Global financial accounting and reporting principles and analysis 3rd by peter watson

T h i r d

EDITION

Walter Aerts
Peter Walton

Global Financial
Accounting and Reporting:
Principles and Analysis

Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States
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Global Financial Accounting and Reporting:
Principles and Analysis 3rd Edition
Walter Aerts and Peter Walton
Publishing Director: Linden Harris
Publisher: Andrew Ashwin
Commissioning Editor: Annabel Ainscow
Editorial Assistant: Lauren Darby
Project Editor: Alison Cooke
Production Controller: Eyvett Davis
Marketing Manager: Anne Renton
Typesetter: S4Carlisle Publishing Services
Cover design: Adam Renvoize

© 2013 Cengage Learning EMEA
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1 2 3 4 5 6 7 8 9 10 – 15 14 13

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Chapter 2 Accounting and accountants

III

brief contents

Preface  X
Acknowledgements  XI
Structure of the book  XII
Walk-through tour  XIV

Part 1 The accounting and business environment  1
1 Financial reporting and regulation  2
2 Accounting and accountants  29

Part 2 Basic financial statements  57






3
4
5
6
7

Measurement concepts and the balance sheet equation  58

Accruals accounting  98
Non-current assets and depreciation  131
Refining the accounting system  165
Preparing financial statements  197

Part 3 An introduction to financial statement analysis  215
8 A framework for interpretation  216
9 Financial statement analysis I  231
10 Statement of cash flows  261

Part 4 The financial statements of multinational companies  291
11
12
13
14
15
16

The annual report  292
Consolidated financial statements  306
Operating segments and foreign operations  344
Issues in financial reporting by multinationals  379
International taxation  412
Auditing and corporate governance  429

Part 5 Advanced financial statement analysis  449
17 Financial statement analysis II  450
18 IFRS and the future  484
Further reading  492
Glossary  495

Index  504
III

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contents

Preface  X
Acknowledgements  XI
Structure of the book  XII
Walk-through tour  XIV

Part 1 The accounting and business environment  1
1 Financial reporting and regulation  2
Introduction 
2

Using this book  3

Annual financial statements  4

Uses of financial statements  6

Accounting choices  10

Qualitative characteristics  12

Accounting regulation  14

International Financial Reporting Standards  20
Summary 
28

Discussion questions  28

2 Accounting and accountants  29
Introduction 
29

Accounting function  30

Accounting database  34

Recording transactions  34

Organization of data within the general ledger  36

Control and audit  38

The accounting profession  52
Summary 
55

Discussion questions  55

Part 2 Basic financial statements  57
3 Measurement concepts and the balance sheet equation  58

Introduction 
59

The balance sheet does not purport to show what the company is worth  60
IV

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contents












V

Company characteristics affecting financial reporting behaviour  60
Content of financial statements  64
The basics of accounting measurement  70
Generally accepted accounting principles  71

Conventional measurement bases  76
Accounting for transactions  80
The IASB definition and recognition criteria for elements of
the statement of financial position and the statement of profit or loss  89
Summary 94
Discussion Questions  94
Assignments 94

4 Accruals accounting  98
Introduction  99

Accruals basis of accounting  99

Credit transactions  101

Recognition of revenue  105

Period costs  108

Inventories and profit measurement  109

Inventory accounting techniques  115

Net realizable value  117

Accruals and the working capital cycle  118
Summary  120

Discussion Questions  120
Appendices  120

Assignments  126

5 Non-current assets and depreciation  131
Introduction  132

General valuation principles of non-current assets  133

Expensing non-current assets  136

Accounting for depreciation  144

Specific valuation principles by type of non-current assets  149

Intangible assets  149

Tangible assets  155
Investments  159
Summary  160

Discussion Questions  161
Assignments  161

6 Refining the accounting system  165
Introduction  166

Accruals and deferrals of expenses and revenues  166
Provisions  172

Asset impairment  178

Bad debts and doubtful debts  185

Hidden reserves  187

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VI

contents

Summary  192

Discussion Questions  192
Assignments  193

7 Preparing financial statements  197

Constructing financial statements  197

Accounting adjustments  205

Uses of financial statements  208
Summary 
209
Assignments 
209

Part 3 An introduction to financial statement analysis  215
8 A framework for interpretation  216









Introduction   217
Financial structure  218
Sources of finance  220
Dividend policy  223
Working capital management  224
Performance measurement  228
Summary 229
Discussion Questions  230

9 Financial statement analysis I  231

Introduction 231
The purpose of analysis  232
Traditional analysis  234
Tools of analysis  236
Management performance ratios  241
Financial strength ratios  247
Analyzing financial statements  250
Summary 254
Assignments 255

10Statement of cash flows  261










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Introduction 262
Usefulness of cash flow information  262
Cash flow cycles  263
Format and structure of the statement of cash flows  264
Cash flows from investing and financing activities  266
Cash flows from operating activities  270

Direct method for reporting operating cash flows  274
Constructing a statement of cash flows 1  277
Disposal of long-term assets  279

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contents

VII


Constructing a statement of cash flows 2  281
Interpretation 284

Presentational differences  286
Summary 287
Discussion questions 287
Assignments 287

Part 4 T
 he financial statements of multinational
companies  291
11The annual report  292
Introduction 292

