Financial Accounting and Reporting

Financial Accounting and Reporting NINTH EDITION Barry Elliott and Jamie Elliott Prentice Hall FINANCIAL TIMES /in imprint of Pearson Education Harlow, England London New York Boston San Francisco Toronto Sydney Singapore Hong Kong Tokyo Seoul Taipei New Delhi Cape Town Madrid Mexico City Amsterdam Munich Paris Milan

Brief Contents Preface and acknowledgements Part I INCOME AND ASSET VALUE MEASUREMENT SYSTEMS xx I 1 Accounting and reporting on a cash flow basis 3 2 Accounting and reporting on an accrual accounting basis 22 3 Income and asset value measurement: an economist's approach 40 4 Accounting for inflation 60 Part 2 REGULATORY FRAMEWORK- AN ATTEMPT TO ACHIEVE UNIFORMITY 97 5 Financial reporting: evolution of the regulatory framework in the UK 99 6 Financial reporting: evolution of international standards 133 7 Conceptual framework 152 8 Published accounts of companies 177 9 Preparation of published accounts 221 Part 3 BALANCE SHEET - EQUITY, LIABILITY AND ASSET MEASUREMENT AND DISCLOSURE 245 10 Share capital, capital maintenance and distributable profits 247 11 Reduction of share capital 267 12 Off balance sheet finance 295 13 Financial intruments 319 14 Employee benefits 338 15 Taxation in company accounts 360 16 Property, plant and equipment (PPE) 385 17 Leasing 417 18 R&D; goodwill and intangible assets; brands 434 19 Inventories 479 20 Construction contracts 502

vi Brief Contents Part 4 CONSOLIDATED ACCOUNTS S11 21 Accounting for groups at the date of acquisition 513 22 Preparation of consolidated balance sheets after the date of acquisition 528 23 Preparation of consolidated income statements 540 24 Accounting for associated companies 554 25 Accounting for the effects of changes in foreign exchange rates under IAS 21 569 Part 5 INTERPRETATION 585 26 Earnings per share 587 27 Cash flow statements 612 28 Review of financial ratio analysis 636 29 Trend analysis and multivariate analysis 674 Part 6 ACCOUNTABILITY 713 30 Corporate governance 715 31 Environmental and social reporting 757 32 Ethics for accountants 791 Appendix: Outline solutions to selected exercises 811 Index 819

Full Contents Preface and acknowledgements Part I INCOME AND ASSET VALUE MEASUREMENT SYSTEMS xx I 1 Accounting and reporting on a cash flow basis 3 1.1 Introduction 3 1.2 Shareholders 4 1.3 What skills does an accountant require in respect of external reports? 4 1.4 Managers 5 1.5 What skills does an accountant require in respect of internal reports? 5 1.6 Procedural steps when reporting to internal users 6 1.7 Agency costs 8 1.8 Illustration of periodic financial statements prepared under the cash flow concept to disclose realised operating cash flows 9 1.9 Illustration of preparation of balance sheet under the cash flow concept 13 1. 10 Treatment of fixed assets in the cash flow model 14 I.I I What are the characteristics of these data that make them reliable? 15 1.12 Reports to external users 16 Summary 17 18 18 21 2 Accounting and reporting on an accrual accounting basis 22 2.1 Introduction 22 2.2 Historical cost convention 23 2.3 Accrual basis of accounting 24 2.4 Mechanics of accrual accounting - adjusting cash receipts and payments 24 2.5 Subjective judgements required in accrual accounting - adjusting cash receipts in accordance with IAS 18 25 2.6 Subjective judgements required in accrual accounting - adjusting cash payments in accordance with the matching principle 27 2.7 Mechanics of accrual accounting - the balance sheet 27 2.8 Reformatting the statement of financial position into a balance sheet 27 2.9 Accounting for the sacrifice of fixed assets 28

