Financial Accounting, Reporting and Analysis

Financial Accounting,

Reporting and Analysis

International Edition

Financial Accounting, Reporting and Analysis

Financial Accounting, Reporting and Analysis

International Edition

Barry Elliott and Jamie Elliott

International Edition 2nd Edition

2nd Edition

2nd

Edition

An imprint of www.pearson-books.com

Cover image © Alamy Images

Additional student support at

www.pearsoned.co.uk/elliott_elliott Additional student support at

www.pearsoned.co.uk/elliott_elliott

The fully updated International Edition of Elliott and Elliott’s market-leading

Financial Accounting and Reporting uses the latest International Accounting

Standards as its framework. It offers a unique balance of theoretical and

conceptual coverage with up-to-date practical applications and illustrations

taken from real world international company reports and accounts. The text

is ideal for financial accounting, reporting and analysis modules on second

and final year undergraduate courses in accounting, business studies and

combined studies. It is also suitable for MBA courses, specialist MSc courses

and professional courses preparing students for accountancy examinations.

Barry Elliott is a training consultant. He has extensive teaching experience at

undergraduate, postgraduate and professional level in China, Hong Kong,

New Zealand and Singapore. He has wide experience as an external

examiner both in higher education and at all levels of professional education.

Jamie Elliott is a Director with Deloitte & Touche. Prior to this he has

lectured at university on undergraduate degree programmes and as an

assistant professor on MBA and executive programmes at the London

Business School.

Key features:

• Completely updated in line with IFRSs and the application of international standards

worldwide.

• New pedagogical features including key points, overviews, chapter objectives and learning

outcomes, summaries and further questions.

• Widespread inclusion of contemporary international case studies.

• Attractive new two-colour design. Illustrations taken from real published accounts to

demonstrate the practical application and limitations of the subject.

• Excellent range of review questions for use in seminars or for revision purposes.

• Exercises of varying difficulty with solutions to selected exercises provided at the back of

the book.

• Extensive references included at the end of each chapter.

• Supported by an Instructor’s Manual containing fully worked solutions to all exercises in

the book.

Elliott

and

Elliott

027370253X_COVER 18/10/05 10:40 AM Page 1

Financial Accounting, Reporting

and Analysis: International Edition

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International Edition (2nd Edition) Companion Website at

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to find valuable student learning material including:

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• Case studies with solutions

FAR_A01.QXD 27/10/05 11:51 Page i

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Financial Accounting,

Reporting and Analysis:

International Edition

2nd Edition

Barry Elliott and Jamie Elliott

FAR_A01.QXD 27/10/05 11:51 Page iii

Pearson Education Limited

Edinburgh Gate

Harlow

Essex CM20 2JE

England

and Associated Companies throughout the world

Visit us on the World Wide Web at:

www.pearsoned.co.uk

First published 2002

Second edition 2006

© Pearson Education Limited 2002, 2006

The rights of Barry Elliott and Jamie Elliott to be identified as authors of this

work have been asserted by them in accordance with the Copyright, Designs,

and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in

a retrieval system, or transmitted in any form or by any means, electronic,

mechanical, photocopying, recording, or otherwise, without either the prior

written permission of the Publishers or a licence permitting restricted copying

in the United Kingdom issued by the Copyright Licensing Agency Ltd,

90 Tottenham Court Road, London W1T 4LP.

ISBN-13: 978-0-273-70253-5

ISBN-10: 0-27370-253-X

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

Library of Congress Cataloging-in-Publication Data

A catalog record for this book is available from the Library of Congress.

10987654321

10 09 08 07 06

Typeset in 9/12pt Ehrhardt by 25.

Printed by Ashford Colour Press Ltd., Gosport.

The publisher’s policy is to use paper manufactured from sustainable forests.

