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Financial Accounting and Reporting

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Financial Accounting and Reporting TWENTIETH EDITION

Jamie Elliott and Barry Elliott

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Brief contents Preface Authors’ acknowledgements Part 1 INTRODUCTION TO ACCOUNTING ON A CASH FLOW AND ACCRUAL ACCOUNTING BASIS 1 2

Accounting and reporting on a cash flow basis Accounting and reporting on an accrual accounting basis

Part 2 PREPARATION OF INTERNAL AND PUBLISHED FINANCIAL STATEMENTS 3 4 5 6

Preparation of financial statements of profit or loss and other comprehensive income, changes in equity and financial position Annual report: additional financial disclosures Statements of cash flows Accounting for price-level changes

Part 3 REGULATORY FRAMEWORK – AN ATTEMPT TO ACHIEVE UNIFORMITY 7 8 9

Financial reporting – evolution of global standards Concepts – evolution of an international conceptual framework Revenue recognition

Part 4 STATEMENT OF FINANCIAL POSITION – EQUITY, LIABILITY AND ASSET MEASUREMENT AND DISCLOSURE 10 Share capital, distributable profits and reduction of capital

11 Liabilities 12 Financial instruments 13 Employee benefits 14 Taxation in company accounts 15 Property, plant and equipment (PPE) 16 Leasing 17 Intangible assets 18 Inventories 19 Construction contracts Part 5 CONSOLIDATED ACCOUNTS 20 Accounting for groups at the date of acquisition 21 Preparation of consolidated statements of financial position after the date of acquisition 22 Preparation of consolidated statements of profit or loss, changes in equity and cash flows 23 Accounting for associates and joint arrangements 24 Introduction to accounting for exchange differences Part 6 INTERPRETATION 25 Earnings per share 26 Review of financial ratio analysis 27 Analysis of published financial statements Part 7 ACCOUNTABILITY 28 Corporate governance 29 Ethical behaviour and implications for accountants 30 Integrated reporting: sustainability, environmental and social Publisher’s acknowledgements Index

Contents Preface Authors’ acknowledgements

Part 1 INTRODUCTION TO ACCOUNTING ON A CASH FLOW AND ACCRUAL ACCOUNTING BASIS 1

Accounting and reporting on a cash flow basis 1.1 Introduction 1.2 Shareholders 1.3 What skills does an accountant require in respect of external reports?

1.4 Managers 1.5 What skills does an accountant require in respect of internal reports?

1.6 Procedural steps when reporting to internal users 1.7 Agency costs 1.8 Illustration of periodic financial statements prepared under the cash flow concept to disclose realised operating cash flows 1.9 Illustration of preparation of statement of financial position 1.10 Treatment of non-current assets in the cash flow model 1.11 What are the characteristics of these data that make them reliable?

1.12 Reports to external users 1.13 Micro businesses Summary Review questions Exercises Notes 2

Accounting and reporting on an accrual accounting basis 2.1 Introduction 2.2 Historical cost convention 2.3 Accrual basis of accounting 2.4 Mechanics of accrual accounting – adjusting cash receipts and payments 2.5 Reformatting the statement of financial position 2.6 Accounting for the sacrifice of non-current assets 2.7 Published statement of cash flows Summary Review questions Exercises Notes

Part 2 PREPARATION OF INTERNAL AND PUBLISHED FINANCIAL STATEMENTS 3

Preparation of financial statements of profit or loss and other comprehensive income, changes in equity and financial position 3.1 Introduction 3.2 Preparing an internal statement of profit or loss from a trial balance 3.3 Reorganising the income and expenses into one of the formats required for publication

3.4

Format 1: classification of operating expenses and other income by function 3.5 Format 2: classification of operating expenses according to their nature 3.6 Other information to be presented in the profit or loss section 3.7 Other comprehensive income 3.8 Presentation of non-recurring items and their effect on operating income 3.9 How decision-useful is the statement of profit or loss and other comprehensive income?

3.10 Statement of changes in equity 3.11 The statement of financial position 3.12 The explanatory notes that are part of the financial statements 3.13 Has prescribing the formats meant that identical transactions are reported identically?

3.14 Fair presentation 3.15 What does an investor need in addition to the primary financial statements to make decisions?