The corporate report  294

Publicity document  297

Statement of comprehensive income  298

Analyzing the annual report  304
Summary 305
Discussion questions 305

12Consolidated financial statements  306
Introduction 307

Rationale for consolidated financial statements  311

Control as the basis for consolidation  313

Consolidation basics  314

Acquisition method  316

Goodwill and its subsequent measurement  321

Non-controlling interest  324

Consolidated statement of profit or loss  325

Associates and joint arrangements  329

Disclosure requirements  335
Summary 336
Discussion questions 337
Assignments 337

13Operating segments and foreign operations  344







Introduction 345
Stock exchange requirements  345
Segment reporting  346
Foreign currency transactions and foreign operations  356
Primary translation – translating foreign currency transactions in the
functional currency  359
Secondary translation – translating foreign currency financial statements in a
group’s presentation currency  362

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VIII

contents

Alternative accounting methods for secondary translation  364
Functional currency and type of foreign operation 370
Hedging a net investment in a foreign operation373
Summary 374
Discussion Questions  375
Assignments 375

14Issues in financial reporting by multinationals  379
















Introduction 380
Values in accounting  380
Measurement attributes  383

The IASB’s mixed-attribute model  388
Financial instruments  389
Investment property and agriculture  392
Pension obligations  395
Provisions 399
Post reporting period events  401
Discontinued operations  403
Environmental disclosures  404
Intellectual capital  408
Summary 409
Discussion Questions  409
Assignments 410

15International taxation  412









Introduction 413
Corporate income tax and dividends  414
Deferred taxation  416
International taxation  424
Transfer pricing  425
Tax havens  427
Summary 427

Discussion Questions  428

16Auditing and corporate governance  429









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Corporate governance  430
Statutory audit  437
Issues in international audit  438
Auditor independence  439
Internal control and risk management  441
Audit committee  445
Summary 447
Discussion questions  447

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contents

IX

Part 5 Advanced financial statement analysis   449
17Financial statement analysis II  450












Introduction 450
Investor relations  451
Income smoothing  452
Why earnings fluctuate  453
Professional analysts  457
Quality of earnings  460
Analytical techniques  463
Strategic ratio analysis  466
Shareholder value  473
Summary 475
Assignments 476

18IFRS and the future  484
Introduction 484

Strategic evolution  485

The IASB’s first decade  487

The 2007 financial crisis  489

The next five years  490
Summary 
491
Further reading  492
Glossary  495
Index  504

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P REFACE

This book was conceived as a support for courses whose objective is to provide
students with a working understanding of financial statements and the meaning
of accounting numbers. Our intention is to place reporting in its business context,
and to make it clear to managers how accounting reflects their work. We also aim
to teach the conceptual foundation of accounting and how this translates into the
financial statements of businesses. The book is aimed at future users of accounting
information–managers and analysts – not at future auditors or accountants.
The book is sited emphatically in an intuitive approach to understanding
accounting and concerns itself with the underlying logic of the corporate accounting system and its exploitation in the financial statements. It is not a bookkeeping course and we have used a spreadsheet for double entry, rather than
T-accounts or debits and credits, since we believe that the latter are technically
unnecessary and are practically an obstacle to non-specialists.

The book does not situate itself in an individual national context. It uses International Financial Reporting Standards (IFRS) as its basis, and reflects, therefore,
the rules followed by nearly all European listed companies and by an increasing
number of Asian, African and American (non-US) companies. We also try to keep
up with current IFRS terminology (e.g. statement of financial position, statement
of profit or loss (and other comprehensive income)) in order to be consistent with
the IFRS extracts used in our book.
Walter Aerts
Peter Walton

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acknowledgEments

This book has evolved out of teaching materials drawn from a wide range of
teaching experiences in Belgium, France, Switzerland, the UK and the USA. As a
result many people, students and colleagues, have influenced the content indirectly, and we are grateful for their help and advice over the years. We should also
like to thank Brendan George, Annabel Ainscow, Lauren Darby and Alison Cooke
for their support and commitment in producing a new edition, as well as the rest
of the publishing team at Cengage Learning.
The text contains quotations from published material and we should like to
thank the following for permission to use these: Trustees of the IASC Foundation,
Association of Chartered Certified Accountants (Accounting & Business), the International Federation of Accountants, the United Nations Conference on Trade
and Development, the Organization for Economic Co-operation and Development, the US Securities and Exchange Commission and the Institute of Chartered
Accountants in England and Wales. We also thank the many companies whose
financial statements have supplied illustrative material.

Reviewer Acknowledgements
The publishers and author team would like to thank the following academics for
their review comments which have helped shape this new edition of the book:
Chris Coles – University of Glasgow
Claus Koss – Fachhochschule Regensburg
Blain Lambert – Fontys International School of Business Economics, Venlo
Eileen Roddy – ESCP-EAP European School of Management
Mark Whittington – University of Aberdeen
Eugene Apakoh – Royal Docks Business School

