CHAPTER 3 FINANCIAL REPORTING STANDARDS

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CHAPTER 3

FINANCIAL REPORTING
STANDARDS

Presenter’s name

Presenter’s title

dd

Month
yyyy

OBJECTIVE OF FINANCIAL
REPORTING


Objective
of general purpose financial
reporting

-
To
provide financial information about the reporting entity that is
useful to
existing and potential investors, lenders, and other
creditors
in making decisions about providing resources to the
entity.
Those
decisions involve buying, selling, or holding equity and debt
instruments and providing or settling loans and other forms of credit
.


Investors

-
Buy, sell, or hold


Lenders and other creditors

-
Lend or not

-
Amount and terms

Copyright © 2013 CFA Institute

2

FINANCIAL
REPORTING
USE IN SECURITY
ANALYSIS AND VALUATION


Decisions by investors to buy, sell, or hold securities depends on
expectations about returns (dividend yield and price appreciation).


Expectations
about
returns depend on prospects for
an entity’s

future
cash flows, and assessing those prospects requires information about
an entity’s

-
resources,

-
c
laims on resources, and

-
use of the resources by management and board.


Financial
reports are not designed to show the value of a reporting
entity; they
provide information to help
users
estimate the value of the
reporting
entity.


Financial reports do not and cannot provide all the information needed
by investors and creditors. Other pertinent information must be
obtained from other sources.


Copyright © 2013 CFA Institute

3

IMPORTANCE OF FINANCIAL REPORTING
STANDARDS IN SECURITY ANALYSIS AND
VALUATION


Complexity involved in setting standards reflects the complexity of the
underlying economic reality.


Complexity and uncertainty create the need for judgment by preparers.


Judgment can vary among preparers, so standards are needed to
achieve consistency.


Even though standards limit the range of acceptable approaches,
preparers still must make judgments and use estimates.


By understanding how and when standards require judgments and
estimates that can affect reported numbers, an analyst can make better
use of the information.



Copyright © 2013 CFA Institute

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EXAMPLE

During
an accounting period,
Incook

Inc., a
hypothetical company
that
imports gourmet cookware
sets,
had the following transactions:


Acquired
office equipment for $9,000 in cash


Paid
rent and other miscellaneous business expenses of $10,000


Purchased 100 sets of cookware at a cost of $700 each and paid
100% on delivery


Sold 60 sets to customers for $
1,200 each
($72,000 total). In order to
make the sales,
Incook

had to offer credit terms to many customers
. At
year
-
end, customers owed
Incook

$15,000 for cookware that had been
delivered (i.e., $57,000 cash was collected from customers and,
therefore, $15,000 remained outstanding from customers
).

Incook’s

two owners plan to split the profits 50/50. If no accounting
standards existed, what alternatives might be proposed as reasonable
ways to compute the profits?


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EXAMPLE


Accounting
standards
limit the range of allowable approaches.


Incook

would report sales revenues of
$
72,000; however, that amount
would likely be
reduced
to reflect an
estimate

for
uncollectible
accounts.


Incook

would report cost
of
goods sold of $42,000
.

-
It sold 60 units, each of which cost $700.

-
If the per
-
unit costs were different, cost of goods sold would require
the choice of inventory cost method.


Incook

would report some amount of expense for at
least part of the
office
equipment. The amount of the expense would depend on

-
Estimated useful
life of the equipment,

-
Estimated salvage value of the equipment at the end of its life, and

-
Choice of depreciation method.

Copyright © 2013 CFA Institute

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STANDARD
-
SETTING BODIES AND
REGULATORY AUTHORITIES


Generally
,

-
Standard
-
setting
bodies set the standards
and

-
R
egulatory
authorities
recognize
and enforce the
standards
.


However, regulators
often retain the legal authority to
establish financial reporting standards in their
jurisdictions
and can overrule
private
sector standard
-
setting
bodies.


Copyright © 2013 CFA Institute

7

EXAMPLES OF STANDARD
-
SETTING BODIES


The International
Accounting Standards
Board
(IASB
) sets
IFRS (International Financial Reporting Standards).


The U.S. Financial
Accounting Standards
Board
(FASB
)
sets U.S. GAAP (generally accepted accounting
principles).

