cfa level 1 notes

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6.20 FINANCIAL REPORTING STANDARDS
6.20.a(i) THE OBJECTIVE OF FINANCIAL STATEMENTS
The objective of accounting standards is to create some measure of comparability
between the financial statements of different firms and that for a firm over time. At the
same time, the standards must allow for some degree of flexibility in order for the
financial statements to better reflect the underlying nature of the firm. For example, the
depreciation standard allows for any one of a number of depreciation methods to be used.
This flexibility would allow a firm to choose the method which best reflects how it uses
its asset. The result then is to allow for some flexibility, but limiting the range of
accounting methods which may be used in order to preserve some measure of consistency
across firms and over time. Therefore, the financial statement of two companies
undertaking the same set of transaction should be comparable, but not necessarily
identical.
6.20.a(ii) THE IMPORTANCE OF REPORTING STANDARDS IN SECURITY
ANALYSIS AND VALUATION
Financial reports are intended to provide information to a wide range of potential users.
Therefore, it is not specifically designed to meet the needs of investors (who may be
more interested in determining a market value for the company). Nevertheless, the
financial reports provide many of the elements and information required in order for the
analyst to construct a fair value estimate for the firm (and its securities).
Therefore, an analyst must have a clear understanding of the accounting methods and
assumptions that were used in order to construct the financial statements, and the effects
those choices had on the reported figures. For example, if an analyst deems company
value as a multiple of its earnings, then earnings reported by a firm using aggressive
accounting methods might be assigned a lower multiple relative to a firm whose earnings
were computed using a more conservative set of accounting methods and assumptions.
6.20.b THE ROLE OF STANDARD SETTING BODIES AND REGULATORY
BODIES
Accounting standard are generally set by independent, not-for-profit, private sector
entities. Therefore, accounting standards are not generally set by governments or their
agencies. The two main standard setting bodies are:
1. The International Accounting Standards Board (IASB), which issues the International
Financial Reporting Standards (IFRS), and
2. The Financial Accounting Standards Board (FASB), which issues the Statements of
Financial Accounting Standards (SFAS), effectively, US GAAP.

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While these private sector entities set the standards, the regulatory authorities (which are
arms of the government) enforce them as generally accepted reporting rules. However,
regulatory authorities are not legally bound to enforce these standards. In fact, they may
even overrule these private sector standards and establish their own set of standards
(however, this is the exception rather than the rule).
Now let’s look at these players in a little more detail.
The stated goals of the IASB are as follows:
a) Develop a high quality set of standards which facilitates transparency and
comparability, and thus assist the users in making better economic decisions.
b) Promote the use of these standards. In fact, all publicly listed companies in the
EU (European Union) are now mandated to use IFRS.
c) Take into account the special reporting needs of small to mid size companies, and
for those companies which are situated in emerging markets.
d) Bring about convergence among the various national accounting standards.
In order to be able to achieve its objectives, an accounting standards setting body should
have adequate resources and competencies. In other words, it must have the budget and
the expertise to investigate the implementation of new standards or changes in existing
ones. While such a body is right to listen to input from various parties that may be
affected by a new (or a change in) standard, ultimately, the standard setting body must
retain its independence when reaching its decision.
The International Organization of Securities Commissions (IOSCO): is a membership of
national securities regulators, which collectively oversee more than 90% of the world’s
capital markets. The stated goals of the IOSCO are as follows:
a) Protect the investor.
b) Ensure that the markets are fair, efficient, and transparent.
c) Reduce systematic risk.
The IOSCO aims to achieve these goals by requiring full disclosure from publicly listed
companies. While each member state has their own unique set of regulations, the aim of
the IOSCO is to eventually have a uniform set of regulations.
The Securities and Exchange Commission (SEC) is the regulatory authority that oversees
the capital market in the U.S. It is charged with enforcing all applicable securities
legislation, including:
a) The Securities Act: which requires all publicly listed companies to periodically
report their financial statements, as well as any material information.
b) Sarbanes-Oxley Act: which oversees auditors (to ensure that they maintain their
independence from the firms that they are auditing), and requires senior managers
(the CEO and the CFO) of the reporting entity to certify that their financial
statements are indeed presented fairly.

