In this reading, we will learn the following:



<ul><li>Objectives of financial statements</li><li>Importance of financial reporting standards</li><li>Role of financial reporting standard-setting bodies</li><li>Global convergence of accounting standards</li><li>Key concepts of IFRS and US GAAP</li><li>Characteristics of a coherent financial reporting standard</li><li>Monitoring financial reporting standards</li><li>Company disclosures of accounting policies</li></ul>

Financial Reporting Standards

We often hear about financial reporting standards such as <a href="https://financetrain.com/difference-between-ifrs-and-us-gaap/">US GAAP and IFRS</a> and that companies need to abide by these standards while preparing their financial reports. One may ask why we need these financial reporting standards. Each business is unique with its own business needs, financial requirements, and style of operations.&nbsp; Then what’s the purpose of these financial reporting standards? The uniqueness of businesses is the exact reason why we need these reporting standards.

The International Accounting Standards Board (IASB), the international accounting standard-setting body, expresses the following:

The objective of financial statements is to provide information about the financial position, performance, and changes in financial position of an entity; this information should be useful to a wide range of users for the purpose of making economic decisions.

The financial statements prepared by a company are used by a variety of people such as investors, creditors, employees, and customers, among other people. For these financial statements to become useful for such wide variety of consumers, the reports must be consistent and comparable. This is what these financial reporting standards help us achieve – consistency and comparability. Businesses are complex, and the financial transactions can get even more complex. Unless there is a set of guiding principles that help us in bringing order to how we record our transactions, the financial statements will remain meaningless, and will lead to a plethora of accounting scandals.

Let’s take a simple example to understand this. Assume that two companies buy similar machinery at the same time. These machines will serve the companies for several years. The financial reporting standards require that at the time of purchase the cost of the machinery should be recorded as an asset and then this cost should be apportioned as depreciation over the estimated life of the machinery. Because it’s a part of the standards each company will be required to record the machinery in this way. If there were no financial reporting standards, each company will record the transaction in their own way. One company may choose to record it as an asset while the other may record it as an expense. Things can just get more difficult with the complexity of transaction, for example, the concept of cash vs. accrual accounting. If the reporting standards did not provide guidelines for recognition of revenue and expenses, different business would have reported their revenues and profits that would be totally incomparable.

These financial reporting standards, while bringing consistency and comparability to the financial statements, also allow some level of flexibility to account for the different economic realities of different businesses. In our example of machinery, the standards allow the companies to have some flexibility over choosing the useful life of the asset depending on how they use it.

We will focus on two key accounting standard-setting bodies, namely, International Accounting Standards Board (IASB), and Financial Accounting Standards Board (FASB), that have developed similar financial reporting standards called International Financial Reporting Standards (IFRS), and the Generally Accepted Accounting Standards (U.S. GAAP).

It is imperative for us to understand these financial reporting standards and the differences between them to be able to able to evaluate the reported financial information with more clarity and be able to better analyze the financials of companies.

Objective of Financial Reporting Standards

Before we delve into the details, it’s important to understand the difference between the Standards-setting bodies and the regulatory bodies.

The standard-setting bodies are private sector organizations, consisting of experienced accountants, auditors, and academicians, who are responsible for setting the financial reporting standards. However, they don’t have the power to enforce these standards. It’s the regulatory authorities, who have the legal authority to enforce these reporting requirements.
<h2>Standard-setting Bodies</h2>
The two key standard-setting bodies are International Accounting Standards Board (IASB), and Financial Accounting Standards Board (FASB).

The FASB establishes the Generally Accepted Accounting Principles in the United States (US GAAP), while the IASB establishes International Financial Reporting Standards (IFRS) outside the US.

Apart from these, many countries have their own reporting standards. Across the world, many countries are moving towards the adoption of IFRS. For example, countries like India have already taken steps towards the adoption of IFRS. Even FASB is aggressively working towards converging the US GAAP with the IFRS. Such convergence and the adoption of a global standard offers many benefits as more and more businesses now have global operations.

It is important to note that some of the older standards of IASB are known as International Accounting Standards (IAS).

