Financial accounting and reporting a global perspective

Lebas, Emeritus Professor, HEC Paris, France Yuan Ding, Professor, China Europe International Business School CEIBS, Shanghai, China New to this edition: > Revised coverage on all the

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FOURTH EDITION

“The book has a clear approach and provides a good basis for intermediate financial courses I am also

pleased to see more Dutch examples included in the new edition.”

Dr Erik van der Veer, Lecturer in Accounting, Business School, University of Amsterdam, The Netherlands

“The book is ideally suited for MBA courses in financial accounting and reporting, and a strength of the

new edition is that the end-of-chapter assignments now reflect a wider range of difficulty levels.”

Dr Jannis Bischof, Lecturer in Accounting and Taxation, Business School, University of Mannheim, Germany

“I use this book with my MSc students because it provides a detailed discussion of the topics with an

excellent use of examples The new edition also contains more real-life examples which will really help

aid student understanding and application.” Dr Ioannis Tsalavoutas, Lecturer in Accounting, Division of

Accounting and Finance, University of Stirling, UK

Now in its fourth edition, the completely revised

version of Financial Accounting and Reporting:

A Global Perspective can be utilized worldwide

by business and management students seeking

an essential introduction to the field

Guidance across the complexities of financial

accounting is offered from an international

and ‘user’ perspective, based on the latest

IFRS standards Its comprehensive coverage

incorporates original case studies,

decision-making orientation and genuine financial

statements from across the globe, maximizing

topicality and relevance for a thorough

understanding of real-world business

A fresh, contemporary presentation of text design

delivers user-friendly tables, figures and diagrams,

helping to make theoretical explanations such as

the technical aspects of accounting transactions

more approachable End-of-chapter assignments

have also been enhanced, now targeting a

range of difficulty levels This aids students with

independent practice and learning at their own

standard of ability

About the Authors:

Hervé Stolowy, Professor, HEC Paris, France

Michel J Lebas, Emeritus Professor,

HEC Paris, France

Yuan Ding, Professor, China Europe International

Business School (CEIBS), Shanghai, China

New to this edition:

> Revised coverage on all the latest IFRS

developments and terminology

> New real-life case examples and studies

> Expanded coverage on international

accounting harmonization

> Extensive developments on fair value

in a completely rewritten Chapter 10 and

a major update of Chapter 13 on consolidation

> New independent assignments and end-

of-chapter problems across three levels

of complexity to aid independent learning and depth of understanding

> Expanded glossary of key terms at the

end of the book

> Enriched provision of digital support

materials, which instructors can share, as needed, with their students

Financial Accounting and Reporting:

a Global Perspective is suitable worldwide

for MBA, professional management and undergraduate level modules in financial accounting and reporting

Hervé Stolowy, Michel Lebas and

Yuan Ding

Publishing Director: Linden Harris

Publisher: Andrew Ashwin

Commissioning Editor: Annabel

Ainscow

Content Project Editor: Alison Cooke

Production Controller: Eyvett Davis

Marketing Manager: Amanda Cheung

Cover design: Design Deluxe

The Author has asserted the right under the Copyright, Designs and Patents Act 1988 to be identified as Author of this Work

British Library Cataloguing-in-Publication DataA catalogue record for this book is available from the British Library ISBN: 978-1-4080-6662-1

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1 2 3 4 5 6 7 8 9 10 – 15 14 13

To my wife, Michael Adler, and to Alfie Each one, in her and his way, provided their support, loving encouragement and the

serenity required by this project.

To Xiaowei and Dale For giving me the serenity and optimism, essential for being an effective teacher and

productive researcher.

PART I INTRODUCTION TO FINANCIAL

3 Financial Statements: Interrelations and Construction 88

4 Accounting Principles and End-of-period Adjustments 120

PART II MAJOR ACCOUNTING TOPICS 161

5 Regulation of Accounting and Financial Reporting 162

PART III FINANCIAL STATEMENT ANALYSIS 527

15 Analysis of the Statement of Financial Position/Balance Sheet 528

17 Analysis of the Statement of Cash Flows and Earnings Quality 574

18 Ratio Analysis, Financial Analysis and Beyond 600

iv

List of Real Companies Referenced xiv

PART 1 INTRODUCTION TO

1 A model of business activity 2

2 Accounting: A language for business 4

2.1 Business creates an agency relationship that

2.2 Accounting is a living language 7

2.3 Accounting is a language with some

3 Definition of financial accounting 10

4 Users of financial accounting 12

4.1 Presentation of the various users 12

4.2 Financial reporting standards: how

5 Introduction to the accounting process 15

6 Financial accounting and managerial

9 History of accounting: From Sumer to Luca

3 Income statement (or I/S or profit and loss

account, also known as P&L statement, or

3.1 Business equation and income statement 54

3.2 Elements of the income statement 54

5.3 Cash, profit and retained earnings 63

6 Consumption of resources and inventory

6.1 Goods purchased for resale (merchandise)

or for use in a transformation process (raw

materials, parts and consumables) 65

6.2 Inventory of goods manufactured 69

7 Financial statement analysis 71

7.1 Trend, common-size analysis and ratio

Review (Solutions are on the book website) 78

Review 2.1 Vivaldi Company (1) 78

Review 2.2 Vivaldi Company (2) 79

Review 2.3 Albinoni Company 79

Assignment 2.1 Multiple-choice questions 80

Assignment 2.2 Vivaldi Company (3) 81

Assignment 2.3 Busoni Company 81

Assignment 2.4 Corelli Company (1) 81

Assignment 2.5 Corelli Company (2) 82

Assignment 2.6 adidas Group* 83

Additional material on the website 86

3 Financial Statements:

Interrelations and Construction 88

1.3 Links between statement of financial position/balance sheet, incomestatement

2 The production process of accounting

2.1 Double entry bookkeeping and the

3 Organization of the accounting system:

Assignment 3.1 Multiple-choice questions 107 Assignment 3.2 Industry identification 107 Assignment 3.3 Schumann Company (1) 109 Assignment 3.4 Schumann Company (2) 109 Assignment 3.5 Bach Company 110 Assignment 3.6 Sibelius Company 116 Assignment 3.7 Internet-based exercise 116 Assignment 3.8 Accounting history 116 Assignment 3.9 Lavender Soap Company case 117

1.1 Main objective of accounting principles:

3 Recording of adjusting entries in practice 136 3.1 Revenues earned but not recorded 136 3.2 Revenues recorded but unearned 137

3.4 Expenses recorded in advance 140

Assignment 4.3 Gounod Company 150

Assignment 4.4 Lalo Company 151

Assignment 4.5 Electrolux* 155

Assignment 4.6 Poulenc Company 156

Assignment 4.7 Debussy Company 157

1 Financial reporting standards 163

1.1 Necessity of financial reporting standards 163

1.2 The International Accounting Standards

2 The content of the annual report 168

3 Financial statements presentation 169

3.1 Possible presentations of the statement of

financial position/balance sheet 169

3.2 Possible presentations of the income

6 Extraordinary and exceptional items 227

7 Reporting accounting changes 228 7.1 Changes in accounting policies 228 7.2 Changes in accounting estimates 229

8 Reporting discontinued operations 230

10.3 Forgivable loans and repayable grants 236

Notes 249

1.2 Accounting issues relating to tangible assets 252

1.3 Definition of tangible fixed assets 253

2.1 Components of a complex tangible asset 258

2.3 Depreciable amount or depreciable base 258

2.4 Useful life (or service life) for accounting

2.8 Recording the depreciation expense 269

2.9 Summary of the income statement

impact of the different methods 269

2.10 Reporting depreciation policies 271

4 Assets constructed by and for the

enterprise (internally generated assets) 272

4.3 Recording of the transactions 274

5 Particular issues relating to reporting

5.1 Cases in which land is a depreciable

6 Costs subsequent to acquisition 276

7 Disposal of long-term assets 277

7.1 Recording of the sale of an asset 277

7.2 Classification in the income statement 277

8 Financial aspects of tangible assets 278

8.2 Reporting movements in tangible assets 279

8.3 Financial statement analysis 280

Review (Solutions are on the book website) 282

Assignment 7.1: Multiple-choice questions 283

Assignment 7.2: Discussion questions 283

Assignment 7.3: Reporting in different sectors

1.2 Main categories of intangibles 293

2 Recognition of intangible assets 297

3 Reporting of changes in intangible assets

3.1 Different possibilities exist of changes in

3.2 Comparison of the approaches of the

4 Accounting for research and development 304

4.2 Elements of the debate over capitalization

5 Accounting for computer software 308

5.2 Reporting computer software costs 309

6 Financial statement analysis 310

Assignment 8.5 R&D intensity 315 Assignment 8.6 CeWe Color* 315 Assignment 8.7 Granados Company 315