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Structure of the book

The aim of this book is to provide a complete companion to financial reporting
that will take business students with no knowledge of accounting through the
mechanics of how financial records are structured through to being able to understand and analyze published consolidated financial statements. However, this is
not to say that every course will want to devote as much time to financial reporting as this would take. The book is therefore structured into what we believe are
separable building blocks.
Part One covers material that is often not taught as such in a course on accounting and financial statement analysis. It is about the environment within
which financial reporting takes place – how it is regulated, what an accounting
department in a company does, how the accounting records are checked. It also
includes the main material on the International Accounting Standards Board. We
think this is useful background, not least because students come to the course

with different previous exposure to accounting and pre-conceptions as to what it
is. However, it can be dispensed with, or can be set as pre-course reading.
Part Two is the core introduction to financial accounting. We examine the basic accounting techniques used by a reasonably simple individual company and
the preparation of annual financial statements from the accounting database.
This presentation is based on using worksheets to show what is happening in
the company’s accounting database, rather than the formal book-keeping techniques which involve the famous debits and credits. Most courses require this
fundamental knowledge of the accounting equation, the iteration between the
Statement of Profit or Loss (Income Statement) and the Statement of Financial
Position (Balance Sheet) and accruals accounting.
Part Three then provides a discussion about how financial statements are interpreted. Chapter 8 provides a thumbnail sketch of some of the finance theory that
informs interpretation. Most accounting books do not contain such a chapter but
we have included it on the basis that accounting is often taught before finance
in an MBA or management course and this may help students get to grips with
the purposes of analysis as opposed merely to the techniques. It can easily be
dispensed with. Chapter 9 contains the basic material on accounting ratios, and
Chapter 10 introduces the Statement of Cash Flows as a statement that analyses
the changes in opening and closing financial position. In our view Parts Two and
Three constitute a basic introduction to accounting for non-financial managers.
However, we are aware that most sets of published financial statements that
a manager will want to review are likely to be consolidated financial statements,
and our preference in our own teaching is to include some material, however limited, on group accounts. In Part Four, we show how groups of companies prepare
consolidated financial statements to enable them to present a worldwide picture
of their economic situation. Chapter 11 provides a little contextual analysis about
the annual reports of multinational companies and their use and introduces the
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Structure of the book

XIII

Statement of Comprehensive Income. Chapter 12 provides the basics of how a
consolidation is done.
A course could certainly stop there, but we provide two chapters with further
technical issues. Chapter 13 aims to show that the consolidated statements are a
confection of statements drawn up in different currencies and dealing with different activities. The chapter addresses segment reporting and foreign currency
translation issues. Chapter 14 analyzes a selection of current technical issues, including a discussion of fair value and financial instruments. We think this may go
beyond what some teachers are aiming to achieve at entry level but we also think
students may find it useful to have such a discussion. Chapters 15 and 16 are offered in the general spirit of trying to address all major issues that intersect with
financial reporting in order to provide a complete guide for the non-financial
manager. Again, many courses may not want to spend time on this, but on the
other hand the student who buys and keeps the book will be able to refer back to
it should the need arise.
Part Five goes further into techniques of financial statements analysis and reviews those such as Z scores, shareholder value and growth calculations. It could
be dropped entirely or be taught with Chapter 9. The final chapter takes a look
at the changing priorities of the IASB since its inception and analyses the likely
changes in standards up to 2015.

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W ALK - THROUGH TOUR

12

PART 1 THE ACCOUNTING AND BUSINESS ENVIRONMENT

CHAPTER 1

the existing Framework document, while removing the parts that they replaced. It
now refers to this document as the Conceptual Framework.

STANDARDS
IASB CONCEPTUAL FRAMEWORK (extracts)
Usefulness of Financial Reporting in Assessing Cash Flow Prospects
OB3. Decisions by existing and potential investors about buying, selling or
holding equity and debt instruments depend on the returns that they expect
from an investment in those instruments, for example dividends, principal
and interest payments or market price increases. Similarly, decisions by existing and potential lenders and other creditors about providing loans and other
forms of credit depend on the principal and interest payments or other returns
that they expect. Investors’, lenders’ and other creditors’ expectations about
the returns depend on their assessment of the amount, timing and uncertainty
of (the prospects for) future net cash inflows to the entity. Consequently, existing and potential investors, lenders and other creditors need information to
help them assess the prospects for future net cash inflows to an entity.

Financial reporting and regulation

This chapter lays out the structure of the book, and the approach it takes to mastering
accounting information. The first step is a review of what financial information is for

Usefulness of Financial Reporting in Assessing Stewardship
OB4. To assess an entity’s prospects for future net cash inflows, existing and
potential investors, lenders and other creditors need information about the
resources of the entity, claims against the entity, and how efficiently and effectively the entity’s management and governing board have discharged their

responsibilities to use the entity’s resources. Examples of such responsibilities include protecting the entity’s resources from unfavourable effects of economic factors such as price and technological changes and ensuring that the
entity complies with applicable laws, regulations and contractual provisions.
Information about management’s discharge of its responsibilities is also useful for decisions by existing investors, lenders and other creditors who have
the right to vote on or otherwise influence management’s actions.

and how it is controlled by governments, the stock exchanges and other institutions.
It introduces International Financial Reporting Standards (IFRS) as the main technical
reference in this book.

Chapter Structure
■
■
■
■
■
■
■
■
■
■

Introduction
Using this book
Annual financial statements
Uses of financial statements
Accounting choices
Qualitative characteristics
Accounting regulation
International Financial Reporting Standards
Summary

Discussion questions

Source: IASB, Conceptual Framework for Financial Reporting: The objective
of general purpose financial reporting issued September 2010

Qualitative characteristics
Qualitative characteristics are the attributes of financial information that underpin the decision-usefulness of financial reporting. Making these explicit does
not, however, necessarily make it any easier for preparers and auditors to make
accounting policy choices. It does, however, provide a framework for discussion
and evaluation.

Introduction

Fundamental versus enhancing characteristics

The ultimate objective of this book is to enable you to use financial accounting
information effectively. Accounting reports are the only way currently available
of getting a picture of what a company is doing, how it is structured and so on.