The IFRS Foundation, as a part of IASB, has the following principle objectives:
<ul>
 	<li>To develop a single set of high quality, understandable, enforceable and globally accepted international financial reporting standards (IFRSs) through its standard-setting body, the IASB;</li>
 	<li>To promote the use and rigorous application of those standards;</li>
 	<li>To take account of the financial reporting needs of emerging economies and small and medium-sized entities (SMEs); and</li>
 	<li>To bring about convergence of national accounting standards and IFRSs to high quality solutions.</li>
</ul>
Source: www.ifrs.org

<h2>Regulatory Authorities</h2>
With respect to the capital markets, in the US the key regulatory authority is the Securities Exchange Commission (SEC), and in the UK it is Financial Services Authority (FSA).

The SEC establishes rules and regulations that govern any company issuing securities or involved in capital markets in the US. The SEC provides the filing requirements for the publicly traded companies in the United States. These company filings, which are available on the SECs website are the most important source of information for financial analysts.
<h2>International Organization of Securities Commissions (IOSCO)</h2>
IOSCO is a multilateral organization of securities regulators. Securities regulators from across the world are members of the IOSCO. Together, its members regulate over 95% of the world’s securities markets. SEC and FSA are also members of IOSCO. IOSCO works with the goal of achieving uniform financial regulations across countries and has three key objectives:
<ul>
 	<li>Protecting investors</li>
 	<li>Ensuring that markets are fair, efficient and transparent</li>
 	<li>Reducing systemic risk</li>
</ul>

Financial Reporting Standard-setting Bodies and Regulatory Authorities

To comply with the various reporting requirements, companies are required to file (complete and submit) various standardized forms issued by SEC.

There are more than 50 such forms for satisfying different requirements. In this article we will list and discuss the forms that provide the most useful information to financial analysts.

Form S-1: Initial Registration Statement required to be filed by prior to new issue of securities. The information filed includes audited financial statements, risk factors, underwriting identification, and details of securities offered.

Form 10-K, 20-F, and 40-F: These forms are filed annually. Form 10-K is for U.S. registrants, Form 40-F is for Canadian registrants, and Form 20-F is for all other non-U.S. registrants. The annual report on Form 10-K provides a comprehensive overview of the company's business and financial condition and includes audited financial statements.

Annual Report to Shareholders: The annual report to shareholders is the principal document used by most public companies to disclose corporate information to their shareholders. It is usually a state-of-the-company report, including an opening letter from the Chief Executive Officer, financial data, results of continuing operations, market segment information, new product plans, subsidiary activities, and research and development activities on future programs. This is a different document than Form 10-K.

Proxy Statement / Form DEF-14A: A company is required to file its annual proxy statement with the SEC no later than the date proxy materials are first sent or given to shareholders. It's called a "DEF 14A" because it's the "definitive," or final, proxy statement. Proxy statement includes important information such as proposals requiring vote, details of securities owned by management, details of executive compensation, etc.

Form 10-Q and 6-K: Apart from the annual reports on Form 10-K, issuers must also submit quarterly reports on Form 10-Q. The Form 10-Q includes unaudited financial statements and provides a continuing view of the company's financial position during the year. Form 6-K is a similar form filed semi-annually by non-US companies.

Form 8-K: In addition to filing annual reports on Form 10-K and quarterly reports on Form 10-Q, public companies must report certain material corporate events on a more current basis. Form 8-K is the “current report” companies must file with the SEC to announce major events that shareholders should know about.

Form 144: This form must be filed with the SEC by an affiliate of the issuer as a notice of the proposed sale of securities in reliance on Rule 144, when the amount to be sold under Rule 144 by the affiliate during any three-month period exceeds 5,000 shares or units or has an aggregate sales price in excess of $50,000.

Form 3, 4 and 5: Corporate insiders – meaning a company's officers and directors, and any beneficial owners of more than ten percent of a class of the company's equity securities registered under Section 12 of the Securities Exchange Act of 1934 – must file with the SEC a statement of ownership regarding those securities. Form 3 is the initial statement, Form 4 reports changes, and Form 5 is the annual report.

