2 Regulation and Principal Financial Statements

©Dermot Williamson, 2012

• Purposes of accounting: provide economic information

to permit informed:

– Decisions

– Judgements about:

o Financial performance – Profit & cash flow

o Financial position & risk

• Users of financial accounting

• Example of failure and its consequences

Seminar 1 Key learning points

1

©Dermot Williamson, 2012 2

Seminar 2Regulation & principal financial statements

• Team presentations about Enron

• Regulation of financial accounting:i. Lawii. Stock exchange rulesiii. Accounting standardsiv. Auditv. Market reaction

--- Break ---

• Principal financial statements, i.e.Statements of:– Financial position (Balance sheet)– Income– Changes in equity– Cash flow

• 1 minute reflection on learning


Enron presentations

This accounting abuse deceived people inside and outside Enron about its performance and financial position

Team 1:

Will argue that the abuse was caused primarily by weak ethics of individuals, and will

Identify individuals who were complicit in the abuse

Team 2:

Will argue that the abuse was caused primarily by failure of regulatory and corporate systems, and will

Identify the organisations and market systems that were complicit in this abuse


If we were the Enron Board approving the 1991 accounts, would we use mark to market accounting?


If we were the Enron Board approving the 1991 accounts, would we use mark to market accounting?

Performance in 1991 was not as good as in 1990, but the company had promissed investors that profits would increase. The reputation of the company, and of its directors, was at stake.

This is a very difficult decision, involving ethics, because directors at the end of 1991, or in early 1992, could not foresee what would happen in the future.

It might have been tempting to use mark to market accounting, and hope that something would happen in the future which would restore the economic reality to what the company had promissed.

However, use of mark to market accounting in this situation did not report the economic reality of the business, because it pushed mark to market accounting beyond the deals of one or two years for which it was designed.


Accounting regulation to discourage abuse

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Regulatory environment fora company listed on a UK or US stock exchange

Externalregulations

i. Law

ii. Stock exchange regulation

iii. Accounting standards

iv. Auditv. Market reaction

Read: Alexander & Nobes, 2010, chapter 4; F&MA, pages 47 - 53


i. UK: Companies Act 2006Shareholders = owners of company

Share capital: usually limited liability

Annual financial statements (responsibility of directors):– Content and form (individual company & consolidated) – To show ‘true & fair view’ Read: Peel; Peel & Felstead– To be audited (except for smaller companies)– To companies registry, so public documents

Audit: – Independent opinion on financial statements– Auditor’s report to shareholders


i. UK: Companies Act 2006Shareholders = owners of company

Share capital: usually limited liability

Annual financial statements (responsibility of directors):– Content and form (individual company & consolidated) – To show ‘true & fair view’ Read: Peel; Peel & Felstead– To be audited (except for smaller companies)– To companies registry, so public documents

Audit: – Independent opinion on financial statements– Auditor’s report to shareholders

European Union EU

All listed EU companies’ consolidated financial statements must use IFRS

Read: F&MA, pp. 28 – 29


IFRS = International Financial Reporting Standards

issued by:IASB =

International Accounting Standards Board

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UK: Financial Services Authority (FSA)regulates London Stock Exchange– Interim half year accounts




USA: Securities and Exchange Commission (SEC) regulator for listed securitiesmore stringent rules than UK, strong enforcement– Interim quarterly accounts




USA: Securities and Exchange Commission (SEC) regulator for listed securitiesmore stringent rules than UK, strong enforcement– Interim quarterly accounts– All US companies must report results using US GAAP, but

Considering requiring US listed companies to use IFRS from 2014


IFRS = International Financial Reporting Standards

issued by:IASB =

International Accounting Standards Board

US GAAP = US Generally Accepted Accounting Principles

issued by FASB and SEC

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USA: Securities and Exchange Commission (SEC) regulator for listed securitiesmore stringent rules than UK, strong enforcement– Interim quarterly accounts– All US companies must report results using US GAAP, but

Considering requiring US listed companies to use IFRS from 2014

SEC can:– Require restatement of financial statements– Stop listing of a company’s securities on US exchanges– Bring cases to court

Read: SEC ‘The Investor’s Advocate…’, ‘The laws…’