As we have seen, the IASB’s conceptual framework says that decision-usefulness
is the over-riding characteristic that is necessary in financial reporting. Chapter

2

Standards These reproduce extracts from the International
Financial Reporting Standards (IFRS) and other sources of information published by the IASB.

Chapter/part openers
Describe the contents of the chapter in outline and how it fits
into the ‘big picture’.

CHAPTER 5 NON-CURRENT ASSETS AND DEPRECIATION

COMPANY REPORT

Significant accounting policies
(H) Intangible Assets
Intangible assets with indefinite useful lives, such as trademarks, are stated at
cost less accumulated impairment losses. Intangible assets with indefinite useful lives are not amortized. Instead, they are tested for impairment annually and
whenever there is an indication that the intangible asset may be impaired.
Intangible assets with finite useful lives are stated at cost less accumulated
amortization and impairment losses.
Intangible assets with finite useful lives, such as acquired technology and
customer relationships are amortized on a straight-line basis over their estimated useful lives, generally for periods ranging from 3 to 20 years.
In accordance with IFRS 3 Business Combinations, if an intangible asset is
acquired in a business combination, the cost of that intangible asset is its fair
value at the acquisition date. The fair value of an intangible asset reflects market expectations about the probability that the future economic benefits embodied in the asset will flow to the entity.
Research and development costs are expensed as they are incurred, except
for certain development costs, which are capitalized when it is probable that a
development project will be a success, and certain criteria, including technological and commercial feasibility, have been met. Capitalized development costs
are amortized on a systematic basis over their expected useful lives.

Company reports These are extracted from
the reports of well-known companies that report
in IFRS GAAP to give a concrete, real-world
accounting and to
usedthe
in thetext.
production or supply of goods and services, or for
dimension

administration.
Source: Agfa, Annual Report, 2010

A detailed analysis of these assets, divided into major classes and showing original cost (or valuation) and accumulated depreciation, has to be shown and is
usually given in the notes to the accounts.

Land and buildings
In general terms, a company would recognize such an asset as land or buildings at
a value which was based on the acquisition cost and any other ancillary costs. A
simple case would be where a company buys a ready-built factory and may only
have ancillary costs for professional fees such as for a surveyor and the solicitor
who drew up the contract. Both the acquisition price and the fees would be capitalized in the value of the asset – the fees represent an integral part of the cost of
bringing the asset to the location and condition necessary for it to be capable of
operating in the manner intended by management.
A more complicated case might be where a company buys a plot of land on
which there is a derelict building, demolishes the building, clears the site and
builds a new factory. The value of the factory in the company’s accounting records would include all those costs, as well as perhaps architect’s fees and so on.

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156

PART 2 BASIC FINANCIAL STATEMENTS

BETWEEN THE LINES
Intellectual capital

AGFA – INTANGIBLE ASSETS (extract)

XIV

157

Intellectual capital is a relatively new and enigmatic concept, relating primarily
to the intangible, highly mutable assets of the firm or, as some have put it, the
‘brain power’ of the organization. This brain power accounts for an increasing
proportion of the capital in traditional industries and forms the backbone of
the rapidly growing technology and knowledge-intensive sectors in the global
economy.
Microsoft is used as the example of the hidden value of these intangible assets of the firm. In 1996 Microsoft’s market value was 11.2 times its tangible asset
value. This ‘missing’ value to a large degree represents the market’s estimation of Microsoft’s stock of intellectual capital that is not captured in its financial
statements.
This is not the exception but rather the rule in financial reporting and illustrates one of the major limitations of the current financial reporting model.
The Canadian Institute of Chartered Accountants concludes that accounting for
intellectual capital will require developing accounting measures that can differentiate between firms in which intellectual capital is appreciating versus firms
in which it is depreciating, and measures that will show the long run return in
investment in people skills, information bases and the technological capabilities of organizations.
Source: Extract from ‘Buried treasure’ by Ramona Dzinkowski, World Accounting Report, May 1999

Between the lines These highlight additional
discussion points throughout the text.
that customer goodwill is separable, a necessary condition to meet the definition
of an intangible asset. As such exchange transactions are rare, this kind of goodwill is not frequently encountered in company accounts. However, if recognized,
the purchased goodwill must be expensed in the usual way. Views differ as to the
appropriate length of the period and the tendency is towards a short economic
life on the basis that once the customers have tried the alternative service it is the
quality of the alternative which will determine whether they remain customers
or not.
IAS 38 explicitly prohibits the recognition of internally generated goodwill as
an asset, because it is not an identifiable (separable) resource controlled by the

company that can be measured reliably at cost.
There is a third type of goodwill (goodwill arising on consolidation) which is
a product of accounting for groups of companies and will be discussed in that
context in Chapter 12.

Tangible assets
Historically, tangible long-term assets have been the major assets of companies.
IAS 16, Property, Plant and Equipment, covers the main non-current tangible assets. Property, plant and equipment are tangible assets held for more than one

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WALK-THROUGH TOUR

28

PART 1 THE ACCOUNTING AND BUSINESS ENVIRONMENT

200

XV

PART 2 BASIC FINANCIAL STATEMENTS

future periods and deferring revenues received but yet unearned at reporting
date. (The information for this in a practical situation comes from examining individual ledger accounts to check the periods covered by payments/
receipts, and examining payments/receipts after the balance sheet date.)

Summary

3. Charging annual depreciation: Debiting the operating expenses and crediting accumulated depreciation (or amortization) to reflect the expensing of
long-term assets consumed during the year.