SEC Filings: Forms Providing Key Information for Analysts

In the recent past, there has been a lot of discussion and activity towards to goal of moving towards a global standard for financial reporting. This is an important topic as businesses are becoming more and more global and complex.

Both International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) have expressed their commitment towards this convergence of standards. In 2002, they both signed the “The Norwalk Agreement”, in which both the FASB and IASB pledged to use their best efforts to (a) make their existing financial reporting standards fully compatible as soon as is practicable and (b) to coordinate their future work programs to ensure that once achieved, compatibility is maintained.

Both the boards have been working on many projects aimed at removing a variety of individual differences between U.S. GAAP and International Financial Reporting Standards (IFRS).

Many countries have already started adopting IFRS by issuing their country equivalents of IFRS. For example, Australia has Australian equivalents to IFRS' (A-IFRS). All listed EU companies have been required to use IFRS since 2005. More than 100 countries around the world are moving towards IFRS.

To have a common financial reporting standard that is accepted worldwide is a huge undertaking and may take several years. There are also several barriers to achieve full convergence.
<ul>
 	<li>The standard-setting bodies and regulators may have different views.</li>
</ul>
<ul>
 	<li>There may be influence and pressure from industry lobbying groups and others who are subject to these accounting standards or are affected by them.</li>
</ul>
<ul>
 	<li>There could be political pressure because of different views and objectives.</li>
</ul>
&nbsp;

Global Convergence of Accounting Standards

The IASB bases its financial reporting standards on the conceptual framework that it adopted in 2010. The conceptual framework was developed by IASB and it lays down the basic concepts and principles that act as the foundation for preparation and presentation of the financial statements. The framework is also used as guide to develop / improve standards and to resolve any accounting conflicts. Note that the conceptual framework is not an accounting standard in itself and cannot be used as an alternative to the financial reporting standards applicable in your country.

The IFRS framework addresses the following:
<ul>
 	<li>Objectives of financial statements</li>
 	<li>Underlying assumptions of the financial statements</li>
 	<li>Qualitative characteristics of financial statements</li>
 	<li>Elements of financial statements</li>
 	<li>Recognition of the elements of financial statements</li>
 	<li>Measurement of the elements of financial statements</li>
</ul>
Objectives of the Financial Statements

In very simple words, the objective of Financial Statements is:

“To provide useful information to the users.”

Let's look at this statement more closely. There are three keywords here:

Useful: The useful here refers to the need for financial statements to be able to provide high quality information to the users. The usefulness is described in the form of the qualitative characteristics of the financial statements.

Information: This refers to what information should the financial statements provide. This includes financial position, financial performance, and changes in financial position. These three tips of information are provided in the three financial statements, namely, balance sheet, income statement, and statement of cash flow.

Users: This refers to the end users of financial statements such as investors, lenders, employees, government, customers, vendors, etc.

Underlying Assumptions of IFRS

There are two fundamental assumptions underlying the financial statements: Going Concern, and Accruals.

Going Concern: Here the idea is that the business will continue to operate for the forceable future. This is a really important assumption because if it was so that the business will close by the end of the year, then all the assets will have to be sold and their sale value would have to be recorded in the books. However, this is not the case and businesses use their assets and resources for many years.

Accruals: The second important assumption is the accrual principal according to which we match any income and expenses to the period in which they were earned or incurred not in the period in which the payment was received or made.

Qualitative Characteristics of Financial Statements

The conceptual framework sets out four qualitative characteristics of financial statements:
<ul>
 	<li>Understandable: The users should be able to understand and appreciate the information.</li>
 	<li>Relevant: The information should be relevant to the users so that they can make their decisions effectively.</li>
 	<li>Reliable: The information should be factually accurate.</li>
 	<li>Comparable: The users should be able to compare the information with the peers or with previous years' information.</li>
</ul>
So, to be useful, the information on financial position, financial performance, and changes in financial position should be understandable, relevant, reliable, and comparable.