2.1 Perpetual (or permanent) inventory system 326

2.4 Presentation of inventories in the income

3 Inventory valuation and reported income 328

3.2 Methods for the valuation of inventory

outflows (costing formulae for

4 Inventories and cash flow 334

5 Decline in value of items in inventories

(end of year adjustments) 334

6 Income statement by nature and income

7 Disclosure of inventory valuation policies 335

8 Financial statement analysis pertaining to

Assignment 9.1 Multiple-choice questions 341

Assignment 9.2 Discussion questions 341

Assignment 9.3 NorthWest Boards & Bikes 342

Assignment 9.4 WPP plc* and Irish Continental* 342

10 Financial Instruments inthe

Statement of Financial Position

1 Definition of financial assets and liabilities 349

2 Cash and cash equivalents 351

3 Financial asset and liability at fair value

3.2 Accounting for financial assets at fair

value through profit or loss 354

3.3 Reporting financial asset at fair value

3.4 Evolution and debate over regulation

7 Financial instrument recognition after 2015 374

8 Financial statement analysis 374

2.4 Different categories of shares 389

2.6 Accounting for share capital 391

6 Capital reduction 401

7 Treasury shares (or own shares,

7.1 Why repurchase one’s own shares? 401

7.2 Purchase of treasury shares to reduce

7.3 Purchase of treasury shares held by the

7.4 Reporting for treasury shares 403

8 Stock options plan (‘Share options plan’) 404

8.2 Accounting for stock options plan 404

9 Share dividend and dividend in kind 405

11 Changes in shareholders’ equity 406

11.1 The prescriptive content of IAS 1 406

11.2 Presentation of the changes in equity 407

12 Financial statement analysis 409

12.1 Impact on financial structure 409

Review (Solutions are on the book website) 413

Review 11.1 Copland Company 413

Review 11.2 Menotti Company 414

Assignment 11.1 Multiple-choice questions 414

Assignment 11.2 Ives Company 415

Assignment 11.3 Bernstein Company 415

Assignment 11.4 Gilbert Company 416

Assignment 11.5 Gerry Weber* 416

1.3 Settlement of the obligation 422

1.4 The current/non-current distinction 422

2 Relative weight of liabilities in the balance

4.4 Sales tax and Value Added Tax (VAT)

4.5 Current portion of long-term debt 429

5.1 No separation between short-term and long-term liabilities on the balance sheet 429 5.2 Short-term and long-term liabilities

reported separately on the balance sheet 430

6 Liabilities, provisions and contingent

7.2 Interest, discount and premium 438

8.1 Accounting recording of leased assets 442 8.2 Finance and operating leases 442 8.3 Capitalization of finance leased assets 443 8.4 Example of accounting for leased assets 444

10 Financial statement analysis 451

Assignment 12.4 Club Me´diterrane´e* 455 Assignment 12.5 Haeffner PLC (2) 455 Assignment 12.6 Stora Enso*, Repsol YPF*,

Assignment 12.7 Nilsson Company 458 Assignment 12.8 United Internet* 459 Assignment 12.9 Saint Gobain* 459 Assignment 12.10 ArcelorMittal* 461

Additional material on the website 463

2.3 Nature of relations between parent

3 Reporting the acquisition of a financial

interest: consolidation methods 471

3.1 Impact of an acquisition on reporting 472

3.2 When no consolidation is required 473

3.3 When full consolidation is required 473

3.4 When equity method is required 481

3.5 When proportionate consolidation is

3.6 Reporting which method(s) was(were)

3.7 Impact of each of the methods of

consolidation on reported group sales

3.8 Synthesis: Interaction between

5 Deferred taxation on consolidation 489

6 Foreign currency translations 489

7.3 Determination of the number of shares

7.4 Determination of the merger premium 491

Review (Solutions are on the book website) 493

Review 13.1 Mater & Filia 493

Assignment 13.1 Multiple-choice questions 493

Assignment 13.2 Mutter & Tochter 494

Assignment 13.3 China International Marine

Container*, Honda Motors*, EVN* and

1 Structure of the statement of cash flows 500

2.4 Developments in international practice 501

3 Definition of the three categories

of activities impacting cash flows 501

4.1 The direct method of calculating cash flows

4.2 The indirect method of calculating cash flows from operating activities 504 4.3 Reporting cash flows from operating

5 Cash and cash equivalents 505

6 Example of a statement of cash flows 506

7 Construction of a statement of cash flows 507 7.1 Cash flows from operating activities 509 7.2 Cash flows from investing activities 516 7.3 Cash flows from financing activities 517 7.4 Full statement of cash flows 519

8 Reporting the statement of cash flows 519

9 Non-cash investing and financing

as vertical analysis) 530

2.2 Usefulness of common-size analysis 530

2.3 Common-size statement of financial

3 Statement of financial position/balance

sheet structure and cash equation 532

3.1 Statement of financial position/Balance

3.2 Cash equation working capital, working

3.3 The statement of financial structure in

practice Comparative analysis of Exxon,

Review (Solutions are on the book website) 546

Review 15.1 Dvorak Company (2) 546

Review 15.2 Chugoku Power Electric

Assignment 15.1 Multiple-choice questions 547

Assignment 15.2 Smetana Company (2) 548

Assignment 15.3 Club Me´diterrane´e* 548

1 Trend analysis (also known as horizontal

or chronological analysis) applied to the

1.2 Advantages and limitations of trend

2 Common-size analysis (also known

as vertical analysis) of the income

Review (Solutions are on the book website) 567

Review 16.1 Chugoku Power Electric

Assignment 16.1 Multiple-choice questions 568

Assignment 16.2 Smetana Company (3) 569

Assignment 16.3 Procter & Gamble* (1) 569

Assignment 16.5 Wipro Limited* 570 Assignment 16.6 China Communications

17 Analysis of the Statement

of Cash Flows and Earnings

1 Analysis of the statement of cash flows 575 1.1 Algebraic sign of cash flows 575 1.2 From excess cash flow to free cash flow 575 1.3 Analyzing the statement of cash flows

3 Using the indirect method of operating cash flow as a tool to analyze the earnings

Review (Solutions are on the book website) 585 Review 17.1 Mitsubishi Electric* 585 Review 17.2 Bartok Company (1) 587

18 Ratio Analysis, Financial

1 Ratio analysis: searching for answers

1.2 Conditions of use of ratio analysis 602

1.5 Additional remarks about ratios

2 Sources of information about business

2.1 Annual report to shareholders 611

2.2 Business newspapers and magazines,

2.4 Financial statements filed with tax

3 Measures of return to investors 613

3.1 Earnings per share and return on equity 613

3.2 Measures of return on capital invested

residual income and economic value

6.1 Enterprise governance defined 625

6.2 Corporate governance and internal

controls, accountability and assurance 626

6.5 Regulating enterprise governance 627 6.6 The causes of violations of the good

(Continued) xiv

Company name Country Chapter

(Continued)

Company name Country Chapter

Company name Country Chapter

Company name Country Chapter

Herve´ Stolowyis Professor of Accounting at HEC Paris (Jouy-en-Josas, France) He holds a degree in ness administration (ESCP – Paris Graduate School of Management), a master’s degree in private law (Uni-versite´ Paris-Val de Marne), a BA in Russian and American studies (Universite´ Paris-Sorbonne), a PhD infinancial accounting (Universite´ Paris-Panthe´on-Sorbonne) and an ‘habilitation a` diriger des recherches’(which certifies him as a qualified doctoral dissertation adviser) He is a certified ‘expert comptable’(French equivalent of a chartered accountant or certified public accountant).

busi-He has authored and co-authored ten books, chapters in 15 collective works and published over 75articles in academic and applied journals, such as Abacus, Accounting Auditing & Accountability Journal,Accounting, Organizations and Society, Advances in International Accounting, Comptabilite´ – Controˆle –Audit, European Accounting Review, Finance – Controˆle – Strate´gie, The International Journal ofAccounting, Issues in Accounting Education, Journal of Accounting and Public Policy, the Journal of Busi-ness Ethics, Les Echos, the Review of Accounting and Finance, the Revue de Droit Comptable and theRevue Française de Comptabilite´

Professor Stolowy’s research and teaching interests span financial and international accounting, andfocus more specifically on IFRS/IAS, intangibles, accounts manipulation (including fraud), and design anduse of statement of cash flows He is a member of the Association Francophone de Comptabilite´ (AFC), theEuropean Accounting Association (EAA), the American Accounting Association (AAA), and CanadianAcademic Accounting Association (CAAA) He is past president of AFC and current co-editor of Compta-bilite´ – Controˆle – Audit He has been a member of the ‘Standards Advice Review Group [SARG] created

to advise the [European] Commission on the objectivity and neutrality of the European Financial ReportingAdvisory Group’s (EFRAG’s) opinions’

Herve´ Stolowy teaches financial accounting and financial statement analysis in the different graduateprograms of HEC Paris (HEC-MBA Program and HEC Master of Science in Management – GrandeEcole)

He was educated both in France (HEC) and in the United States (Tuck School at Dartmouth College andStanford University Graduate School of Business) After a brief career as an economic analyst for a US mul-tinational company in Boston, and later as a staff consultant in the New York office of then Price Water-house, he joined the academic profession while maintaining an active freelance consulting practice He isnow a freelance consultant and executive education trainer, working for multinational companies and vari-ous international Executive MBA programs in Europe, Asia, North America and Africa

Professor Lebas’ field of interest and consulting concentrates on advanced practices in managementaccounting and performance management systems He was one of the academic research associates in theBeyond Budgeting Round Table Program from 1989 until 2008; from July 1992 to July 2000 he repre-sented the French Ordre des Experts Comptables and the Compagnie des Commissaires aux Comptes onthe then ‘Financial and Management Accounting Committee’ (FMAC) (currently ‘Accountant in BusinessCommittee’) of the International Federation of Accountants (IFAC) He is the founder, and was, from 1992until 1996, co-editor of the management accounting section of the Revue Française de Comptabilite´ Hispublications, in addition to this textbook, include chapters in major international collective works, co-authorship/editorship of a Glossary of Accounting English, co-authorship of a Management AccountingGlossary, as well as a French language management accounting textbook He co-authored a CAM-I

xix

ous articles have been published in many academic and professional journals including Administracio´n deEmpresas, Les Cahiers de l’ANACT, Cahiers Français, Comptabilite´ – Controˆle – Audit, De Accountant,Les Echos, European Accounting Review, European Management Journal, The Financial Times, Interna-tional Journal of Production Economics, Journal of Management Studies, Management AccountingResearch, Performances Humaines et Techniques, Problemi di Gestione, Revue Française de Comptabilite´,Revue Française de Gestion Industrielle, Sviluppo & Organizzazione, Travail, and in the publications ofIFAC.