FAR_A01.QXD 27/10/05 11:51 Page iv

Brief Contents

Preface and acknowledgements xviii

Part 1

REGULATORY FRAMEWORK – AN ATTEMPT TO ACHIEVE

UNIFORMITY 1

1 Financial reporting – evolution of international standards 3

2 Conceptual framework 24

3 Published accounts of companies 49

4 Preparation of published accounts 94

Part 2

BALANCE SHEET – EQUITY, LIABILITY AND ASSET

MEASUREMENT AND DISCLOSURE 117

5 Share capital, distributable profits and reduction of capital 119

6 Off balance sheet finance 144

7 Financial instruments 171

8 Employee benefits 190

9 Taxation in company accounts 212

10 Property, plant and equipment (PPE) 239

11 Leasing 271

12 R&D; goodwill and intangible assets; brands 291

13 Inventories 322

14 Construction contracts 345

Part 3 CONSOLIDATED ACCOUNTS 361

15 Accounting for groups at the date of acquisition 363

16 Preparation of consolidated balance sheets after the date of acquisition 380

17 Preparation of consolidated income statements 392

18 Accounting for associated companies 410

19 Accounting for the effects of changes in foreign exchange rates under IAS 21 425

FAR_A01.QXD 27/10/05 11:51 Page v

Part 4 INTERPRETATION 443

20 Earnings per share 445

21 Cash flow statements 470

22 Review of financial ratio analysis 495

23 Trend analysis and multivariate analysis 537

24 An introduction to financial reporting on the Internet 577

Part 5 ACCOUNTABILITY 589

25 Corporate governance 591

26 Environmental and social reporting 622

27 Ethics for accountants 659

Appendix: Outline solutions to selected exercises 679

Index 685

vi • Brief Contents

FAR_A01.QXD 27/10/05 11:51 Page vi

Full Contents

Preface and acknowledgements xviii

Part 1

REGULATORY FRAMEWORK – AN ATTEMPT TO ACHIEVE

UNIFORMITY 1

1 Financial reporting – evolution of international

standards 3

1.1 Introduction 3

1.2 National differences 3

1.3 Reasons for differences in financial reporting 4

1.4 Classification of national accounting systems 8

1.5 Attempts to reduce national differences 9

1.6 The work of international bodies in harmonising and standardising

financial reporting 9

1.7 Arguments in support of standards 16

1.8 Arguments against standards 17

1.9 US GAAP 18

1.10 Reconciliations and supplementary statements 20

Summary 21

Review questions 21

Exercises 21

References 22

2 Conceptual framework 24

2.1 Introduction 24

2.2 Historical overview of the evolution of financial accounting theory 25

2.3 IASC Framework for the Presentation and Preparation of Financial Statements 28

2.4 ASB Statement of Principles 1999 30

2.5 AICPA Improving Business Reporting – A Customer Focus:

Meeting the Information Needs of Investors and Creditors 40

2.6 ICAS Making Corporate Reports Valuable 41

Summary 42

Review questions 44

Exercises 45

References 48

FAR_A01.QXD 27/10/05 11:51 Page vii

3 Published accounts of companies 49

3.1 Introduction 49

3.2 A public company’s financial calendar 50

3.3 Criteria for information appearing in a published income statement

and balance sheet 51

3.4 The prescribed formats – the income statement 51

3.5 What information is required to be disclosed in Format 1 and

Format 2? 52

3.6 Cost of sales 53

3.7 Distribution costs 57

3.8 Administrative expenses 57

3.9 Other income 57

3.10 What costs and income are brought into account after calculating

the trading profit in order to arrive at the profit on ordinary activities

before tax? 57

3.11 Does it really matter under which heading a cost is classified in the

income statement provided it is not omitted? 58

3.12 Discontinued operations disclosure in the income statement 58

3.13 Items requiring separate disclosure 61

3.14 The prescribed formats – the balance sheet 61

3.15 Statement of changes in equity 65

3.16 Reporting comprehensive income 67

3.17 Segment reporting 70

3.18 The fundamental accounting principles underlying the published income

statement and balance sheet 71

3.19 Disclosure of accounting policies 71

3.20 Fair view treatment 76

3.21 Additional information in the annual report 78

3.22 What information do companies provide to assist comparison

