Advanced financial accounting - Riassunti

Advanced financial accounting: IFRSs

Key definitions

• IFRSs: It means the whole current accounting standards and interpretations (IFRS, IAS, IFRIC, SIC) issued by IASB.
• IASB: International Accounting Standards Board. Independent international standard-setting body, part of the IFRS Foundation.
• IFRS: International Financial Reporting Standards: accounting principles more recently published by IASB.
• IAS: International Accounting Standards: accounting principles less recently published by IASB.
• IFRIC Interpretations: Interpretations more recently issued by IASB on specific problems of application of the standards.
• SIC Interpretations: Interpretations less recently issued by IASB.

Standards and interpretations

Standards and interpretations can be:

• Under revision/reconsideration
• Amended
• Withdrawn: taken out without being substituted (e.g., IAS 30)
• Superseded: taken out but being substituted (e.g., IAS 22)

New standards or new interpretations can be issued.

The main steps of the standard-setting process are:

• Research project
• Discussion paper
• Exposure draft
• Published IFRS
• Adoption by the EU or by a country
• Post-implementation review

Three basic documents

• The IFRS Conceptual Framework: Conceptual Framework for Financial Reporting. It is not properly a standard, but:
  • A "general guide" for IASB and for national standards setters
  • A point of reference for preparers of financial statements
• IAS 1: Presentation of Financial Statements
• IAS 7: Dedicated to the statement of Cash Flows

Other key IFRS principles are:

• IAS 8: Accounting policies, changes in accounting estimates, and errors
• IAS 10: Events after the reporting period
• IAS 2: Inventories

Hierarchy of standards

Very important is the hierarchy of standards:

1. First, we have the IAS/IFRS standards and the SIC/IFRIC interpretations.
2. In absence of the above, if the written rules don’t solve the problem, we develop an accounting policy conforming to the Conceptual Framework.
3. In absence of the above, we refer to pronouncements of other standard setters, accounting literature, and industry practices not conflicting with IFRSs and the Conceptual Framework.

General purpose of financial statements

To provide financial information about the reporting entity’s:

• Nature and amounts of economic resources and claims
• Changes in economic resources and claims, resulting from:
  • Financial performance
    • Accrual-based information
    • Cash flow
  • Other events and transactions (e.g., issuing debt or equity instruments)

Accrual accounting and going concern

Accrual accounting: Means that the effects of transactions and other events are recognized when they occur and not when the cash or cash-equivalent is received or paid.

Going concern: It means preparing financial statements presuming that the company will continue in its normal business for at least 12 months. The entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations.

The COVID-19 crisis

The COVID-19 crisis had a huge impact on the economy:

• There were assessments of going concern
• Specific disclosure required
• Some of the major issues:
  • Possible urgent legal interventions by governments/regulators/accounting principles setters
  • Impacting on financial statement

Elements directly related to financial position

Asset: Resource controlled by the entity as a result of past events, from which future economic benefits are expected to flow to the entity.

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.

Equity: The residual interest in the assets of the entity after deducting all of its liabilities.

Performance

Income: Increases in economic benefits during the period.

Expenses: Decreases in economic benefits during the period.

Fundamental qualitative characteristics of financial statements

• Relevance: Information that can influence economic decisions of users (predictive or confirmative). One very important sub-constant of relevance is materiality: information whose omission could mislead the economic decision.
• Faithful representation: Financial information must be "reasonably" complete, neutral, and free from error.

Other qualitative characteristics that enhance the usefulness of information:

• Comparability: Information that can be compared with similar information about other entities or the same entity through time. Consistency helps to achieve the goal of comparability.
• Verifiability: Different knowledgeable and independent observers could reach consensus.
• Timeliness: Available in time for decisions.
• Understandability: Clear and concise.

The financial statement (IAS 1)

Financial statements are designed to show the financial results and financial position of a business. A complete set of financial statements includes:

• Statements of Financial Position at the end of the period (N.B. it doesn’t mean Financial Statement) → asset liability and equity →
• Statement of Comprehensive Income for the period: income and expenses
• Statement of Changes in Equity for the period →
• Statement of Cash flows for the period: point of view of the cash inflow vs cash outflow
• Notes to the Financial Statement, which include information about accounting policies and other explanatory information

• Comparative information: on the preceding period
• Management Commentary: it’s a general guideline

State of comprehensive income (SCI)

It’s a financial report that summarizes an entity’s revenue, expenses, and net income or loss. The intent of such a statement is to show the financial results of a business over a specific period of time.