Professor Lebas has been Associate Dean for Academic Affairs of the HEC Grande Ecole (1986–1989)

He has held visiting appointments at Aalto School of Business (formerly Helsinki School of Economics), theAarhus Business School, SDA Bocconi in Milan, the Fletcher School of Law and Diplomacy at Tufts Uni-versity, INSEAD, the Mediterranean School of Business in Tunis, the Darden Graduate School of Business

at the University of Virginia, and at the Foster School of Business of the University of Washington MichelLebas is a member of the Association Francophone de Comptabilite´, the American Accounting Association,and the Institute of Management Accountants He lives in Seattle, Washington, USA

Yuan Ding is Cathay Capital Chair Professor in Accounting at CEIBS (China Europe International BusinessSchool) Prior to joining CEIBS, he was a tenured faculty member at HEC Paris, France He received hisPhD in Accounting from the Universite´ Montesquieu (Bordeaux IV), France He also holds a Master’s inEnterprise Administration from the Universite´ de Poitiers, France

Professor Ding’s research has been published in Accounting, Organizations and Society, Journal ofAccounting and Public Policy, European Accounting Review, Abacus, The International Journal ofAccounting, Review of Accounting and Finance, Advances in International Accounting, Issues in Account-ing Education, the Journal of Business Ethics, Managerial Finance, Journal of Business Venturing, Journal

of International Business Studies, Management International Review, Corporate Governance: An tional Review, International Journal of Disclosure and Governance and several leading French academicjournals

Interna-Professor Ding is a member of the European Accounting Association, the Association Francophone deComptabilite´ and the American Accounting Association He is Co-Editor of The International Journal ofAccounting and Associate Editor of China Journal of Accounting Research He is also Editorial BoardMember of Journal of Accounting and Public Policy, Global Perspectives on Accounting Education Jour-nal, and Research in Accounting in Emerging Economies His current research is focused on intangibles,international accounting harmonization, earnings management and accounting frauds, analyst forecasts,corporate governance issues, IPO issues and accounting reform in China

Professor Ding lectures in financial accounting, financial statement analysis, international accountingand corporate governance in Master’s of Science in Management, MBA, EMBA and PhD programs inEurope and in China He designed and delivered in-company special and open executive education pro-grams in China and in Europe At CEIBS, he co-founded the first CFO open program in China in 2005 and

is involved in many top executive programs co-organized with Harvard, Wharton, INSEAD, New YorkUniversity, London School of Economics, IESE and HEC Paris He frequently provides consulting servicesfor many multinational and Chinese companies in the areas of financial communication, corporate gover-nance, cost control system design, investment and M&A In May 2011, Prof Ding launched ‘Ding YuanIndex Neutral Fund’ in a share market and became the first accounting and finance professor in mainlandChina running a hedge fund He also serves on the Boards of Directors of several listed firms and financialinstitutions in China, Europe and North America

The author team is a reflection of the spirit and the tone of the text Herve´ Stolowy and Yuan Ding bringthe accounting and reporting practitioner/researcher and external financial analyst viewpoint, while MichelLebas brings the internal and managerial preoccupations in the design of information systems and the inter-pretation of accounting information Currently living and working in three different continents (Europe,America and Asia), the team brings a unique combined global vision on current accounting issues and theirmanagement implication

This fourth edition comes out at a time of both turmoil and hope for financial accounting.

Turmoil because the convergence between IFRS (the standards on which this book is mainly based) and

US GAAP, after a fast track forward until the crisis, and many ups and downs since, seems not to be gainingtraction at the time of this writing

Turmoil following the financial scandals and the economic crisis that started in mid 2008

Turmoil, because that storm challenged both accounting rules and practices

Hope, because accounting standards held fast, and helped the economic boat stay the course, even ifstill showing some potential weak points (mainly around the concept of fair value)

Hope, because the importance of good accounting and reporting is now more evident than ever Hadmany of the disabled firms followed best accounting practices, shareholders showed some common senseand less gullibility, and managers indulged in less greed, much of the misery created around the worldwould not have taken place, even if accounting alone could not have prevented some form of crisis

Hope, because the field of accounting, even at over 3,800 years of age, is more alive and full of the ity of youth than ever, and still developing to serve the needs of businesses of all sizes and activities andinvestors, small and large

vital-More people, business students and executives, see the usefulness of gaining an ability to read and stand financial statements, and rely on trained qualified professionals to produce them

under-This fourth edition acknowledges the turmoil and offers tools to comfort and reinforce the hope, in linewith harmonization of best practices and respectful of local cultural differences

A book to meet changing student and faculty expectations

The success of the first three editions of this award-winning textbook confirmed that the authors’ originalpoint of view remains correct: most students of and in business or management around the world want andneed, regardless of their career plans, to understand how accounting figures and documents are produced

in order to better decode them and extract their informational content for decision making

The profile of executive, graduate and undergraduate business students in the programs where theauthors teach is more and more international, whether it is because programs have developed without refer-ence to borders, or because executive trainees, students and faculty show increasing worldwide mobility

To these students as to most managers, English is the lingua franca of business More and more businessprograms are being taught in part or completely in ‘International English’, regardless of the location oftheir venue

Most students or executive program participants in our target audience know their career is already, orwill be, in an international context, i.e., neither where they grew up, nor where they were educated

The composition of the team of authors reflects this quasi supra-nationality of accounting Herve´ lowy, based in France, brings a European viewpoint, Michel J Lebas, based in the US, teaches and consults

Sto-on four cSto-ontinents, and Yuan Ding, based in China, teaches and cSto-onsults in Asia and Europe All threeauthors teach in international programs, each one its own mini melting pot of cultures, of educational back-grounds, of diverse previous experiences, of a variety of firms from industrial, commercial or service sec-tors, of different professional responsibilities, and of individual career or professional objectives

The book is written first and foremost for all managers and students of management, more than it isconceived for future or existing professional accountants The authors trust these, however, will find the

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richness of the Web-based appendices and supplements extends the reach of the book to include advancedaccounting students and make it a life-long reference tool, regardless of career evolutions.

Students and managers want and need, in a context of continuous learning, to be trained to appreciate,understand and analyze a variety of Financial Accounting and Reporting issues from a theoretical, universaland generic point of view They know the principles and tools they will have mastered through this text-book will allow them to adapt and apply their understanding of accounting and financial reporting to anylocal circumstances they will face The authors’ choice has been to provide many real-world case data from

a variety of contexts, industrial, commercial, distribution or services, variety of firm size (from the singleproprietorship to the multinational corporation), or variety of countries of operation in Europe, Asia,America or Africa These real-world cases are analyzed and used in illustrations in the chapters or are thebasis for well-focused and progressive assignments The book’s content of principles, practices, tools andtechniques can be immediately applied to the rich and complex environment where our readers do workand will work

A book based on three simultaneous perspectives

The authors conceived their work to allow the teaching of Financial Accounting and Reporting to a specialist audience with the following three perspectives in mind:

implications for quality information, usable by decision makers, or in the practice of analyzing financial statements.

problems, with multiple possible solutions and positions As much as possible, all likely solutions are examined with their own logic and pros and cons The accounting language is presented as a natural language rather than

as an esoteric jargon, reserved for the few and the brave Accounting issues are created by business needs, and

by the ever increasing, and evolving, globalization of the economy They transcend local politics and economic upturns or downturns.

authors are aware of, and fully acknowledge and explain, the implications of the different positions other tors may have taken on relevant issues Our choice simply reflects the growing (even if slow) harmonization and convergence between local rules and regulations and the leading international providers of principles, rules and regulations.

regula-Target audience for this text

This textbook is designed primarily for:

insti-tutions where knowledge of a single (national) accounting system is recognized as being insufficient preparation for the world where the graduates will work;

financial techniques and information, who wish to understand the financial performance of the entities they interact with and be able to decode their reporting to the outside world;

sup-plementing the text with the full power of the appendices on the dedicated website.

Our approach derives from the characteristics of our targeted audience

The book approach is based on the following ideas:

held belief that business ‘students’ (graduate, senior undergraduate, or executive trainees), regardless of the area

of specialization they have selected, or the career(s) they will embrace over their lifetime, will be, first and foremost, and on a regular basis, users of financial statements.

users (investors, credit analysts, etc.) they will need to interpret accounting data to be able to communicate and decide.