The object of this chapter was to start to explain the environment of accounting. It has looked at the main financial statements published by companies and
discussed the framework through which these are regulated. It has noted that
governments need to regulate accounting to ensure the efficient running of the
economy and the financial markets in particular, since business relies heavily on
accurate information about other businesses. Government also wants to collect
taxes and accounting is linked directly with the calculation of taxable profits.
Apart from this, there are other bodies with an interest, notably stock exchanges,
specialist standard-setting agencies and bodies organized by the accounting profession or industry sectors.
In the international field there is a strong movement towards the use of International Financial Reporting Standards which are promulgated by the IASB.
These enable company reports to be compared across national boundaries and
help smooth management decision-making in the context of global business.

4. Updating provisions: Adjusting existing provisions for uses and reversals and
adding new provisions.
5. Reviewing assets for potential impairment: If an impairment test evidences an
impairment loss, the asset value will be decreased (credited) while the impairment loss will be accounted for in the statement of profit or loss as an
operating expense (debiting an expense account).
The easiest way to see what happens in practice is if we now take an example, and
work through the adjustments individually.

Worked example
The trial balance of Mornington Crescent Emporium SA as at 31 December 20X1
was as follows:

Discussion Questions

Mornington Crescent Emporium SA

Trial balance as at 31 December 20X1

www.cengage.co.uk/walton_aerts2
1.
2.
3.
4.
5.
6.
7.

€

What are the annual financial statements of a company?
Contrast broadly the regulatory traditions in continental Europe as opposed
to the anglophone countries.
Are the financial accounting requirements of entities in the public sector
different from those of business in the private sector?
Compare and contrast the different types of accounting regulation that exist.
How is the IASB’s organizational setting structured?
Explain the potential trade-off between relevance and verifiability.
Explain what is meant by relevance, faithful representation and
comparability and how they make financial information useful.

Assets
Land
Equipment (at cost)
Accumulated depreciation
Inventory at 1 January X1
Trade receivables

Bank

30 000
15 000
–4 500
13 250
23 000
18 560
95 310

Financing
Share capital
Retained profits
Trade payables
Sales
Purchases
Salaries and wages
Rent
Insurance
Legal and professional expenses
Telephone
Light and heat

50 000
10 500
16 850
193 000
–145 000
–15 325
–10 000

–2 500
–1 250
–345
–620
95 310

Summary  Each chapter ends with a comprehensive summary that provides a thorough recap of issues in each chapter,
helping you to assess your understanding and revise key
content.

162

Worked examples  
These clearly apply the principles covered in the book to illustrate
the meaning clearly.

CHAPTER 7 PREPARING FINANCIAL STATEMENTS

PART 2 BASIC FINANCIAL STATEMENTS

Summary
In this chapter we first looked at the question – central to profit measurement –
of the treatment of the costs of using up the company’s productive capacity. We
have seen that where an asset has a determinable life within the company, the cost
of using up the asset must be allocated over this life, and impacts upon the estimate of profit for each accounting period. We have seen that there are several
conventional bases for measuring depreciation and these do not necessarily reflect
their economic consumption when there are tax considerations involved. We have
noted that the depreciation charge reduces profit but does not cause any cash flow,
thereby introducing another systematic difference between profit and cash flow on
a period-to-period basis. When a long-term asset is disposed of, both gross acquisition value and accumulated depreciation are offset against disposal proceeds and a

gain or loss on disposal is included in the statement of profit or loss.
We have also considered the accounting treatment and valuation specifics of the
main long-term asset categories. Specific recognition and measurement rules with
regard to intangible assets, tangible assets and investments have been reviewed.

Discussion Questions
1.
2.

3.
4.
5.

Contrast the accounting consequences of financing the acquisition of a
building through a bank loan or as a finance lease.
What is included in the acquisition cost of a long-term tangible asset? Give
examples of at least four costs that would be included in the acquisition cost
of a new production line.
Discuss the recognition rules for research and development costs.
Under what conditions will the disposal of a long-term tangible asset lead to
a loss? How will the sale affect the financial statements?
What are the most common causes of the depreciation of a long-term tangible asset?

Assignments
The following questions have answers on the lecturer side of the website at
www.cengagelearning.co.uk/walton_aerts2
1.

Profit forecasts
A company is considering investing in a project with a five-year useful life.

The project involves paying €75 000 for a licence to manufacture a new product and equipping a production line at a cost of €300 000. The product is expected to have a useful life of five years only, and at the expiry of that time
the production line will be sold and should yield a salvage value of €50 000.
In order to launch the product the company plans a three-month advertising
campaign which will cost €100 000.

211

Summary
In this chapter we have demonstrated the technique used to prepare annual financial statements from the ledger. This involves extracting a trial balance and
then using that as a working paper in which we incorporate adjustments for revenues and expenses that fall either side of the year end. The objective is to assign
revenue and expense to the appropriate year. We have also discussed how different capital structures are treated in the financial statements.

Assignments
The following questions have answers on the lecturer side of the website at
www.cengage.co.uk/walton_aerts2
1.

