Lecture 2 ifa1 2011(1)(1)(1)

Chapter 5 1

Lecture 2 IFA1

Chapter 5

Regulation of accounting and financial reporting

Chapter 6

Revenue recognition issues

Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2 © 2010 H. Stolowy, M. J. Lebas and Y. Ding

1

Chapter 5 2Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2

© 2010 H. Stolowy, M. J. Lebas and Y. Ding 2

Chapter 5Regulation of reporting and

financial reportingFinancial Accounting and Reporting -

A Global Perspective (third edition)



Major topics

1 International Accounting Standards Board2 Annual report3 Presentation balance sheet4 Presentation income statement5 Notes to financial statements6 Terminology



1 International Accounting Standards Board

• Necessity of financial reporting standards

• The International Accounting Standards Board – Objectives of the IASB– History of the IASB– Structure (see Fig. 5.1)



Figure 5.1 Overview (source: www.iasb.org)



• New terminology– International Accounting Standards Board – IASB

- replaces the International Accounting Standards Committee – IASC

– IAS (International Accounting Standard) / IFRS (International Financial Reporting Standard)

• Implementation of IFRS/IAS

• The relationship IASB/SEC

• IFRS/IAS in the USA?



2 Annual report• Document published annually by:

– listed companies– some non-listed but large companies

• Content, order and terminology of the information included in the annual report may vary across countries

• See example of components of an annual report (Table 5.2)

• Traditional structure:– Business reporting– Financial reporting



Content of the annual report (example)

• Business reporting– Key financial information– Letter from the President– Management report

• Financial reporting– Consolidated financial statements– Notes to the consolidated financial statements– Report of the auditors– Financial statements of the parent company– Information on shares



3 Figure 5.2 Presentation of the balance sheet



Figure 5.3 Vertical format

• Vertical format = Report form• Single-step: assets at the top, liabilities and shareholders’ equity at the bottom



Figure 5.4 Horizontal format

• Horizontal format = account form• Assets on the left, liabilities and shareholders’ equity on the right



Difference between single-step and multiple-step

Single-step Assets = Liabilities + Shareholders’ equity Multiple-step Assets – Liabilities = Shareholders’ equity

Difference refers to the two different ways to write the basic business

equation (see Chapter 2)



Table 5.3 Balance sheet (Examples of ‘multiple-step’ vertical format)

• Multiple-step format: list of subsets of the three main categories of assets and liabilities and shareholders’ equity• Example 1: A - L = SE

Example 1 Example 2 Assets Assets

- Current liabilities - Current liabilities = Assets minus current liabilities = Assets minus current liabilities - Non-current liabilities Shareholders’ equity = Total net assets + Long-term liabilities = Shareholders’ equity = Long-term funding Control: Net assets =

Shareholders’ equity Control: Assets minus current

liabilities = Long-term funding



Table 5.4 Balance sheet by term (in increasing liquidity and maturity)

• Less liquid assets (fixed assets) at the top and most liquid assets (cash) at the bottom• Less mature items (shareholders equity) at the top and most mature (current liabilities) at the bottom

Assets Shareholders’ equity and liabilities

Fixed assets Shareholders’ equity Current assets Liabilities Inventory Long-term (non-

current) Accounts receivable Short-term (current) Cash



Table 5.5 Balance sheet by term (in decreasing liquidity and maturity)

• Most liquid assets (cash) at the top and less liquid assets (fixed assets) at the bottom• Most mature items (current liabilities) at the top and less mature (shareholders’ equity) at the bottom

Assets Liabilities and shareholders’ equity

Current assets Liabilities Cash Short-term (current) Accounts

receivable

Inventory Long-term (non-current)

Fixed assets Shareholders’ equity



Table 5.6 Balance sheet by nature

• The term has no importance

Assets Shareholders’ equity and liabilities Fixed assets Intangible assets Tangible assets Financial fixed assets

Shareholders’ equity

Liabilities Current assets Inventory Accounts receivable Cash

Financial (including the current portion)

Operating (due within the time horizon of the operating cycle)



Table 5.8 UK Format Multiple-step vertical balance sheet

Fixed assets (1) 100Current assets (2) 70Cred itors (amounts falling due within one year) (3) -60Net current assets/(liabilit ies) (4)=(2+3) 10Total assets less current liabilities (5)=(1+4) 110Cred itors (amounts falling due after more than one year) (6) -20Provisions for liabilities and charges (7) -10Total net assets (8)=(5+6+7) 80Capital and reserves (9) 80Total equity (10)=(9) 80The balance sheet balances with (10)=(8)