3.16 IAS 1 ED General Presentation and Disclosures Summary Review questions Exercises Notes 4

Annual report: additional financial disclosures 4.1 Introduction 4.2 IAS 10 Events after the Reporting Period 4.3 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors 4.4 What do segment reports provide?

4.5 IFRS 8 Operating Segments

4.6

Benefits and continuing concerns following the issue of IFRS 8 4.7 Discontinued operations – IFRS 5 Non-current Assets Held for Sale and Discontinued Operations 4.8 Held for sale – IFRS 5 Non-current Assets Held for Sale and Discontinued Operations 4.9 IAS 24 Related Party Disclosures Summary Review questions Exercises Notes 5

Statements of cash flows 5.1 Introduction 5.2 Development of statements of cash flows 5.3 Applying IAS 7 (revised) Statement of Cash Flows 5.4 Step approach to preparation of a statement of cash flows – indirect method 5.5 Additional notes required by IAS 7 5.6 Analysing statements of cash flows 5.7 Approach to answering questions with time constraints 5.8 Preparing a statement of cash flows when no statement of income is available 5.9 Critique of cash flow accounting Summary Review questions Exercises Notes

6

Accounting for price-level changes 6.1 Introduction 6.2 Review of the problems of historical cost accounting (HCA) 6.3 Inflation accounting 6.4 The concepts in principle

6.5

The four models illustrated for a company with cash purchases and sales 6.6 Critique of each model 6.7 Operating capital maintenance – a comprehensive example 6.8 Critique of CCA statements 6.9 Measurement bases 6.10 The IASB position where there is hyperinflation 6.11 Future developments Summary Review questions Exercises Bibliography Notes Part 3 REGULATORY FRAMEWORK – AN ATTEMPT TO ACHIEVE UNIFORMITY 7

Financial reporting – evolution of global standards 7.1 Introduction 7.2 Why do we need financial reporting standards?

7.3 Why do we need standards to be mandatory?

7.4 Arguments in support of standards 7.5 Arguments against standards 7.6 The Financial Reporting Council (FRC) as a regulatory body 7.7 The International Accounting Standards Board 7.8 Standard setting and enforcement in the European Union (EU) 7.9 Standard setting and enforcement in the US 7.10 Advantages and disadvantages of global standards for publicly accountable entities

7.11 How do reporting requirements differ for non-publicly accountable entities?

7.12 IFRS for SMEs 7.13 Why have there been differences in financial reporting?

7.14 Move towards a conceptual framework Summary Review questions Exercises Notes 8

Concepts – evolution of an international conceptual framework 8.1 Introduction 8.2 Different countries meant different financial statements 8.3 Historical overview of the evolution of financial accounting theory 8.4 Developing the Framework for the Preparation and Presentation of Financial Statements 8.5 Conceptual Framework for Financial Reporting 2018 8.6 Current developments – concept of materiality Summary and evaluation of position to date Review questions Exercises

9

Revenue recognition 9.1 Introduction 9.2 The issues involved in developing the new standard 9.3 IFRS 15 Revenue from Contracts with Customers 9.4 Five-step process to identify the amount and timing of revenue 9.5 Disclosures Summary Review questions Exercises

Notes Part 4 STATEMENT OF FINANCIAL POSITION – EQUITY, LIABILITY AND ASSET MEASUREMENT AND DISCLOSURE 10

Share capital, distributable profits and reduction of capital 10.1 Introduction 10.2 Common themes 10.3 Total owners’ equity: an overview 10.4 Total shareholders’ funds: more detailed explanation 10.5 Accounting entries on issue of shares 10.6 Creditor protection: capital maintenance concept 10.7 Creditor protection: why capital maintenance rules are necessary 10.8 Creditor protection: how to quantify the amounts available to meet creditors’ claims 10.9 Issued share capital: minimum share capital 10.10 Distributable profits: general considerations 10.11 Distributable profits: how to arrive at the amount using relevant accounts 10.12 When may capital be reduced?

