Internal controls and fraud are not really an area that I write a lot on. Just before Christmas I read this article from CIMA about fraud at Japanese firm Olympus. It includes interviews with Michael Woodward, who was at the heart of putting things right. The are a lot of issues in the article and it is worth a read.
As you may know, public companies publish a lot of financial information. As accountants, the first of such information that comes to mind is the annual report and accounts – which is a legal requirement. Other such information includes regular notifications and reports to stock exchanges. Normally, the format, content and timing of any financial information releases by public companies is well-regulated and usually a mass communications medium is used. Of course, like all other aspects of business life the pace of technological change – in particular the use of Internet and social media – is causing some issues for the reporting of financial and similar information by companies.
Take for example the recent Netflix issue. In July 2012, the CEO of Netflix commented on Facebook
“Netflix monthly viewing exceeded 1 billion hours for the first time ever in June.”
The Facebook page had close on 250,000 followers at that time. The result of this post was an approximate 30% increase in stock price the following day. Later in July, a quarterly earnings release showed a substantial fall in revenues and the stock price fell. The US Securities and Exchange Commission (SEC) were not overly impressed with the initial release via Facebook, arguing that the information was material and should have been disclosed by means of a regulatory filing or press release. So, in essence, the argument of the SEC is that Facebook (or other social media) are not necessarily the correct communications medium. The counter argument would of course be that social media may actually be a communication medium with a much broader spread.
Perhaps what this example shows is the need for a policy for how and when to use the internet/social media as a means to reporting key financial and business information using social media?
Some recent items in the CGMA magazine summarise some of the features and issues with integrated corporate reporting. Integrated corporate reporting means reporting means more than just reporting the traditional financial/economic type reports to shareholders. Instead, an integrated reporting approach considers social, economic and environmental factors. In the longer term, it can be argued that if firms ignore the environment and society, then firm itself may not be sustainable.
Ideally, a business should be able to prepare a single report which shows now only the typically legally required financial reports, but also how its financial performance affects society and the environment. Some global companies are already doing this. For example, PUMA publishes and environmental profit and loss which values its impacts in terms of resource usages (see here). The CGMA has embarked on an integrated reporting pilot programme over the next two years. They asked an investor, accounts preparer and an integrated reporting advocate for their views. They make for some interesting reading – click on the links to read more. One of the key points emerging is not the difficulties faced in preparing the report or getting the information. Instead, trying to introduce more non-financial data without increasing the information loads (mainly legally driven) given to investors is a great challenge.
I have written before on balanced scorecards at London’s Heathrow Airport. London Gatwick too has a balance scorecard which has similar performance measures (e.g. security wait time, seat availability, flights on time etc.).
I noticed the monthly performance report at Gatwick was displayed publicly again, on the walk-way to the departure gates – better than a corridor to the gents for sure as at Heathrow. Both the Heathrow and Gatwick scorecards are linked to a scheme operated by the UK Civil Aviation Authority (CAA), and the main objective of these scheme is to reward for meeting targets that improve customer service. If targets are achieved then, extra public funding can be paid to the airport, whereas failure to meet targets results in payments by the airport.
The performance measures in both these scorecards are no doubt related to a strategic objective something like “to improve and maintain customer service” – which I imagine would be quite an important objective to any airport. It seems the targets too are reviewed on a regular basis by the CAA, which means customer performance improvement is at least possible. Have a look at the scorecard web page to see more.
At end of last year (December 2011), Ireland’s tax collection authority (Revenue Commissioners) issued a consultation document on iXBRL. I have written a post of two on XRBL previously. XBRL is mark-up language (like XML or HTML) which has been specifically designed to assist in the electronic filing of financial reporting documents. If agreed as a global standard, XBRL would present great advantages for state agencies like tax authorities, company registries and statistical bodies. This is simply due to the fact that XBRL presents a common a relatively easy to use electronic way for businesses to file financial statements, without the need for any form of manual interference and without the need to send files more than once.
So what is iXBRL and how is it different from XBRL? iXRBL stands for “inline” XBRL. It is more or less the same as XBRL in that it uses tags to identify data within a file. For example, a tag would identify the figure for same in the statement of financial position. Using tags means that data can be intelligibly read using software, which makes data manipulation a whole lot easier. The only problem with tagged data is that is typically not human readable. Where iXBRL differs is that all the tagged data is “hidden” within a human readable document. For example, a PDF file of a company’s financial statements might include all the necessary tagged data. The major advantage of this is there no need to produce a separate special XBRL file. You can read lots more about XBRL and iXBRL here.