Table 5.9 Single-step vertical balance sheet

Fixed assets (1) 100Current assets (2) 70Total assets (3)=(1+2) 170Capital and reserves (4) 80Provisions for liabilities and charges (5) 10Creditors (6) 80Total equity and liabilities (7)=(4+5+6) 170The balance sheet balances with (7)=(3)

Most continental European firms tend to report this format



4 Figure 5.6 Presentations of the income statement



Figure 5.7 Vertical versus horizontal presentations



Table 5.11 Vertical income statement (multiple-step)

• Revenues and expenses are mixed• Determination of intermediate levels of income

Operating revenues - Operating expenses = Operating income (or margin) (1) Financial revenues - Financial expenses = Financial income (or margin) (2) = Net income (1) + (2)



Table 5.12 Vertical income statement (by nature)

Net sales + Other operating revenues - Purchases of merchandise - Changes in inventories of merchandise - -

Personnel expense Other operating expenses

- Depreciation expense = Operating income

• Simple method• No allocation of expenses• Personnel expense: typical line item (see next slide)• Depreciation expense also found in the format by function



Table 5.13 Vertical income statement (by function)

Presentation closer to managerial accounting

Net sales - Cost of goods sold (cost of sales) = Gross margin - Commercial and distribution expenses - Administrative expenses - R&D expense - Other operating expenses = Operating income



Table 5.17 U.S. multiple-step income statement

Net sales (1) Cost of goods sold (2) Gross profit (3)=(1)-(2) Commercial, Selling and distribution expenses (4) Administrative expenses (5) Operating income (6)=(3)-(4)-(5) Interest revenue and expenses (7) Gain or loss on sale of equipment (8) Pretax income from continuing operations (9)=(6)-(7)±(8) Income tax expense (10) Income from continuing operations (11)=(9)-(10) Discontinued operations (gain or loss on disposal) (12) Extraordinary items (13) Cumulative effect of change in accounting principle (14) Net income (15)=(11)+(12)±(13)±(14)



Table 5.18 Comparison between income statement by nature and by function

Income statement by nature Income statement by function Sales of merchandise 17,000 Sales of merchandise 17,000 - Purchases of merchandise -8,000 - Cost of goods sold -9,000 - Inventory change of merchandise (a) -1,000 = Gross margin 8,000 - Personnel expenses (b) -6,000 - Selling expenses (c) -4,000 - Depreciation expense -1,000 - Administrative expenses (d) -3,000 = Operating income 1,000 = Operating income 1,000 (a) Beginning minus ending

(b) Sales personnel (4,000) plus administrative personnel (2,000=

(c) Sales personnel remunerations (d) Administrative labor (2,000)+ Depreciation (1,000)



5 Notes to financial statements

• Clarification and a supplement to the balance sheet, income statement and statement of cash flows

• Notes are required by the IASB (IAS 1, IASB 2007: § 10): ‘A complete set of financial statements comprises: (…) (e) notes, comprising a summary of significant accounting policies and other explanatory information’

• ‘Notes provide narrative descriptions or disaggregation of items presented in those statements and information about items that do not qualify for recognition in those statements’ (IAS 1: § 7)



Table 5.19 Example of information found in the notes

Notes = qualitative and quantitative comments or specification of hypotheses

Qualitative Information Quantitative Information Accounting policies: Fixed assets – movements for the year Accounting principles Depreciation – movements for the year Basis of consolidation Measurement bases

Amortization and provision – movements for the year

Specific accounting policy Analysis of debt by maturity



6 Table 5.20 Accounting terminology differences!

• See page 199 and 200



Chapter 6Revenue recognition issues

Financial Accounting and Reporting -

A Global Perspective (third edition)



Major topics

1 Issues of revenue recognition (focus today)

2 Deferred taxation (focus today)

3 Long-term contracts

4 Extraordinary items

5 Reporting accounting changes

6 Comprehensive income



1 Issues of revenue recognition

• To recognize revenue = to record the impact of a transaction on the revenue component of the income statement

• Rules for three categories of transactions and events:– sale of goods– rendering of services– interest, royalties and dividends



Sale of goods

• Conditions satisfied:– transfer of the significant risks and rewards of

ownership of the goods– no managerial involvement or effective control

over the goods sold– amount of revenue measured reliably– probability of economic benefits– costs related to the transaction measured reliably



Rendering of services

• Conditions:– amount of revenue measured reliably– probability of economic benefits– stage or percentage of completion of the transaction

on the balance sheet date measured reliably– costs related to the transaction measured reliably



Interest, royalties and dividends• Interest: proportionately to the length of the

period during which the asset was actually made available and on the basis of the agreed upon interest rate

