Financial Accountingand Reporting

NINTH EDITION

Barry Elliott and Jamie Elliott

Prentice HallFINANCIAL TIMES

/in imprint of Pearson EducationHarlow, England • London • New York • Boston • San Francisco • Toronto • Sydney • Singapore • Hong KongTokyo • Seoul • Taipei • New Delhi • Cape Town • Madrid • Mexico City • Amsterdam • Munich • Paris • Milan

Brief Contents

Preface and acknowledgements xx

Part IINCOME A N D ASSET VALUE MEASUREMENT SYSTEMS I

1 Accounting and reporting on a cash flow basis 3

2 Accounting and reporting on an accrual accounting basis 22

3 Income and asset value measurement: an economist's approach 40

4 Accounting for inflation 60

Part 2REGULATORY F R A M E W O R K - A N ATTEMPT TO ACHIEVEUNIFORMITY 97

5 Financial reporting: evolution of the regulatory framework in the UK 99

6 Financial reporting: evolution of international standards 133

7 Conceptual framework 152

8 Published accounts of companies 177

9 Preparation of published accounts 221

Part 3BALANCE SHEET - EQUITY, LIABILITY A N D ASSETMEASUREMENT A N D DISCLOSURE 245

10 Share capital, capital maintenance and distributable profits 247

11 Reduction of share capital 267

12 Off balance sheet finance 295

13 Financial intruments 319

14 Employee benefits 338

15 Taxation in company accounts 360

16 Property, plant and equipment (PPE) 385

17 Leasing 417

18 R&D; goodwill and intangible assets; brands 434

19 Inventories 479

20 Construction contracts 502

vi • Brief Contents

Part 4 CONSOLIDATED A C C O U N T S S11

21 Accounting for groups at the date of acquisition 513

22 Preparation of consolidated balance sheets after the date of acquisition 528

23 Preparation of consolidated income statements 540

24 Accounting for associated companies 554

25 Accounting for the effects of changes in foreign exchange rates under IAS 21 569

Part 5 INTERPRETATION 585

26 Earnings per share 587

27 Cash flow statements 612

28 Review of financial ratio analysis 636

29 Trend analysis and multivariate analysis 674

Part 6 ACCOUNTABIL ITY 713

30 Corporate governance 715

31 Environmental and social reporting 757

32 Ethics for accountants 791

Appendix: Outline solutions to selected exercises 811Index 819

Full Contents

Preface and acknowledgements xx

Part II N C O M E A N D ASSET VALUE M E A S U R E M E N T SYSTEMS I

1 Accounting and reporting on a cash flow basis 31.1 Introduction 31.2 Shareholders 41.3 What skills does an accountant require in respect of external reports? 41.4 Managers 51.5 What skills does an accountant require in respect of internal reports? 51.6 Procedural steps when reporting to internal users 61.7 Agency costs 81.8 Illustration of periodic financial statements prepared under the cash flow

concept to disclose realised operating cash flows 91.9 Illustration of preparation of balance sheet under the cash flow concept 131. 10 Treatment of fixed assets in the cash flow model 14I.I I What are the characteristics of these data that make them reliable? 151.12 Reports to external users 16

Summary 17Review questions 18Exercises 18References 21

2 Accounting and reporting on an accrual accounting basis 222.1 Introduction 222.2 Historical cost convention 232.3 Accrual basis of accounting 242.4 Mechanics of accrual accounting - adjusting cash receipts and payments 242.5 Subjective judgements required in accrual accounting - adjusting cash

receipts in accordance with IAS 18 252.6 Subjective judgements required in accrual accounting - adjusting cash

payments in accordance with the matching principle 272.7 Mechanics of accrual accounting - the balance sheet 272.8 Reformatting the statement of financial position into a balance sheet 272.9 Accounting for the sacrifice of fixed assets 28

viii • Full Contents

2.10 Reconciliation of cash flow and accrual accounting dataReview questionsExercisesReferences

32343538

Income and asset value measurement: an economist's approach 403.13.23.33.43.53.63.7

IntroductionRole and objective of income measurementAccountant's view of income, capital and valueCritical comment on the accountant's measureEconomist's view of income, capital and valueCritical comment on the economist's measureIncome, capital and changing price levelsSummaryReview questionsExercisesReferencesBibliography