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8

EXAMPLES OF REGULATORY
AUTHORITIES

Country

Regulatory authority with primary responsibility for
securities regulation in the country

Australia

Australian Securities and Investments Commission

Belgium

Financial Services and Markets Authority

Brazil

Comissão

de
Valores

Mobiliários

China

China Securities Regulatory Commission

France

Autorité

des
marchés

financiers

Germany

Bundesanstalt

für

Finanzdienstleistungsaufsicht

India

Securities and Exchange Board of India

Japan

Financial Services Agency

Morocco

Conseil déontologique des valeurs mobilières

Nigeria

Securities and Exchange Commission Nigeria

Copyright © 2013 CFA Institute

9

EXAMPLES OF REGULATORY AUTHORITIES
(CONTINUED)

Country

Regulatory authority with primary responsibility for
securities regulation in the country

Portugal

Comissão do Mercado de Valores Mobiliários

Spain

Comisión Nacional del Mercado de Valores

South Africa

Financial Services Board

Turkey

Capital Markets Board of Turkey

United Kingdom

Financial Services Authority*

United States

Securities

and Exchange Commission (SEC)

Uruguay

Banco

Central del Uruguay

Copyright © 2013 CFA Institute

10

*FSA to be succeeded by the Financial Conduct Authority and the Prudential


Regulation Authority in 2013.

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INTERNATIONAL ORGANIZATION OF
SECURITIES COMMISSIONS (IOSCO)


Not a regulatory authority, but an international association
of
securities
regulators formed in 1983


Objectives of IOSCO members:

-
Develop international standards of market regulation to protect
investors and address systemic risks.

-
Exchange information and cooperate in enforcement to enhance
investor protection and promote investor confidence.

-
Exchange information to assist in development of markets,
infrastructure, and regulation.

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IFRS USE AROUND THE WORLD

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12

Country

Status for
Listed Companies
as of December 2011

Argentina

Required for fiscal years beginning on or after 1 January 2012

Australia

Required for all private sector reporting entities and as the
basis for public sector reporting since 2005

Brazil

Required for consolidated financial statements of banks and
listed companies from 31 December 2010 and for individual
company accounts progressively since January 2008

Canada

Required from 1 January 2011 for all listed entities and
permitted for private sector entities including not
-
for
-
profit
organizations

China

Substantially converged national standards

European Union

All member states of the EU are required to use
IFRS
as
adopted by the EU for listed companies since 2005

India

India is converging with
IFRS

at a date to be
confirmed


Indonesia

Convergence process ongoing; a decision about a target date
for full compliance with
IFRS
is expected to be made in 2012

IFRS
USE
AROUND THE
WORLD

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13

Country

Status for
Listed Companies
as of December 2011

Japan

Permitted from 2010 for a number of international companies;
decision about mandatory adoption by 2016 expected around
2012

Mexico

Required from 2012

Republic of
Korea

Required from 2011

Russia

Required from 2012

Saudi Arabia

Required for banking and insurance companies. Full
convergence with
IFRS
currently under consideration.


South Africa

Required for listed entities since 2005

Turkey

Required for listed entities since 2005

United States

Allowed for foreign issuers in the
U.S.
since 2007; target date
for substantial convergence with
IFRS was
2011 and decision
about possible adoption for
U.S.
companies
expected.

CONTINUING DEVELOPMENTS IN FINANCIAL
REPORTING STANDARDS


As illustrated on the preceding slides, although many countries have
adopted IFRS, not all countries have done so.


Financial reporting standards (both IFRS and home
-
country GAAP)
continue to evolve for various reasons, including

-
Changes in economic activity (new types of products and
transactions),

-
Improvements to existing standards, and

-
Convergence between international and home
-
country standards.


An analyst needs to understand whether and how differences in
financial reporting standards affect comparability in cross
-
sectional
analysis.



Copyright © 2013 CFA Institute

14

GLOBAL
CONVERGENCE OF ACCOUNTING
STANDARDS: DIFFERENCES REMAIN


Different reporting systems are used in different countries.


For example, despite convergence efforts, differences remain between
U.S. GAAP and IFRS.