10.13 Writing off part of capital which has already been lost and is not represented by assets 10.14 Repayment of part of paid-in capital to shareholders or cancellation of unpaid share capital 10.15 Purchase of own shares Summary Review questions Exercises Notes

11

Liabilities 11.1 Introduction 11.2 Provisions – a decision tree approach to their impact on the statement of financial position

11.3 11.4

Treatment of provisions The general principles that IAS 37 applies to the recognition of a provision 11.5 Management approach to measuring the amount of a provision 11.6 Application of criteria illustrated 11.7 Provisions for specific purposes 11.8 Contingent liabilities 11.9 Contingent assets 11.10 Criticisms of IAS 37 11.11 Future progress Summary Review questions Exercises Notes 12

Financial instruments 12.1 Introduction 12.2 Financial instruments – the IASB’s problem child 12.3 IAS 32 Financial Instruments: Disclosure and Presentation 12.4 IFRS 9 Financial Instruments 12.5 IFRS 7 Financial Instruments: Disclosure Summary Review questions Exercises Notes

13

Employee benefits 13.1 Introduction 13.2 Greater employee interest in pensions 13.3 Financial reporting implications 13.4 Types of scheme 13.5 Accounting for defined contribution pension schemes 13.6 Accounting for defined benefit pension schemes 13.7 IAS 19 Employee Benefits

13.8

The asset or liability for pension and other postretirement costs 13.9 Changes in the pension asset or liability position 13.10 Comprehensive illustration 13.11 Multi-employer plans 13.12 Disclosures 13.13 Other long-service benefits 13.14 Short-term benefits 13.15 Termination benefits 13.16 IFRS 2 Share-based Payment 13.17 Scope of IFRS 2 13.18 Recognition and measurement 13.19 Equity-settled share-based payments 13.20 Cash-settled share-based payments 13.21 Transactions which may be settled in cash or shares 13.22 IAS 26 Accounting and Reporting by Retirement Benefit Plans Summary Review questions Exercises Notes 14

Taxation in company accounts 14.1 Introduction 14.2 Corporation tax 14.3 Corporation tax systems – the theoretical background 14.4 Dividends pre- and post-2016 14.5 Corporation tax systems – avoidance and evasion 14.6 IAS 12 – accounting for current taxation 14.7 Deferred tax 14.8 A critique of deferred taxation 14.9 Value added tax (VAT) Summary Review questions Exercises Notes

15

Property, plant and equipment (PPE) 15.1 Introduction 15.2 PPE – concepts and the relevant IASs and IFRSs 15.3 What is PPE? 15.4 How is the cost of PPE determined?

15.5 What is depreciation?

15.6 What are the constituents in the depreciation formula?

15.7 Calculation of depreciation 15.8 Measurement subsequent to initial recognition 15.9 IAS 36 Impairment of Assets 15.10 IFRS 5 Non-current Assets Held for Sale and Discontinued Operations 15.11 Disclosure requirements 15.12 Government grants towards the cost of PPE 15.13 Investment properties 15.14 Effect of accounting policy for PPE on the interpretation of the financial statements Summary Review questions Exercises Notes

16

Leasing 16.1 Introduction 16.2 Need for an accounting standard on leasing 16.3 Terms and conditions of a lease 16.4 Leases in the financial statements of lessees under IFRS 16 16.5 Leases in the financial statements of lessors 16.6 Sale and leaseback transactions Summary Review questions Exercises Note

17

Intangible assets

17.1 Introduction 17.2 Intangible assets defined 17.3 Accounting treatment for research and development 17.4 Why is research expenditure not capitalised?

17.5 Capitalising development costs 17.6 Disclosure of R&D 17.7 IFRS for SMEs’ treatment of intangible assets 17.8 Internally generated and purchased goodwill 17.9 The accounting treatment of goodwill 17.10 Critical comment on the various methods that have been used to account for goodwill 17.11 Negative goodwill/badwill 17.12 Brands 17.13 Accounting for acquired brands 17.14 Intellectual capital disclosures (ICDs) in the annual report 17.15 Review of implementation of IFRS 3 17.16 Review of the implementation of identified intangibles under IAS 38 Summary Review questions Exercises Notes 18

Inventories 18.1 Introduction 18.2 Inventory defined 18.3 The impact of inventory valuation on profits 18.4 IAS 2 Inventories 18.5 Inventory valuation 18.6 Work in progress 18.7 Inventory control 18.8 Creative accounting 18.9 Audit of the year-end physical inventory count 18.10 Published accounts 18.11 Agricultural activity