between companies reporting under different reporting regimes? 80

Summary 84

Review questions 84

Exercises 86

References 93

4 Preparation of published accounts 94

4.1 Introduction 94

4.2 Stage 1: preparation of the internal income statement from a trial

balance 94

4.3 Stage 2: preparation of the income statement of Illustrious SpA in

Format 1 style 96

4.4 Stage 3: preparation of the balance sheet 99

4.5 Preparation of accounts in Format 1 following IAS 8 and IFRS 5 100

4.6 Additional information value of IFRS 5 104

4.7 Additional information value of IAS 24 105

Summary 107

Review questions 108

Exercises 109

References 116

viii • Full Contents

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Part 2

BALANCE SHEET – EQUITY, LIABILITY AND ASSET

MEASUREMENT AND DISCLOSURE 117

5 Share capital, distributable profits and reduction of capital 119

5.1 Introduction 119

5.2 Total owners’ equity: an overview 121

5.3 Total shareholders’ funds: more detailed explanation 122

5.4 Accounting entries on issue of shares 124

5.5 Creditor protection: capital maintenance concept 125

5.6 Creditor protection: why capital maintenance rules are necessary 126

5.7 Creditor protection: how to quantify the amounts available to meet

creditors’ claims 127

5.8 Issued share capital: minimum share capital 127

5.9 Distributable profits: general considerations 128

5.10 Distributable profits: how to arrive at the amount using relevant

accounts 129

5.11 When may capital be reduced? 129

5.12 Writing off part of capital which has already been lost and is not

represented by assets 130

5.13 Repayment of part of paid-in capital to shareholders or cancellation

of unpaid share capital 136

5.14 Purchase of own shares 136

Summary 139

Review questions 140

Exercises 140

References 143

6 Off balance sheet finance 144

6.1 Introduction 144

6.2 Primary financial statements: their interrelationship 144

6.3 Primary financial statements: changes in their interrelationship 145

6.4 Reasons that companies borrow 145

6.5 Capital gearing and its implications 146

6.6 Off balance sheet finance 148

6.7 Substance over form 149

6.8 Impact of converting to IFRS 152

6.9 Balance sheet as valuation document 155

6.10 Why companies take steps to strengthen their balance sheets 156

6.11 Definitions cannot remove uncertainty: IAS 10 and IAS 37 157

Summary 165

Review questions 166

Exercises 167

References 169

Full Contents • ix

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7 Financial instruments 171

7.1 Introduction 171

7.2 IAS 32 Financial Instruments: Disclosure and Presentation 171

7.3 IAS 39 Financial Instruments: Recognition and Measurement 181

Summary 187

Review questions 187

Exercises 188

References 189

8 Employee benefits 190

8.1 Introduction 190

8.2 Financial reporting implications 191

8.3 Types of scheme 191

8.4 Defined contribution pension schemes 193

8.5 Defined benefit pension schemes 194

8.6 IAS 19 (revised) Employee Benefits 196

8.7 The liability for pension and other post-retirement costs 196

8.8 The income statement 199

8.9 Comprehensive illustration 199

8.10 Plan curtailments and settlements 201

8.11 Multi-employer plans 202

8.12 Disclosures 202

8.13 Other long-service benefits 203

8.14 Short-term benefits 203

8.15 Termination benefits 204

8.16 IAS 26 Accounting and Reporting by Retirement Benefit Plans 205

Summary 208

Review questions 208

Exercises 210

References 211

9 Taxation in company accounts 212

9.1 Introduction 212

9.2 Corporation tax 212

9.3 Corporation tax systems – the theoretical background 213

9.4 Corporation tax systems – avoidance and evasion 214

9.5 Corporation tax – the system from 6 April 1999 216

9.6 IFRS and taxation 218

9.7 IAS 12 – accounting for current taxation 219

9.8 Deferred tax 221

9.9 FRS 19 (the UK standard on deferred taxation) 228

9.10 A critique of deferred taxation 229

9.11 Examples of companies following IAS 12 232

9.12 Value added tax (VAT) 234

Summary 235

Review questions 236

Exercises 236

References 237

x • Full Contents

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10 Property, plant and equipment (PPE) 239