Inventory



IFRS does not allow for the use of the
LIFO (last in, first out)
costing
methodology for inventory, which is permitted under U.S. GAAP.


In the United States,
the Internal Revenue Service
(IRS)
has
conformity provisions such that certain methods of accounting are
allowed for
income tax
purposes only if the entity also uses that
method for financial reporting
purposes. LIFO
is one such method
subject to conformity provisions.


Thus
,
without
a change in IRS rules, eliminating LIFO from U.S. GAAP
would, in effect, eliminate its use for tax purposes as well.


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GLOBAL
CONVERGENCE OF ACCOUNTING
STANDARDS
:

DIFFERENCES REMAIN


Despite convergence efforts, differences remain between U.S. GAAP
and IFRS.

Measurement of Certain Asset
Classes

(optionality
permitted under
IFRS)


Under IFRS, certain assets (e.g., capitalized acquired intangibles and
property, plant, and equipment)
are initially recognized at cost. For
subsequent measurement, entities
have a choice:

-
to
continue with a cost model or

-
To revalue
the assets within each class to fair market value (less any
subsequent accumulated amortization or depreciation).


U.S
. GAAP
does not permit
use of a revaluation model.


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GLOBAL
CONVERGENCE OF ACCOUNTING
STANDARDS
:

DIFFERENCES REMAIN


Despite convergence efforts, differences remain between U.S. GAAP
and IFRS.

Impairment

(property, plant, and equipment; inventory; and intangible
assets)


The
IFRS models allow for reversals of impairments up to a certain
amount if there is an indication that an impairment loss has
decreased


U.S
. GAAP
does not allow reversals
of impairments.


The SEC staff believes that the distinction
could result in differences in
the timing and extent of recognized impairment losses.


Therefore, U.S
. issuers could experience greater income statement
volatility if the IFRS models were
incorporated (flowing
from recoveries
of values previously written
down).


Copyright © 2013 CFA Institute

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GLOBAL
CONVERGENCE OF ACCOUNTING
STANDARDS
:

DIFFERENCES REMAIN


Despite convergence efforts, differences remain between U.S. GAAP and
IFRS.

Certain Nonfinancial Liabilities


The recognition of certain nonfinancial liabilities (e.g., contingencies and
environmental liabilities) is governed by the probability that a liability has been
incurred under both U.S. GAAP and IFRS. However, U.S. GAAP and IFRS
differ in their definitions of what is “probable.”


For example, the definition of
probable

for contingencies is

-
For IFRS, “more
likely than not to occur.”

-
For U.S
.
GAAP, “the
future event or events are likely to occur.”



Likely” is considered to be a higher threshold than “more likely than not,”
meaning U.S. GAAP has a higher recognition threshold than does IFRS.


Therefore,
a liability will often be recognized earlier under
IFRS than
under
U.S. GAAP
.


Copyright © 2013 CFA Institute

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IFRS

CONCEPTUAL FRAMEWORK

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Financial

Position

o

Assets

o

Liabilities

o

Equity



Performance

o

Income

o

Expenses

o

Capital Maintenance Adjustments

o

Past Cash Flows



o

Reporting Ele

Reporting Ele
ments



Relevance
*



Faithful Representation



Comparability, Verifiability,
Timeliness,
Understandability

Qualitative Characteristics

To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity




Objective

Constraint



Cost (cost/benefit considerations)

Underlying Assumption



Accrual Basis



Going Concern

*
Materiality is an aspect of relevance.

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IFRS
CONCEPTUAL FRAMEWORK
:

OBJECTIVE OF FINANCIAL REPORTING


At the core of the
Conceptual
Framework
is
the
objective to
provide
financial information that
is useful to current and potential
providers of resources in making
decisions.


All
other aspects of the
framework flow from that central
objective.


Copyright © 2013 CFA Institute

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Financial

Position

o

Assets

o

Liabilities

o

Equity



Performance

o

Income

o

Expenses

o

Capital Maintenance Adjustments

o

Past Cash Flows



o

Reporting Ele

Reporting Ele
ments



Relevance
*



Faithful Representation



Comparability, Verifiability,
Timeliness,
Understandability

Qualitative Characteristics

To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity




Objective

Constraint



Cost (cost/benefit considerations)

Underlying Assumption



Accrual Basis



Going Concern

*
Materiality is an aspect of relevance.