Accounting for inflation4.14.24.34.44.54.64.74.84.94.104.11

IntroductionReview of the problems of historical cost accounting (HCA)Inflation accountingThe concepts in principleThe four models illustrated for a company with cash purchases andCritique of each modelOperating capital maintenance - a comprehensive exampleCritique of CCA statementsThe ASB approachThe IASC/IASB approachFuture developmentsSummaryReview questionsExercisesReferencesBibliography

404043464753535555565859

6060606161

sales 636669808284868687889595

Part 2REGULATORY FRAMEWORK - A N ATTEMPT TO ACHIEVEUNIFORMITY 97

5 Financial reporting: evolution of the regulatory frameworkin the UK 99

5.1 Introduction 995.2 Mandatory regulations 995.3 Arguments in support of standards 1035.4 Arguments against standards 1055.5 Structure of regulatory framework 1055.6 The operating and financial review (OFR) 108

5.75.85.95.105.115.12

6

6.16.26.36.46.56.6

6.76.8

77.17.27.3

7.47.5

7.6

88.18.28.3

8.4

Full Contents

The Financial Reporting Review PanelThe Financial Services AuthorityThe revised Combined Code (July 2003)Interim Reports following CadburyDevelopments for small companiesEvaluation of effectiveness of mandatory regulationsSummaryReview questionsExercisesReferences

Financial reporting - evolution of internationalstandardsIntroductionNational differencesReasons for differences in financial reportingClassification of national accounting systemsAttempts to reduce national differencesThe work of international bodies in harmonising and standardisingfinancial reportingUSGAAPReconciliations and supplementary statementsSummaryReview questionsExercisesReferences

Conceptual frameworkIntroductionHistorical overview of the evolution of financial accounting theoryIASC Framework for the Presentation and Preparation of FinancialStatementsASB Statement of Principles 1999AICPA Improving Business Reporting -A Customer Focus:Meeting the Information Needs of Investors and CreditorsICAS Making Corporate Reports ValuableSummaryReview questionsExercisesReferences

Published accounts of companiesIntroductionA public company's financial calendarCriteria for information appearing in a published income statementand balance sheetThe prescribed formats

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112115115119121128130130131131

133133133134138139

139146148149149150150

152152153

156158

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179179

8.5 What information is required to be disclosed in Format I andFormat 2? 179

Full Contents

8.6 Cost of sales 1818.7 Distribution costs - 1848.8 Administrative expenses 1848.9 Other operating income 1858.10 What costs and income are brought into account after calculating

the trading profit in order or arrive at the profit on ordinary activitiesbefore tax? 185

8.11 Does it really matter under which heading a cost is classified In theincome statement provided it is not omitted? 185

8.12 Discontinuing operations disclosure in the income statement 1858.13 Items requiring separate disclosure 1888.14 The balance sheet 1898.15 Statement of changes in equity 1948.16 Reporting comprehensive income 1958.17 Segment reporting 1988.18 The fundamental accounting principles underlying the published income

statement and balance sheet 1988.19 Disclosure of accounting policies 1998.20 Fair view treatment 2038.21 Additional information in the annual report 2058.22 What information do companies provide to assist comparison

between companies reporting under different reporting regimes? 207Summary 211Review questions 211Exercises 212References 220

9 Preparation of published accounts 2219.1 Introduction 2219.2 Stage I: preparation of the internal income statement from a trial

balance 2219.3 Stage 2: preparation of the income statement of Illustrious SpA in

Format I style 2239.4 Stage 3: preparation of the balance sheet 2269.5 Preparation of accounts in Format I following IAS 8 and IFRS 5 2279.6 Additional information value of IFRS 5 2319.7 Additional information value of IAS 24 232

Summary 234Review questions 235Exercises 236References 243

Par t 3BALANCE SHEET - EQUITY, L IABILITY A N D ASSETMEASUREMENT A N D DISCLOSURE 245

10 Share capital, capital maintenance and distributable profits 24710.1 Introduction 24710.2 Total owners'equity: an overview 248