viii Full Contents 2.10 Reconciliation of cash flow and accrual accounting data 32 34 35 38 Income and asset value measurement: an economist's approach 40 3.1 3.2 3.3 3.4 3.5 3.6 3.7 Introduction Role and objective of income measurement Accountant's view of income, capital and value Critical comment on the accountant's measure Economist's view of income, capital and value Critical comment on the economist's measure Income, capital and changing price levels Summary Bibliography Accounting for inflation 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 Introduction Review of the problems of historical cost accounting (HCA) Inflation accounting The concepts in principle The four models illustrated for a company with cash purchases and Critique of each model Operating capital maintenance - a comprehensive example Critique of CCA statements The ASB approach The IASC/IASB approach Future developments Summary Bibliography 40 40 43 46 47 53 53 55 55 56 58 59 60 60 60 61 61 sales 63 66 69 80 82 84 86 86 87 88 95 95 Part 2 REGULATORY FRAMEWORK -AN ATTEMPT TO ACHIEVE UNIFORMITY 97 5 Financial reporting: evolution of the regulatory framework in the UK 99 5.1 Introduction 99 5.2 Mandatory regulations 99 5.3 Arguments in support of standards 103 5.4 Arguments against standards 105 5.5 Structure of regulatory framework 105 5.6 The operating and financial review (OFR) 108

Full Contents ix 5.7 5.8 5.9 5.10 5.11 5.12 6 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 7 7.1 7.2 7.3 7.4 7.5 7.6 The Financial Reporting Review Panel The Financial Services Authority The revised Combined Code (July 2003) Interim Reports following Cadbury Developments for small companies Evaluation of effectiveness of mandatory regulations Summary Financial reporting - evolution of international standards Introduction National differences Reasons for differences in financial reporting Classification of national accounting systems Attempts to reduce national differences The work of international bodies in harmonising and standardising financial reporting USGAAP Reconciliations and supplementary statements Summary Conceptual framework Introduction Historical overview of the evolution of financial accounting theory IASC Framework for the Presentation and Preparation of Financial Statements ASB Statement of Principles 1999 AICPA Improving Business Reporting -A Customer Focus: Meeting the Information Needs of Investors and Creditors ICAS Making Corporate Reports Valuable Summary 112 115 115 119 121 128 130 130 131 131 133 133 133 134 138 139 139 146 148 149 149 150 150 152 152 153 156 158 168 169 170 172 173 176 8 8.1 8.2 8.3 Published accounts of companies Introduction A public company's financial calendar Criteria for information appearing in a published income statement and balance sheet The prescribed formats 177 177 178 179 179 8.4 8.5 What information is required to be disclosed in Format I and Format 2? 179

Full Contents 8.6 Cost of sales 181 8.7 Distribution costs - 184 8.8 Administrative expenses 184 8.9 Other operating income 185 8.10 What costs and income are brought into account after calculating the trading profit in order or arrive at the profit on ordinary activities before tax? 185 8.11 Does it really matter under which heading a cost is classified In the income statement provided it is not omitted? 185 8.12 Discontinuing operations disclosure in the income statement 185 8.13 Items requiring separate disclosure 188 8.14 The balance sheet 189 8.15 Statement of changes in equity 194 8.16 Reporting comprehensive income 195 8.17 Segment reporting 198 8.18 The fundamental accounting principles underlying the published income statement and balance sheet 198 8.19 Disclosure of accounting policies 199 8.20 Fair view treatment 203 8.21 Additional information in the annual report 205 8.22 What information do companies provide to assist comparison between companies reporting under different reporting regimes? 207 Summary 211 211 212 220 9 Preparation of published accounts 221 9.1 Introduction 221 9.2 Stage I: preparation of the internal income statement from a trial balance 221 9.3 Stage 2: preparation of the income statement of Illustrious SpA in Format I style 223 9.4 Stage 3: preparation of the balance sheet 226 9.5 Preparation of accounts in Format I following IAS 8 and IFRS 5 227 9.6 Additional information value of IFRS 5 231 9.7 Additional information value of IAS 24 232 Summary 234 235 236 243 Part 3 BALANCE SHEET - EQUITY, LIABILITY AND ASSET MEASUREMENT AND DISCLOSURE 245 10 Share capital, capital maintenance and distributable profits 247 10.1 Introduction 247 10.2 Total owners'equity: an overview 248