Their knowledge of the preparation of accounting and reporting numbers needs only encompass enough comprehension of key principles to allow the user to not be at the mercy of the information preparer An old Chi- nese proverb says: ‘If you want to build a bridge, ask the river’ If a manager wants to make the right decision about a business, she or he had better listen to what the firm says about itself, how it reports on its performance

or its cash flow Understanding the past allows the decision maker to formulate, within the global economic text, a view of the future financial performance of the entity and of the risks inferred from the firm’s past behavior, its business model and the decisions it can make or has made.

con-The book’s target audience is a mix of specialists and non-specialists While helping non-specialists become skilful in financial information understanding and use, our approach opens a new perspective for specialists to review, from the user viewpoint, the information they prepare, and rethink their financial communication strategy

to more effectively satisfy the users’ needs.

reports of well-known firms and excerpts from the financial press Some of these elements of annual reports are commented on in detail, in order to prepare the students for reading and interpreting annual reports and articles

in the financial press.

we have chosen to first examine the economic logic of the problem and second to identify generic possible tions and what impact each might have on a company’s or decision-maker’s decisions Accounting rules and reg- ulations and practices result from well-reasoned arguments, which are dissected, when appropriate, in the chapters.

Stand-ards Board (IASB) standStand-ards (i.e., IFRS/IAS) We strongly believe that, in many situations, the IASB tions, with the leeway and flexibility they contain, offer a good a-national approach, but we do not hesitate to highlight the areas where the debate is still open, or where we feel in disagreement, with aspects of a currently

recommenda-‘recommended’ solution, always taking the point of view of the user We take into account all sources of good accounting principles and practices: the IASB (which produces IFRS), the US-based Financial Accounting Stand- ards Board (which produces SFAS), the Financial Market regulators such as IOSCO (International Organization of Securities Commissions) or the US SEC (Securities and Exchange Commission) and their national or regional partners or equivalents.

and solutions, (3) Assignments, including Multiple Choice Questions on the key points, (4) References, and (5) ther readings.

supple-mented, on the dedicated book website, by appendices that deal with particularly technical issues or special cases.

decision makers The ability to read and understand accounting statements is as essential to managers as their ability to read newspapers, magazines and books, or to attend professional conferences Good accounting, like good journalism, follows rules and is limited only by professionalism, culture, ethics and tradition The talent of the accountant, like that of the journalist, rests in his or her ability to choose the right descriptors that will give a true and fair view of events and of their implications Accounting describes the economic reality of enterprises by using

a dedicated language We hope, with this book, to help demystify the world of financial reporting.

A few practical considerations

the book, in keeping with our a-national editorial choice, and the current practice of the IASB, a generic Currency Unit (or CU), except when we refer to real-life examples in which case the original currency is always used.

asterisk next to the name of the company to highlight the ‘real-world’ origin of the assignment.

common practice in many countries.

the number (For example: Table 12.1A would be in the web-based appendices to Chapter 12, while Table 12.1 would be in Chapter 12 in the textbook you hold in your hands, physically or in some electronic format).

Web-based supplementary materials for students and instructors

Students have access to the following resources on Cengage’s interactive ‘CourseMate’ platform via theprinted access card in the front of the book, which contains access details and a unique access code:

reviews nor assignments)

Instructors have access to the following additional resources (via specific instructor login details whichthey can request from the Cengage sales representative after adoption of the book):

special notes to the instructor, indicating frequently made mistakes, and alternative acceptable solutions

New features of the fourth edition

In addition to updating the third edition throughout for the latest developments in the IFRS program andbringing the IAS up-to-date (and quoting the relevant FASB pronouncements, when useful), and using themost recently available company financial statements at the time of writing, the fourth edition offers:

of countries throughout the world, with a large development of cases about businesses headquartered in Asia.

and reference to the duality of valuations throughout the text.

visi-bility (or life expectancy of the business model).

13 Fair value measurement).

for the part related to consolidated financial statements and SIC 12 on Special Purpose Entities, IFRS 11 Joint arrangements [replaces IAS 31 and SIC 13, replaces proportional integration by equity method for joint ventures while a special technique is used for joint operations], IFRS 12 Disclosure of interests in other entities).

analysis.

Chapter 6).

students.

Brendan George (who has now left Cengage), our publisher for this fourth edition, followed in the footsteps

of Jennifer Pegg (at Thomson Learning) for the first edition, Patrick (Pat) Bond (Thomson Learning andCengage) for the second edition and Stephen Wellings for the third edition He provided us with caring sup-port, showed us the same constructive and positive attitude and professionalism as his predecessors.Our renewed appreciation also goes to all on the staff at Cengage who have contributed, around Anna-bel M Ainscow, commissioning editor, and Alison E Cooke, content project editor, to the creation of thisfourth edition Annabel must be particularly acknowledged for her diplomacy and immense patience,which allowed her to firmly prod, encourage and support the authors, with great effectiveness, while givingthem the space and the resources needed to formulate their ideas and meet deadlines, without sacrificingquality A fine balancing act we, once again, appreciated and are grateful for

Our special appreciation goes to Claire Martin, once again our copy editor, whose flexibility, intelligenceand understanding has been essential to our meeting our deadlines, and hopefully to the quality of thebook, even if we assume full responsibility for any remaining lack of clarity or error

Anonymous reviewers and adopters of the previous editions played a significant role in shaping thefourth edition Their constructive comments helped us narrow down or focus our views and, we believe,improve the pedagogical approach in this fourth edition They ‘kept us honest’ by telling us where our pet-topics had led to outsized sections or had led us to overlook some critical issue Adopters and reviewershelped us create what we feel is now a better-balanced text Some of these evaluators, who also, often,helped us in the design of the previous editions, have accepted the loss of their anonymity and we gladlyacknowledge in person these friends and kindred souls:

Jannis Bischof, Assistant Professor, University of Mannheim

Jaime Bonet, Professor, ESCI

Ignace De Beelde, University of Gent

Begon˜ia Giner Inchausti, University of Valencia

Phil Cahill, Ecole de Management de Normandie

Stefano De Cesaris, Visiting Lecturer, Cass Business School

Axel Haller, University of Regensburg

Agnieszka Herdan, University of Greenwich

Christopher Hossfeld, Associate Professor, ESCP Europe

Paul Jennings, University of Winchester

Ann Jorissen, University of Antwerp

Josephine Maltby, University of Sheffield

Jan Marton, University of Gothenberg

Francoise Pierrot, Assistant Professor, ISEM University of Montpellier

Pat Sucher, Royal Holloway College, University of London

xxv

Anne Ullathorne, University of Birmingham

Didier Van Caillie, Professor of Management Control Systems, HEC School of Management, University of Lie`ge Charles P van Wymeersch, University of Namur, Belgium

Stefano Zambon, University of Ferrara

Our students, and users from all over the world, have been our, often, toughest evaluators They havechallenged, criticized and commented on the previous editions of this book Our greatest appreciation goes

to these truly international students for their patience and tolerance with our occasional remaining areas ofshadow and weaknesses and for their generally constructive comments

We wish to recognize Luc Paugam, our research assistant on this edition whose initiative, energy andpatience helped update the financial reports we use, and helped us identify new and interesting cases Wealso want to acknowledge Nils Clotteau, Sophie Marmousez and Michael Erkens, our research assistants

on the previous editions who helped us build a sound base on which we kept building Our students andassistants’ work has allowed us to create this more focused, better balanced and updated fourth edition.The multilingual Glossary (available on the website) is a collective work and we are pleased to acknowl-edge our co-authors: Eva Eberhartinger (Professor of Tax Management, Department of Finance, Account-ing and Statistics, WU Vienna University of Economics and Business, Austria), Jose´ Antonio Gonzalo(Professor of Accounting and Financial Economics, Department of Managerial Science, University ofAlcala´, Spain), and Stefano Zambon (Professor of Business Economics, Department of Economics andManagement, University of Ferrara, Italy)

Lastly and certainly not the least, we wish to thank Georges Langlois who has translated and adaptedthis edition as well as the second and the third ones for the French speaking markets Translation is a veryunforgiving test for the authors, as any lack of clarity becomes perfectly obvious once the sentences need to

be translated, even by a brilliantly competent translator/adaptor Georges’ almost real time comments andquestions helped us clarify our English text, correct errors and made sure we remained on the straight andnarrow of both our objectives and accounting theory

We warmly thank all these contributors for the generosity of their time and intelligence

The authors, nonetheless, assume full responsibility for the ideas expressed and for any errors or sions

omis-We will appreciate any and all comments from readers and users

Herve´ Stolowy, Paris, France

Michel J Lebas, Seattle, USA

Yuan Ding, Shanghai, China

Chapter opening page Learning objectives set out concisely what

is to be learned in the chapter, and ultimately link in to the key

points at the end of the chapter Introductory text expands on the

learning objectives and shows how the chapter fits in with other

chapters This helps readers to put the chapter in context and see

the ‘big picture’

Key terms Basic definitions and clarification of key

terms are given in a glossary section at the end of the

book

Real-life examples Extracts from the financial statements of companies from around the world help bring the learning points to life.

Diagrams and figures These are exceptionally clear to help the reader conceptualize abstract ideas such as income statement formats Tables clearly present financial statements in an accessible format

After studying this chapter, you will understand:

1 That accounting is a language that helps model, describe, and understand business activity.

2 What accounting, financial accounting and managerial accounting represent.

3 That financial accounting is, in practice, based on a process of recording transactions.

4 That reporting on the financial condition of the firm through financial statements is the end-product of this

process.