International Financial Reporting Standards (IFRS) were adopted by the European Union in 2005 for all public listed companies. The standards cover a range of topics in financial statement preparation, from relatively simple issues such as Non-Current Assets to complex issues such as pension funds (see www.ifrs.org for a summary of all standards). However, the standards can also be used for the preparation of accounts of other entities. The use varies by country (EU and globally), so here is a very useful map prepared by PWC. Simply click on a country to see how the IFRS are used.
If you have studied management accounting, you’ll have heard the term balanced scorecard. A scorecard is a report of key performance indicators – both financial and non-financial – of an organisation. Many organisations not only use some form of scorecard, but also publish it on their websites or display it in a public place within the organisation.
Take for example London’s Heathrow airport. As you can see on the graphic here, they produce a monthly report (see here) which looks at many areas of performance for each terminal. Like many firms, they use a colour-coded system, where red usually means a target has not been achieved – for example, seat availability seems to be an issue in Terminal 3 on the example here.
This scorecard is a great example – if you click the link above you’ll see it has much more than I show here. I have only one negative thing to say about it – and this falls from a recent trip through Terminal 1. I discovered this wonderful colourful (and positive) scorecard on my way to the gents – on the corridor into the toilets to be specific. Surely there’s a better place to display results? Or maybe it does not matter as only us management accountants take any notice of such things.
The October 2011 issue of CIMA’s Financial Management had a good article summarising the development to date of iphone/ipad/android apps for financial reporting. Since the advent of the internet, most public companies (and many other organisations) now publish their financial statements on their websites. Some just provide a static PDF file, while others offer more dynamic PDF files, Excel downloads and even XBRL formats. I suppose it is only logical that some firms are now providing a corporate reporting app, which not only make financial information more readily available, but also available in an offline format. According to the article, only a few companies have taken the “ground-breaking” step to develop and provide an app solely for financial information. Nestle launched the first such app (30,000 downloads), which incorporates news, financial reports, presentations and share prices. The article also mentions (just) two other firms, Shell (3,000 downloads) and Cemex – i think Tesco also have an app. There are obvious benefits of an app – reducing distribution and print costs, faster information dissemination – but the objective according to the article is to make the user’s experience far more interactive than web pages currently do. At present, given the infancy of such apps, interaction is their biggest downfall too. According to the author, only increased interactivity and a more user-friendly approach will increase the use of financial reporting apps. But, no matter what way these apps develop over the coming years, one thing is for sure – mobile communication will increase. Perhaps these early adopters of financial reporting apps may become the leaders in the field soon – only time will tell.
CIMA’s e-zine (June, 2011) suggests a more responsive corporate reporting system is need for organisations. The report by CIMA, PwC and a think-tank called Tomorrow’s Company suggests that an evolving reporting system is necessary to reduce risk within organisations and meet the changing needs to both organisations and society. From from brief reading of the report, a central argument seems to be that the traditional (and incumbent) corporate reporting system is still primarily aimed at the providers of capital. Other elements or reporting have been appended on to this system e.g. environmental reporting, rather than the full reporting system itself called into question. You may ask why change what is currently there. I’m not sure this is the definite answer, but changes in technology, the business environment and business risk (to mention but a few) have been arguably more drastic in the past 20 years than the previous 100 years.
The report argues that a new corporate reporting systems needs to have six characteristics, which I summarise below. It argues that if these are incorporated within internal reporting and management processes, the external reporting will likewise improve.
- Encourage innovation and change. This should allow a reporting system to respond effectively to shifts in the business environment.
- Balance judgement and compliance i.e. go beyond compliance reporting solely. What information is needed as a basis for good decisions.
- Focus more on long-term value, by more integrated management and external reporting.
- Make reporting accessible, timely and relevant.
- Give shareholder and investors more information in long term sustainability and value creating capabilities.
- Ensure some balances and checks are incorporated into the overall reporting system and make someone responsible for this.
In March 2011, the Irish Times reported on a new voluntary code for charities in Ireland. Yes, it’s a while ago and has been on my “to do” list for quite a while. Following the enacting of the Charities Act 2009, all Irish charities must submit an annual activity report to the Charities Regulatory Authority. Larger charities also have to complete and file audited accounts. The new proposed code aims to make charities more transparent financially, going beyond the requirements of the Act. The five key elements of the code are:
- charities commit to good practice and ensure fundraising activities are open and legal
- a donor charter will be introduced
- a complaints and feedback procedure
- a monitoring group will monitor code compliance
- an annual report and a statement of annual accounts will be publicly available
The Guardian (May 1, 2011) reported on a new proposal put forward by the High Pay Commission recently. The proposal is a very simple addition to the annual financial statements. One though which is certainty aimed at stakeholders in the broadest sense, not just investors. The proposal comes about as a result of the many high salaries and bonuses of many banking and other executives which continued to be paid despite huge losses. The idea is simple. A company will have to report on how it has distributed its profit over each of the past three years. The distribution of profits as reinvestment, dividends or pay/bonuses is to be disclosed. Some of this is already in financial statements, but the latter certainty is not easy to decipher. A simple statement like that proposed would be really useful in my view, even helping people form a view on the longer term sustainability of the business. We’ll have to wait and see if this proposal becomes a reality.