The trial balance of Arénières Inc. at 31 December 20X4 was:
€
Land
Buildings (at cost)
Accumulated depreciation buildings
Equipment (at cost)
Accumulated depreciation equipment
Bank account
Trade receivables
Inventory at 1 January
Share capital
Reserves
7 per cent debenture

Trade payables
Sales
Purchases
Salaries
Other operating expenses
Interest expense
Interim dividend

82 100
120 000
–36 000
89 500
–53 700
83 200
91 300
214 300
100 000
185 600
50 000
184 800
942 700
–398 100
–343 600
–102 200
–3 500
–25 000

The following additional information is provided:
(a) The closing inventory at 31 December 20X4 was €216 300.
(b) No depreciation has been provided for 20X4. The company assumes zero

residual values and uses the following straight-line rates: buildings 2 per
cent and equipment 20 per cent.
(c) The audit fee for 20X4 is expected to be €20 000.

Assuming that in each year the expected sales are €1 000 000 and expenses
other than those detailed above are €800 000, draw up two alternative

Discussion Questions  These appear in some
chapters and help to reinforce and test your knowledge
and understanding providing a basis for group discussions and activities.

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Assignment Questions These appear in some
chapters and test the application of principles covered –
the answers are provided on the password-protected part
of the website.

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XVI

digital support resources

Global Financial Accounting and Reporting

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PART ONE

The accounting and
business environment

This first section of the book is intended to provide context and background to the
world in which financial reporting takes place. Many management students may
never previously have come across accounting nor have any idea of the structures
within which it takes place. This section tries to provide background information that
should help students understand the subject better in a real world setting. Chapter 1
introduces financial statements and the institutional framework within which
International Financial Reporting Standards are developed. Chapter 2 talks about
accountants and their different functions.

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CHAPTER 1

Financial reporting and regulation

This chapter lays out the structure of the book, and the approach it takes to mastering
accounting information. The first step is a review of what financial information is for
and how it is controlled by governments, the stock exchanges and other institutions.
It introduces International Financial Reporting Standards (IFRS) as the main technical
reference in this book.

Chapter Structure
nIntroduction
n Using

this book
financial statements
n Uses of financial statements
n Accounting choices
n Qualitative characteristics
n Accounting regulation
n International Financial Reporting Standards
nSummary
n Discussion questions
n Annual

Introduction
The ultimate objective of this book is to enable you to use financial accounting
information effectively. Accounting reports are the only way currently available
of getting a picture of what a company is doing, how it is structured and so on.
2

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Chapter 1 Financial reporting and regulation

3

Photographs can show you the company’s physical locations and, if it manufactures
or sells physical products, what these look like. Words can describe the company
and its products, but only accounting data can tell you about a company’s profitability, its size and its financial structure in a format which is more or less comparable with other companies and carries with it an assurance that this is the whole of
the company, warts and all, that you are looking at, not just the good-looking parts.
Financial accounting is intimately linked with business and, as Karl Marx was
the first to point out, business cannot exist, except in very primitive forms, without
accounting. Accounting data make the business visible, measure its progress and
make it possible to manage the business and understand it. Accounting enables
the business to work in many locations, directed by a central team. Multinational
companies can only work because accounting is there to control what is going on
in distant places, to monitor this and to provide information back to centre.
If you look at developing countries and those in transition to a market economy, the lack of accounting skills and of reliable and independent auditors to
verify data and ensure that resources are used as intended are major obstacles to
economic progress.
On the whole, most managers meet accounting in the form of financial reports, and are rarely concerned with the day-to-day running of the accounting
department. However, they do interface with this in areas such as salaries, expense refunds, authorizing payment of invoices and so on. Financial reports and
understanding them are the central issue in this book, although we will certainly
pass by the accounting department to see what is going on there, as well as review audit, both internal and external. We will focus also on published financial
reports. The calculation and dissemination of internal reports is itself a long and
complicated subject, usually dealt with as management accounting or managerial
accounting, and calling for adaptation of standard accounting data for internal
purposes. In order to understand that, you need to know about standard accounting data, and that is the purpose of this book. What you learn here will enable
you to understand the annual financial statements published by companies
but also the basis of most internal reports as well, since they use the same source
data. Externally disseminated financial statements have to be drawn up by reference to a set of accounting rules (sometimes referred to as a ‘comprehensive
basis of accounting’). This book focuses on the rules issued by the International
Accounting Standards Board (IASB) which are used by listed companies in many
countries in the world, including the European Union.

Using this book
The book is organized to take you into the accounting world in a series of steps;
these do not involve your learning how to be an accountant. In Part One, we will
look at the environment within which financial reporting takes place – how it is
regulated, what an accounting department in a company does, how the accounting records are checked. In Part Two, we will go on to examine basic accounting
techniques used by a reasonably simple individual company and the preparation
of annual financial statements from the accounting database. This presentation
will be based on using worksheets to show what is happening in the company’s
accounting database, rather than the formal book-keeping techniques which involve the famous debits and credits. Part Three will then discuss how financial
statements are interpreted.

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4

Part 1 The accounting and business environment

We then move on to look at larger companies. In Part Four, we see how groups
of companies prepare consolidated financial statements to enable them to
present a worldwide picture of their economic situation. We will then go on to
consider related issues of international taxation, auditing, corporate governance
and dissemination of information to stock exchanges. Part Five will come back
to financial statement analysis and review more sophisticated techniques such
as growth calculations, integrated ratio analysis, shareholder value and Z scores.
While the structure of the book has been designed to lead you logically through
a potential minefield as comfortably as possible, you can, of course, choose to
omit some chapters. Our intention is not merely to teach you to understand the

nature of accounting information but also to enable you to understand the interactions between accounting and management in a wider sense and to see how
intimately accounting links with the life of the company, both internally and in
helping manage relations with the outside environment in which the company
operates.

