissed. Following the Bannerman ruling PricewaterhouseCoopers was the first major firm to change its audit opinion statement to include: “We do not, in giving this opinion, accept or assume responsibility for any other purpose or to any other person to whom this report is shown or in whose hands it may come save where expressly agreed by our prior consent in writing.”
Most audit reports now contain a “Bannerman disclaimer” – the auditors do not accept any responsibility to third parties using the annual report.
It is now common for auditors, in agreement with a company’s directors and shareholders, to set limits to their liability. In the UK they are allowed to apply to shareholders for a liability limitation agreement (LLA). Most EU countries have some form of limit to auditors’ liability.
Management accountability for information disclosure and control
The chief executive and chief financial officer must certify that they consider the financial statements to be accurate and that they have established, maintained and evaluated all appropriate disclosure controls and procedures. Directors are expected to take responsibility for the effectiveness of the internal control system, and each year to review and report on it in the annual report. They should report that “the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and result of operations”.
UK Listing Rules require directors to provide a going-concern statement. This indicates that they consider their company will continue in business for at least the next year and that they have no intention of liquidation. If this were not the case, the valuation of assets and liabilities in the balance sheet could change dramatically. In 2009 the FRC supported the view that the going-concern concept underlies all the financial statements and offered guidance to companies on its application.
Directors have accepted responsibility for full disclosure in financial reports and are personally responsible. Auditors require a guarantee of the quality of the information provided to them.
Corporate governance
The annual report often contains examples of senior managers in photogenic poses together with an organisation chart, but these are of little practical assistance in understanding how the company is actually being managed. What are its strategic objectives and how are they to be achieved? Answers to these questions are needed before reaching any conclusions based on quantitative analysis of the financial statements. In the 1990s, after a series of examples of blatant mismanagement (if not fraud) in public companies, corporate governance became a major issue in both the UK and the US. Additional disclosure was demanded so that shareholders and others interested in a company might gain confidence in its management and likely future viability.
In the UK in 1998 the Hampel Committee concluded that a board of directors should always act in the best interests of its shareholders and in doing so adopt the highest principles of corporate governance. Hampel reinforced and expanded on the recommendations of the Committee on the Financial Aspects of Corporate Governance (Cadbury Code, 1992) and the Greenbury Code (1996). The result was the publication of the Combined Code on Corporate Governance. This was followed in 1999 by the Turnbull Committee, which dealt with the internal control of companies, the Higgs Committee (2003), which looked at the effectiveness of non-executive directors, and the Smith Committee (2003), which dealt with audit committees.
Corporate governance encompasses how a company is managed, its operational framework, accountability and responsibilities, its interaction with society, and what dictates its behaviour. Probably the best definition of corporate governance was produced by the Cadbury Committee – “the system by which companies are directed and controlled”.
Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors, and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the board include setting the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The board’s actions are subject to laws, regulations and the shareholders in general meeting.
In 2012 the FRC published the UK Corporate Governance Code, replacing the Combined Code, which was applicable to all UK listed companies from October that year. The UK Stewardship Code, which provides guidance on good practice for communication between directors and investors, should be seen as a companion to this code. It is aimed at institutional investors in an attempt to improve their role as active participants in the corporate governance of their investments and their stewardship responsibilities.
To find out how a company is managed, and how well it is doing, read the information provided to comply with the code. If a company is not complying with the code, it must explain why – “comply or explain”. The code is reviewed every two years. It is not a set of rules but is based on principles, offering a guide to best practice, and has five main sections. In its 2011 and 2012 annual reports Marks & Spencer, a multinational retailer, made good use of these as the framework for its management discussion. The five sections are as follows:
Audit committee
In 1999 the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ) made independent audit committees a requirement for all listed companies, reinforced in 2002 by the Sarbanes-Oxley Act. In 2006 the EU’s Eighth Directive followed the same pattern. The UK’s Corporate Governance Code has a similar requirement for the establishment of an audit committee. In 2012 the FRC issued detailed guidance on the process of working with the auditor. The annual report should contain a report from the audit committee on its activities during the year. Full information, including its terms of reference, will probably be found on a company’s website. In the UK, shareholders are given the opportunity to vote on whether they consider the audit committee’s report provides sufficient information. The audit committee has taken over from management the responsibility of overseeing the appointment, remuneration and terms of reference of the auditor.
The chairman’s report
Each year the chairman is expected to publish a report. A chairman can say whatever he or she wants, and this is not subject to strict audit. It is a personal statement in which almost anything goes, from attacking the government to spreading a little homespun philosophy. It is unusual for it to take up more than two pages at the beginning of the annual report. Whatever the company’s performance, the language used is normally biased towards the positive in an attempt to give a good impression; this is referred to as the “Pollyanna effect”. If things are going well, this can be claimed as the result of positive management action and the language is clear and simple. When performance has been poor the language is more technical, with blame placed on the environment or other non-controllable factors.
The UK Corporate Governance Code encourages the chairman to describe how the principles of the code have been applied to the role and effectiveness of the board in running the company. There is normally an overview of performance, often with only the bright spots highlighted, and a comment on the general business outlook. It is rarely found to be downbeat and is almost certain to be biased – so read it with caution and healthy scepticism. A chairman’s performance at the AGM is likely to be more significant than the written report. It should be possible to watch this on the company’s website.