A cash flow statement is a financial statement that describes the sources of cash in a business and how that cash was spent. It does not include non-cash items seen in other financial statements such as depreciation. This makes it useful for determining the short-term viability of a company, particularly liquidity and solvency.
The cash flow statement is similar to the income statement in that it records a company’s performance over a specified period of time – normally a year. A difference is that the income statement also takes into account some non-cash accounting items such as depreciation, accrued expenses and provisions for bad debts. The cash flow statement excludes all non-cash items and shows exactly how much actual cash the a business has generated. Cash flow statements show how companies have performed in managing inflows and outflows of cash. It provides a sharper picture of a company’s ability to pay creditors, and finance growth.
It is possible for a company that is profitable to fail if there isn’t enough cash on hand to pay bills. Comparing the amount of cash generated to outstanding debt, known as the “operating cash flow ratio,” illustrates the company’s ability to service its loans and interest payments.
Unlike the varying treatments on some transactions in accounting , there is little a company can do to manipulate its cash flow. Analysts will look closely at the cash flow statement of any company in order to understand its overall health.
The cash flow statement
Cash flow statements classify cash receipts and payments according to whether they are operating, investing, or financing cash flows. A cash flow statement is divided into sections by these same three functional areas within the business:
• Cash from Operations – this is cash generated from day-to-day business operations.
• Cash from Investing – cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment, or other non-current assets.
• Cash from Financing – cash paid or received from issuing and borrowing of funds. This section also includes dividends paid – although dividends can be listed under cash from operations.)
• Net Increase or Decrease in Cash – increases in cash from previous year will be written normally, and decreases in cash are typically written in (brackets). The net movement in cash should be the differences between the opening and closing balances on the bank account (as per the balance sheet).
There are two ways to prepare a cash flow statement according to International Accounting Standard (IAS7) – the direct method and the indirect methods. The direct methods means looking at the cash records of the business and classifying according to the headings above (operations, finance and investing, which are specified by IAS7). While the direct methods seems practical, most of the time the indirect method is used. This is because IAS7 only requires a cash flow statement to be produced annually (this does not mean internal cash flow forecasts won’t be needed). The indirect method uses the income statement and balance sheet to extract cash flows. While this takes a bit of work, the information is easily available.
A balance sheet (or statement of financial position) is an accounting report that provides a snapshot of a business’s position at a given point in time, including its assets, its liabilities and its total or net worth (assets less liabilities). “A balance sheet does not aim to depict ongoing company activities,” wrote Joseph Simini in Balance Sheet Basics for Nonfinancial Managers. “It is not a movie but a freeze-frame. Its purpose is to depict the dollar value of various components of a business at a moment in time.”
Balance sheets are typically presented in a vertical report form. Asset accounts are listed first, with the liability and owners’ equity accounts listed in sequential order directly below the assets. The term “balance sheet” originates from the the fact that the balance sheet is a representation of the accounting equation (assets=liabilities + capital), thus the two totals should balance.
Contents of a balance sheet
Most of the contents of a business’s balance sheet are classified under one of three categories: assets, liabilities, and (owners) equity.
Assets are items owned by the business, whether fully paid for or not. These items can range from cash to inventories, equipment, patents, and deposits held by other businesses. Assets are further categorized into current assets and non-current assets.
Current assets include cash, accounts receivable, inventories, prepaid expenses, and any other item that could be converted to cash in the normal course of business within one year.
Non-current assets include property,equipment (from office equipment to heavy operating machinery), vehicles, fixtures, and other assets that can reasonably be assumed to have a life expectancy of several years. In practice most non-current assets—excluding land—will lose value over time. This is reflected in accounts through a a process called depreciation. Non-current assets are reported net of depreciation in the balance sheet.
Non-current assets also include intangibles like the value of trademarks, copyrights, and a difficult category known as “goodwill.” When someone buys a company and pays more for it than the worth of its assets, the difference is written into the books of the acquired entity as “goodwill.”