Summary Review questions Exercises Notes 19

Construction contracts 19.1 Introduction 19.2 Construction contracts 19.3 IFRS 15 treatment of construction contracts 19.4 Accounting for a contract – an example 19.5 Illustration – loss-making contract using the step approach 19.6 Public – private partnerships 19.7 Requirements of IFRIC 12 Service Concession Arrangements 19.8 Worked example of service concession accounting Summary Review questions Exercises Note

Part 5 CONSOLIDATED ACCOUNTS 20

Accounting for groups at the date of acquisition 20.1 Introduction 20.2 Preparing consolidated accounts for a wholly owned subsidiary 20.3 IFRS 10 Consolidated Financial Statements 20.4 Fair values 20.5 Illustration where there is a wholly owned subsidiary 20.6 Preparing consolidated accounts when there is a partly owned subsidiary 20.7 The treatment of differences between a subsidiary’s fair value and book value

20.8

The parent issues shares to acquire shares in a subsidiary 20.9 IFRS 3 Business Combinations treatment of goodwill at the date of acquisition 20.10 When may a parent company not be required to prepare consolidated accounts?

20.11 When may a parent company exclude or not exclude a subsidiary from a consolidation?

20.12 IFRS 13 Fair Value Measurement 20.13 What advantages are there for stakeholders from requiring groups to prepare consolidated accounts?

Summary Review questions Exercises Notes 21

Preparation of consolidated statements of financial position after the date of acquisition 21.1 Introduction 21.2 Uniform accounting policies and reporting dates 21.3 Pre- and post-acquisition profits/losses 21.4 The Bend Group – assuming there have been no intergroup transactions 21.5 Inter-company transactions 21.6 The Prose Group – assuming there have been intergroup transactions Summary Review questions Exercises Notes

22

Preparation of consolidated statements of profit or loss, changes in equity and cash flows 22.1 Introduction 22.2 Eliminate inter-company transactions

22.3

Preparation of a consolidated statement of profit or loss – the Ante Group 22.4 The statement of changes in equity (SOCE) 22.5 Other consolidation adjustments 22.6 A subsidiary acquired part-way through the year 22.7 Published format statement of profit or loss 22.8 Consolidated statements of cash flows Summary Review questions Exercises Notes 23

Accounting for associates and joint arrangements 23.1 Introduction 23.2 Definitions of associates and of significant influence 23.3 The treatment of associated companies in the financial statements of the investor 23.4 The Brill Group – group accounts with a profit-making associate 23.5 The Brill Group – group accounts with a loss-making associate 23.6 The acquisition of an associate part-way through the year 23.7 Joint arrangements 23.8 Disclosure in the financial statements Summary Review questions Exercises Notes

24

Introduction to accounting for exchange differences 24.1 Introduction 24.2 How to record foreign currency transactions in a company’s own books 24.3 Boil plc – a more detailed illustration

24.4

IAS 21 Concept of Functional and Presentation Currencies 24.5 Translating the functional currency into the presentation currency 24.6 Preparation of consolidated accounts 24.7 How to reduce the risk of translation differences 24.8 Critique of the use of presentational currency 24.9 IAS 29 Financial Reporting in Hyperinflationary Economies Summary Review questions Exercises Notes Part 6 INTERPRETATION 25

Earnings per share 25.1 Introduction 25.2 Why is the earnings per share figure important?

25.3 How is the EPS figure calculated?

25.4 The use to shareholders of the EPS 25.5 Illustration of the basic EPS calculation 25.6 Adjusting the number of shares used in the basic EPS calculation 25.7 Rights issues 25.8 Adjusting the earnings and number of shares used in the diluted EPS calculation 25.9 Procedure where there are several potential dilutions 25.10 Exercise of conversion rights during the financial year 25.11 Disclosure requirements of IAS 33 25.12 Enhanced disclosures Summary Review questions Exercises Notes

26

Review of financial ratio analysis 26.1 Introduction 26.2 Overview of techniques for the analysis of financial data 26.3 Ratio analysis – a case study 26.4 Introductory review 26.5 Financial statement analysis, part 1 – financial performance 26.6 Financial statement analysis, part 2 – liquidity 26.7 Financial statement analysis, part 3 – financing 26.8 Peer comparison 26.9 Report based on the analysis 26.10 Caution when using ratios for prediction Summary Review questions Exercises