5 That different users, with often different objectives, are interested in financial accounting information Thus,

accounting practice is a compromise between the requirements of each constituency.

6 How basic transactions are recorded and impact financial statements.

7 That there are three financial statements: the statement of financial position (or balance sheet), the income

statement and the statement of cash flows.

8 What are the characteristics and roles of each financial statement.

9 That accounting, historically, is a very old recording tool and decision making support tool.

Accounting is inseparable from business and management In this book onaccounting and reporting, we will be

dis-cussing business issues and decisions from the point of view of both management and investors ‘Accounting is the

lan-expression.

1 A MODEL OF BUSINESS ACTIVITY

Business is about action (transformation of resources) and involves transactions between several people

(Robinson Crusoe, alone on his island may have had ‘undertakings’, but could not have had a ‘business’).

2

n to be rewarded by either dividends or interest payment,

n to be provided with information (reporting) about how efficiently the business is functioning,

n to use that information as a proxy for how the firm is likely to perform in the future, as long as the business

model is not changed.

Since accounting reflects all economic transactions, it is the key medium of communication inside the

firm, as well as with its partners or stakeholders, including capital providers and lenders among the many

we list in endnote 3.

2.1.2 Reporting to business ‘partners’

Although, technically, the firm is not an agent of employees, customers or suppliers (the firm has not

they be kept informed since they are de facto ‘partners’ in the future success of the firm All others who

ing reports that were originally prepared mainly for capital providers These other users will do so by

sur-process both in terms of efficiency and relevance, but also in terms of security of provision of funds by

capi-tal providers (we call this ‘financial statement analysis’ and Chapters 15 to 18 are devoted entirely to such

activity).

2.1.3 Reporting to superiors and peers

Accounting describes transactions linked to – and results of – actions and decisions It is normal (and

rior uses accounting information to verify the subordinate discharged her or his responsibility

appro-report to capital providers might prove to be sufficient (financial accounting is ‘results oriented’),

ested in the detailed steps undertaken by the subordinate in fulfilling her or his mission In this case

rial accounting’.

2.2 Accounting is a living language

As we have seen, accounting provides a description of what actors in the transformation process of the firm

the broad sense of the term resources, i.e., financial and non-financial) are created as the outcome of the

transformation process than were consumed in its course.

The process of doing business changes over time (the application of the generic ‘cash pump’ changes

continuously) in order to adapt to innovations and the evolution of competitive pressures Business

fied the way the transformation process is organized Web-based market-places and speed of

communi-appear with the evolution of society For example, 75 years ago, few businesses paid significant

atten-tion to the possible creaatten-tion of a retirement income for their former employees New business issues 4

are born every day that accounting must be able to describe as an enrichment of what was previously

language must therefore be very strong and flexible and rest on solid principles that will allow that

flexibility.

Accounting is a language and its ‘words’ are symbols that reflect a certain view of the world Just like

our everyday language evolves continuously, accounting must be able to adapt to the needs of the time.

Accounting is a very special language in that, the way it describes the world of business, affects the

timing or recognition and measurement of wealth creation Just to give a brief example, when one

machine during the first year (a procedure called ‘cash accounting’) or one could consider that the

year, only a part of the cost of the machine (‘depreciating’ the machine over its useful life, a part of

CHAPTER 1 ACCOUNTING: THE LANGUAGE OF BUSINESS 7

however, the largest electronics company by capitalization, does very well with only 2.24 per cent of its second having outsourced most manufacturing, and but also having a gross margin of 40 per cent and a net margin of 23.9 per cent).

The average R&D intensity for a sample of 1000 EU firms and 1000 non-EU firms (R&D Scoreboard) reported by the 2011 EU Industrial R&D Investment Scoreboard of the European Commission 4 is 2.2 per cent and 3.7 per cent respectively for 2011 with significant positive skewness and very large standard devia- tions both between and within countries.

6.1.2 R&D personnel intensity and effectiveness Financial analysts will not only look at the financial intensity (and the ratio of R&D costs to cash flow measures of output of the research.

53 300 patents worldwide in its continuing operations, compared to approximately 51 400 patents last year In many and – for the first time in the company’s history – first in Europe In terms of the number of patents granted, placed among the top ten By comparison, in calendar year 2009 Siemens occupied the third place in Germany,

in fiscal 2011 – approximately 40 per working day.

b Average number of employees in fiscal year.

c In italics: our computation.

d Number of inventions submitted by Business Units based on an internal reporting.

e First filings as part of the inventions submitted to patent offices.

CHAPTER 8 INTANGIBLE FIXED ASSETS 301

Figure 5.1 The IASB Structure (Source: Adapted from the IASB website, www.ifrs.org)

IFRS Foundation (22 trustees)

(Appoints: IFRS AC, IASB, IFRS IC)

International Accounting Standards Board (Board = 16 members)

(Approves IFRS, ED, IFRS

Interpretations)

IFRS Interpretations Committee (14 members)

(Publishes draft Interpretations and prepare draft of final Interpretations)

IFRS Advisory Council

(Advises the Board)

Monitoring board (of public capital market authorities)

(Appoints: IFRS Foundation trustees)

IFRS = International Financial Reporting Standard

ED = Exposure Draft

CHAPTER 5 REGULATION OF ACCOUNTING AND FINANCIAL REPORTING 161

No single format of the multiple-step approach appears to be dominating in practice Each firm chooses the representation that best communicates its intended emphasis on specific points and messages.

n Preference for a classification by nature often reflects pressure exercised by some governmental statistics agency

is often the case in continental European countries) 8 Such a presentation can be difficult to decipher by users, especially if they want to prepare forecasts, one of the key purposes of the use of financial reports.

n Preference for a functional presentation often reflects an emphasis on the income creation process It is the informational content of such annual statements is easily understandable and usable by ordinary investors The IASB chooses sides by stating that the presentation by function can ‘provide more relevant informa- tion to users than the classification of expenses by nature’ (IAS 1, IASB 2007: § 103) However, it draws tions may require arbitrary allocations and involve considerable judgment’ In conclusion, paragraph 105 depends on historical and industry factors and the nature of the entity Both methods provide an indication

pre-of those costs that might vary, directly or indirectly, with the level pre-of sales or production pre-of the entity’ Proponents of the classification by nature highlight the fact that this method may allow for a user-spe- cific analysis of the performance of the firm They point out that, in theory, the cost of goods sold (or the

Table 5.12 Income statement by nature (vertical presentation)

Net sales

þ Other operating revenues

 Purchases of merchandise

 Change in inventories of merchandise

 Labor and personnel expense

 Other operating expenses

Key points Key points conclude the chapter and

highlight the core learning points covered They link

in to the learning objectives introduced at the start of

the chapter They are a useful reminder for a reader

who is reviewing the chapter

Review The review section at the end of the chapter contains

questions, the solutions to which are found on the dedicated

book website Readers are encouraged to attempt answering

the questions without first looking at the solutions.

References and Further reading These provide directions

to further sources of information.

Assignments The numerous assignments test a range of issues covered in the chapter Solutions are provided on the companion website and are available only to instructors adopting the book

Review 6.2 Schall Company Topic:Deferred taxation Level of difficulty:Moderate Schall Company realized in the year X1 a fiscal pre- into account a one-off royalty fee expense for 10 CU for the use by Schall Co of a new technology for

to recognize as an expense, for reporting purposes, X2 However, tax regulations require an immediate

Royalty fee expense recorded for tax purposes 10 Pre-tax income after recording the fee 100 Yearly amortization of the fee expense (over two years) 5

Select the right answer (only one possible answer unless otherwise stated).

1 Which category(ies) of transactions and events is recognition process?

(a) The sale of goods.

(b) The use by others of entity assets.

(c) The rendering of service.

(b) The entity retains an obligation in case of warranty provisions.

unsat-(c) The receipt of the revenue from a particular sale the buyer from its sale of the goods.

(d) The goods are shipped subject to installation, the contract, which has not yet been com- behalf.

3 The recognition of revenue by reference to the referred to as the percentage of completion method (a) True.

(b) False.

4 Progress payments and advances received from can be used to reliably determine the percentage of completion.

(a) True.

(b) False.

5 When the outcome of a transaction involving the which of the following statements is correct? (a) Revenue should not be recognized (b) Revenue should be recognized for the total amount specified in the contract (c) Revenue should be recognized only up to expenses.

ren-(d) None of these.

6 In the four situations below, regarding revenue that royalties and dividends), which of the four situations the revenue?

(a) When it is probable that the economic benefits enterprise.

n A perpetual inventory system is a continuous record

withdrawals).

n The periodic inventory system relies on the required

value the quantities in the ending inventory.

n Inventory valuation and costing methods have a

great impact on net income.

n There are four methods for costing items withdrawn

(first-in, first-out), LIFO (last-in, first-out) and WAC

(weighted average cost).

n The IASB no longer allows the use of LIFO for external reporting of a business financial position.

n Financial analysts are mainly concerned with the inventory of a business with that which would appear

to be appropriate given the firm’s business’s environment and strategy Their measures to evaluate this coherence are (1) inventory turnover accounting period), and/or (2) average days of turnover ratio).