Liabilities are the business’s obligations to other entities as a result of past transactions. Liabilities may be due to employees (salaries), investors ( for loans) or to other companies (who have supplied goods or services). Liabilities are typically divided into two categories: current liabilities and non-current liabilities.
Current Liabilities are due to be paid within a year. These include payments to suppliers, payable taxes and accrued expenses (like wages and salaries). Current liabilities also include the “current” portion of long-term debt payable within the coming year. Non-current liabilities are amounts owed to lenders, mortgage holders, and other creditors payable over more than one year
Once a business has determined its assets and liabilities, it can then determine (owners’) equity i.e. the book value of the business. Owners’ equity, Or shareholders equity in the case of a limited company, is in essence the company’s net worth.
A balance sheet, if studied closely, can tell the any business owner much about the enterprise’s health. In Balance Sheet for Nonfinancial Managers, for instance, Simini points out that “in a well-run company current assets should be approximately double current liabilities.” He goes on: “By analyzing a succession of balance sheets and income statements, managers and owners can spot both problems and opportunities. Could the company make more profitable use of its assets? Does inventory turnover indicate the most efficient possible use of inventory in sales? How does the company’s administrative expense compare to that of its competition? For the experienced and well-informed reader, then, the balance sheet can be an immensely useful aid in an analysis of the company’s overall financial picture.”
(Some of the material in this post has been adapted from inc.com, the original post can be found here http://www.inc.com/guides/2010/06/how-to-read-a-balance-sheet.html)
This is the first of three posts which give you a quick guide to reading the three key financial statements – the income statement, balance sheet and statement of cash flows. This post deals with the income statement, with the other two coming over the next few weeks.
The Income Statement
An income statement presents the results of a company’s operations for a given period—usually a year. The income statement presents a summary of the revenues, expenses, profit or loss of an entity for the period. This statement is similar to a moving picture of the entity’s operations during the time period specified. Along with the balance sheet and the statement of cash flows, the income statement is one of the primary means of reporting financial performance. The key item listed on the income statement is the profit or loss.
Within the income statement there’s a good bit of information. If you’re knowledgeable about reading financial statements, in a company’s income statement you’ll find information about return on investment, risk, financial flexibility, and operating capabilities.
The current view of the income statement (in line with International Financial Reporting Standards (IFRS)) is that income should reflect all items of profit and loss recognised during the accounting period. The following summary income statement illustrates the format under IAS 1 – Presentation of Financial Statements (image from http://www.accaglobal.com):
This example above is fairly typical of the income statement of a large public company. I’ll explain some items below.
Some terms on the income statement explained
According to the IASB’s IAS 18, revenue is defined as “the gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends)”. This means that revenue is typically the figure for sales of goods or provision of services for the period of the income statement.
Cost of sales.
The cost of sales figure includes all expenses incurred in buying to making the product or service which generates revenue.
This is income from sources like interest or investment income.
Expenses are classified as either distribution cost, administrative expenses, other expenses or finance costs. No further detail is needed.
Share of profit of associates
This figure is the share of the profits made in an associate company – one where 20-49% is owned by the company (or group of companies) the income statement is prepared for.
The final item in the example above represents a loss made in a section of a business which is discontinued. This separate disclosure is required by accounting standards. Additionally, IAS1 also requires a short statement of comprehensive income, which shows unrealised gains (like unrealised asset revaluations, or currency gains/loses on translation). I don’t include it here, but it is usually no more than a few lines.
CIMA commented recently (see here) on an IFAC report which suggests that financial reports have become too complex with the result that the underlying financial performance of a business is hidden. Add to this the increasingly complex nature of businesses and you get some idea if the problems in compiling clear concise and meaningful reports. The IFAC report quotes Tanya Branwhite, executive director of strategy research at Macquarie Securities in Australia: ‘If financial accounts are not prepared with the users in mind, then we risk a whole area of unaudited “shadow reporting” being provided directly to investors that doesn’t go through the rigorous financial accounting process,’ she warns.
I remember from my early accounting lectures that a ‘knowledgeable’ investor in seen as the defining user of accounting reports. If you are prepared to stick your money where your mouth is, you’ll want to know all the detail. But the problem is that financial statements just can’t provide this, or as the IFAC report highlights, are too complex. According to the IFAC report, business reporting suffers from a number of significant issues at present: information overload, fair value accounting, operational performance, convergence of accounting standards, real time reporting, management commentary and sustainability reporting. The big questions is how can financial reporting help solve these? One simple answer suggested is that investors might become more actively involved in the standard setting process (i.e. IFRS) and discussions about the presentation and content of financial reports.