Authoritative statements on financial reporting in financial statements

Generally issued by private sector bodies, e.g.:– International Accounting Standards Board (IASB), issues

• International Accounting Standards (IAS), and now• International Financial Reporting Standards (IFRS)






– USA: Financial Accounting Standards Board (FASB), their standards together with SEC rules are ‘US

GAAP’






– USA: Financial Accounting Standards Board (FASB), their standards together with SEC rules are ‘US

GAAP’

Enforcement depends on country:– IASB relies on national regimes– UK: Financial Reporting Review Panel (FRRP):

• Can request company to restate financial statements, or

• Take company to court– USA: by SEC


International Accounting Standards Board (IASB)formerly International Accounting Standards Committee

Objectives:– Develop a single set of high quality, understandable,

enforceable and globally accepted accounting standards, so as

to

– Help participants in world capital markets & other users make

economic decisions

– Promote use of these standards

– Convergence of national accounting standards and IFRS

Read: F&MA, pp. 23 – 30


International Accounting Standards Board (IASB)formerly International Accounting Standards Committee

Objectives:– develop a single set of high quality, understandable, enforceable

and globally accepted accounting standards, so as to

– Help participants in world capital markets & other users make

economic decisions

– Promote use of these standards

– Convergence of national accounting standards and IFRS

Read: F&MA, pp. 23 – 30

Developments:– 2005 IASB & FASB commit to convergence of IFRS and US GAAP– 2007 No need for foreign companies in USA to reconcile their

IFRS accounts to US GAAP– 2008 SEC considers moving USA to IFRS

Read: SEC ‘SEC Proposes Roadmap… ; Williamson ‘IASB & US GAAP …’


iv. Audit

Independent opinion that financial statements :– Show ‘true & fair view’– Comply with accounting standards– Prepared per Companies Act 2006

that directors’ report is consistent with financial statements

UK


iv. Audit

Independent opinion that financial statements:– Show ‘true & fair view’– Comply with accounting standards– Prepared per Companies Act 2006

that directors’ report is consistent with financial statements

Based on:– Test of sample of transactions– Company’s system of internal control– Assessment of accounting judgements

To give reasonable assurance that accounts free from material misstatement

Read: F&MA, pp. 31 – 43, 311 – 320; Audit report in annual report you have downloaded; Tait

UK


From Daimler’s auditor’s report, p.171

“In our opinion, based on the findings of our audit,

KPMG AG

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“In our opinion, based on the findings of our audit, the

consolidated financial statements comply with IFRSs as

adopted by the EU, the additional requirements of German

commercial law pursuant to § 315a Abs. 1 HGB and IASB-IFRS

KPMG AG

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and give a true and fair view of the net assets, financial

position and results of operations of the Group in accordance

with these requirements.

KPMG AG

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and give a true and fair view of the net assets, financial

position and results of operations of the Group in accordance

with these requirements. The group management report is

consistent with the consolidated financial statements

and as a whole provides a suitable view of the Group’s

position and suitably presents the opportunities and

risks of future development.”

KPMG AGRead: F&MA, pp. 31 – 43, 311 – 320; Audit report in annual report you have

downloaded; Tait 26


i. Law in USA: Sarbanes-Oxley Act 2002

Political response to scandals: Enron, Worldcom, Tyco

• Public Company Accounting Oversight Board:– Regulate auditing for all US listed companies, including

their overseas subsidiaries

• Auditors not allowed to provide non-audit services

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i. Law in USA: Sarbanes-Oxley Act 2002

Political response to scandals, e.g. Enron

• Public Company Accounting Oversight Board:– Regulate auditing for all US listed companies,

including their overseas subsidiaries

• Auditors not allowed to provide non-audit services

• CEO & CFO certify that financial statements

fairly present results & financial position

• If material non-compliance, CFO & CEO forfeit bonuses

& profit on sale of shares in next year

• No loans to directors & executives

• Report on internal control in annual report:– Directors responsible for internal financial control

– Assessment of internal financial control Read: Bruce, 2005, ‘Floodgates …’; Economist, 2006, ‘The trial …’;

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v. Market reaction to creative accounting

Market suspicion of creative accounting or poor ‘quality of earnings’, may lead to:

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v. Market reaction to creative accounting

Market suspicion of creative accounting or poor ‘quality of earnings’, may lead to:

• Shareholders may sell their shares, lowering the share price

• Directors’ and managers bonuses that are linked to the share price may be affected

• Creditors call in loans early, and are reluctant to give more loans

• Rating agencies, e.g. Moody’s, lower their credit rating that lenders use to assess credit risks

• Suppliers insist on being paid before delivery • Customers may stop buying• Staff may look for another job• Directors may be sacked by shareholders• The company may be taken over by another company

Read: Williamson 2003 ‘Ahold …’

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Break


Principal financial statements

• Statements of

– Financial position (or Balance sheet)

– Income (or Profit and loss account)

– Cash flows

– Changes in equity

• Difference between profit and cash flow

Read: F&MA, pages 53 – 69; Stolowy et al., page 41 - 66

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Balance sheet equation

Financial position at a point in time:Assets = Liabilities + Owners’ or

shareholders’ equityRead: F&MA, pages 63 - 68

Daimler at 31 December 2010 p.174, € millions (on LUVLE)

135,830 = 97,877 + 37,953


Asset

“A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity”

IASB (See Glossary on LUVLE)

• Expect future benefit• Control access to benefit• From past event

N.B. Legal ownership does NOT determine what is an asset

Read: F&MA, pages 65 - 67




shareholders’ equity

e.g.Buildings, equipmentInventoriesTrade receivablesCash


Liability

“A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits ”

IASB• Obligation• Expected• Transfer economic benefits outside the entity

e.g.LoansProvisionsTrade payablesTax due

Read: F&MA, pages 67 - 68




shareholders’ equity

e.g.Power plant Loans SharesInventories Provisions Retained earningsTrade receivables Trade payablesCash Tax due


Owners’ or shareholders’ equity

Residual interest in assets after deducting all

liabilities

Equity = Assets – Liabilities

= Net assets

Daimler at 31 December 2010 p.174, € millions

37,953 = 135,830 - 97,877


Example: Quality Courier Corporation

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€s= +

1/1/8: Quality Courier Corporation GmbH established, issues shares for €12,000

Cash 12,000 Share capital 12,000

Assets Liabilities Equity



40

€s= +

1/1/8: Quality Courier Corporation GmbH established, issues shares for €12,000

Cash 12,000 Share capital 12,000

2/1/8: Buys motor bike, owes €8,000 to Bike Shop BS

Motor bike 8,000 Payable: BS 8,000 Share capital 12,000Cash 12,000


See also F&MA, pp. 57 – 63, ‘Reliable Runner SA’ example; Stolowy et al, pages 48 – 58, 63 – 66 ‘Verdi’ example


Income statement equation

Performance in a period as:Profit = Income* - Expenses(The Income statement equation)

* At this stage we assume that Income consists only of sales revenue

increase in wealth

Net profit is added to Retained earnings Net profit = owners’ equity

if no owners’ contributions or distributions

= Assets – Liabilities= Net assets



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€s= +

At close of 2 January:





43

€s= +



3 January: Delivers goods for client A, who pays €400




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€s= +




Motor bike 8,000 Payable: BS 8,000 Share capital 12,000Cash 12,400 Retained earnings 400

4 January: Pays €300 for publicity for the QCC business




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€s= +





4 January: Pays €300 for publicity for the QCC businessMotor bike 8,000 Payable: BS 8,000 Share capital 12,000Cash 12,100 Retained earnings 100

20,100 8,000 12,100




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At close of 4 January:Motor bike 8,000 Payable: BS 8,000 Share capital 12,000Cash 12,100 Retained earnings 100

5 January: Delivers goods to client C, who owes €600



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5 January: Delivers goods to client C, who owes €600Motor bike 8,000 Payable: BS 8,000 Share capital 12,000Receivable: C 600 Retained earnings 700Cash 12,100

6 January: Receives €500 from client C



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6 January: Receives €500 from client CMotor bike 8,000 Payable: BS 8,000 Share capital 12,000Receivable: C 100 Retained earnings 700Cash 12,600

7 January: Pays BS €3,000



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6 January: Receives €500 from client CMotor bike 8,000 Payable: BS 8,000 Share capital 12,000Receivable: C 100 Retained earnings 700Cash 12,600