Annual financial statements
All commercial companies produce annual financial statements (also known as the
annual report, the annual accounts). Generally these have to be filed with the
government, either centrally or in regional offices, and they have to be sent to
shareholders. In many countries the government file is available to the public, so
the financial statements are in effect public and available to competitors or customers or suppliers, and are regularly consulted by these. Equally there are credit
information companies, such as Dun & Bradstreet, Standard & Poor’s or Moody’s
Corporation, which collect financial information and sell it to interested parties.
Many small companies do not like this exposure, but large companies generally welcome it and indeed publish the data widely, including on their websites.
Large companies are well aware that this is the only independently confirmed
information on the company which is widely available, and is a major tool in
engendering confidence in those with whom the company wishes to do business.
The annual financial statements typically consist of the following elements:

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n

The statement of profit or loss (also referred to as ‘income statement’ or ‘profit
and loss account’) reports on the revenue, costs and profit of the company for the year and consequently is the main performance indicator as
far as profitability is concerned. The IASB has recently enlarged the scope
of this financial performance statement and now calls it the ‘statement of
comprehensive income’ (which is also described as the ‘statement of profit

or loss and other comprehensive income’ referring to its two components).



n

The balance sheet (the IASB terminology is ‘statement of financial
­position’) gives a picture at a given moment – the last day of the financial year – of how the company has been financed and how that money
has been invested in productive capacity (plant, buildings, computers,
­inventories etc.).



n

The notes to the accounts (in North America these are called ‘footnotes’)
can be anything from two or three pages to 40 or 50 – the notes provide
­detailed analysis of some of the figures in the Statements of Financial
­Position and Comprehensive Income, such as the dates when loans fall

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Chapter 1 Financial reporting and regulation

5

due for repayment, or the different constituents of the total inventory.
­Importantly, the notes also contain a statement of the accounting
­policies followed by the company. They are increasingly a means of

conveying non-accounting information, such as contingent environmental
liabilities, to interested outsiders. The notes are subject to audit.


n

The statement of cash flows is an analysis of the main cash movements
through the company in the previous 12 months – cash created by the
company through profitable operations, cash spent on acquiring new
­capacity, cash repaid to lenders and new borrowings. This statement is
obligatory in most developed countries but not all.



n

The statement of changes in equity is now, under IFRS, a separate report which
details dividend payments, issues of capital and other transactions that
change equity, including the net profit (net income) for the year.



n

The audit report is the statement by the independent auditors of their opinion on the other statements.

For a large multinational, these reports are usually bundled together with a lot
of voluntary disclosures about group activities. Typically the published ‘annual
report’ of a company will start with a chairman’s statement, thanking the management team and saying what a good (usually, but just occasionally bad or indifferent) year it has been and so on. This is followed by many pages of photographs
of managers, products and plant, as well as lots of charts, graphs and other data

which show how individual divisions in the group have behaved. None of this
data is subject to independent checking – but it is nonetheless very useful information which no one should neglect. It very often gives a more detailed picture
of the deeds behind the numbers, and helps an analyst get a feel for the company.
We will discuss corporate governance issues in more detail in another chapter, but between the operating information and the hard accounting information,
many companies put in disclosures, which stock exchanges and other regulators have encouraged or even made mandatory, about company policy in what
are perceived as key areas – above all, future prospects, but also things like the
company’s continuing viability, the risks that it faces, the nature of the control
systems which enable the management to believe that they know what is going
on in the company worldwide, and how the company deals with sensitive issues
such as relations between the management and the auditors, and the award of
salary increases to senior management.
If you’ve never seen the hard copy of a company’s annual report, you should
have a look at one and preferably several. Generally all you need do is go to the
company’s website and follow a link to ‘investors’ or ‘investor relations’. In most
cases the full annual report is directly downloadable from the company website.
It may have occurred to you that publishing the annual report is an extremely
expensive business – it is. Aside from the cost of creating the financial statements
in the first place and indeed having them audited, the cost of producing the
photo-graphs, artwork and analytical copy, plus running them past your company
lawyers and your public relations advisers, is very high before you even get into
the cost of printing probably several million copies and having translations made
if, like many multinationals, your report is available in several languages. Internally the annual report will involve the accounting managers, the legal and company secretarial specialists, the investor relations staff and public relations – apart
from the chief executive, chairman and the board. Also note that companies try

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Part 1 The accounting and business environment

to publish their annual report as soon as possible after the financial year end –
companies listed in the US often aim at six to eight weeks after the year end.
More than 12 weeks is unusual, and the EU specifies a maximum of four months
for listed companies.

Uses of financial statements
It is a standard question to ask who uses company financial statements. Broadly,
very many people inside and outside the company look at these documents – as
we have said already, they constitute the only performance indicator that is publicly available and independently verified. So we can be confident that they are
used. What no one has been able to prove incontestably is how financial data
are integrated into decision-making and how different accounting scenarios influence users. Accounting data is, or should be, only one of several sources of
information about a company and its future prospects. They are concerned with
past performance which is not in all circumstances a guide to future performance.
Many people prefer to let a specialist (a broker, financial analyst or financial journalist) look at the data and then provide an opinion.
The IASB – of whom more later – says the following:

STANDARDs
IASB CONCEPTUAL FRAMEWORK (extracts)
The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential
equity investors, lenders, and other creditors in making decisions about providing resources to the entity.
Source: IASB, Conceptual Framework for Financial Reporting:
The objective of General Purpose Financial Reporting, para OB2, issued September 2010

While usefulness for decision-making as an objective of financial statements
makes sense, it needs to be put into context. There are two major different traditions in accounting which affect not only how accounting is regulated but also
how it is done and how it is used. These are the Anglo-Saxon tradition and the
continental European tradition, and we will need to come back to these ideas

time and again to explain how accounting works.