Full Contents xi 10.3 Total shareholders'funds: more detailed explanation _ 249 10.4 Accounting entries on issue of shares 251 10.5 Creditor protection: capital maintenance concept 252 10.6 Creditor protection: why capital maintenance rules are necessary 253 10.7 Creditor protection: how to quantify the amounts available to meet creditors' claims 254 10.8 Issued share capital: minimum share capital 254 10.9 Distributable profits: general considerations 255 10.10 Distributable profits: general rule for private companies 256 10.11 Distributable profits: general rule for public companies 257 10.12 Distributable profits: how to arrive at the amount using relevant accounts 260 10.13 Distributable profits: realisation principle applies 260 10.14 What are the implications of IAS compliance on distributions? 261 Summary. 262 263 263 266 11 Reduction of share capital 267 I. I Introduction 267 1.2 Capital: restrictions on reduction of capital 267 1.3 Non-distributable reserves: share premium 268 1.4 Non-distributable reserves: capital redemption reserve 269 1.5 Capital: redemption of shares by a public company 271 1.6 Capital: redemption of shares by a private company 273 1.7 Distributable profits: effect of accumulated trading losses 276 1.8 Proposals for changes to company law 282 1.9 Buyback of own shares - treasury shares 11.10 Developments in other countries the Singapore experience 286 Summary 289 289 290 Bibliography 294 12 Off balance sheet finance 295 12.1 Introduction 295 12.2 Primary financial statements: their interrelationship 295 12.3 Primary financial statements: changes in their interrelationship 296 12.4 Reasons that companies borrow 296 12.5 Capital gearing and its implications 297 12.6 Off balance sheet finance 299 12.7 Substance over form 300 12.8 Balance sheet as valuation document 303 12.9 Why companies take steps to strengthen their balance sheets 305 12.10 Definitions cannot remove uncertainty: IAS 10 and IAS 37 306 Summary 314 315 316 318

xii Full Contents 13 Financial instruments 319 13.1 Introduction 319 13.2 IAS 32 Financial Instruments: Disclosure and Presentation 319 13.3 IAS 39 Financial Instruments: Recognition and Measurement 329 Summary 334 335 335 337 14 Employee benefits 338 14.1 Introduction 338 14.2 Financial reporting implications 339 14.3 Types of scheme 339 14.4 Defined contribution pension schemes 341 14.5 Defined benefit pension schemes 342 14.6 IAS 19 (revised) Employee Benefits 344 14.7 The liability for pension and other post-retirement costs 344 14.8 The income statement 347 14.9 Comprehensive illustration 347 14.10 Future developments 349 14.11 Plan curtailments and settlements 350 14.12 Multi-employer plans 350 14.13 Disclosures 351 14.14 Other long-service benefits 351 14.15 Short-term benefits 352 14.16 Termination benefits 353 14.17 IAS 26 Accounting and Reporting by Retirement Benefit Plans 353 Summary 356 356 358 359 15 Taxation in company accounts 360 15.1 Introduction 360 15.2 Corporation tax 360 15.3 Corporation tax systems the theoretical background 361 15.4 Corporation tax systems - avoidance and evasion 362 15.5 Corporation tax - the system from 6 April 1999 364 15.6 IAS 12 - accounting for current taxation 366 15.7 Deferred tax 368 15.8 FRS 19 (the UK standard on deferred taxation) 375 15.9 A critique of deferred taxation 376 15.10 Examples of companies following IAS 12 379 15.11 Value added tax (VAT) 381 Summary 382 383 383 384

Full Contents xiii 16 Property, plant and equipment (PPE) 385 16.1 Introduction 385 16.2 What is PPE? 386 16.3 How is the cost of PPE determined? 387 16.4 What is depreciation? 389 16.5 What are the constituents in the depreciation formula? 392 16.6 How is the useful life of an asset determined? 392 16.7 Residual value 393 16.8 Calculation of depreciation 393 16.9 Measurement subsequent to initial recognition 398 16.10 IAS 36 Impairment of Assets 400 16.11 IFRS 5 Non-Current Assets Held for Sale and Discontinued Operations 405 16.12 Disclosure requirements 406 16.13 Government grants towards the cost of PPE 407 16.14 Investment properties 408 16.15 Effect of accounting policy for PPE on the interpretation of the financial statements 409 Summary 411 412 412 416 17 Leasing 417 17.1 Introduction 417 17.2 Background to leasing 417 17.3 IAS 17 (and its national equivalents)-the controversy 419 17.4 IAS 17 - classification of a lease 421 17.5 IAS 17 - accounting for leases by lessees 423 17.6 Leasing - a form of off balance sheet financing 428 17.7 Accounting for leases - a new approach 429 Summary 430 430 431 433 18 R&D; goodwill and intangible assets; brands 434 18.1 Introduction 434 18.2 Accounting treatment for research and development 434 18.3 How are development costs defined? 436 18.4 Introduction to goodwill and intangible assets 438 18.5 Introduction to the current position 438 18.6 Historical developments 440 18.7 Intangible assets 443 18.8 Goodwill 448 18.9 Economic consequences of each method 457 18.10 Arguments relating to amortisation versus immediate write-off 458 18.11 IFRS 3 Business Combinations 461 18.12 Brand accounting 464 18.13 Intellectual property 465 Summary 470