7 January: Pays BS €3,000Motor bike 8,000 Payable: BS 5,000 Share capital 12,000Receivable: C 100 Retained earnings 700Cash 9,600

17,700 5,000 12,700


Financial positionat 31 Dec 2000

Financial positionat 31 Dec 2001

Income

for year 2001

AssetslessLiabilities=Owners’

equity

AssetslessLiabilities=Owners’

equity

RevenueslessExpenses=Net profit

Statements of:


Financial positionat end of 1 January


€Assets:

Cash 12,000

______Net assets 12,000

Shareholders’ equity: Share capital 12,000Retained earnings 0

12,000


€Motor bike 8,000Receivables 100Cash 9,600

17,700

Payables 5,000 ______

Net assets 12,700


12,700

Period2-7 January




€Assets:

Cash 12,000

______Net assets 12,000


12,000


€Revenue 400 + 600 = 1,000lessExpenses -300

Net profit 700

Period2-7 January


17,700

Payables 5,000 ______

Net assets 12,700


12,700


Daimler Statement of changes in equity, p. 175

€ millions

Equity at 31 December 2009 31,827

Profit for the year 2010 4,674

Dividends -93

Issue of shares 1,450

Other 95

Equity at 31 December 2010 37,953




Period2-7 January

€Assets:

Cash 12,000

______Net assets 12,000


12,000


Profit cash flow


Net profit 700


17,700

Payables 5,000 ______

Net assets 12,700


12,700




Period2-7 January

€Assets:

Cash 12,000

______Net assets 12,000


12,000


Profit cash flow


Net profit 700

€

Cash flow -2,400


17,700

Payables 5,000 ______

Net assets 12,700


12,700


Profit cash flow

Events affecting profit not cash, e.g. :• Increase in assets:

– Sell goods on credit at a profit


Profit cash flow


– Sell goods on credit at a profit• Reduction asset value:

– Equipment wears out– Supplies damaged– Customer cannot pay what is owed


Profit cash flow


– Sell goods on credit at a profit• Reduction asset value:

– Equipment wears out– Supplies damaged– Customer cannot pay what is owed

• Increase in liability from:– Tax assessed but not yet paid


Cash flow statement

Analyses cash generated & used in a period

Indicates liquidityLiquidity: ability to meet financial obligations over the short term

Companies fail because they run out of cash (i.e. have insufficient liquidity), not because this have insufficient profit

Williamson 2007 ‘Northern Rock …’; 2009 ‘Cash flow flight …’


Cash flow statement

Analyses cash generated & used in a period

Indicates liquidityLiquidity: ability to meet financial obligations over the short term

Companies fail because they run out of cash (i.e. have insufficient liquidity), not because this have insufficient profit

Williamson 2007 ‘Northern Rock …’; 2009 ‘Cash flow flight …’

Dilemma: financial performance as profit or cash flow?


Financial position

includingRetained

earnings

Cash balances

Financial position

includingRetained

earnings

Cash balances

at 31 Dec 2008 at 31 Dec 2009for year 2009

Statements of:


Income

Financial performanceas creating wealth

Indicates profitability

Financial position

includingRetained

earnings

Cash balances

Financial position

includingRetained

earnings

Cash balances

Statements of:



Income

Financial performanceas creating wealth

Indicates profitability

Cash Flows

Generation and use of cash

for survival & expansion

Indicates liquidity

Financial position

includingRetained

earnings

Cash balances

Financial position

includingRetained

earnings

Cash balances


Statements of:


Statement of comprehensive income

Has further gains or losses that are included in changes in equity, but not in the income statement

These gains or losses are beyond the scope of this module

Therefore we will not be studying this statement

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• Enron: – Regulatory system failure– Unethical accounting abuse by individuals

• Regulation of accounting:– Law– Stock exchange regulation– Accounting standards– Audit– Market

• Principal financial statements:– Financial position, at a point in time– Income, profit for a period– Cash flow, cash generated & used in a period– Changes in equity, for a period

• Profit cash flow

Seminar 2 Key learning points

65


1 minute reflection on learning

Complete sheet anonymously:

– What in this seminar was

most important to your

learning?

– What main points did you not understand?

Leave sheet in lecture theatre when you leave

2 Regulation and Principal Financial Statements

Documents

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