REVIEW (SOLUTIONS ARE ON THE BOOK WEBSITE)

Review 9.1 Ericsson*

Topic:Reporting for inventory

Level of difficulty:Moderate

Based in Sweden, Ericsson is a leading provider in the

tele-telecom and datacom technologies with freedom of

mobility for the user.

The 2010 and 2011 annual reports show inventories

to be as follows:

December 31, SEK million Note 2011 2010 2009

Assets ( .) Inventories C13 33,070 29,897 22,718

The notes to the consolidated financial statements contain the following information:

Note 13: INVENTORIES 2011 2010 2009

Raw materials, components, consumables and manufacturing work in progress 8,772 8,509 6,190

Contract work in progress includes amounts related to delivery-type contracts, service contracts and construction-type contracts with ongoing work in

progress Reported amounts are net of obsolescence allowances of SEK 3,343 (3,090 and 2,961) million.

Movements in obsolescence allowances 2011 2010 2009 2008

1 What are ‘obsolescence allowances’ usually called?

2 What do the ‘Additions’ in these allowances

accumu-n A new loan was granted No loan was repaid.

n 80 were raised from the issue of shares in cash (share capital of 50 plus share premium of 30).

n Some bonds were repaid at maturity; they had a total face value of 70.

REFERENCES ASB (1991, revised 1996) Financial Reporting Stand- ard No 1, Cash flow statements, London, UK.

FASB (1987) Statement of Financial Accounting Standards No 95, Statement of cash flows, Nor- walk, CT.

IASB (1992) International Accounting Standard No 7, Statement of cash flows, London.

IASB (2007) International Accounting Standard No 1, Presentation of Financial Statements, London.

FURTHER READINGS Boussard, D and Colasse, B (1992) Funds-flow statement and cash-flow accounting in France:

Review, 1(2), 229–54.

Broome, O.W (2004) Statement of cash flows: Time for change! Financial Analysts Journal, 60 (2), 16–22.

Cheng, C and Hollie, D (2008) Do core and non-core cash flows from operations persist differentially in tive Finance & Accounting, 31(1), 29–53.

Cheng, C.S.A., Liu, C.S and Schaefer, T.F (1997) The value-relevance of SFAS No 95 cash flows effects Accounting Horizons, 11(3), 1–15.

Clinch, G., Sidhu, B and Sin, S (2002) The usefulness

of direct and indirect cash flow disclosures Review

of Accounting Studies, 7 (4), 383–402.

Dhar, S (1998) Cash flow reporting in India – A case study Indian Accounting Review, 2(2), 39–52.

Haller, A and Jakoby, S (1995) Funds flow reporting

in Germany: A conceptual and empirical state of the art European Accounting Review, 4(3), 515–34.

Jing, L., Nissim, D and Thomas, J (2007) Is cash flow king in valuations? Financial Analysts Journal, 63(2), 56–68.

Kim, M and Kross, W (2005) The ability of earnings to predict future operating cash flows has been Research, 43(5), 753–80.

Kinnunen, J and Koskela, M (1999) Do cash flows reported by firms articulate with their income state- from Finland European Accounting Review, 8(4), 631–54.

Krishnan, G.V and Largay III, J.A (2000) The tive ability of direct method cash flow information 215–45.

predic-Kwok, H (2002) The effect of cash flow statement format on lenders’ decisions The International Journal of Accounting, 37 (3), 347–62 Lian Fen, L (2012) Incentives to inflate reported cash from operations using classification and timing The Accounting Review, 87(1), 1–33.

Nissan, S., Kamata, N and Otaka, R (1995) Cash reporting in Japan The International Journal of Accounting, 29, 168–80.

Orpurt, S.F and Zang, Y (2009) Do direct cash flow disclosures help predict future operating cash 893–935.

514 PART II MAJOR ACCOUNTING TOPICS

n

equipment’ i.e., PPE, ‘plant assets’, ‘operational

over several periods and represent significant

investments that must be put in place before any

economic activity can take place.

n Fixed assets are, by nature, the most illiquid assets

accounting tradition is more ‘patrimonial’ they will

countries where the accounting culture favors

liquidity, the tangible assets will be listed at the

bottom of the list.

n Fixed assets can be divided into three categories:

and (3) financial assets (see Chapter 10).

n The various accounting issues that arise when

acquisition (definition, recognition, measurement),

use (depreciation), and disposal (sale or removal).

n Depreciation is ‘the systematic allocation of the

depreciable cost of an asset over its useful life’.

n reporting to shareholders should theoretically be the asset’s service potential and should therefore be specific to each class of tangible assets.

n Two categories of methods are available: (1) based depreciation methods (straight-line or accelerated, the latter including declining balance

time-on activity level (productive output or service quantity).

n In any given year, depreciation expenses are ‘non-cash for, and depreciation expenses are only a time-based original cost, as mentioned above) This means that cash balance (the impact is only indirect, through the impact on after-tax cash is even greater, in the early life

is allowed for tax purposes.

REVIEW (Solutions are on the book website)

Review 7.1 Gibbons

Topic:Determining the cost of acquisition

Level of difficulty: Moderate

Gibbons Co., a coffee shop, purchases a new coffee

the manufacturer is running a special offer, and Gibbons

lower than the list price Freight expenses for the delivery

expenses amount to 100 CU During installation,

unin-on the machine of 200 CU Training the baristas in the use of the new machine represented a cost of 75 CU.

Required

1 Compute the acquisition cost of the machine.

2 Record the acquisition in the format of your choice cial statements).

xxviii

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Resources include:

summary corresponding to each chapter

files complete solutions The authors have, when appropriate, written special notes to the

instructor, indicating frequently made mistakes, and alternative acceptable solutions

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Instructors can use the integrated Engagement Tracker in CourseMate to track students’

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a whole, or for individual students.

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Students can access CourseMate using the unique personal access card included in the front

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Student resources

CourseMate offers a range of interactive student learning tools tailored to the fourth edition of

Financial Accounting and Reporting: A Global Perspective, including:

book which are neither reviews nor assignments)

xxix

PART I

INTRODUCTION

TO FINANCIAL

ACCOUNTING

After studying this chapter, you will understand:

1 That accounting is a language that helps model, describe and understand business activity.

2 What accounting, financial accounting and managerial accounting represent.

3 That financial accounting is, in practice, based on a process of recording transactions.

4 That reporting on the financial condition of the firm through financial statements is the end-product of this process.

5 That different users, with often different objectives, are interested in financial accounting information Thus, accounting practice is a compromise between the requirements of each constituency.

6 How basic transactions are recorded and impact financial statements.

7 That there are three financial statements: the statement of financial position (or balance sheet), the income statement and the statement of cash flows.

8 What are the characteristics and roles of each financial statement.

9 That accounting, historically, is a very old recording tool and decision-making support tool.

Accounting is inseparable frombusinessand management In this book onaccountingand reporting, we will be cussing business issues and decisions from the point of view of both management and investors ‘Accounting is the lan- guage of business’ is a frequently heard expression Let us see what is behind what has, by now, become a banal expression.

dis-1 A MODEL OF BUSINESS ACTIVITY

Business is about action (transformation of resources) and involves transactions between several people(Robinson Crusoe, alone on his island may have had ‘undertakings’, but could not have had a ‘business’)

2

specialized skill-set that will be used in the enterprise’s transformation process.

Business is about transforming1resources into something else (product or service, tangible or intangible)aimed at meeting some customer’s expectation The market offering by the producer is its ‘value proposi-tion’ (functionalities, availability, durability, selection, location, etc of the product or service) Creatingand delivering the value proposition consumes resources The customers who choose to acquire a ‘valueproposition’ will hand over some of their resources to its producer The purpose (and requirement for sur-vival) of business is that the resources acquired from sales exceed the resources consumed in creating thesale, i.e., that it creates ‘profit’

Each skill-set provided by individuals or groups of individuals (marketing, R&D and engineering, chasing, manufacturing, selling, hiring, coordinating, managing, measuring, etc.) contributes to the trans-formation process of resources into making available, and delivering effectively, a product or service valueproposition to a (solvent) customer base

pur-Business decisions involve how resources will be acquired, allocated to each skill-set and utilized (i.e.,transformed) to ‘serve’ customers All decisions in an enterprise are therefore built on a representation ofthe transformation process that includes a description of the role of each skill-set Each firm has its ownvision of its transformation process (and therefore about its allocation of resources): it is its specific strat-egy The strategy of firms in the same sector, such as global clothing retailers, may be very different interms of market segments targeted, sourcing, brand policies or stores location For example, Inditex, ofSpain, the world’s largest clothing retailer, operates under ten brand names to serve broad segments ofthe market The best known of these brands, Zara, represents only a third of its outlets and caters to theneeds of young men and women Hennes & Mauritz, of Sweden, the second largest global clothingretailer, after Inditex, uses only the one single brand H&M and caters mostly to women Inditex islargely vertically integrated and controls both the in-house design and manufacturing of its products(only partially outsourced to low-cost countries) Meanwhile, Hennes & Mauritz is much more decen-tralized and uses over 800 horizontally specialized factories in low-cost countries to produce the gar-ments it designs, often with the help of guest designers Inditex operates over 5,000 stores in 80countries, while H&M operates 2,300 stores in 43 countries and thus have different supply chains.These enterprises are the two world leaders in apparel distribution, but, even if they are in the same riskclass, their strategies are different and their operations follow different approaches Yet, accounting must

be able to generate documents that allow users to compare their financial performance and their pects, despite their differences Accounting must, therefore, be generic enough to be applicable to a vari-ety of situations and business models

pros-A generic representation of the activity of any business is shown in Figure 1.1 as a ‘cash pump’ cycle Inthis cycle, acquired resources are transformed into a value proposition, physically ‘packaged’ as goods orservices delivered to customers These, in turn, exchange cash (or other resources equivalent to cash) forsaid goods, and that cash is, in due course, used for the acquisition of additional resources The ‘cashpump’ cycle is essentially endless, as long as the enterprise can acquire resources and continues giving satis-faction to enough customers (who perceive this value proposition as being better than that of competitors)

Figure 1.1 The generic business model is a ‘cash pump’ cycle

The BUSINESS transformation process

Decisions andactions

Cash received

Customers

Value propositionand goods delivered

Cash outflows(payments)

Resources markets

(potential suppliers)

Resources obtained

Flow of cash: Arrows pointing left

Flow of resources, goods or services: Arrows pointing right

providers) that allow the transformation cycle to continue to take place.