xiv Full Contents 19 Inventories 19.1 Introduction 19.2 Inventory defined 19.3 The controversy 19.4 IAS 2 Inventories 19.5 Inventory valuation 19.6 Work-in-progress 19.7 Inventory control 19.8 Creative accounting 19.9 Audit of the year-end physical inventory count 19.10 Published accounts Summary 20 Construction contracts 20.1 Introduction 20.2 Identification of contract revenue 20.3 Identification of contract costs 20.4 Recognition of contract revenue and expenses Part 4 CONSOLIDATED ACCOUNTS 21 Accounting for groups at date of acquisition 21.1 Introduction 21.2 The definition of a group 21.3 Consolidated accounts and some reasons for their preparation 21.4 The definition of control 21.5 Alternative methods of preparing consolidated accounts 21.6 The treatment of positive goodwill 21.7 The treatment of negative goodwill 21.8 The comparison between an acquisition by cash and an exchange of shares 21.9 Minority interests 21.10 The treatment of differences between a subsidiary's fair value and book value 21.11 How to calculate fair values Summary 470 472 476 479 479 479 480 481 482 489 491 492 494 496 497 498 499 501 502 502 502 503 503 506 507 511 513 513 513 513 515 516 517 518 518 518 520 521 522 522 524 526

Full Contents xv 22 Preparation of consolidated balance sheets after the date of acquisition 528 22.1 Introduction 528 22.2 Pre- and post-acquisition profits 528 22.3 Inter-company balances 530 22.4 Unrealised profit on inter-company sales 532 22.5 Provision for unrealised profit affecting a minority 536 22.6 Uniform accounting policies and reporting dates 536 22.7 How is the investment in subsidiaries reported in the parent's own balance sheet? 536 Summary 536 536 537 539 23 Preparation of consolidated income statements 540 23.1 Introduction 540 23.2 Preparation of a consolidated income statement - the Ante Group 540 23.3 Dividends or interest paid by the subsidiary out of pre-acquisition profits 543 23.4 A subsidiary acquired part of the way through the year 544 23.5 Published format income statement 547 Summary 547 548 548 553 24 Accounting for associated companies 554 24.1 Introduction 554 24.2 Definitions of associates and of significant influence 554 24.3 The treatment of associated companies in consolidated accounts 555 24.4 The Brill Group - the equity method illustrated 555 24.5 The treatment of provisions for unrealised profits 558 24.6 The acquisition of an associate part-way through the year 558 24.7 Joint ventures 560 Summary 561 562 562 568 25 Accounting for the effects of changes in foreign exchange rates under IAS 21 569 25.1 Introduction 569 25.2 The difference between conversion and translation and the definition of a foreign currency transaction 569 25.3 The functional currency 570 25.4 The presentation currency 570 25.5 Monetary and non-monetary items 571 25.6 The rules on the recording of foreign currency transactions 571

xvi Full Contents 25.7 The treatment of exchange differences on foreign exchange transactions 571 25.8 Foreign exchange transactions in the individual accounts of companies ' illustrated - Boil pic 572 25.9 The translation of the accounts of foreign operations where the functional currency is the same as that of the parent 573 25.10 Granby Ltd illustration 573 25.11 The use of a presentation currency other than the functional currency 580 25.12 Granby Ltd illustration continued 580 582 582 584 Part 5 INTERPRETATION 585 26 Earnings per share 587 26.1 Introduction 587 26.2 Why is the earnings per share figure important? 587 26.3 How is the EPS figure calculated? 588 26.4 The use to shareholders of the EPS 589 26.5 Illustration of the basic EPS calculation 590 26.6 Adjusting the number of shares used in the basic EPS calculation 590 26.7 Rights issues 593 26.8 Adjusting the earnings and number of shares used in the diluted EPS calculation 598 26.9 Procedure where there are several potential dilutions 600 26.10 Exercise of conversion rights during financial year 602 23.11 Disclosure requirements of IAS 33 603 23.12 The Improvement Project 605 Summary 605 606 607 611 27 Cash flow statements 612 27.1 Introduction 612 27.2 Development of cash flow statements 612 27.3 Applying IAS 7 (revised) Cash Flow Statements 613 27.4 IAS 7 (revised) format of cash flow statements 615 27.5 Consolidated cash flow statements 619 27.6 Analysing a cash flow statement 622 27.7 Critique of cash flow accounting 624 Summary 625 626 626 635

