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2020 Curriculum CFA Program Level I Financial Reporting and Analysis

Financial Reporting Standards

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Introduction

Financial reporting standards provide principles for preparing financial reports and determine the types and amounts of information that must be provided to users of financial statements, including investors and creditors, so that they may make informed decisions. This reading focuses on the context within which these standards are created. An understanding of the underlying framework of financial reporting standards, which is broader than knowledge of specific accounting rules, will allow an analyst to assess the valuation implications of financial statement elements and transactions—including transactions, such as those that represent new developments, which are not specifically addressed by the standards.

Section 2 of this reading discusses the objective of financial reporting and the importance of financial reporting standards in security analysis and valuation. Section 3 describes the roles of financial reporting standard-setting bodies and regulatory authorities and several of the financial reporting standard-setting bodies and regulatory authorities. Section 4 describes the International Financial Reporting Standards (IFRS) framework and general requirements for financial statements. Section 5 compares IFRS and alternative reporting systems, and Section 6 discusses the importance of monitoring developments in financial reporting standards. A summary of the key points concludes the reading. 

Learning Outcomes

The member should be able to:

  • describe the objective of financial reporting and the importance of financial reporting standards in security analysis and valuation;
  • describe the roles of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards;

  • describe the International Accounting Standards Board’s conceptual framework, including qualitative characteristics of financial reports, constraints on financial reports, and required reporting elements;

  • describe general requirements for financial statements under International Financial Reporting Standards (IFRS); 

  • describe implications for financial analysis of alternative financial reporting systems and the importance of monitoring developments in financial reporting standards.

Note: Changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of the readings on financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are not responsible for anything that occurs after the readings were published. In addition, candidates are expected to be familiar with the analytical frameworks contained in the readings, as well as the implications of alternative accounting methods for financial analysis and valuation discussed in the readings. Candidates are also responsible for the content of accounting standards, but not for the actual reference numbers. Finally, candidates should be aware that certain ratios may be defined and calculated differently. When alternative ratio definitions exist and no specific definition is given, candidates should use the ratio definitions emphasized in the readings. 

Summary

An awareness of financial reporting and underlying financial reporting standards can assist in security valuation and other financial analysis. This reading describes the conceptual objectives of financial reporting standards, the parties involved in standard-setting processes, and the implication for analysts in monitoring developments in reporting standards.

Some key points of the reading are summarized below:

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

  • Financial reporting requires policy choices and estimates. These choices and estimates require judgment, which can vary from one preparer to the next. Accordingly, standards are needed to ensure increased consistency in these judgments.

  • Private sector standard setting bodies and regulatory authorities play significant but different roles in the standard setting process. In general, standard setting bodies make the rules, and regulatory authorities enforce the rules. However, regulators typically retain legal authority to establish financial reporting standards in their jurisdiction.

  • The IFRS framework sets forth the concepts that underlie the preparation and presentation of financial statements for external users.

  • The objective of fair presentation of useful information is the center of the IASB’s Conceptual Framework. The qualitative characteristics of useful information include fundamental and enhancing characteristics. Information must exhibit the fundamental characteristics of relevance and faithful representation to be useful. The enhancing characteristics identified are comparability, verifiability, timeliness, and understandability.

  • IFRS Financial Statements: IAS No. 1 prescribes that a complete set of financial statements includes a statement of financial position (balance sheet), a statement of comprehensive income (either two statements—one for net income and one for comprehensive income—or a single statement combining both net income and comprehensive income), a statement of changes in equity, a cash flow statement, and notes. The notes include a summary of significant accounting policies and other explanatory information.

  • Financial statements need to reflect certain basic features: fair presentation, going concern, accrual basis, materiality and aggregation, and no offsetting.

  • Financial statements must be prepared at least annually, must include comparative information from the previous period, and must be consistent. 

  • Financial statements must follow certain presentation requirements including a classified statement of financial position (balance sheet) and minimum information on both the face of the financial statements and in the notes.

  • A significant number of the world’s listed companies report under either IFRS or US GAAP.

  • In many cases, a user of financial statements will lack the information necessary to make specific adjustments required to achieve comparability between companies that use IFRS and companies that use US GAAP. Instead, an analyst must maintain general caution in interpreting comparative financial measures produced under different accounting standards and monitor significant developments in financial reporting standards.

  • Analysts can remain aware of ongoing developments in financial reporting by monitoring new products or types of transactions; actions of standard setters, regulators, and other groups; and company disclosures regarding critical accounting policies and estimates.