Full Contents • xi

10.3 Total shareholders'funds: more detailed explanation _ 24910.4 Accounting entries on issue of shares 25110.5 Creditor protection: capital maintenance concept 25210.6 Creditor protection: why capital maintenance rules are necessary 25310.7 Creditor protection: how to quantify the amounts available to meet

creditors' claims 25410.8 Issued share capital: minimum share capital 25410.9 Distributable profits: general considerations 25510.10 Distributable profits: general rule for private companies 25610.11 Distributable profits: general rule for public companies 25710.12 Distributable profits: how to arrive at the amount using relevant

accounts 26010.13 Distributable profits: realisation principle applies 26010.14 What are the implications of IAS compliance on distributions? 261

Summary . 262Review questions 263Exercises 263References 266

11 Reduction of share capital 267I. I Introduction 2671.2 Capital: restrictions on reduction of capital 2671.3 Non-distributable reserves: share premium 2681.4 Non-distributable reserves: capital redemption reserve 2691.5 Capital: redemption of shares by a public company 2711.6 Capital: redemption of shares by a private company 2731.7 Distributable profits: effect of accumulated trading losses 2761.8 Proposals for changes to company law 2821.9 Buyback of own shares - treasury shares

11.10 Developments in other countries — the Singapore experience 286Summary 289Review questions 289Exercises 290Bibliography 294

12 Off balance sheet finance 29512.1 Introduction 29512.2 Primary financial statements: their interrelationship 29512.3 Primary financial statements: changes in their interrelationship 29612.4 Reasons that companies borrow 29612.5 Capital gearing and its implications 29712.6 Off balance sheet finance 29912.7 Substance over form 30012.8 Balance sheet as valuation document 30312.9 Why companies take steps to strengthen their balance sheets 30512.10 Definitions cannot remove uncertainty: IAS 10 and IAS 37 306

Summary 314Review questions 315Exercises 316References 318

xii • Full Contents

13 Financial instruments 31913.1 Introduction 31913.2 IAS 32 Financial Instruments: Disclosure and Presentation 31913.3 IAS 39 Financial Instruments: Recognition and Measurement 329

Summary 334Review questions 335Exercises 335References 337

14 Employee benefits 33814.1 Introduction 33814.2 Financial reporting implications 33914.3 Types of scheme 33914.4 Defined contribution pension schemes 34114.5 Defined benefit pension schemes 34214.6 IAS 19 (revised) Employee Benefits 34414.7 The liability for pension and other post-retirement costs 34414.8 The income statement 34714.9 Comprehensive illustration 34714.10 Future developments 34914.11 Plan curtailments and settlements 35014.12 Multi-employer plans 35014.13 Disclosures 35114.14 Other long-service benefits 35114.15 Short-term benefits 35214.16 Termination benefits 35314.17 IAS 26 Accounting and Reporting by Retirement Benefit Plans 353

Summary 356Review questions 356Exercises 358References 359

15 Taxation in company accounts 36015.1 Introduction 36015.2 Corporation tax 36015.3 Corporation tax systems — the theoretical background 36115.4 Corporation tax systems - avoidance and evasion 36215.5 Corporation tax - the system from 6 April 1999 36415.6 IAS 12 - accounting for current taxation 36615.7 Deferred tax 36815.8 FRS 19 (the UK standard on deferred taxation) 37515.9 A critique of deferred taxation 37615.10 Examples of companies following IAS 12 37915.11 Value added tax (VAT) 381

Summary 382Review questions 383Exercises 383References 384

Full Contents • xiii

16 Property, plant and equipment (PPE) 38516.1 Introduction 38516.2 What is PPE? 38616.3 How is the cost of PPE determined? 38716.4 What is depreciation? 38916.5 What are the constituents in the depreciation formula? 39216.6 How is the useful life of an asset determined? 39216.7 Residual value 39316.8 Calculation of depreciation 39316.9 Measurement subsequent to initial recognition 39816.10 IAS 36 Impairment of Assets 40016.11 IFRS 5 Non-Current Assets Held for Sale and Discontinued Operations 40516.12 Disclosure requirements 40616.13 Government grants towards the cost of PPE 40716.14 Investment properties 40816.15 Effect of accounting policy for PPE on the interpretation of the financial

statements 409Summary 411Review questions 412Exercises 412References 416

17 Leasing 41717.1 Introduction 41717.2 Background to leasing 41717.3 IAS 17 (and its national equivalents)-the controversy 41917.4 IAS 17 - classification of a lease 42117.5 IAS 17 - accounting for leases by lessees 42317.6 Leasing - a form of off balance sheet financing 42817.7 Accounting for leases - a new approach 429