• Royalties: on an accrual basis in accordance with the substance of the relevant agreement

• Dividends: when the shareholder’s right to receive payment is established (decision of the shareholders’ General Assembly)



Reporting for revenue recognition

• Accounting policies adopted for the recognition of revenue

• Amount of each significant category of revenue recognized during the period including revenue

• Amount of revenue arising from exchanges of goods or services included in each significant category of revenue



2 Deferred taxation

• Pre-tax income and taxable income– Depreciation– Warranty costs– Expenses benefiting several years

• Permanent differences and temporary differences



Figure 6.1 Differences between taxable and pre-tax income



Table 6.1 Method 1: Direct computation

Taxable revenues - Deductible expenses = Taxable income = Reported income



Table 6.2 Method 2 – Reconciliation in year X1

Pre-tax income for the year X1 (i.e., using accounting rules for reporting to shareholders)

Positive tax adjustments + Expenses in X1 never deductible + Expenses in X1 deductible in X2 or later + Revenues in X0 not taxable in X0 but taxable in X1 Negative tax adjustments - Revenues in X1 never taxable - Revenues in X1 taxable in X2 or later - Expenses in X0 not deductible in X0 but deductible in X1 = Taxable income in X1



Table 6.3 Permanent differences

Impact of permanent differences

Financial statements Income tax return Pre-tax income before non deductible penalty

110

- Non deductible penalty -20 = Pre-tax income 90 Pre-tax income 90 + Permanent difference (expense added

back) 20

= Taxable income 110 - Income tax expense 44 Income tax expense (taxable income x rate:

110 x 40%) 44

= Net income (after tax) (pre-tax income – income tax = 90 – 44)

46



Figure 6.2 Temporary differences and income



Table 6.4 Examples of expenses that are tax deductible in a period later than they are

recorded under financial accounting rules |(see also Case 1 on the next slide)

Examples Accounting timing Tax timing Tax on net sales revenue At time of original sale (possibly

subject to the establishment of a provision for returns)

After returns and claims are known

Product warranty-costs provision At time of sale When costs are actually incurred Bad debt expense (or doubtful accounts) provision

When claim is created When risk materializes

Interest or royalties payable Accrued with passage of time When actually paid Provisions for repairs and maintenance

When established When actual costs incurred

Retirement benefit costs As employee accrues benefits When retirement contribution to pension fund (or benefit) is paid out

Research costs (incorporation or other start up costs)

Year incurred May be amortized over a few years (actual duration is specified by tax code)



Case 1, method 1, Table 6.5 Effect of a provision when local GAAP do not allow

deferred tax accountsGAAP Financial statements Income tax return

Year X1 Year X2 Year X1 Year X2

Pre-tax income before actual warranty expense

100 100

Actual warranty expense 0 -10 Pre-tax income before accounting for product warranty provision

100 90 Pre-tax income 90 100

Product warranty provision expense -10 0 Provision added back +10 Reversal of provision 0 +10 Reversal of provision -10 Pre-tax income 90 100 Taxable income 100 90 Income tax expense -40 -36 Income tax expense 40 36 Net reported income after tax 50 64



Case 1, method 2, Table 6.6 Accounting for deferred income taxes

Tax expense based on financial reporting Reminder: Tax expense based on tax return Year X1 Year X2 Year X1 Year X2

Pre-tax income (from Table 6.5) 90 100 (Theoretical) Income tax expense (40 % of pre-tax income)

36 40 (Actual) Income tax expense (40% of taxable income from Table 6.5)

40 36

Net income 54 60 Year X1 Year X2 Deferred tax +4 -4



Figure 6.3 Recording a deferred tax asset in the financial accounting (GAAP-based) books



Case – Revenues or gains that are taxable in an earlier period than they are recognizable

under financial accounting rules

• Examples:

– A latent gain on marketable securities

– Cash received in advance for rent is sometimes taxable in the year received while it generally must be accrued under the local GAAP



Case – Expenses (or losses) that are deductible in earlier periods for tax purposes

than they are recorded under financial accounting rules

• Examples:– Expenses spread over several years according to

the local GAAP (in application of the matching principle) but that are tax deductible for the full amount in the year initially incurred

– Greater depreciation for tax purposes than for financial reporting purposes in the early periods of an asset’s life



Illustration

Income before depreciation and taxes 180 Asset purchased 20 Depreciation for tax purposes (Asset is depreciated in one year)

20

Depreciation for reporting purposes (Asset is depreciated over two years)

10

Income tax rate 40%



Table 6.7 Case of an expense which is tax deductible earlier than under

GAAP (method 1)