10.1 Introduction 239

10.2 What is PPE? 240

10.3 How is the cost of PPE determined? 241

10.4 What is depreciation? 243

10.5 What are the constituents in the depreciation formula? 246

10.6 How is the useful life of an asset determined? 246

10.7 Residual value 247

10.8 Calculation of depreciation 247

10.9 Measurement subsequent to initial recognition 252

10.10 IAS 36 Impairment of Assets 254

10.11 IFRS 5 Non-Current Assets Held for Sale and Discontinued Operations 259

10.12 Disclosure requirements 260

10.13 Government grants towards the cost of PPE 261

10.14 Investment properties 262

10.15 Effect of accounting policy for PPE on the interpretation of the

financial statements 263

Summary 265

Review questions 266

Exercises 266

References 270

11 Leasing 271

11.1 Introduction 271

11.2 Background to leasing 271

11.3 IAS 17 (and its national equivalents) – the controversy 273

11.4 IAS 17 – classification of a lease 275

11.5 IAS 17 – accounting for leases by lessees 277

11.6 Accounting for the lease of land and buildings 282

11.7 Leasing – a form of off balance sheet financing 283

11.8 Accounting for leases – a new approach 284

11.9 Accounting for leases by lessors 285

Summary 286

Review questions 287

Exercises 288

References 290

12 R&D; goodwill and intangible assets; brands 291

12.1 Introduction 291

12.2 Accounting treatment for research and development 291

12.3 Research and development 293

12.4 Introduction to goodwill and intangible assets 297

12.5 Application of IAS 38 Intangible Assets 297

12.6 Is there a correct treatment for amortising goodwill? 301

12.7 Other types of intangible asset under IAS 38 306

12.8 Disclosure of intangible assets under IAS 38 307

12.9 Brand accounting 307

12.10 Intellectual property 309

Summary 313

Review questions 314

Exercises 316

References 320

Full Contents • xi

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13 Inventories 322

13.1 Introduction 322

13.2 Inventory defined 322

13.3 The controversy 323

13.4 IAS 2 Inventories 324

13.5 Inventory valuation 325

13.6 Work-in-progress 332

13.7 Inventory control 334

13.8 Creative accounting 335

13.9 Audit of the year-end physical inventory count 337

13.10 Published accounts 339

Summary 340

Review questions 341

Exercises 342

References 344

14 Construction contracts 345

14.1 Introduction 345

14.2 Identification of contract revenue 345

14.3 Identification of contract costs 346

14.4 Recognition of contract revenue and expenses 346

14.5 Public-private partnerships (PPPs) 349

Summary 354

Review questions 355

Exercises 355

References 359

Part 3

CONSOLIDATED ACCOUNTS 361

15 Accounting for groups at the date of acquisition 363

15.1 Introduction 363

15.2 The definition of a group 363

15.3 Consolidated accounts and some reasons for their preparation 363

15.4 The definition of control 365

15.5 Alternative methods of preparing consolidated accounts 366

15.6 The treatment of positive goodwill 367

15.7 The treatment of negative goodwill 368

15.8 The comparison between an acquisition by cash and an exchange

of shares 368

15.9 Minority interests 368

15.10 The treatment of differences between a subsidiary’s fair value and

book value 370

15.11 How to calculate fair values 371

Summary 372

Review questions 373

Exercises 374

References 379

xii • Full Contents

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16 Preparation of consolidated balance sheets after the date of

acquisition 380

16.1 Introduction 380

16.2 Pre- and post-acquisition profits
losses 380

16.3 Inter-company balances 382

16.4 Unrealised profit on inter-company sales 384

16.5 Provision for unrealised profit affecting a minority 388

16.6 Uniform accounting policies and reporting dates 388

16.7 How is the investment in subsidiaries reported in the parent’s own

balance sheet? 388

Summary 388

Review questions 389

Exercises 389

References 391

17 Preparation of consolidated income statements 392

17.1 Introduction 392

17.2 Preparation of a consolidated income statement – the Ante Group 392

17.3 Dividends or interest paid by the subsidiary out of pre-acquisition

profits 395

17.4 A subsidiary acquired part of the way through the year 396

17.5 Published format income statement 399

Summary 399

Review questions 400

Exercises 400

References 409

18 Accounting for associated companies 410

18.1 Introduction 410

18.2 Definitions of associates and of significant influence 410

18.3 The treatment of associated companies in consolidated accounts 411

18.4 The Brill Group – the equity method illustrated 411

18.5 The treatment of provisions for unrealised profits 414

18.6 The acquisition of an associate part-way through the year 414

18.7 Joint ventures 416

Summary 417

Review questions 418

Exercises 418

References 424

19 Accounting for the effects of changes in foreign exchange

rates under IAS 21 425

19.1 Introduction 425

19.2 The difference between conversion and translation and the definition

of a foreign currency transaction 425

19.3 The functional currency 426

19.4 The presentation currency 426

19.5 Monetary and non-monetary items 427

19.6 The rules on the recording of foreign currency transactions 427

Full Contents • xiii

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19.7 The treatment of exchange differences on foreign currency

transactions 427

19.8 Foreign exchange transactions in the individual accounts of companies

illustrated – Boil plc 428

19.9 The translation of the accounts of foreign operations where the

functional currency is the same as that of the parent 429

19.10 Granby Ltd illustration 429

19.11 The use of a presentation currency other than the functional

currency 436

19.12 Granby Ltd illustration continued 436

19.13 Implications of IAS 21 438

Summary 439

Review questions 439

Exercises 439

References 441

Part 4

INTERPRETATION 443

20 Earnings per share 445

20.1 Introduction 445

20.2 Why is the earnings per share figure important? 445

20.3 How is the EPS figure calculated? 446

20.4 The use to shareholders of the EPS 447

20.5 Illustration of the basic EPS calculation 448

20.6 Adjusting the number of shares used in the basic EPS calculation 448

20.7 Rights issues 451

20.8 Adjusting the earnings and number of shares used in the diluted EPS

calculation 456

20.9 Procedure where there are several potential dilutions 458

20.10 Exercise of conversion rights during financial year 460

20.11 Disclosure requirements of IAS 33 461

20.12 The Improvement Project 463

Summary 463

Review questions 464

Exercises 465

References 469

21 Cash flow statements 470

21.1 Introduction 470

21.2 Development of cash flow statements 470

21.3 Applying IAS 7 (revised) Cash Flow Statements 471

21.4 IAS 7 (revised) format of cash flow statements 473

21.5 Consolidated cash flow statements 477

21.6 Analysing a cash flow statement 480

21.7 Critique of cash flow accounting 482

Summary 483

Review questions 484

Exercises 484

References 494

xiv • Full Contents

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