Full Contents xvii 28 Review of financial ratio analysis 636 28.1 Introduction 636 28.2 Accounting ratios and ratio analysis 637 28.3 Six key ratios 638 28.4 Description of the six key ratios 640 28.5 Description of subsidiary ratios 642 28.6 Application of pyramid of ratios to JD Wetherspoon pic 647 28.7 Segmental analysis 650 28.8 Inter-firm comparisons and industry averages 656 28.9 Inter-firm comparisons: JD Wetherspoon and the brewing industry 658 28.10 World Wide Web pages for company information 660 28.11 Non-financial ratios 661 28.12 Interpretation problems when using consolidated financial statements 661 Summary 662 662 663 673 29 Trend analysis and multivariate analysis 674 29.1 Introduction 674 29.2 Horizontal analysis between two periods 674 29.3 Trend analysis over a series of periods 676 29.4 Historical summaries 678 29.5 Vertical analysis - common size statements 678 29.6 Multivariate analysis - Z-scores 681 29.7 H-scores 683 29.8 A-scores 683 29.9 Accounting polices 685 29.10 Balanced scorecards 685 29.11 Valuing shares of an unquoted company - quantitative process 687 29.12 Valuing shares of an unquoted company - qualitative process 687 29.13 Shareholder value analysis (SVA) 690 29.14 Measuring and reporting values in the annual report 691 29.15 Shareholder information needs 696 29.16 Professional risk assessors 699 29.17 Impact of differences between lass and national standards on trend analysis 701 Summary 702 702 705 712 Part 6 ACCOUNTABILITY 713 30 Corporate governance 715 30.1 Introduction 715 30.2 The need for corporate governance guidlines 715 30.3 Corporate governance in different countries 716 30.4 Corporate governance requirements 718

30.13 30.14 30.15 30.16 30.17 30.18 UK Voluntary Code -The Cadbury Report 721 The Greenbury Report 722 The Hampel Report 723 The Higgs Report 723 The Smith Report 726 The Combined Code 727 Directors' remuneration 727 Directors' remuneration - illustration from the Annual Report of Diageo pic 731 Directors' remuneration - conclusion 740 Relations with shareholders 740 Institutional investors 740 The Myners Report 741 Corporate governance - summary 743 Auditors 743 Summary 750 750 752 755 31 Environmental and social reporting 757 31.1 Introduction 757 31.2 Accountants' role in a capitalist industrial society 757 31.3 31.4 31.5 31.6 31.7 31.8 31.9 31.10 Sustainability 758 Background to companies' reporting practices 759 European Commission recommendations for disclosures in annual accounts 760 Evolution of stand-alone environmental reports 762 International charters and guidelines 763 Economic consequences of environmental reporting 767 Summary on environmental reporting 767 Environmental auditing: international initiatives 768 The activities involved in an environmental audit 769 31.11 31.12 Concept of social accounting 771 31.13 Background to social accounting 773 31.14 Corporate social responsibility 776 31.15 Need for comparative data 776 31.16 International initiatives towards tripple bottom line reporting 778 Summary 781 781 783 789 Bibliography 790 32 Ethics for accountants 791 32.1 Introduction 791 32.2 The nature of business ethics 791 32.3 Ethical codes for businesses 793 32.4 The background to business ethics 795

Full Contents xix 32.5 The role of ethics in modern business 796 32.6 The role of professional accounting ethics 799 32.7 The role of the accountant as guardian of business ethics 803 32.8 Growth of voluntary standards 804 Summary 807 808 810 Bibliography 810 Appendix: Outline solutions to selected exercises 811 Index 819