This cash cycle needs to be monitored by the managers of the firm Every transaction between suppliersand the enterprise or between the enterprise and its customers, but also inside the transformation process –whether it is contributing to procurement, manufacturing, or collecting from customers – needs to berecorded in order to serve as a basis for analysis over time For example:

cus-tomer or create a new product or service?

keep human talent inside the firm?

The only way for the various managers and actors in the firm (actors operating the ‘cash pump’) to beable to analyze transactions and take any action required to maintain the competitiveness of the firm is

to agree on shared rules for describing transactions so decision makers can communicate with oneanother In other words, they need to share a language with its vocabulary, grammar and syntax todescribe events and transactions that need to be examined in order to manage the ‘cash pump’ That lan-guage is called accounting

2 ACCOUNTING: A LANGUAGE FOR BUSINESS

Accounting is a specialized language that has the specificity of being able to:

amounted to 12 million Currency Units (CU)’).

advertising campaign worth 750,000 CU was run on TV in the first week of October; market share increased by

10 percent between October 1 and October 31; on October 1 prices were reduced by 5 percent from what they had been since last year; additional customers were acquired etc.’).

result – be it for a time period, or for a market, or a responsibility center – is better (or worse) than that result’.Figure 1.1 must therefore be amended to show that accounting is needed to support decision making.Figure 1.2 illustrates such amendment

Accounting records every event of an economic nature that flows through the ‘cash pump’ or ness cycle Accounting records economic variables principally using monetary units It can, however,

busi-Figure 1.2 Accounting describes – and is linked to – every part of the activity of the firm

The BUSINESS transformation process

Decisions and actions

ACCOUNTING INFORMATION

Cash received

Customers

Value proposition and goods delivered

Cash outflows (payments)

Resources markets (potential suppliers)

Resources obtained

The thin solid lines refer to internally generated accounting data and information, while the dotted lines refer to data

and information, used in accounting but emanating from either suppliers or customers.

which, in a well-managed organization, must be equal to the weight of finished goods plus that ofwaste.2

Accounting is an integral part of the life of business It is as inseparable from business activity as theshadow is to the illuminated object Accounting helps managers know what was done so they can modifytheir future actions in order for the future to yield results that will be either as coherent or more coherentwith their intent and objective as those of previous periods

The reader will remember that the title of this book is Financial Accounting and Reporting Why alsoreporting?

2.1 Business creates an agency relationship that calls for reporting

Business is about delegation:

awarded; and

coordi-nated and coherent way to create wealth (among other things for capital providers, but also for other participants

in the business process).

requires thatinformationbe provided about what the ‘delegate’ (or agent, i.e., beneficiary of a delegation

of right to make decisions) did and what results were achieved The flow of information, allowing control

by the ‘delegator’ (or principal), is called reporting

Reporting is accounting for what the subordinate, or delegate, has done with the resources she or he hasreceived from her or his superior or principal A ‘report’ may document effort, or results, or both If ‘effort’(on the part of the agent) is reported, accounting will be detailed and will provide the values of thoseparameters needed to describe the business processes transforming resources into a value proposition andits delivery Reporting on effort will be strictly internal and business-specific (it is called ‘managerialaccounting’) If, on the contrary, only ‘results’ are reported, the report may be generic since questions from

report will be the focus of this text and is part of what we call ‘financial accounting’

The questions (or informational wants or needs) – are essentially about three topics:

return on investment, given a certain level of risk – and will continue to do so at what kind of rate of growth,

business).

2.1.1 Reporting to capital providers

The ‘cash pump’ cycle described in Figure 1.1 is not completely operational Like any pump, this one toomust be primed How can the business acquire resources to feed its transformation process unless there isalready some cash in the enterprise before it starts to operate? Suppliers might extend credit to prime thepump, but the operating (transformation) cycle might be much longer than the duration of the credit thesuppliers are willing to extend

There must be capital providers who provide initial financial resources that will be used to prime thetransformation cycle The business manager is therefore the agent of the capital provider: she or he hasreceived the mandate to use the capital to earn a positive return within acceptable risk-taking practices

In some cases the entrepreneur/manager and the capital provider might be one and the same personbut, as we will see later, it is essential to distinguish the business’ activities from those engaged-in pri-vately by the individuals who are either providing capital or are the operators of the transformationprocess

Since the providers of capital are not, in a capitalistic system, doing so without the motive of earning areturn on their investment, it is normal for a business to report on what they used the funds for and whatoutput and outcome was obtained from their application to the transformation process, i.e., what wealthwas created

n Those (known as shareholdersin the case of an incorporated business) who (a) are investing capital for an unspecified term, (b) are willing to assume or share (directly or vicariously) the risks of the business (in exchange

will sell their shares) and (c) are participating in decision making (directly or through the Board of Directors senting them).

guar-anteed return on their provision of funds within (c) a specified short-, medium- or long-term horizon.

Each category of funds provider has specific needs in terms of reporting, which the accounting tion system will need to satisfy

informa-Lenders are mainly interested in being kept informed about the ability of the business to pay interests in

a timely fashion and reimburse the money it has borrowed by the due date The emphasis is therefore onthe cash generation potential of the firm

Shareholders, by way of contrast, are interested in two types of information: on the one hand, from afiduciary point of view, shareholders want to know, periodically, what the firm they have invested in owns

or controls (and what their share of ownership is) and be sure that appropriate checks and balances are inplace to avoid inappropriate disbursement of resources (we call the accounting report that serves this pur-pose thestatement of financial positionorbalance sheet); on the other hand they are interested in knowinghow much residual wealth was created in the transformation process that they can claim as theirs (we callthe accounting report that serves this purpose theincome statementorprofit and loss account)

In addition, both lenders and capital providers are interested in knowing more about the plans of thebusiness and the dynamics of the evolution of the relevant and specifically defined ‘cash pump’

Figure 1.2 can now be enriched again to recognize the complexity of all processes behind the life of anenterprise Figure 1.3 reflects, in addition to the representation of the business cycle (the ‘cash pump’), the

Figure 1.3 Flow of funds and flows of information (accounting and reporting) between a business and its funds providers

Decisions and actions

The BUSINESS transformation process

Frontiers of the firm

Internal and external ACCOUNTING INFORMATION

REPORTING:

Goals, actions, results, key-events, performance, prospects, etc.

Cash received

Customers

Value proposition and goods delivered

Cash outflows (payments)

Non-financial resources markets

Financial resources obtained Physical and intelligence resources obtained

Financial resources markets

‘resource’ that flows between parties Reporting to funds providers originates from the accounting information system (which

is straddling the frontier of the business entity) but also includes additional data that also pertain to the firm’s success and its ability to remain a going concern such as goals, actions, results, etc.

Long-term funds providers need:

model is not changed.