Elements of Financial Statements

The framework lists five elements of financial statements:
<ul>
 	<li>Assets: An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.</li>
 	<li>Liabilities: A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.</li>
 	<li>Equity: Equity is the residual interest in the assets of the entity after deducting all its liabilities.</li>
 	<li>Income: Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.</li>
 	<li>Expense: Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.</li>
</ul>
We see the assets, liabilities, and equity in the statement of financial position (Balance Sheet), and we see the income and expenses in the statement of financial performance (Income Statement).

Recognition of the Elements of Financial Statement

Along with the five elements, the framework also provides guidelines about when these elements are recognized in the financial reports.

To be recognized, an item must meet the definition of an element, and satisfy the following criteria:
<ul>
 	<li>It is probable that any future economic benefit associated with the item will flow to or from the entity; and</li>
 	<li>The item's cost or value can be measured with reliability.</li>
</ul>
Measurement of the Elements of Financial Statement

The final part of the framework describes how we should measure an item once it has been recognized. It suggests the following conceptual models:
<ul>
 	<li>Historical Cost</li>
 	<li>Current Cost</li>
 	<li>Realizable (Settlement) Value</li>
 	<li>Present Value</li>
</ul>
Among these, historical cost is the most commonly used measure. Note that the IFRS framework does not provide which measurement model should be used for a particular element. Such details are provided in the reporting standards.

IASB Conceptual Framework for Financial Reporting

To be recognized, an item must meet the definition of an element provided in the conceptual framework, and satisfy the following criteria:
<ul>
 	<li>It is probable that any future economic benefit associated with the item will flow to or from the entity; and</li>
 	<li>The item's cost or value can be measured with reliability.</li>
</ul>
The general criteria for recognizing elements in financial statements is provided below:
<ul>
 	<li>Assets: An asset is recognized in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. The economic benefits contribute, directly or indirectly, in the form of cash or cash equivalents. Even though many assets are in physical form, such as machinery, the physical form is not essentials. For example, patents and intellectual property are assets controlled by the entity and have future economic benefits.</li>
</ul>
<ul>
 	<li>Liabilities: A liability is recognized in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. For example, accounts payables are present obligations, which will result in an outflow of resources embodying economic benefits.</li>
</ul>
<ul>
 	<li>Income: Income is recognized in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. In effect, the recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities. For example, when a sale is made, it results in a net increase in assets (cash). Income includes both revenues and gains, such as from sale of assets that are not a part of the normal business activity.</li>
</ul>
<ul>
 	<li>Expenses: Expenses are recognized when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. In effect, the recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets. For example, the depreciation of an asset decreases the asset and the expense is recognized. Expenses include both expenses and losses.</li>
</ul>
&nbsp;

Conceptual Framework - Recognition of Elements of Financial Statements

The FASB establishes the Generally Accepted Accounting Standards in the United States (US GAAP), while the IASB establishes International Financial Reporting Standards (IFRS) outside the US.

Both the standards are working towards convergence and have a common worldwide standard. However, it's a slow process and at present there are many differences between the two frameworks:

Listed below are the important differences between the two frameworks:
<ol>
 	<li>The U.S. GAAP provides separate objectives for business entities and nonentities while the IFRS provides one objective for both.</li>
 	<li>Going Concern and Accrual concepts are not well developed in US GAAP. In IFRS, they form the underlying assumptions.</li>
 	<li>IASB framework includes two elements related to financial performance, namely, income and expenses. FASB framework includes five elements: revenues, expenses, gains, losses, and comprehensive income. Comprehensive income has much broader scope than net income, as it also includes changes in equity.</li>
 	<li>In FASB as asset is defined as a future economic benefit, while in IASB, an asset is a resource from which future expected benefits are expected to flow. Another important point is that FASB uses the word "probable" in its definition of assets and liabilities. IASB uses the word "probable" in its recognition criteria, however, with a different meaning.</li>
 	<li>FASB does not allow revaluations, except for some financial instruments that need to be carried out at fair value.</li>
</ol>
While there are many differences in the two standards, these are the broad level differences at the conceptual level.