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IFRS
CONCEPTUAL FRAMEWORK
:

FUNDAMENTAL QUALITATIVE CHARACTERISTICS


Two
fundamental

qualitative
characteristics that make
financial information useful:

-
Relevance
:

Information that
could potentially make
a
difference in users’
decisions.

-
Faithful Representation
:
Information that faithfully
represents
an
economic
phenomenon that it purports
to
represent. It
is ideally

-
complete
,

-
neutral, and

-
free
from
error.


Copyright © 2013 CFA Institute

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Financial

Position

o

Assets

o

Liabilities

o

Equity



Performance

o

Income

o

Expenses

o

Capital Maintenance Adjustments

o

Past Cash Flows



o

Reporting Ele

Reporting Ele
ments



Relevance
*



Faithful Representation



Comparability, Verifiability,
Timeliness,
Understandability

Qualitative Characteristics

To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity




Objective

Constraint



Cost (cost/benefit considerations)

Underlying Assumption



Accrual Basis



Going Concern

*
Materiality is an aspect of relevance.

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IFRS
CONCEPTUAL FRAMEWORK
:


ENHANCING QUALITATIVE CHARACTERISTICS


Four
enhancing

qualitative
characteristics
that make
financial
information useful:

-
Comparability
:
Companies
record
and report information in a similar
manner.

-
Verifiability
:
Independent
people
using the same methods arrive at
similar
conclusions.

-
Timeliness
:
Information
is available
before it loses its
relevance.

-
Understandability:
Reasonably
informed users should be able to
comprehend the
information.


Copyright © 2013 CFA Institute

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Financial

Position

o

Assets

o

Liabilities

o

Equity



Performance

o

Income

o

Expenses

o

Capital Maintenance Adjustments

o

Past Cash Flows



o

Reporting Ele

Reporting Ele
ments



Relevance
*



Faithful Representation



Comparability, Verifiability,
Timeliness,
Understandability

Qualitative Characteristics

To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity




Objective

Constraint



Cost (cost/benefit considerations)

Underlying Assumption



Accrual Basis



Going Concern

*
Materiality is an aspect of relevance.

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IFRS
CONCEPTUAL FRAMEWORK
:


REPORTING ELEMENTS


Elements directly
related to the
measurement of financial
position:

-
Assets
: Resources controlled by
the enterprise as a result of past
events and from which future
economic benefits are expected to
flow to the enterprise.

-
Liabilities
: Present obligations of
an enterprise arising from past
events, the settlement of which is
expected to result in an outflow of
resources embodying economic
benefits.

-
Equity
:
R
esidual
interest in the
assets after subtracting the
liabilities
.

Copyright © 2013 CFA Institute

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Financial

Position

o

Assets

o

Liabilities

o

Equity



Performance

o

Income

o

Expenses

o

Capital Maintenance Adjustments

o

Past Cash Flows



o

Reporting Ele

Reporting Ele
ments



Relevance
*



Faithful Representation



Comparability, Verifiability,
Timeliness,
Understandability

Qualitative Characteristics

To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity




Objective

Constraint



Cost (cost/benefit considerations)

Underlying Assumption



Accrual Basis



Going Concern

*
Materiality is an aspect of relevance.

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IFRS
CONCEPTUAL FRAMEWORK
:

REPORTING ELEMENTS


Elements directly
related to the
measurement of performance
:

-
Income
: Increases in economic
benefits in the form of inflows or
enhancements of
assets
or
decreases of liabilities that result
in an increase in equity (other than
increases resulting from
contributions by
owners).

-
Expenses
:

Decreases in economic
benefits in the form of outflows or
depletions of
assets
or increases
in liabilities that result in decreases
in equity (other than decreases
because of distributions to
owners).

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Financial

Position

o

Assets

o

Liabilities

o

Equity



Performance

o

Income

o

Expenses

o

Capital Maintenance Adjustments

o

Past Cash Flows



o

Reporting Ele

Reporting Ele
ments



Relevance
*



Faithful Representation



Comparability, Verifiability,
Timeliness,
Understandability

Qualitative Characteristics

To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity




Objective

Constraint



Cost (cost/benefit considerations)

Underlying Assumption



Accrual Basis



Going Concern

*
Materiality is an aspect of relevance.

