Advanced financial reporting

Subsidiary

involves majority control or ownership, more than 50% of the voting shares via acquisition method

Associate - IAS 28

has a significant influence over business, 20 - 50% control or ownership via equity method

• participation in policy-making

• material transactions between inv

• interchange of managerial personnel 

• provision of essential technical information 

Group accounts IFRS 10

• Financial statements of the group resented as those of a single economic entity

Why do we need IFRS 10

• Multinational operations - need separate legal entities in different countries because of differing legal systems

• Tax - may be tax advantages in operating as separate legal entities

• Control - reflect hierarchical org structure

• Chronological events - reflects history in the way which the group was constructed and the order of subsidiary acquisition

Control

exists when :

Power over the investee

Exposure or rights to variable returns from its involvement with the investee

Ability to use its power over the investee to affect the amount of the investors returns

direct control

• control assumed where there is more than 50% of voting rights

Indirect control

• Control may exist where there is less than 50%

Reasons for preparing consolidated accounts

• The shareholders of a parent company have an indirect interest in the net assets and in the profits or losses of the company's subsidiaries. Accordingly, parent companies are required to prepare and present a set of accounts for the group as a whole

• Prevent manipulation

• Inflating sales by selling within the group

• More meaningful EPS figure

• Better measurement of management performance using ROCE

Reasons why control might exist (indirect )

• agreement with other investors gives power under 50%

• power over financial and operating policies

• power to appoint or remove majority board members

• Power to casr the majority of votes at a board meeting

Why do we need group accounts

• inerco tradfing

• off SOFP borrowing in subsidiaries - not shown in the holding company

• wed find it difficult to evaluate BOD preformance

• subsidiaries are gen shown as investments (HC)

Reasons of preparinf CA

• prevent manipulation

• better measurement of management preformance using ROCE

• More meaningful EPS figure

• inflating sales by selling within a group

Goodwill - IFRS 3

• must use acquisition method

• identify the acquirer;

• Determine the acquisition date;

• Recognise and measure the identifiable net assets acquired;

• Recognise and measure any non-controlling interest; and

• Recognise and measure goodwill or gain from a bargain purchase

NCI - IFRS 3

part of the subsidiary not owned by the parent

1. partial methos

2. fair value

When recognising IDNA

• net assets = assets - liabiltiy = SC + Reserves or RE

IFRS 3 - impairment and positive good will - CSPL (P/L expense)

• at date of acquisition:

• Goodwill is recognised at cost, i.e.
  cost of acquisition of the subsidiary
  less net assets at fair value.

• Thereafter an annual impairment
  test is conducted to establish whether
  any reduction in the carrying amount
  is needed.

• Goodwill must not be amortised.

• Goodwill is carried at cost less
  accumulated impairment losses.

  
  

CSFP - working

1. Group structure

2. Net assets

3. Goodwill

4. NCI

5. Group retained earnings

Adjustments - Intra group bal

• when single entity concept applies transactions between the group must be eliminated - only recognised profit from third parites

• lending money / one GC may have a current acount with another GC / One GC my buy goods from another

• receivables and payables need to be cancelled

Significant influence - IAS 28

• the power to participate in the financial and operating policy decision of the investee but is not control over these polciies

• rep on BOD

• partipation in policy making

• material transaction between entity and investee

• interchnage of managerial personnel

• provision of essential tech information

Initial cost of investment

• IIA intitally recognised at costs - rep investor share of the FV of the nat assets + goodwill from acquisition

Conversion - indiv company

Process of exchanging one currency to another

• P/L

Translation - consolidated financial statements

• doesn’t involve exchanging currencies

• required when a company still holds assets and liability

• OCI

Individual company - conversion / transalation

• individual company which trades overseas

• intial recognition - date of exchange / average rate used if stable

• subsequent year ends

  • monetary - use closing rate

  • non monetary items (non current assets) which are carried at historical cost use the exchange rate at the date of transaction

  • non monetary items which are carried at fair value use exchange rate at the date the values are determined

Foreign transactions - IFRS 21

transaction denominated in or requires settlement in a foreign currency inc:

(a) buys/sells goods/services whose price is denominated in a foreign currency;

(b) borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency;

(c) otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency.