27

Analysis of published financial statements 27.1 Introduction 27.2 Alternative performance measures 27.3 EBITDA 27.4 EBITDAR 27.5 EBITDARM 27.6 Regulators’ reaction to use of an alternative management performance measure (APM) 27.7 Use of ratios as thresholds 27.8 Predicting corporate failure 27.9 Investor-specific ratios 27.10 Published financial statements – their limitations for interpretation purposes 27.11 Improvement of information for shareholders 27.12 Valuing shares of an unquoted company – quantitative process 27.13 Valuing shares of an unquoted company – qualitative process 27.14 Possible effects of a pandemic (Covid-19) 27.15 Possible effects of Brexit

Summary Review questions Exercises Notes Part 7 ACCOUNTABILITY 28

Corporate governance 28.1 Introduction 28.2 A systems perspective 28.3 Different jurisdictions have different governance priorities 28.4 The effect on capital markets of good corporate governance 28.5 Risk management 28.6 The role of internal control, internal audit and audit committees in corporate governance 28.7 External audits in corporate governance 28.8 Detection of fraud 28.9 The Regulator’s approach to promoting improved disclosures 28.10 International perspective (IFIAR) 28.11 The future of audit 28.12 Executive remuneration in the UK 28.13 Corporate governance – ways to make directors accountable Summary Review questions Exercises Notes

29

Ethical behaviour and implications for accountants 29.1 Introduction 29.2 The meaning of ethical behaviour 29.3 The accounting standard-setting process and ethics

29.4

The International Code of Ethics for Professional Accountants 2018 29.5 Implications of ethical values for the principles – versus rules-based approaches to accounting standards 29.6 Ethics in the accountant’s work environment – a research report 29.7 Implications of unethical behaviour for stakeholders using the financial reports 29.8 The increasing role of whistle-blowing 29.9 Legal requirement to report – national and international regulation 29.10 Why should students learn ethics?

Summary Review questions Exercises Notes 30

Integrated reporting: sustainability, environmental and social 30.1 Introduction 30.2 Environmental and social disasters, the adverse consequences that can follow and the lessons to be learnt 30.3 Management accountability for environmental and social responsibility 30.4 Integrated reporting concepts 30.5 The historical context of the evolution of integrated reporting including the drivers of this movement 30.6 The seriousness of current threats: sustainability – climate change and pollution 30.7 The efforts on which integrated reporting builds 30.8 The contribution of accountants 30.9 Integrated reporting – its impact on the future development of financial reporting and accounting 30.10 Reporting to stakeholders to account for stewardship 30.11 Reporting to stakeholders to assist decision making

30.12 Real-time reporting 30.13 Other means of communication with stakeholders 30.14 The way forward for improved sustainability disclosure Summary Review questions Exercises Notes Publisher’s acknowledgements Index

Preface What is financial accounting and reporting?

Financial accounting is the accurate recording of all transactions and combining these into a statement which shows the performance for an accounting period which is normally a year and a statement which shows the resources and liabilities at the end of the period.

Financial reporting presents the performance, the resources and liabilities to the stakeholders in accordance with International Financial Reporting Standards. It is a dynamic area, intellectually demanding and full of interest. It aims to inform and provide the information in way that holds management to account and is ‘decision useful’ by making inter-period and inter-firm comparisons more accessible. We see it as extremely important that the text should reflect this and be kept current.

A self-contained introduction This book gives a self-contained introduction to financial accounting and reporting and has been widely adopted on: ● second-year undergraduate courses for Accounting, Business and Management Studies;

● final-year undergraduate courses for Accounting, Business and Management Studies; ● MBA courses; ● specialist MSc courses; and ● professional and accredited courses preparing students for professional accountancy examinations.

Accountants are working in a fast-changing world In today’s world there are many risks that both companies and the accounting profession face.

This means that accountants need to have commercial understanding and technical competence. This is why in this 20th edition we have significantly updated two of the chapters in the final part of this book on Accountability.

The risks that companies face include: ● The risk of a company failing as seen with the collapse of the British construction and services giant Carillion Group going into liquidation.

The company had tendered at an unrealistically low price and suffered when there were cost overruns. This came about due to management decisions. However, accountants and auditors have both been heavily criticised with the chair of the Parliamentary Business Committee commenting that Carillion’s annual reports were ‘worthless as a guide to the true financial health of the company’. ● The risk of Professional negligence claims against auditors for audit failures.

Auditors have seen increased pressure from the regulators to improve their performance and the operational split of audit and consultancy