We can either prepare:

• A single statement
• Two separate documents:
  • Statement of Income: It includes expenses vs revenues
  • Statement of Recognized Gains and Losses (Other Comprehensive Income): It contains all changes that are not permitted to be recorded within the income statement because they have not yet been realized. Some examples are:
    • Changes in revaluation surplus
    • Actuarial gains and losses on defined benefit plans
    • Currency translation effects
    • Changes in valuation of some classes of financial assets, other than equity assets, at fair value through other comprehensive income
    • Gains and losses on cash-flow hedges

Statement of income

• In short: It discloses accrued revenues and expenses according to the IFRSs
• Its final line is “[Net] Profit (Loss) for the period”

Statement of recognized gains and losses

• First line: [Net] Profit (Loss) for the period
• Following lines: Components of OCI (Other Comprehensive Income)
• Next to last line: Other Comprehensive Income (Expense) (or Other Recognized Gains and Losses)
• Last line: [Total] Comprehensive Income (Expense) == [Net] Profit (Loss) for the period ++ Other Comprehensive Income (Expense)

Analysis of income statement of Italian banks

We have 3 major areas to produce profit regarding a bank:

• Net interest margin: Lending and borrowing activity
• Net fees and commissions: For all kinds of services
• Net margin on other financial operations (e.g., dividend income)

Gross profit means how much the bank would gain or lose if no other things were present (e.g., losses on loans, taxes).

If we deduce from the gross profit impairment losses and write-backs on financial operations, we get the net profit.

In the end, if we also deduce the operating expenses (all the expenses needed to make the bank work, such as staff expenses), we get the operating profit from continuing operations.

In this example of Income Statement, we can see that we have a drop in interests and in fee and commissions, due probably to a reduction in the volume of the activities.

The main reason was because Unicredit was reorganizing its business model.

We can also see a raise in the impairment losses due to a stricter rule in vending loans.

Returning to the scheme we saw before, we are normalizing the profit.

We can see that we have positive taxes (we have a credit).

Statement of recognized gains and losses (other comprehensive income, OCI)

The components of OCI are changes in value which cannot be charged to profit or loss (e.g., revaluation, changes in fair value, gains, and losses on cash flow hedges).

Recognized gains and losses must be measured net of tax.

We have two alternatives:

• Either each component is presented after tax
• Or each component is presented before tax and total taxation effect is disclosed in a unique aggregate

The OCI has the following structure:

• First line: [Net] Profit (Loss) for the period
• Following lines: Components of OCI
• Next to last line: Other Comprehensive Income (Expense) (or Other Recognized Gains and Losses)
• Last line: [Net] Profit (Loss) for the period ++ Other Comprehensive Income (Expense) = [Total] Comprehensive Income (Expense)

This scheme was valid up to 2012.

This is the scheme used nowadays. The recognized gains and losses are divided into two blocks:

• Other recognized gains and losses with recycling to profit & losses
• Other recognized gains and losses without recycling to profit & losses

Reclassification adjustments (recycling) are needed whenever amounts recognized in OCI in previous periods are reclassified to Profit or Loss in the current period.

The purpose is to avoid double-counting of OCI items.

So, items of OCI should be grouped based on whether or not they are potentially classifiable to Profit or Loss at a later date.

Statement of changes in equity

The statement of changes in equity discloses equity dynamics during the period: important information for financial markets/operators.

No matter the choice for one single document or two separate documents: in the IFRSs financial statement system, equity value is increased (decreased) by total comprehensive income.

This effect can be disclosed in the Statement of Changes in Equity in two ways:

• Synthetical
• Analytical

Simplified scheme:

• Share capital
• Share premium: Additional amount of money that a company asks shareholders subscribing share capital increases
• Reserves from profit & other: The major component is the part of profits that have not been distributed to shareholders as dividends (retained earnings)
• Valuation reserves
• Treasury shares: Shares of the company purchased by the company itself (these operations are done to intervene temporarily on the supply and demand of the shares)
• Net profit/loss of the year

We have in order:

• Balance at the last year
• Change in the opening balance (that we do, for example, when we find major errors in the balance of last year)
• Balance at the start of the year
• Orange part:
  • Allocation of previous year profit – Reserves: we want to see where the profit was allotted, and in this case, the major part was allotted to retained earnings (and a small part was sent to dividends)
  • Allocation of previous year profit – Dividends
• Violet part:
  • Issue of new shares: During the year there was a share capital increase by 1.705,6. This increase was performed asking the shareholders a premium of 2.511. Some of these shares won’t be distributed, and so the effect of the shareholder's equity is not the sum of the two lines
• Comprehensive income: We can see where we took the values
• Shareholder's equity at 31.12.2009

Attention:

• Due to the "more volatile" components influencing OCI, valuation reserves could also be negative.
• Another possible (usually "more stable") component influencing OCI and therefore valuation reserves could be changes in revaluation reserves (revaluation surplus) of fixed assets.