Exchange difference

• amount paid/received in settlement of foreign currency transaction during an accounting period translated at DOS and any exchange difference is taken to the SOPOL as a realised gain/loss

Currency translation

Exchange rate differences from transactions differ to those which were intially recorded are operating income or other operating expenses

Hedging transaction - IAS 39/IFRS 9

• avoids exchange risk

• To neutralise risk so the company knows how much a transaction will cost when a settlement is required at a later date

• Via forward / operating contract

Functional currency

• currency of primary economic environment in which the entity operates- if your in the uk the FC everyone is operating it the sterling despite holding company being in the US 

Presentation currency

The currency in which the financial statements are presented

Monetary items

• asset/liability carrying a value that wont change in the future ie recievables, payables

Key factors affecting functional currency

• Currency that influences sale price, labour,material and other costs of sale 

• The currency of the  country whose competitive forces and regulations mainly determine the sales prices

• The currency in which financial funds are generated

• The currency in which the receipts from operating activities are usually retained

• Is foreign entity an extension of the reporting entity 

• Whether transactions with the reporting entity are a high or low proportion of the foreign operations activities

• Whether cashflows from the activities of the foreign operation directly affect the cashflows of the reporting entity and are readily available for remittance to it

• Whether cashflows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity

IAS 21 Foreign subsidy

IAS 38 - asset

• resource controlled by the entity as a result of past events and from which economic benefits are expected to flow

Current asset

•  reasonably expected to be converted into cash with a year / company relies on its current assets to fund ongoing operations and pay current expenses 

Non current asset

• long term investments where the full value will not be realised within the accounting ye

IAS 38 intangible asset

•  identifiable non-monetary item without physical substance, which is within the control of the entity and is capable of generating future economic benefits for the entity.

IAS 38 IA IDEN

•  arises from contractual or other legal rights 

• It is "separable“ (i.e., is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged". 

• Being identifiable is very important as this will help users to distinguish intangible assets from goodwill, which is outside the scope of IAS38. 

• Goodwill arises from factors such as an entity's good reputation and, by definition, is not identifiable

IAS 38 IA - Monetary items

• defined as "money held and assets to be received in fixed or determinable amounts of money". 

• Intangible assets must be non-monetary. Therefore, items such as cash, bank deposits and trade receivables are not intangible assets. Such items are in fact financial assets

IAS 38 IA - without physical substance

• Intangible assets are distinguished from property, plant and equipment by the fact that they are without physical substance. 

  • Such as computer software, patents and copyrights, import quotas, franchises etc.

IAS 38 IA - Control

• The entity must have the power to obtain the future economic benefits flowing from the resource. This power will usually (but not necessarily) stem from legally enforceable rights.

• In the absence of such rights, it is much more difficult to demonstrate control and therefore much more difficult to prove that an asset exists.

  • Technical knowledge protected by a patent or copyright.  (There  is a power of control)

Expenditure on staff training may result in improved staff skills which are expected to generate future economic benefits.  (No power/control)

IAS 38 Initial types of recognition

1. separately acquired intangible assets

2. acquired from business combination

3. internally generated

IAS 38 acquired from business combination

• Business combination as "a transaction or other event in which an acquirer obtains control of one or more businesses". 

• The cost of that asset is specified by IAS38 (in accordance with IFRS3) to be the asset's fair value on the date of acquisition. 

• Fair value (IFRS13) as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurent date"

• evidence of future economic benefits

IAS 38 - internally generated

• ie R and D/ goodwill (doesnt meet criteria since there is no guarantee there will be a future economic benefit /hard to measure it reliably)

• allowed when there is an identifiable cost and yields future economic benefits 

IAS 38 / IFRS 3 - GOODWILL

• future economic benefits arising from assets that are not capable of being individually identified and separately recognised’.