Financial statements as reported Income tax return Year X1 Year X2 Year X1 Year X2

Pre-tax income before accounting for depreciation expense

180 180 Pre-tax income 170 170

Depreciation expense (GAAP based)

-10 -10 Reported depreciation expense added back

+10 +10

Pre-tax income 170 170 Deductible expense (full depreciation in year X1)

-20

Taxable income (under tax rules) 160 180 Income tax expense -64 -72 Income tax expense 64 72 Net income reported 106 98



Table 6.8 Accounting for deferred income taxes (method 2)

Tax expense based on financial reporting Reminder: Tax expense based on tax return Year X1 Year X2 Year

X1 Year X2

Pre-tax income based on local GAAP (see Table 6.7)

170 170

Income tax expense (40% of pre-tax reported income)

68 68 Income tax expense (40% of taxable income) (table 6.7)

64 72

Net income reported 102 102 Year X1 Year X2 Deferred tax -4 +4



Figure 6.4 Recording a deferred tax liability

Income tax expense Income tax payable

Liabilities Assets

Balance sheet

64

Revenues Expenses

Income statement

68

Deferred tax liability

4

Income tax payable

Liabilities Assets

Balance sheet

72

Revenues Expenses

Income statement

Income tax expense

68

Deferred tax liability

4 4

Opening balances are shown in italics



Case – Revenues (or gains) that are taxable in later periods than they are recognized under

GAAP • Examples:

– The revenue from credit sales (that give rise to an account receivable) may be fully recognized under GAAP when the sale takes place, but only be taxable for tax purposes on a cash basis, i.e., only when the customer settles his/her debt

– Interest revenue is generally received in arrears and is included in GAAP accounting profit on a time-apportioned accrual basis (in application of the matching principle) but is included in taxable profit only on a cash basis



Accounting for and reporting income taxes

• Taxes payable accounting (or flow-through method or integrated model)

• Deferred taxation accounting (or full provision method or deferred tax model)



Deferred taxation

• Recognition of a net deferred tax asset: see Appendix 6.1

• Accounting for net operating losses– Loss carry-back– Loss carry-forward– See Table 6.9 and Appendix 6.2

• Changes in tax rates: see Appendix 6.3



3 Long-term contracts

• Construction contracts (IASB terminology – IAS 11)• Principles: two types of contract

– a fixed price contract– a cost plus contract

• One recommended method (IAS 11, § 22): percentage of completion method

• If the conditions for this method are not met => use of a variation of the percentage of completion

• Alternative method not endorsed by the IASB: completed-contract method

• See developments in Appendix 6.4



4 Extraordinary and exceptional items

• Former distinctions: – Extraordinary/Ordinary– Exceptional/Current (or usual or operating)

• IAS 1 (revised 2003): no ‘Extraordinary’ items

• See developments in Appendix 6.6



5 Reporting accounting changes

• Changes in accounting policies

• Changes in accounting estimates

• Prior period errors



Why a change in accounting policies?

• ‘Required by an IFRS; or

• Results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flow’ (IAS 8, IASB 2003: § 14)



Changes in accounting policies• Adjustment to the opening balance of retained

earnings• Prescribed disclosure in the notes (IAS 8: § 29):

– nature of the change

– reasons for the change

– amount of the adjustment for the current period and for each period presented

– amount of the adjustment relating to periods prior to those included in the comparative information

– fact that comparative information has been restated or that it is impracticable to do so



Changes in accounting estimates

• Estimation process involves judgments

• Estimates required (bad debts, inventory obsolescence or the useful life of depreciable assets)

• Use of reasonable estimates

• Change in accounting estimates



Prior period errors

• Possible errors:– mathematical mistakes– mistakes in applying accounting policies– misinterpretation of facts– fraud or oversights

• If significant effect on the financial statements: ‘prior period errors’

• Adjustment of opening retained earnings

• Disclosure in the notes



6 Comprehensive income• No definition of ‘comprehensive income’ per se by the

IASB• ‘Total comprehensive income’: ‘change in equity during

a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners’

• ‘Other comprehensive income’: ‘Items of income and expense (including reclassification adjustments) that are not recognized in profit or loss as required or permitted by other IFRSs)’ (IAS 1, 2007: § 7)



Figure 6.5 Components of the total comprehensive income

Annual report Heineken

2009

Intermediate Financial Accounting IIntermediate Financial Accounting I

Content

• Consolidated balance sheet• Consolidated income statement• Consolidated cash flow statement• Consolidated statement of changes in equity

Lecture 2 ifa1 2011(1)(1)(1)

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