2 regulation and principal financial statements
TRANSCRIPT
©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
©Dermot Williamson, 2012 3
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
©Dermot Williamson, 2012 4
If we were the Enron Board approving the 1991 accounts, would we use mark to market accounting?
©Dermot Williamson, 2012 5
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.
©Dermot Williamson, 2012
Accounting regulation to discourage abuse
6
©Dermot Williamson, 2012 7
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
©Dermot Williamson, 2012 8
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
©Dermot Williamson, 2012 9
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
©Dermot Williamson, 2012
IFRS = International Financial Reporting Standards
issued by:IASB =
International Accounting Standards Board
10
©Dermot Williamson, 2012 11
ii. Stock exchange regulation
UK: Financial Services Authority (FSA)regulates London Stock Exchange– Interim half year accounts
©Dermot Williamson, 2012 12
ii. Stock exchange regulation
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
©Dermot Williamson, 2012 13
ii. Stock exchange regulation
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– All US companies must report results using US GAAP, but
Considering requiring US listed companies to use IFRS from 2014
©Dermot Williamson, 2012
IFRS = International Financial Reporting Standards
issued by:IASB =
International Accounting Standards Board
US GAAP = US Generally Accepted Accounting Principles
issued by FASB and SEC
14
©Dermot Williamson, 2012 15
ii. Stock exchange regulation
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– 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…’
©Dermot Williamson, 2012 16
iii. Accounting standards
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)
©Dermot Williamson, 2012 17
iii. Accounting standards
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’
©Dermot Williamson, 2012 18
iii. Accounting standards
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’
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
©Dermot Williamson, 2012 19
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
©Dermot Williamson, 2012 20
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 …’
©Dermot Williamson, 2012 21
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
©Dermot Williamson, 2012 22
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
©Dermot Williamson, 2012
From Daimler’s auditor’s report, p.171
“In our opinion, based on the findings of our audit,
KPMG AG
23
©Dermot Williamson, 2012
From Daimler’s auditor’s report, p.171
“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
24
©Dermot Williamson, 2012
From Daimler’s auditor’s report, p.171
“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
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
25
©Dermot Williamson, 2012
From Daimler’s auditor’s report, p.171
“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
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
©Dermot Williamson, 2012
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
27
©Dermot Williamson, 2012
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 …’;
28
©Dermot Williamson, 2012
v. Market reaction to creative accounting
Market suspicion of creative accounting or poor ‘quality of earnings’, may lead to:
29
©Dermot Williamson, 2012
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 …’
30
©Dermot Williamson, 2012
Break
©Dermot Williamson, 2012
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
32
©Dermot Williamson, 2012 33
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
©Dermot Williamson, 2012 34
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
©Dermot Williamson, 2012 35
Balance sheet equation
Financial position at a point in time:Assets = Liabilities + Owners’ or
shareholders’ equity
e.g.Buildings, equipmentInventoriesTrade receivablesCash
©Dermot Williamson, 2012 36
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
©Dermot Williamson, 2012 37
Balance sheet equation
Financial position at a point in time:Assets = Liabilities + Owners’ or
shareholders’ equity
e.g.Power plant Loans SharesInventories Provisions Retained earningsTrade receivables Trade payablesCash Tax due
©Dermot Williamson, 2012 38
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
©Dermot Williamson, 2012
Example: Quality Courier Corporation
39
€s= +
1/1/8: Quality Courier Corporation GmbH established, issues shares for €12,000
Cash 12,000 Share capital 12,000
Assets Liabilities Equity
©Dermot Williamson, 2012
Example: Quality Courier Corporation
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
Assets Liabilities Equity
See also F&MA, pp. 57 – 63, ‘Reliable Runner SA’ example; Stolowy et al, pages 48 – 58, 63 – 66 ‘Verdi’ example
©Dermot Williamson, 2012 41
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
©Dermot Williamson, 2012
Example: Quality Courier Corporation
42
€s= +
At close of 2 January:
Motor bike 8,000 Payable: BS 8,000 Share capital 12,000Cash 12,000
Assets Liabilities Equity
©Dermot Williamson, 2012
Example: Quality Courier Corporation
43
€s= +
At close of 2 January:
Motor bike 8,000 Payable: BS 8,000 Share capital 12,000Cash 12,000