Other comprehensive income (loss) must be considered a change in ("next to market") value of equity of the entity due to changes in fair (market) values.

Therefore, profit distributable to shareholders doesn’t include other comprehensive income.

The structure of the statement of changes in equity is a "double-entry" table and it reports all the operations affecting equity:

• Cash operations (issue of new shares for cash, payments to shareholders)
• Non-cash operations (issue of bonus shares, other comprehensive income)
• Mixed cash/non-cash operations ("mixed issue" of shares: new shares for cash + bonus shares)

Statement of cash flows (SCF)

SCF is a fundamental document in the FS of an entity. The statement of cash flows is the third point of view related to the entity (the first is the statement of financial position and the second is the statement of income with extension of other comprehensive income).

This scheme tries to represent how and how much the company produced and used cash during the period. For instance, operating activities produced more than 6 billion of cash and, of this 6 billion of cash, 1.161 were used in investing activities and 5.3 billion used were used in financing activities.

The objective of the SCF is to provide information about the entity’s activities that generated ("inflows" or "receipts") and utilized ("outflows" or "payments") cash during a period, and consequently about:

• The entity’s ability to generate and utilize cash
• The timing of cash generation and use
• The level of certainty of cash generation and use

The focus of SCF is cash and cash equivalents. Note that in the SCF the accrual rules don’t apply.

Cash and cash equivalents

We consider:

• Cash: Cash on hand and demand deposits with banks
• Cash equivalents: Investments complying with all these characteristics:
  • Short-term
  • Highly liquid
  • Readily convertible to known amounts of cash, and
  • Subject to an insignificant amount of risk of changes in value

Amount due on bank borrowings in SCF

Generally, they are considered part of financing activities (therefore not as a negative component of cash and cash equivalents).

In some cases/countries: Bank overdrafts (negative) balances can be considered a negative component of cash equivalents, if they comply with all these characteristics:

• Are repayable on demand
• Form an integral part of the entity’s cash management system
• The bank balance fluctuates from positive to overdrawn during the period

Categories of cash flows

We distinguish 3 major categories of cash flows:

• Operating Activities: All the cash that is produced and used by the entity due to its usual operations (its core activity). We have:
  • Cash inflows: Cash produced by the sale of goods or services, including interest and dividend received
  • Cash outflows: Cash used to pay operating costs, including interest paid and income tax paid
• Investing Activities: The activities relating to acquisition (capital expenditure) and disposal of long-lived assets and other investments not included in cash equivalents. Examples are:
  • Cash inflows: Proceeds from sale of property, plant & equipment, of investments/businesses, of intangible fixed assets; repayment of cash advances
  • Cash outflows: Purchase of property, plant & equipment, of investments/businesses, of intangible fixed assets; cash advances made to third parties
• Financing Activities: Funds provided by and paid to owners and third parties. Examples are:
  • Cash inflows: Cash received on issue of shares, on issue of bonds, on bank borrowings
  • Cash outflows: Payment of dividends to shareholders; bond or bank borrowings repayments

Non-cash transactions

Only cash and cash equivalents transactions are reported in the SCF. Non-cash transactions are not reported in the SCF. Examples in non-cash transactions are the issue of share against assets/businesses acquired (we have a contribution of capital with no cash) or a conversion of existing debt to equity. These types of information should be given elsewhere in the FS.

Alternatives for reporting cash flows from operation activities

• Direct Method (analytical): Each major class of gross cash receipts and payments from operations are analytically disclosed. It is not used much, and the vast majority of entities use the Indirect method, because there are problems for obtaining and processing information necessary for the direct method.
• Indirect Method (synthetical): Profit or losses before taxes are adjusted for the effects of:
  • Transactions of non-cash nature (e.g., depreciation, provisions): We eliminate these transactions
  • Income or expenses associated with investing or financing activities (e.g., gains or losses on disposal of fixed assets)
  • Changes in working capital from operations (trade and other receivables, inventories, trade and other payables)

We start from the statement of income and we make adjustments to convert the income numbers into cash flow numbers.

Applied example

This is after the Mexico’s Gulf disaster, and we are looking at an oil giant. We have a half year’s report.

The first thing that we see is that, even if BP is a British corporation, in the scheme we have dollars, not pounds. We can look at:

• A strong increase in sales (from 104.646 to 150.288) due to an increase in oil prices.
• A strong increase in operation costs, in which we have:
  • 32.192 new expenses in extraordinary expenses for the Gulf of Mexico oil spill.
• We have 10.003 new entries caused by tax credit on extraordinary expenses for the Gulf of Mexico oil spill.
• We have a net loss (10.860).