The directors’ report
The directors’ report normally provides personal details of each director and details of any changes to the board during the year (new appointments or retirements). At the AGM directors will be put forward in rotation for re-election with a formal vote by shareholders taking place at the meeting.
Directors are accountable to shareholders. They have overall responsibility for the management of all a company’s assets and equity. Part of their responsibility involves providing shareholders with not only financial statements but also adequate information on the principal aspects of the business. The director’s report will give details of the principal activities of the company. The dividend to be proposed at the AGM will also be disclosed. At the AGM shareholders have the opportunity to raise any questions they wish. One of the principal tasks of a company’s chairman is to manage the AGM.
Management commentary
The annual report should include a management commentary (MC), referred to as the strategic report (SR) in the UK and the management discussion and analysis (MD&A) statement in the US. The MD&A became an SEC requirement in 1980, the intention being to allow investors to see the company “through the eyes of management”. Companies listed in the US must also file an annual 10-K report, which may be used as an alternative to the full annual report. It contains the MD&A, 3–5 years’ selected financial data, a listing of the important risk factors facing the company and details of the auditors and their fees.
Following amendments to the UK Companies Act in 2013, the SR replaced the business review and the operating and financial review (OFR) for UK listed companies. The SR should offer a fair, balanced and comprehensive review of the company’s business and analysis of performance during the year. A description of the principal risks and uncertainties being faced should also be included. If the directors consider that there is anything that might affect the company’s future development, performance and position, they should draw this to shareholders’ attention. The auditor’s only duty is to ensure that the SR is consistent with the financial statements.
The SR is seen as a way of helping investors form a view as to the competence and success of the directors in running the business during the year and the viability of the year-end financial position (see Chapter 10 for more details).
Key performance indicators (KPIs) may be used to assist in understanding a company’s activity and performance. These can be financial or non-financial measures used in the management of operations. Financial measures are typically defined in terms of profit, revenue, return on capital, shareholders’ return and cash flow. Nonfinancial measures may be concerned with customer satisfaction, product lines, environmental issues, health and safety.
The MC is a good starting point for studying a company. Though aimed at shareholders, it is intended to be read and understood by anybody and therefore is relatively free of specialist terminology and jargon. If figures are included, such as those concerned with gearing or earnings per share, they should be clearly linked with those appearing in the financial statements. There should be a reference to accounting policies with a full discussion of any changes in the way in which the financial statements have been prepared or presented. Increasingly, companies are moving beyond explaining what they do and beginning to explain and discuss their business objectives and business model. The business model describes how a company creates value; you will find a good example in Marks & Spencer’s 2012 annual report.
The MC should not just focus on good news and victories, as is so often the case with statements by the chairman or CEO. It should provide a basis for assessing how successful a company’s strategy has been and what the likely prospects are for the future. It would be unreasonable to expect a company to publish its corporate plan, but it should discuss business trends. Each year the MC sets out the historical performance and activity of the company together with some indication of management’s view of likely future developments. Any major deviation from these should be explained the following year. It is intended to “assist the user’s assessment of the future performance of the reporting entity by setting out the directors’ analysis of the business”.
Ideally, there are three sections offering a description of the business, its objectives and overall strategy; its actual performance; and its financial position. The qualities of comprehensibility and comparability should be evident.
The AICPA set up a committee to study the relevance and usefulness of business reporting. The Jenkins Report, published in 1994, offered six broad headings for the MD&A:
The intention is to produce a plain-language report incorporating the basic qualitative financial information attributes already described in this chapter for financial reporting.
The MC should be based on the information used internally by management in running the company, with the main focus on how it intends to create long-term value for shareholders. It should be forward-looking and directly related to management’s plans describing the opportunities, risks and uncertainties the company faces. Non-financial measures supporting a view of performance should be incorporated.
When faced with uncertainty, poor performance, or the need to hide incompetence or fraud, directors may be attracted to presenting “proforma” figures in their reports to investors. They develop their own measures of performance that do not necessarily correlate with the published financial statements or support objective analysis.
If the terms “adjusted”, “normalised” or “underlying” are used in the review of a company’s performance, be on your guard. Examples of such measures may be found in the use of earnings before interest, taxation, depreciation and amortisation (EBITDA – see Chapter 6). A company showing a loss in its published income statement could produce a positive EBITDA figure. If in the discussion of performance management choose to use a measure other than one firmly based on the reported financial figures and GAAP, a clear explanation must be provided.
The hindsight factor
There is only one attribute needed to ensure perfect financial analysis and investment: hindsight. A few days after a major event anyone can articulate precisely what occurred and the impact it had on a company and its share price. Parmalat is an example. In its annual report in one year it claimed to have sold enough milk powder to Cuba to provide more than 50 gallons of milk for every person in the country. After the event it is difficult to see how this was not questioned. But as it was published by a large and historically successful company, perhaps not – there was no reason to even think about doubting the figures.
It is easy to criticise the annual report as an ineffectual document. There are numerous examples of companies failing shortly after publishing apparently healthy figures. With hindsight there may have been clear evidence of directors’ incompetence, if not misrepresentation and fraud. It is often the poor auditors who bear the brunt of criticism over their apparent inability to discover and draw attention to the real situation before shareholders lose their investment. However, the annual report is all we have, so we have to make the best use of it that we can.