Anglo-Saxon accounting
The IASB statement owes more to the Anglo-Saxon than to the continental tradition of accounting. Anglo-Saxon is the term widely used, but ‘anglophone’ would
be more appropriate. In this tradition, countries (US, UK, Australia, Canada, New
Zealand, etc.) had in the early twentieth century no free-standing accounting regulations on their statute book (although they had criminal laws, tax laws, etc.).
Instead businesses were left to work out their own accounting rules (but alongside disclosure requirements enshrined in company or stock exchange law), and

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Chapter 1 Financial reporting and regulation

7

this often took place alongside the development of a powerful accounting profession. You could call this a market solution – to the extent that companies need to
­communicate understandably, such as to raise finance, they use understandable
common measures, but no one obliges them to do so.
What has then happened is that the government has reinforced the market
from time to time, so that the legal obligation to provide information has
grown over time. The regulations have generally been made heavier following
on from some market abuse – such as the Enron frauds in the US or, further back,
historically the Wall Street crash of 1929. This last was blamed on adventurous
accounting, and the Securities and Exchange Commission (SEC), which is the
world’s leading stock market regulator, was created by the US government as a
response.
Accounting regulation in the anglophone countries is a function of the legal
vehicle used, not a function of the kind of activity carried on by the business (although there are often special rules for banks and insurance companies, which we

do not address in this book). So if you are a US company that wants to be listed
on the New York Stock Exchange, you will need to meet stringent SEC accounting
requirements, but if you want to run the same business with no public offering of
shares, there are hardly any formal accounting requirements which apply in the
US. Similarly, if you want to constitute your business as a public limited company
(plc – not necessarily listed on the London Stock Exchange) in the UK, you will
have to comply with many corporate accounting rules, but if you constitute it as
a partnership, there are no statutory requirements for accounting.

STANDARDS
IASB CONCEPTUAL FRAMEWORK (extracts)
Users of financial statements
OB5. Many existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must
rely on general purpose financial reports for much of the financial information
they need. Consequently, they are the primary users to whom general purpose financial reports are directed.
OB10 Other parties, such as regulators and members of the public other
than investors, lenders and other creditors, may also find general purpose
financial reports useful. However, these reports are not primarily directed to
these other groups.
Source: IASB, Conceptual Framework for Financial Reporting:
The objective of General Purpose Financial Reporting, issued September 2010

In an Anglo-Saxon accounting context, the financial statements are traditionally a function of the financing of the company. They derive from the Industrial
Revolution when technology first transformed business and entrepreneurs started
looking for vehicles through which they could raise capital to start industrial
ventures. Prior to the Industrial Revolution most business investment was made
by owner-managers and was inevitably relatively small scale. But from this point

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8

Part 1 The accounting and business environment

on, the managers of companies were less and less often the source of finance for
those companies, and financial reports developed as a means of informing outside ­financiers (shareholders principally but also banks) as to what had been done
with their money. We have the start of a split between management and capital: professional managers started to run ‘companies’ in which several investors,
eventually many, had put money.
The annual accounts were a necessary means of informing the investors (shareholders) and creating an atmosphere of confidence, which in turn would encourage investors to reward the managers – in conditions of uncertainty, the investors
would reduce the reward to managers because they could not be sure that it had
been earned. At the same time, the idea of independent audit developed as a
means of increasing the degree of confidence which shareholders might have in
the financial statements. In more recent times, companies have simply extended
this principle to customers, suppliers, staff and the general public, as these have
become more sophisticated in their understanding of financial data.

Continental Europe
The continental European accounting tradition has its roots much earlier in business history than Anglo-Saxon accounting. The main model for European systems
started out in 1673 as a French government statute (known as the ‘Savary Ordonnance’), which was borrowed by other countries in this form or in its later form as
part of Napoleon’s Commercial Code (1807). The French required all businesses
(in whatever legal form, but companies as such were rare at that time) to calculate
an annual ‘inventory’ – in effect a statement of financial position (balance sheet).
The French model was subsequently borrowed by many countries, one way and
another, and in particular by Belgium, Spain, Germany and Italy (this is not to suggest that accounting regulation in those countries is still exactly the same now –
regulation is constantly evolving).
The main reason for its introduction in France is believed to have been government regulation of the economy. The government was concerned at the large number of business bankruptcies. Apart from causing people to lose money, bankruptcies
also damage confidence in the market, and this, you will appreciate, is essential if the

market is to function correctly. Government concern to strengthen the operation of
the market, and thus the national economy, is often a key trigger of regulation.
The effect in continental Europe has been to create a tradition where all businesses are subject to accounting rules (with extra rules for limited liability companies and listed ones), and where accounting regulation is primarily the concern of
the government rather than the accounting profession or companies themselves.
This remains broadly the case in these countries still.

Link with taxation
These different historical roots can probably also explain another important
aspect of accounting regulation – the link between measuring performance for
shareholders and measuring profits for tax purposes. This link is looser in AngloSaxon countries than in continental European ones. In the United Kingdom, income tax was introduced first in 1799 – well before there was any accounting
regulation as such. There grew up a tradition, therefore, where measurement

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