Since accounting reflects all economic transactions, it is the key medium of communication inside thefirm, as well as with its partners orstakeholders, including capital providers and lenders among the many

we list in endnote 3

2.1.2 Reporting to business ‘partners’

Although, technically, the firm is not an agent of employees, customers or suppliers (the firm has not received

a mandate from them), it is normal, if the relationships with these actors are to be durable, that they be keptinformed since they are de facto ‘partners’ in the future success of the firm All others who need to evaluatethe risks of a business and the likelihood of its survival will use, for that purpose, accounting reports thatwere originally prepared mainly for capital providers These other users will do so by surmising the businessmodel and looking at telltale ratios or metrics describing the ‘health’ of the ‘cash pump’ process both in terms

of efficiency and relevance, but also in terms of security of provision of funds by capital providers (we callthis ‘financial statement analysis’ and Chapters 15 to 18 are devoted entirely to such activity)

2.1.3 Reporting to superiors and peers

Accounting describes transactions linked to – and results of – actions and decisions It is normal (and venient, since the information already has been captured to satisfy capital providers) that a superior usesaccounting information to verify the subordinate discharged her or his responsibility appropriately If thesuperior is only interested in results, information in a format similar to the one used to report to capital pro-viders might prove to be sufficient (financial accounting is ‘results oriented’), while, if the superior is inter-ested in evaluating the effort of the subordinate, she or he might be interested in the detailed stepsundertaken by the subordinate in fulfilling her or his mission In this case the accounting report will bemore process oriented and will be called, as already mentioned, ‘managerial accounting’

con-2.2 Accounting is a living language

As we have seen, accounting provides a description of what actors in the transformation process of the firm

do The process of the ‘cash pump’ is one of value creation Business makes sense only if more resources (inthe broad sense of the term resources, i.e., financial and non-financial) are created as the outcome of thetransformation process than were consumed in its course

The process of doing business changes over time (the application of the generic ‘cash pump’ changes tinuously) in order to adapt to innovations and the evolution of competitive pressures Business relation-ships are affected by technology For example, the introduction of the Internet has greatly modified the waythe transformation process is organized Web-based market-places and speed of communication change therelationships between enterprises, suppliers and customers Similarly new issues appear with the evolution

con-of society For example, 75 years ago, few businesses paid significant attention to the possible creation con-of aretirement income for their former employees New business issues4 are born every day that accountingmust be able to describe as an enrichment of what was previously provided The reality that accountingdescribes is alive and evolving continuously The accounting language must therefore be very strong andflexible and rest on solid principles that will allow that flexibility

Accounting is a language and its ‘words’ are symbols that reflect a certain view of the world Just likeour everyday language evolves continuously, accounting must be able to adapt to the needs of the time.Accounting is a very special language in that the way it describes the world of business affects thetiming or recognition and measurement of wealth creation Just to give a brief example, when onebuys a machine, one could offset the purchase cost against the revenue generated by the use of themachine during the first year (a procedure called ‘cash accounting’) or one could consider that themachine will be useful to generate sales over several years and therefore one would offset, in the firstyear, only a part of the cost of the machine (‘depreciating’ the machine over its useful life, a part of

greatly the perceived timing of the wealth created through the use of the machine to serve customers.Accounting is so important for the smooth operation of a society that few countries have allowed itsevolution to go unchecked.

Language is essential to the operation of any organized society Cardinal de Richelieu, Prime Minister tothe French King Louis XIII, founded in 1635 the Acade´mie Française to create, standardize and regulatethe French language His decision was both political and economical It was, of course, part of a process tounify the kingdom (there were over 25 main local languages or dialects spoken in the kingdom) and facili-tate its government but, also, to facilitate inter-regional trade (there is no easy business transaction if thetwo parties do not speak a relatively common language) In a process similar to the unique case of theFrench attempt at standardizing their language, accounting standards-setting bodies have been created inmany countries to define (regulate) the terms of this special language to facilitate measurement of wealthcreation and therefore open exchanges and facilitate the support financial markets provide to the develop-ment of businesses

Today, regulation of the accounting language is carried out at the global level because businesses tradeglobally, and financial markets, as well, span the globe, thus local regulations tend to be on a path towardsconvergence (see Chapter 5)

2.3 Accounting is a language with some maneuvering room

Accounting, because of the variety of requirements placed on its applicability and evolution, remains, bynecessity, built on very broad generic principles This leaves some room for customizing the representations

it creates to the specific needs of businesses, or classes of users of accounting information The accountinglanguage must be able to describe any business activity It must allow any user to shape their opinion about

an economic entity by looking at the entity’s financial statements These statements are the ‘end product’ ofthe accounting process

The users’ opinions and decision making are built on several aspects of a business entity’s potential:financial situation (through the statement of financial position/balance sheet), sales performance and effi-ciency in its consumption of resources for the generation of sales (through the income statement), and cashgeneration and its uses (through the statement of cash flows)

Financial statements allow users to take very concrete decisions such as whether to invest or not in thebusiness entity, to acquire additional resources for the entity, to give (or receive) credit terms for settlingaccounts between customers (or suppliers) and the business entity, to grant (or seek) or not a loan, to pro-vide the basis for calculation of taxation of business entities by tax authorities, etc

Since there are different (yet perfectly legitimate)5 ways of describing the same reality (especiallythe timing of recognition of profit), the choice of an accounting ‘solution’ (embodiment of principlesinto practice) will impact the perception financial markets and funds-providers hold about a businessenterprise

The stakes are high in communicating fairly and effectively the value created and the value creationpotential of the business-segments a firm manages Practitioners, managers and the media have even coinedthe expression ‘accounting strategy’ to reflect the fact that there is ‘wiggle room’ in describing a given real-ity An accounting strategy means that, sometimes, when needed (in theory to better serve the users), onecan alter the accounting representation to achieve better the purpose of communicating at that time Clearlythat maneuvering space has to be regulated Although room exists for variations in measurement, timingand classification of a given reality, over the long run the results are always the same (but the decisions ofthe users of accounting information may have been affected in the meantime) Someaccounting changesare also required by regulation Some quotes illustrate this point

Chinese online book retailer E-Commerce China Dangdang Inc.’s fourth-quarter 2010 net profit fell 33 cent from a year earlier due to an accounting change Dangdang said net income would have improved with-out the change Net profit fell because the company started recognizing promotion fees it receives fromsuppliers on a quarterly basis in its last fiscal year, rather than once a year (adapted from Dow Jones Interna-tional News, 9 March 2011 Source: Factiva database)

per-This example illustrates the concept of revenue recognition (see Chapter 6) Here the change in ing method is related to the periodicity of recording of promotion fees received from suppliers Thesefees, a common practice in the distribution sector, are usually recorded as a reduction of expenses(‘cost of sales’ or ‘cost of revenues’) and increase net earnings Until 2009, the company used to record

account-along the year, every quarter Consequently and mechanically, the earnings of the fourth quarter of

2010 are impacted only by the amount of promotional fees corresponding to those recognized in thatquarter only and not, unlike in 2009, by the fees received for the entire year 2009 Comparing earnings

of the fourth quarter 2010 and the fourth quarter 2009 shows a reduction of earnings due to thischange

NTPC Ltd6 topped market expectations with a 38 percent rise in fourth-quarter net profit, as India’slargest power producer by capacity benefited from higher sales and a change in accounting rules Thecompany said that a change in accounting rules helped drag its depreciation cost for the quarter 4.6 per-cent lower to INR6.98 billion (adapted from Dow Jones International News, 10 May 2011 Source: Fac-tiva database)

This example illustrates a change in the depreciation method (a concept, which will be more fully covered

in Chapter 7) applied to a tangible asset According to the 2010–11 annual report of the company, thereduction in the amount of depreciation is due to change in the accounting policy pursuant to the opinionexpressed by the Comptroller & Auditor General of India In this opinion, power utilities companiesshould apply new depreciation rates As the annual report does not provide more information about thenew depreciation rates, we can only guess that the depreciation rates have been reduced by the new regula-tion, due to their likely allowing an increase of the useful life of the power plants

LAN Airlines, the Chilean international air carrier, announced as a preliminary estimate that the impact of theadoption of IFRS7will result in a 4.3 percent decline in the Company’s shareholders’ equity [share capital andnon-distributed earnings – see Chapters 2 and 11] as of December 31, 2007 This represents a US$42 millionreduction and as a result adjusted shareholders’ equity will amount to US$946 million (adapted from BusinessWire, 30 September 2008, Source: Factiva database)

This example illustrates the impact of the implementation of International Financial Reporting ards (IFRS), i.e., the change of the whole coding system The change may be perceived as detrimental tothe immediate apparent profitability, but it is mainly a modification in the rules guiding the timing ofrecognition of expenses and revenues and possibly a change in the rules concerning the recognition ofcertain elements of the commitments of the firm Whether switching from one standard of reporting toanother or from a whole framework to another, for example from local GAAP (Generally AcceptedAccounting Principles) to IFRS, the change most of the time has a real impact on the reported income

Stand-of a firm (or its shareholders’ equity, i.e., the book value Stand-of their claim on the firm’s assets) Howeverthe directionality of the impact cannot be specified ex ante The apparent paradox that switching toIFRS appears to have a short-term impact which may appear to be either positive or negative to theunprepared user can easily be explained: the set of standards and topics covered in the IFRS isextremely wide Depending on the topic covered, the impact on companies’ accounts can vary widely,depending on the standard that used to be followed and the firm’s circumstances However, in the longrun, the impact is generally negligible since it mainly reflects differences in timing of recognition of fulleffects of transactions

These examples also illustrate that accounting is not just a blind application of mechanical or tic rules This is why the field has drawn so much interest for so long: within a limited set of rules and prin-ciples, the language of accounting is there to serve the users by giving the most useful, true and fairdescription of a sometimes ambiguous reality (especially when it comes to the timing of the recognition ofexpenses and revenues)

determinis-This chapter defines financial accounting, introduces the various users of financial information anddescribes some elements of the accounting process The following section revisits the distinction we brieflytouched on in the introduction between reporting issues to shareholders and to third parties (financialaccounting) and issues of efficiency in the use of resources (managerial accounting), before presenting thequalitative characteristics of useful financial statements

Accounting is almost as old as human economic activity We therefore provide a short overview of thehistory and evolution of accounting over the years Accounting, being the language of business, is, like art,

an open language An artist can use a variety of techniques to create a representation (a portrait, for ple) of the reality of her or his ‘model’ However, unlike art, accounting, because it must be universal, willfollow a socially-accepted set of rules of representation of reality These rules evolve over time, just likethose of painting or sculpture, with technological advances and changes in social and societal values regard-ing relevance