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6.20.c(i) THE INTERNATIONAL FINANCIAL REPORTING STANDARDS
(IFRS) FRAMEWORK
Framework refers to the set of principles used in creating specific accounting standards
(rules). To illustrate, most accounting frameworks incorporate conservatism as one of
their principles. This in turn has led to the creation of a number of standards which
impose a more stringent set of criteria to either recognize revenue early or to defer
expenses to later periods. The point is that financial statements are created in accordance
with a set of accounting standards, which are in turn shaped by a set of accounting
principles (the framework). While the IASB and the FASB may have very similar
frameworks, the two resulting set of standards are not necessarily the same.
6.20.c(ii) THE OBJECTIVES OF FINANCIAL STATEMENTS
The objectives of financial statements include the following:
a) Presentation of the firm’s financial position as of a point in time.
b) Presentation of the firm’s performance over the reporting period.
c) Presentation of the firm’s cash position and how that position changed over the
period.
6.20.c(iii) QUALITATIVE CHARACTERISTICS OF FINANCIAL
STATEMENTS
The qualitative characteristics of an ideal set of financial statements include the
following:
1. Relevance: the information is timely and detailed enough to help the end user make
well-informed decision. As well, the information must be material (i.e. it could be used in
making a decision).
2. Faithful Representation: which in turn incorporates the following 3 features:
a) Completeness: there is enough information to allow the user to understand the
underlying nature of the firm’s activities.
b) Neutrality: the information is free from bias. For example, the information
does not deliberately over report or under report current earnings.
c) Free from error.
In addition to Relevance and Faithful Representation, the following qualities will also
enhance the usefulness of financial statements:
1. Comparability: The information is presented in a consistent manner over time and
across peer groups. For example, it would help the end user tremendously if Mega Auto
Co. used the same inventory reporting method that it has used in the past and that its peer
companies use as well.

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2. Understandability: The information should be presented in a clear manner so that even
users with a basic understanding of business and accounting will be able to comprehend
it. Information should not be excluded just because it is deemed to be complex.
3. Verifiability: Informed users would be able to agree that the information does correctly
reflect underlying economic events at the firm.
4. Timeliness: The information is made available early enough to enable the end user to
make a decision soon after economic events take place at the firm. However, timeliness
may come at the expense of verifiability. For instance, when an exploration company
makes a discovery, it may take months to get a proper estimate with respect to the
potential size of the discovery. While this delay in reporting would certainly make the
information more verifiable, it will nonetheless make it less timely. On the other hand, if
the firm chose to release its findings too soon (thus making the information more timely),
then it would be less verifiable (as the initial estimates of the finding would be less
certain).
6.20.c(iv) CONSTRAINTS IN PREPARING FINANCIAL STATEMENTS
A number of constraints or tradeoffs will be faced whenever a firm prepares its set of
financial statements. For example, the current market value of a firm’s assets would be
more relevant to the reader; however, because fair value estimates require a lot of
subjectivity, they would not be as reliable as their historic cost amounts. A second
example of the tradeoff which exists between reliability and relevance occurs when a
firm makes a sale on credit and is therefore required to make an estimate of the portion
which will not likely be collected in the future. By making a provision for bad debts
(estimated uncollectible amounts) at the time of sale, the income statement becomes more
relevant, as it now takes into account the likely amount of collectible revenue. However,
because the allowance for bad debts is an estimate, the information becomes less reliable.
We can see then how financial statements cannot incorporate all the required qualitative
characteristics simultaneously. Often times, these characteristics are in conflict with each
other.
Firms must also take into account the cost of providing reliable information. For
example, asset write-downs are based on management estimates of how much the asset’s
fair value has fallen below its book value. To increase reliability, one supposes that the
firm could spend thousands of dollars in obtaining multiple consultant estimates of fair
value for the asset. However, this would not make economic sense. Furthermore, since
assets are typically recorded at historic cost, financial statements omit the true economic
value of the firm (although the firm’s economic value will eventually be reflected
through its future earnings). Consequently, the reader must be aware of these limitations
when examining the financial statements of a firm.

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6.20.c(v) ASSUMPTIONS IN PREPARING FINANCIAL STATEMENTS
There are two main assumptions used in the preparation of financial statements:
i) Accrual: is a process which reflects transactions as they occur, and not when the
associated cash flow takes place.
ii) Going concern: allows the reporting of balance sheet items at values other than
liquidation values.
These two assumptions determine how financial statement items are recognized and how
their respective amounts are measured.
6.20.c(vi) REQUIRED REPORTING ELEMENTS
There are 5 reporting elements which appear in 2 financial statements:
1. Balance Sheet includes: a) Assets, b) Liabilities, and c) Owners’ Equity
2. Income Statement includes: a) Revenue and b) Expenses.
An item is generally recognized in the financial statements if the following conditions are
met:
i) It’s probable that an economic benefit associated with the item will flow to or
from the firm, and
ii) The item has a cost or value which can be measured reliably.
If an item does not meet these criteria, then it may instead be disclosed in the footnotes.
For example, if the firm was fined a standard amount by regulators for violations that the
firm pleaded guilty to, then that pending liability must be recognized on the balance sheet
(since it is almost certain that the firm will pay the fine and its amount is fairly reliable).
On the other hand, if the firm is currently engaged in a legal fight over some patent
infringement, then all it could do is disclose this matter in its notes (since the outcome of
the case is uncertain and any estimate for the settlement amount would be unreliable). In
other words, it would not meet the criteria for inclusion in the financial statements.
6.20.d GENERAL REQUIREMENTS FOR FINANCIAL STATEMENTS
A complete set of financial statements would include the following:
a) Balance Sheet
b) Income Statement
c) Statement of Changes in Owner’s Equity
d) Statement of Cash Flows
e) Notes.