• Approaches for the subsequent measurement:

• (a)writing off the cost of the goodwill directly to reserves in the year of acquisition;

• (b)reporting goodwill at cost in the statement of financial position (this was attractive to management as there was no charge against profits in any year); Intangible assets

• (c)reporting goodwill at cost, amortising over its expected life; and

(d)reporting goodwill at cost, but checking it annually for impairment.

Components of the regulatory framework

1. financial reporting standards

2. conceptual framework

3. code of ethics

What is regulation

• rules that have been developed by an independent authoritative body that has been given the power to govern how we are to prepare financial statements

• involves monitoring and enforcement compliance with specific regulatory requirements

• FRC - Financial Reporting Committee

arguments in favour of a free market for information

1. overproduction of a public/ free good

2. Adam Smith

3. Individual contracting

4. Market for lemons

5. Market for managers

6. Market for corporate takeover

overproduction of a public/ free good

• Some argue free goods are often overproduced as a result of regulation

• leads to the free rider problem in which the public know since they don’t have to pay will overstate theory need for the good

• could lead to accounting standard overload since regulator need to constantly keep making more regulation to deal with the massive amount of information as well as monitoring business compliance

Free market - adam smith

• invisible hand of economics

• no need for regulation as participants maximise sell interests naturally

• market interactions will naturally ensure the mutually beneficial exchange of goods

• typically misquoted - gov intervention needed to protect vunerable

REGULATION NEEDED - Adam smith

• ignores market failures and uneven distributions of power

• comments on the negative impact of unrestrained powerful interests

Free market - individual contracting

• contracting - the relations between the business and different stakeholders with creditors

• for these to take place FI needed / businesses need to provide high-quality information to attract investors

  • too much accounting information will overwhelm regulators

Market for lemons

• Necessary to distinguish from poor performing companies so it keeps its good relations with investors

• If firms don’t provide information investors/lenders are unable to distinguish between good and bad firms / any firm which doesnt disclose FI will be penalised by the market

  • market may not know that they aren’t disclosing information ie volkswagon scandal

  • withholding information may be in interest of the firm

NO REG Markets for managers

• states there is a direct relationship of maximisation of firm value and pay

• for the benefit of the manager to work in the best interest of the company and shareholder

  • do they know how much info is optimal

  • is past performance reflective of current preformnce ie different jobs in different sectors

NO REG Market for corporate takeover

• underpreforming organisation will be taken over replacing existing management managers motivated to maximise firm value to prevent this

  • not clear how much information a manger needs to disclose to stop being fired MC = MB determination not clear

Challenges in regulation - industry capture

• Accounting regulation may have high costs and a negative impact on that particular sector

• ie banks / retail banks

Challenges in regulation - Lobbying

• a group of firms lobbying against regulation which may cause them harm

Challenges in regulations - Political power

Regulation exam answer

• no regulation - idealistic scenario

• principles based approach ie conceptual framework - growing calls for this as a context to ensure rules are consistence as a source of guidance

• rules based approach - detailed guidance - too rigid ensuring consistent accounting treatments

Conceptual framework - what does it contain

• objective of financial reporting - providing useful info for decision making

• qualitive characteristics - relevance/materiality / faithful representation/

• reporting entity

• element, recognition and measurement

• concepts of capital maintenance

Conceptual framework

• provides a set of consistent principles to guide the regulation and reporting of financial information ie judgement / faithful representation (completness/free from error/neutralality following prudence principle)

  • provides guidance to standard setters

  • provides guidance to accountants when situation is vague

Conceptual framework tension are qualitative characteristics achievable

• maybe a sacrifice between judgement and reliability

• sacrifice between judgement and faithfulness

• sacrifice between judgement and measurement

Arguments in favour of conceptual framework

• adapts to changing business structure

• helps deal with future situation

• free from political bias

• international compatibility of accounting standard

• Useful for users ie qulaitative characteristics

Short term benefits

• benefits usually recieved at a point when the work is done

• apply basic accounting principles ie unpaid beenefits are recognised as a liability/cost of the benefit recognised as an expense when the benefit is given

• wages / sick pay

Deferred benefits

• Wages overtime

• recieved at a later date

• pension , bonuses

Defined contribution scheme - accounting treatment

• cost of providing a pension is recorded as a renumeration expense in the OCI int he period it is due