Summary 430Review questions 430Exercises 431References 433

18 R & D ; goodwill and intangible assets; brands 43418.1 Introduction 43418.2 Accounting treatment for research and development 43418.3 How are development costs defined? 43618.4 Introduction to goodwill and intangible assets 43818.5 Introduction to the current position 43818.6 Historical developments 44018.7 Intangible assets 44318.8 Goodwill 44818.9 Economic consequences of each method 45718.10 Arguments relating to amortisation versus immediate write-off 45818.11 IFRS 3 Business Combinations 46118.12 Brand accounting 46418.13 Intellectual property 465

Summary 470

xiv • Full Contents

Review questionsExercisesReferences

19 Inventories19.119.219.319.419.519.619.719.819.919.10

IntroductionInventory definedThe controversyIAS 2 InventoriesInventory valuationWork-in-progressInventory controlCreative accountingAudit of the year-end physical inventory countPublished accountsSummaryReview questionsExercisesReferences

20 Construct ion contracts20.1 Introduction20.2 Identification of contract revenue20.3 Identification of contract costs20.4 Recognition of contract revenue and expenses

Review questionsExercises

Part 4CONSOLIDATED ACCOUNTS

21 Accounting for groups at date of acquisition21.1 Introduction21.2 The definition of a group21.3 Consolidated accounts and some reasons for their preparation21.4 The definition of control21.5 Alternative methods of preparing consolidated accounts21.6 The treatment of positive goodwill21.7 The treatment of negative goodwill21.8 The comparison between an acquisition by cash and an exchange

of shares21.9 Minority interests21.10 The treatment of differences between a subsidiary's fair value and

book value21.11 How to calculate fair values

SummaryReview questionsExercisesReferences

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Full Contents • xv

22 Preparat ion of consolidated balance sheets after the date ofacquisition 52822.1 Introduction 52822.2 Pre- and post-acquisition profits 52822.3 Inter-company balances 53022.4 Unrealised profit on inter-company sales 53222.5 Provision for unrealised profit affecting a minority 53622.6 Uniform accounting policies and reporting dates 53622.7 How is the investment in subsidiaries reported in the parent's own

balance sheet? 536Summary 536Review questions 536Exercises 537References 539

23 Preparat ion of consolidated income statements 54023.1 Introduction 54023.2 Preparation of a consolidated income statement - the Ante Group 54023.3 Dividends or interest paid by the subsidiary out of pre-acquisition

profits 54323.4 A subsidiary acquired part of the way through the year 54423.5 Published format income statement 547

Summary 547Review questions 548Exercises 548References 553

24 Account ing for associated companies 55424.1 Introduction 55424.2 Definitions of associates and of significant influence 55424.3 The treatment of associated companies in consolidated accounts 55524.4 The Brill Group - the equity method illustrated 55524.5 The treatment of provisions for unrealised profits 55824.6 The acquisition of an associate part-way through the year 55824.7 Joint ventures 560

Summary 561Review questions 562Exercises 562References 568

25 Accounting for the effects of changes in foreign exchangerates under IAS 21 56925.1 Introduction 56925.2 The difference between conversion and translation and the definition

of a foreign currency transaction 56925.3 The functional currency 57025.4 The presentation currency 57025.5 Monetary and non-monetary items 57125.6 The rules on the recording of foreign currency transactions 571

xvi • Full Contents

25.7 The treatment of exchange differences on foreign exchangetransactions 571

25.8 Foreign exchange transactions in the individual accounts of companies 'illustrated - Boil pic 572

25.9 The translation of the accounts of foreign operations where thefunctional currency is the same as that of the parent 573

25.10 Granby Ltd illustration 57325.11 The use of a presentation currency other than the functional

currency 58025.12 Granby Ltd illustration continued 580

Review questions 582Exercises 582References 584

Part 5INTERPRETATION 585

26 Earnings per share 58726.1 Introduction 58726.2 Why is the earnings per share figure important? 58726.3 How is the EPS figure calculated? 58826.4 The use to shareholders of the EPS 58926.5 Illustration of the basic EPS calculation 59026.6 Adjusting the number of shares used in the basic EPS calculation 59026.7 Rights issues 59326.8 Adjusting the earnings and number of shares used in the diluted EPS

calculation 59826.9 Procedure where there are several potential dilutions 60026.10 Exercise of conversion rights during financial year 60223.11 Disclosure requirements of IAS 33 60323.12 The Improvement Project 605