3 January: Delivers goods for client A, who pays €400
Assets Liabilities Equity
©Dermot Williamson, 2012
Example: Quality Courier Corporation
44
€s= +
At close of 2 January:
Motor bike 8,000 Payable: BS 8,000 Share capital 12,000Cash 12,000
3 January: Delivers goods for client A, who pays €400
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
Assets Liabilities Equity
©Dermot Williamson, 2012
Example: Quality Courier Corporation
45
€s= +
At close of 2 January:
Motor bike 8,000 Payable: BS 8,000 Share capital 12,000Cash 12,000
3 January: Delivers goods for client A, who pays €400
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 businessMotor bike 8,000 Payable: BS 8,000 Share capital 12,000Cash 12,100 Retained earnings 100
20,100 8,000 12,100
Assets Liabilities Equity
©Dermot Williamson, 2012
Example: Quality Courier Corporation
46
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
©Dermot Williamson, 2012
Example: Quality Courier Corporation
47
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 €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
©Dermot Williamson, 2012
Example: Quality Courier Corporation
48
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 €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 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
©Dermot Williamson, 2012
Example: Quality Courier Corporation
49
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 €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 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
©Dermot Williamson, 2012 50
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:
©Dermot Williamson, 2012 51
Financial positionat end of 1 January
Financial positionat end of 7 January
€Assets:
Cash 12,000
______Net assets 12,000
Shareholders’ equity: Share capital 12,000Retained earnings 0
12,000
Example: Quality Courier Corporation
€Motor bike 8,000Receivables 100Cash 9,600
17,700
Payables 5,000 ______
Net assets 12,700
Shareholders’ equity: Share capital 12,000Retained earnings 700
12,700
Period2-7 January
©Dermot Williamson, 2012 52
Financial positionat end of 1 January
Financial positionat end of 7 January
€Assets:
Cash 12,000
______Net assets 12,000
Shareholders’ equity: Share capital 12,000Retained earnings 0
12,000
Example: Quality Courier Corporation
€Revenue 400 + 600 = 1,000lessExpenses -300
Net profit 700
Period2-7 January
€Motor bike 8,000Receivables 100Cash 9,600
17,700
Payables 5,000 ______
Net assets 12,700
Shareholders’ equity: Share capital 12,000Retained earnings 700
12,700
©Dermot Williamson, 2012 53
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
©Dermot Williamson, 2012 54
Financial positionat end of 1 January
Financial positionat end of 7 January
Period2-7 January
€Assets:
Cash 12,000
______Net assets 12,000
Shareholders’ equity: Share capital 12,000Retained earnings 0
12,000
Example: Quality Courier Corporation
Profit cash flow
€Revenue 400 + 600 = 1,000lessExpenses -300
Net profit 700
€Motor bike 8,000Receivables 100Cash 9,600
17,700
Payables 5,000 ______
Net assets 12,700
Shareholders’ equity: Share capital 12,000Retained earnings 700
12,700
©Dermot Williamson, 2012 55
Financial positionat end of 1 January
Financial positionat end of 7 January
Period2-7 January
€Assets:
Cash 12,000
______Net assets 12,000
Shareholders’ equity: Share capital 12,000Retained earnings 0
12,000
Example: Quality Courier Corporation
Profit cash flow
€Revenue 400 + 600 = 1,000lessExpenses -300
Net profit 700
€
Cash flow -2,400
€Motor bike 8,000Receivables 100Cash 9,600
17,700
Payables 5,000 ______
Net assets 12,700
Shareholders’ equity: Share capital 12,000Retained earnings 700
12,700
©Dermot Williamson, 2012 56
Profit cash flow
Events affecting profit not cash, e.g. :• Increase in assets:
– Sell goods on credit at a profit
©Dermot Williamson, 2012 57
Profit cash flow
Events affecting profit not cash, e.g. :• Increase in assets:
– Sell goods on credit at a profit• Reduction asset value:
– Equipment wears out– Supplies damaged– Customer cannot pay what is owed
©Dermot Williamson, 2012 58
Profit cash flow
Events affecting profit not cash, e.g. :• Increase in assets:
– 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
©Dermot Williamson, 2012 59
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 …’
©Dermot Williamson, 2012 60
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?
©Dermot Williamson, 2012 61
Financial position
includingRetained
earnings
Cash balances
Financial position
includingRetained
earnings
Cash balances
at 31 Dec 2008 at 31 Dec 2009for year 2009
Statements of:
©Dermot Williamson, 2012 62
Income
Financial performanceas creating wealth
Indicates profitability
Financial position
includingRetained
earnings
Cash balances
Financial position
includingRetained
earnings
Cash balances
Statements of:
at 31 Dec 2000 at 31 Dec 2001for year 2001
©Dermot Williamson, 2012 63
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
at 31 Dec 2000 at 31 Dec 2001for year 2001
Statements of:
©Dermot Williamson, 2012
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
64
©Dermot Williamson, 2012
• 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
©Dermot Williamson, 2012 66
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