It is important for financial analysts to understand these differences while interpreting and comparing financial statements that are prepared under different accounting standards. Some companies also prepare reconciliation statements to make their financial results useful to a larger user group. For example, if a company uses US GAAP, it will also provide a reconciliation statement which will present the figures had the company used IFRS.

Differences in IFRS and US GAAP Frameworks

For a financial reporting framework to be effective, the first requirement is that it must be coherent, i.e., all components should work together logically.

Such a framework will have several characteristics:
<ul>
 	<li>Transparent: The framework should increase the transparency of the financial aspects of a business, i.e., the users of the financial statements should be able to get a clear understanding of the underlying economics by reading the financial statements.</li>
 	<li>Comprehensive: The framework should be comprehensive, i.e., it should be able to capture all kinds of transactions having financial consequences.</li>
 	<li>Consistent: The framework should be able to bring consistency in financial reporting across companies and time periods. This means that all companies in different time periods should measure and present transactions in a similar manner.</li>
</ul>
Barriers to a Coherent Framework

Even though such a coherent system is possible, there are several barriers that limit a financial reporting standard. Specifically, there are three areas of conflict:
<ul>
 	<li>Valuation: There are several methods for measuring the value of assets an liability, namely, historical cost, current cost, realizable value, and present value. Methods such as historical require little judgement, while others require a good amount of judgement.</li>
 	<li>Standard-setting approach: For setting there standards there are three approaches: Principles-based, Rules-based, and Objectives-oriented. Each approach follows a different philosophy. The principles-based approach follows a broad framework, for example, IFRS. A rules-based approach provides specific rules for classifying transactions, for example, the US GAAP. The objectives-oriented approach blends the two approaches. FASB's US GAAP is moving towards the objectives-oriented approach.</li>
 	<li>Measurement: The balance sheet provides information at one point in time, while the income statement reflect the changes in financial performance during the period. There is a conflict in these two and a financial reporting standard will tend to be biased towards one. An asset/liability approach will focus more on balance sheet while the revenue/expense approach will focus more on income statement.</li>
</ul>

Characteristics of an Effective Financial Reporting Framework and the Barriers

The financial reporting standards will continue to evolve in the times to come and these developments will affect the financial statements of a company. It is therefore important that the financial analysts monitor the developments in financial reporting standards closely and keep themselves updated with the latest changes. Their understanding of the financial reporting standards will also help them evaluate the new types of financial products and transactions developed in the financial markets.



Two good sources of information for monitoring the reporting standards are IASB (<a href="http://www.iasb,org/">www.iasb,org</a>) and FASB (<a href="http://www.fasb.org/">www.fasb.org</a>) websites. Apart from this they should also read professional journals.

Monitoring Developments in Financial Reporting Standards

Apart from the financial statements, the foot notes in the annual reports disclose a great deal of information about the accounting policies and transactions. Many disclosures related to significant policies are also made under the section ‘Management Discussion and Analysis’.&nbsp;



The footnotes of a US GAAP or IFRS reporting company will discuss many important things such as its inventory accounting methods, accounting for long-lived assets, tax treatment, and its accounting treatment of leases.



If there is any change in an accounting standard or if the comoany is adopting a new standard the management will also discuss the impact of this change on the financial statements.&nbsp;



The analyst should carefully read these disclosures and use this information in their financial analysis.

Analyzing Company Disclosures

This video by Arif Irfanullah provides a very clear understanding of the Financial Reporting Standards as a part of the CFA Level 1 syllabus. This first video talks about:



<ul><li>Objective of Financial Statements</li><li>Importance of Reporting Standards</li><li>Standard Setting Bodies</li><li>IASB - Stated Goals</li><li>International Organization of Securities COmmissions (IOSCO)</li><li>Barriers to Developing One Standard (Convergence)</li><li>IASB Framework</li><li>IASB General Requirements</li><li>FASB Vs. IFRS GAAP Frameworks</li><li>Characteristics of Effective Framework; Barriers</li><li>Standard Setting Approach</li></ul>



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https://www.youtube.com/watch?v=0ufX-y33h5Y
</div></figure>

Financial Reporting Standards - Video

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