Summary 605Review questions 606Exercises 607References 611

27 Cash flow statements 61227.1 Introduction 61227.2 Development of cash flow statements 61227.3 Applying IAS 7 (revised) Cash Flow Statements 61327.4 IAS 7 (revised) format of cash flow statements 61527.5 Consolidated cash flow statements 61927.6 Analysing a cash flow statement 62227.7 Critique of cash flow accounting 624

Summary 625Review questions 626Exercises 626References 635

Full Contents • xvii

28 Review of financial ratio analysis 63628.1 Introduction 63628.2 Accounting ratios and ratio analysis 63728.3 Six key ratios 63828.4 Description of the six key ratios 64028.5 Description of subsidiary ratios 64228.6 Application of pyramid of ratios to JD Wetherspoon pic 64728.7 Segmental analysis 65028.8 Inter-firm comparisons and industry averages 65628.9 Inter-firm comparisons: JD Wetherspoon and the brewing industry 65828.10 World Wide Web pages for company information 66028.11 Non-financial ratios 66128.12 Interpretation problems when using consolidated financial statements 661

Summary 662Review questions 662Exercises 663References 673

29 Trend analysis and multivariate analysis 67429.1 Introduction 67429.2 Horizontal analysis between two periods 67429.3 Trend analysis over a series of periods 67629.4 Historical summaries 67829.5 Vertical analysis - common size statements 67829.6 Multivariate analysis - Z-scores 68129.7 H-scores 68329.8 A-scores 68329.9 Accounting polices 68529.10 Balanced scorecards 68529.11 Valuing shares of an unquoted company - quantitative process 68729.12 Valuing shares of an unquoted company - qualitative process 68729.13 Shareholder value analysis (SVA) 69029.14 Measuring and reporting values in the annual report 69129.15 Shareholder information needs 69629.16 Professional risk assessors 69929.17 Impact of differences between lASs and national standards on

trend analysis 701Summary 702Review questions 702Exercises 705References 712

Part 6ACCOUNTABILITY 713

30 Corporate governance 71530.1 Introduction 71530.2 The need for corporate governance guidlines 71530.3 Corporate governance in different countries 71630.4 Corporate governance requirements 718

30.1330.1430.1530.1630.1730.18

31

UK Voluntary Code -The Cadbury Report 721The Greenbury Report 722The Hampel Report 723The Higgs Report 723The Smith Report 726The Combined Code 727Directors' remuneration 727Directors' remuneration - illustration from the Annual Report ofDiageo pic 731

Directors' remuneration - conclusion 740Relations with shareholders 740Institutional investors 740The Myners Report 741Corporate governance - summary 743Auditors 743Summary 750Review questions 750Exercises 752References 755

Environmental and social report ing 75731.1 Introduction 75731.2 Accountants' role in a capitalist industrial society 757

Sustainability 758Background to companies' reporting practices 759European Commission recommendations for disclosures inannual accounts 760Evolution of stand-alone environmental reports 762International charters and guidelines 763Economic consequences of environmental reporting 767Summary on environmental reporting 767Environmental auditing: international initiatives 768The activities involved in an environmental audit 769

31.12 Concept of social accounting 77131.13 Background to social accounting 77331.14 Corporate social responsibility 77631.15 Need for comparative data 77631.16 International initiatives towards tripple bottom line reporting 778

Summary 781Review questions 781Exercises 783References 789Bibliography 790

31.331.431.5

31.631.731.831.931.1031.11

32 Ethics for accountants 79132.1 Introduction 79132.2 The nature of business ethics 79132.3 Ethical codes for businesses 79332.4 The background to business ethics 795

Full Contents • xix

32.5 The role of ethics in modern business 79632.6 The role of professional accounting ethics 79932.7 The role of the accountant as guardian of business ethics 80332.8 Growth of voluntary standards 804

Summary 807Review questions 808References 810Bibliography 810

Appendix: Outline solutions to selected exercises 811Index 819