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IFRS
CONCEPTUAL FRAMEWORK
:
CONSTRAINTS AND ASSUMPTIONS


Constraint: The benefits of
information should exceed the
costs of providing it.


Underlying Assumptions:

-
Accrual Basis
: Financial
statements should reflect
transactions in the period when
they actually occur, not
necessarily when cash
movements
occur.

-
Going Concern
: Assumption
that the company will continue
in business for the foreseeable
future.

Copyright © 2013 CFA Institute

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Financial

Position

o

Assets

o

Liabilities

o

Equity



Performance

o

Income

o

Expenses

o

Capital Maintenance Adjustments

o

Past Cash Flows



o

Reporting Ele

Reporting Ele
ments



Relevance
*



Faithful Representation



Comparability, Verifiability,
Timeliness,
Understandability

Qualitative Characteristics

To Provide Financial Information
Useful in Making Decisions about
Providing Resources to the Entity




Objective

Constraint



Cost (cost/benefit considerations)

Underlying Assumption



Accrual Basis



Going Concern

*
Materiality is an aspect of relevance.

FINANCIAL STATEMENTS

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A
complete set of financial statements
includes


Statement of financial position


Statement
of
comprehensive income


Statement of
changes
in
equity


Statement of
cash flows


Notes

GENERAL
FEATURES OF FINANCIAL
STATEMENTS

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27


Fair presentation


Going concern


Accrual basis


Materiality and
aggregation


No offsetting


Frequency of reporting


Comparative
information


Consistency

STRUCTURE AND CONTENT REQUIREMENTS
FOR
FINANCIAL STATEMENTS (IAS
NO.
1)

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Classified
statement
of
financial position
:

Balance
sheet
required to
distinguish between current and
noncurrent assets and
between
current and
noncurrent
liabilities unless a presentation based on
liquidity provides more relevant and reliable information (e.g., in the
case of a bank or similar financial institution).


Minimum
information
on the
face
of the
financial statements
:
Minimum
line item disclosures on the face of, or in the notes to, the financial
statements are specified.


Minimum information
in the
notes
(or on the face of financial
statements):
Disclosures
about information to be presented in the
financial
statements are specified.


Comparative information
: For all amounts reported in a financial
statement, comparative information
for
the previous
period is required.

COHERENT FINANCIAL REPORTING
FRAMEWORK

Characteristics of a coherent
financial reporting
framework


Transparent


Comprehensive


Consistent

Barriers to creating such a
framework


Valuation
: alternative
measurement approaches


Standard
-
Setting
Approach
:

balance
between principles and
rules.


Measurement
: alternative
emphasis on balance
sheet versus income
statement.

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DISCLOSURES OF SIGNIFICANT ACCOUNTING
POLICIES


Companies
are required to disclose their accounting
policies and estimates in the notes to the financial
statements.


Companies also discuss in the management commentary
(MD&A
) those policies that management deems most
important.


Many
of the policies are discussed in both the
management commentary and the notes to the financial
statement.


Companies also disclose information about changes.

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MD&A DISCLOSURES OF SIGNIFICANT
ACCOUNTING POLICIES: EXAMPLE 1

“In
certain instances, accounting principles generally accepted in the United
States of America allow for the selection of alternative
accounting methods
. The
Company’s significant policies that involve the selection of alternative methods
are accounting for shipping and handling costs
and inventories
.

“Shipping
and handling costs may be reported as either a component of cost of
sales or selling, general and administrative expenses.
The Company
reports such
costs, primarily related to warehousing and outbound freight, in the
Consolidated Statements of Income as
a component
of Selling, general and
administrative expenses. Accordingly, the Company’s gross profit margin is not
comparable with
the gross
profit margin of those companies that include
shipping and handling charges in cost of sales. If such costs had been included
in
cost of
sales, gross profit margin as
a percent
of sales would have decreased
by 750 bps, from 57.3% to 49.8% in 2011 and decreased by 730 bps in 2010
and 2009, with
no impact
on reported earnings
.”