• disclosure is required of the pension contribution charged to the statement of comprehensive income

Defined benefot - challenges

• Greater uncertainty of required contributions to meet the actual benefit payable 

  • Cannot be estimated we need to recognise the liability / reliant on actuarial assumption 

• Costly to employer - Regulation / Life expectancy / Interest rates / Returns / Variable contributions 

IAS 19 - disclosures

• Major disclosure requirements require entities to present information that 

  • Explains the characteristics of its defined benefits plan and risks associated 

  • Identifies and explains the amount in its financial statements rising from defined benefot plans

• described the DBP effect on amount, timing, uncertianty of entity future cash flows

Share based payments

• Transactions where entities purchases goods or services from other parties 

• Through issuing shares or through options 

  • Benefits - align interests / cash flows / tax benefits - mitigates the agency problem 

  • IFRS 2 issued to deal with this

Share based payments - challenges

• Share option schemes often  have an exercise price that is higher or at least equal to the current market value 

• No intrinsic value means that the costs cannot be recorded 

• Inconsistent with benefits paid in cash

Debates on whether it should be charged to P and L

• No costs as the reward is given to employees in their capacity in their capacity as shareholders - no charge - ignores that the transaction has occurred - employees have provided a service and are being rewarded 

• Earnings per share are hit twice meaning overstated profits 

• Adverse economic conditions 

IFRS 2 - all share based payments

• Equity settled share based transactions 

• Cash settled share based transactions 

• Transactions where entity or supplier has a choice of cash or equity settlement

IAS 32

• principle for presentation of FA and I

• Any contract that gives rise to both a financial asset in one entity and a financial liability in another 

IAS 32 financial asset

• contractual right

IAS 32 financial liability

• contractual obligation to deliver

Derivatives

• financial instrument

  • Value changes in response to underlying financial variables 

  • Insignificant initial investment and costs / settled at a later date 

• F muse be classified as a financial asset a financial liability or equity according to its substance 

IFRS 9 -

• Initial recognition

• Recognised as soon as contractual provisions of the instruments exist (INCLUDES DERIVATIVES)

• Party to the contract

• As far as the entity carries the risks and rewards that make up the asset and the obligations charge of the liability.

• Different to recognition from the criteria in CF where items recognised where there is a probable outflow of resources and a cost that can be reliably measured

Recognition of financial assets

1. held to maturity

2. available for sale

3. held for trading

Held to maturity

• -Amortised cost (Receivables, government bonds) if the objectives of the business mean the asset is held to collect the cash flows and the asset gives rise on specified dates to cashflows that are solely payments of the principal and interest  on the principal amount outstanding

Available for sale

•  Fair value through other comprehensive income asset is held within a business model whose objective is achieved by collecting cashflows

• and selling FA and the contractual terms give rise to specific dates and payments of the primciple and interest on the principle amount outstanding

Held for trading

• Fair value through the P&L normally relates to equity unless an election is made on initial purchase to recognise through OCI. If the financial asset does not meet the conditions above.

Why does accounting for FI involve risk

• Complexity of financial instruments 

• Fair value measurement 

• Market volatility 

• Credit risk 

• Liquidity risks 

• Disclosure and transparency 

• Regulatory changes

Hedging

• allowed in certain strictly defined circumstances

• Companies will enter into transactions to offset financial risk and uncertainty

• interest rate or exchange rate fluctuations

• Changes in value of commodities

• The purpose of hedge accounting is to reflect the entity’s risk management objectives

Conditions of Hedge accounting

• Must be a direct hedging relationship 

  • Economic relationship 

  • Effect of credit card risk does not dominate in value 

  • Hedged items and instrument are similar size 

• Must be formal documentation to mitigate level or risks 

Examples of hedging instruments

• Derivatives / Forward contract / Future contract/ Options / Swaps -

• Non derivative instruments - Commodity contract /insurance policies 

• Could be misleading and could leave users of financial statment unaware of the level of risk that the company faces - more restriction 

• Recognition - initial contract 

• Value - settle value can fluctuate bear no resemblance to original estimate

Cash flow Hedge

• Hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with the recognised asset or liability that will affect net income 