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The principles that underlie the preparation of financial statements include the following:
a) Fair presentation (the methods and assumptions used fairly depict the underlying
business)
b) Going concern ( allows balance sheet account values to be carried over to future
reporting periods)
c) Accrual basis (as opposed to cash basis)
d) Consistency (across firms and over time)
e) Materiality (material items should be shown separately)
The presentation requirements are as follows:
a) Aggregation of similar items: however, items which are different in nature should be
presented separately, unless their amounts are immaterial.
b) No offsetting of elements: asset and liability amounts should be shown separately, not
netted against each other. The same principle applies to revenues and expenses on the
income statement.
c) Classified balance sheet: meaning that current accounts must be distinguished from
non-current accounts.
d) A minimum amount of information must appear on the face of the financial statements
(i.e. financial statements cannot be summarized into just a few accounts).
e) A minimum amount of information must be included in the notes: in order to help
explain how some of the figures in the financial statements were derived.
f) Comparative information must be provided: for example, firms often re-present prior
periods’ financial statements in conjunction with those of the current period in order to
provide some basis for comparison over time.
In the notes section, the following items must be disclosed:
a) Accounting policies used, which includes:
i) measurement bases (ex. historic cost or fair value)
ii) accounting methods used (ex. straight line vs. accelerated depreciation)
iii) estimates and assumption used (ex. short vs. long useful life).
b) Key assumptions used which may have a significant risk of causing material changes
to the carry value reported on the financial statements.
c) Other disclosures: such as a description of the entity, the nature of its operations, etc.
6.20.e(i) IMPLICATION OF ALTERNATIVE FINANCIAL REPORTING
SYSTEMS FOR FINANCIAL ANALYSIS
The differences between accounting standards make it more difficult to compare financial
statements prepared under the different set of standards. However, with a good
understanding of the rules, methods, and assumptions and the impact that they have on
the reported values, an analyst should be able to adjust the financial statements in order to
facilitate some degree of comparison. The following are just some of the scenarios which
are possible:

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1. Valuation: Both IFRS and SFAS realize that some elements on the financial
statements are better reported using fair values, as opposed to historic cost. However,
fair value measurements are very subjective. Therefore, while fair value may be more
relevant, it is not as reliable as historic cost.
2. Differences in reporting standards. For example, reporting standards can be based on:
i) A set of principles (broad concepts): consequently, a lot of judgment would be required
in determining how to actually report an event within the broad scope of these principles.
ii) A set of rules (more specific than principles): yes and no reporting rules would exist
for most types of activities.
iii) A combination of principles and rules: also referred to as being objective oriented.
To demonstrate how these different systems function, suppose that a firm incurs some
research and development (R&D) expenditures, the future benefits of which are highly
uncertain. If the firm reported its activities using a set of principles, then it would be up
to the firm to determine how to allocate this R&D expenditure over the various periods. If
one of those principles should be related to conservatism, then this would guide the firm
to recognize more of that expenditure in the current period. On the other hand, if the
firm reported its activities using a set of rules, then surely there would be a rule
stipulating how to allocate R&D expenditures over time. IFRS relies more on principles,
whereas at least in the past, SFAS was more rule based. The SFAS has begun a
movement towards an objective based system.
3. Measurement: Often a tradeoff exists between either making the balance sheet or the
income statement more relevant. For example, suppose that a firm starts off the year with
2,000 units of inventory, each having been acquired for $5 apiece. During the year, the
firm purchases an additional 5,000 units at $7 apiece while only selling 2,000 units at $10
apiece. If the firm assumes that it was the initial units of inventory that were sold first
(first-in, first-out), then the cost of goods sold (income statement item) would be reported
at $10,000 (2,000 X $5) while the ending inventory (balance sheet item) would be
reported at $35,000 (5000 X $7). In other words, the ending inventory better reflects the
recent cost of the inventory, while the cost of goods sold is measured using outdated
inventory costs.
Had the firm assumed that it was the more recently purchased inventory units that were
sold first (last-in, first-out), then the cost of goods sold measurement would be more
timely, while the inventory balance would be left with the older cost amounts. In recent
years, the standard setters have been leaning more towards preserving the relevance of
the balance sheet.

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6.20.e(ii) MONITORING DEVELOPMENTS IN FINANCIAL REPORTING
STANDARDS
The implementation of a new standard can have a significant effect on the company’s
reported financial statements. For example, once firms were required to expense
employee stock options, reported profits decreased, even if economically, nothing had
changed from how companies previously granted stock options. However, there is often
a lag from the time that a standard is proposed to the time that it becomes mandated,
creating an ample amount of time for an analyst to forecast how a proposed change in
accounting standards will impact the company’s financial statements in the future, and
perhaps, its valuation. Usually, new standards are proposed when it becomes necessary
to facilitate the financial reporting of a new set of activities. For example, 50 years ago,
no one could have conceived that there would be a need for an accounting standard
related to the reporting of software development costs.