Excerpt from MD&A in Colgate Palmolive Company’s 2011 Annual Report

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FOOTNOTE DISCLOSURE OF SIGNIFICANT
ACCOUNTING POLICIES: EXAMPLE 1 (CONTINUED)

Shipping
and Handling Costs

“Shipping
and handling costs are classified as Selling, general
and
administrative
expenses and were $
1,250,
$1,142 and $1,116 for
the
years ended
December 31, 2011, 2010 and 2009, respectively
.”








Excerpt from footnotes in Colgate Palmolive Company’s 2011 Annual Report

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FOOTNOTE DISCLOSURE OF SIGNIFICANT
ACCOUNTING POLICIES: EXAMPLE 1 (CONTINUED)

Use
of Estimates

“The
preparation of financial statements in accordance with accounting
principles generally accepted in the United States of America
requires
management
to use judgment and make estimates that affect the reported
amounts of assets and liabilities and disclosure of contingent gains
and losses
at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. The level
of uncertainty
in estimates and
assumptions increases with the length of time until the underlying transactions
are completed. As such, the
most significant
uncertainty in the Company’s
assumptions and estimates involved in preparing the financial statements
includes pension and
other retiree
benefit cost assumptions, stock
-
based
compensation, asset impairment, uncertain tax positions, tax valuation
allowances and legal and
other contingency
reserves.
…Actual
results could
ultimately
differ from
those estimates
.”



Copyright © 2013 CFA Institute

33

Excerpt from footnotes in Colgate Palmolive Company’s 2011 Annual
Report

FOOTNOTE DISCLOSURES OF ACCOUNTING
PRINCIPLES AND METHODS: EXAMPLE 2


General Information
.

The
consolidated financial statements of Henkel AG &
Co.
KGaA

as
of December 31, 2011 have been prepared in accordance
with
International
Financial Reporting Standards (IFRS) as
adopted by
the European
Union and in compliance with Section 315a
of the
German Commercial Code
[HGB
]….”

“Scope
of
consolidation.
In
addition to Henkel AG & Co.
KGaA

as the ultimate
parent company
, the consolidated financial statements at December
31, 2011
include seven German and 170 non
-
German
companies in
which Henkel AG &
Co.
KGaA

has a dominating
influence over
financial and operating policy, based
on the
concept of
control
..... Compared
to December 31, 2010, four new
companies have
been included
in the scope of consolidation and eleven
companies
have left the scope of consolidation. Seven mergers also
took place
.
The changes in the scope of consolidation have
not had
any material effect on
the main items of the
consolidated financial
statements
.”


Excerpt
from footnotes of Henkel 2011 Annual Report


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FOOTNOTE DISCLOSURES OF ACCOUNTING
PRINCIPLES AND METHODS: EXAMPLE 2

Accounting estimates, assumptions and
discretionary judgments

Preparation of the consolidated financial statements is
based on
a
number of accounting estimates and assumptions.
These have
an impact
on the reported amounts of assets,
liabilities and
contingent liabilities at
the reporting date and the
disclosure of
income and expenses for the
reporting period.
The actual
amounts may differ from these
estimates.

“The
accounting estimates and their underlying
assumptions are
continually reviewed
....The
judgments of the
Management Board
regarding the application of those IFRSs which have
a significant
impact
on the consolidated financial
statements are
presented in the explanatory
notes on taxes on income

… intangible assets...
,
pension
obligations…
,
financial instruments
and
share
-
based
payment plans...”

Excerpt
from footnotes of Henkel 2011 Annual Report


Copyright © 2013 CFA Institute

35

SUMMARY


Objective of financial reporting is to provide financial information about
the reporting entity that is useful to
existing and potential investors,
lenders, and other creditors
in making decisions about providing
resources to the entity.


Fundamental

qualitative characteristics that make financial information
useful include


Relevance and


Faithful representation (complete, neutral, free from error)


Enhancing

qualitative characteristics that make financial information
useful include
Comparability
,

Verifiability
,

Timeliness
, and
Understandability


Constraint: benefits of info should exceed costs


Underlying Assumptions


Accrual accounting


Going
concern

Copyright © 2013 CFA Institute

36