• The gain or loss on the hedging instrument is recognised directly in other comprehensive income

• Gain or loss on the hedge - initially recognised in other comprehensive income then follows the item to be hedged 

• Hedged item 

  • Through the OCI with the exception of where the hedged utem is an equity investment 

Blockchain

• Blockchain is a sequential database connected by time stamps connected through each block and another , these cannot be inverted without recoding the programme 

• Each entry is record into hash codes 

• Decentralised open database, expected to reduce time and costs while eliminating manipulations through maximising transactions auditability 

  • PWC 2018 - 84% clients involved in blockchain between testing and implementation 

  • Deloitte (2016) - blockchain likely to enhance relationships between business and individuals contributing to a more efficient/sustainable economy

Key features of blockchain

• Monitoring - All users and beneficiaries are given access to monitor transactions, enhancing transparency of accounting information also allows all to manage supply chain 

• Verifiability- Invoices are approved by suppliers and management and saved in blocks, increasing accuracy 

• Irreversibility function - sequential database archive of info which is secured by method of cryptographic proofs using hash functions which cannot be reversed to recover the original proof

Benefits of blockchain

- Acts as an immune system against manipulation, enhancing corporate governance.

- Transforms the audit profession with accurate, timely monitoring for financial information.

- Reduces opportunities for earnings management (e.g., backdating, forward booking).

- Lowers risks of fraud and errors in financial records.

- Increases visibility of transactions, limiting managers' profit manipulation and improving compensation control.

- Simplifies period-end reporting, reducing the need for multiple reconciliations.

- Enables customized financial statements for better decision-making.

Challenges to Blockchain

• limited by the abilities of different users

• risk of obsolesces

• regulators are not ready

• transparency of blockchain

• potential collusion by the network users

• cybersecurity breaches and blockchain hacks

Impacts of blockchain - mitigates agency problem

• Irreversibility and consistency of blockchain ledger would prevent management from backdating existing transaction and creating unreal ones 

• Better monitoring of managers performance 

• Less conflict between stakeholders

• EL DIRI - Many stakeholders lack blockchain expertise, making earnings manipulation harder to detect during early adoption managers may smooth earnings to avoid poor short-term financial performance.

Impact of blockchain - Less information asymmetry

• Smaller information gap between managers and outside stakeholders 

• Managers would not be able to manipulate profits sue to transparency which would result in reputational damage

Impact of blockchain - less contracting costs

• More transparency and high accounting information quality would result in lower costs in establishing contracts

Impact of blockchain - Aggravated agency problem - Worse

• Significant costs as it consumes portions of Rand D provisions 

• Risk of experiencing a drop in their earnings and cash flows 

• According to a blockchain implementation leader interviews from oracle usually reaching millions of euros many drop out 

• Length of the project and invisibility of the investment outcomes

Impact of blockchain - Managerial ability - Worse

Imapact of blockchain - worse - Bounded rationalities

• Financial technology illiteracy of most users could be an obstacle for them un extracting financial information from a blockchain type ledger 

• Training is provided to allow people to make the nest use of blockchain functionalities 

• The arguments isnt valid in practice 

Application of blockchain

• Current 

  • Supply chain/ International payments and trade finance 

• Developing 

  • Auditing of transactions / Improving the transparency of ownership e.g stock exchanges - switzerland working on this 

  • Public sector accounting/ Corporate proxy voting system

• Future 

  • Sustainability reporting  / Recoding of taxation impacts of transactions - HMRC required access to platforms such as deliveroo to allow them to have direct access to their income so they can avoid tax evasion 

Yermack 2017 blockchain disadvantages

• Activists would struggle to secretly build ownership stakes because blockchain increases ownership transparency.

• Shareholder activism may become less profitable.

Yermack 2017 Blockchain benefits

This strengthens shareholder democracy evolving the profession

• Accurate shareholder registers.

• Faster vote counting.

• Lower administrative costs.

• Greater transparency.

• Reduced voting errors.

• Less opportunity for "empty voting" (voting rights without economic ownership).