Annual reports and financial statements

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MODULE 7 UNIT 1 Financial reporting

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Table of contents 1. Introduction 3 2. The role and importance of financial reporting 3 3. Structure and components of an annual report 4

3.1 Financial statements 4 3.2 Notes to the financial statements 5 3.3 Directors’ report 5 3.4 Audit report 5

4. Corporate governance, corporate social responsibility, and ethics 6 4.1 Corporate governance 6 4.2 Corporate social responsibility 7

5. Qualitative characteristics of financial information for decision-making 8 5.1 Fundamental qualitative characteristics 8 5.2 Enhancing qualitative characteristics 8

6. Financial reporting standards 9 6.1 The regulatory framework 9 6.2 International Accounting Standards (IAS) 10

7. Conclusion 10 8. Bibliography 10

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Learning outcomes:

LO1: Recognise the importance of financial reporting, the regulatory framework, and standard setting.

LO2: Discuss the qualitative characteristics of financial information for decision-making.

LO3: Apply your knowledge of annual financial reports to a real-life example.

1. Introduction In Module 5, you learnt how to compile an income statement and statement of financial position for a business, and discovered which components are included in the statement of cash flows. In this set of notes, you will learn more about the standards that should be followed to ensure that the financial statements are consistent and can be used by different parties around the globe.

The information contained in the financial statements is of great importance to all the business stakeholders. However, it is not the only information about a business that is useful when making decisions. To this end, listed companies publish annual reports, which contain more comprehensive information for decision-makers than financial statements present in isolation. A real company’s annual report will be used to guide you through these notes, giving you the opportunity to familiarise yourself with the components you might come across in your own business’s annual report.

2. The role and importance of financial reporting The aim of financial reporting is to:

Provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.

(IFRS Foundation, 2010)

You learnt more about these users and their specific requirements in Module 5. The information included in financial statements is useful for the following reasons (among others):

• Management can use it to plan, and to compare the business’s performance with that of similar businesses in the industry.

• It helps the business raise capital, either through loans or shareholder investment.

• It provides stakeholders, such as employees and investors, with an overview of the performance of the business and the ways its resources are allocated.

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• Information included in financial statements is used by auditors to form an opinion on the business’s compliance to statutory requirements.

However, while financial statements provide information on how a business used its resources, they do not provide background information explaining why certain decisions were made.

Stakeholders might be interested in knowing about the key events that influenced decisions during the year, or the strategic goals of the business for the financial period and if those goals were met. Since senior management should be held accountable, it is expected of them to explain the steps they took to increase shareholder wealth while at the same time being socially responsible and adhering to best practices.

As a result, listed companies must issue a comprehensive annual report, which includes not only their financial statements, but also other information that may be of interest to different stakeholders. The annual report delivers a holistic overview of the activities of a business, providing information that will give different users the detailed view they need to make informed decisions. It also provides stakeholders with the assurance that the company is adhering to the principles of good corporate governance and acting in the best interest of society.

Case study – M&S:

The annual report of M&S (one of the biggest retailers in the UK) will be used as a reference throughout this module, serving as a practical example of the concepts discussed.

3. Structure and components of an annual report The more comprehensive and transparent an annual report is, the more likely the company is to attract new investors and gain a good reputation in the market. Listed companies may include in their annual report any information that they believe users will need to make good decisions. However, there are some components that must be included in all annual reports. This section explores and discusses each of these components.

3.1 Financial statements Financial statements illustrate how the company used its resources to achieve its strategic goals. It indicates how much profit the business made, how many assets and liabilities the business has, and whether the business has enough cash at its disposal to meet its obligations. The following financial statements are included in an annual report:

• Income statement (or statement of comprehensive income)

• Statement of financial position (or balance sheet)

• Statement of cash flows

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• Statement of changes in equity

If a company consists of a parent company with subsidiaries (businesses in which the parent company has a controlling share), consolidated financial statements are also presented. Consolidated financial statements are the combined statements for a group of companies.

Case study – Consolidated financial statements:

Refer to Pages 92 to 95 in M&S’s annual report to view its consolidated financial statements.

3.2 Notes to the financial statements The financial statements also include notes, which provide more information to users about the amounts included on the face of the statements. For example, only a final amount is included under assets in the statement of financial position. The note provides more information on the procurement and disposal of assets, and the depreciation of assets recorded during the financial period.

The notes also provide information on the accounting policies used (such as the methods used to calculate depreciation, for instance).

Case study – Notes to the financial statements:

Refer to Pages 96 to 127 in M&S’s annual report to view the notes to the consolidated financial statements.

3.3 Directors’ report The directors’ report provides a high-level overview of the state of the business and what it has achieved during the financial period. It also provides more information regarding the matters the board of directors were responsible for, and discloses the remuneration that was paid to directors as well as possible conflicts of interest directors might have experienced.

Case study – Directors’ report:

Refer to Pages 34 to 83 in M&S’s annual report to view its directors’ report.

3.4 Audit report The audit report is compiled by external, independent auditors. This report provides assurance that the financial statements have been compiled in line with international accounting standards, and that they are a fair representation of the financial state of the company. An auditor can deliver one of the following opinions:

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• An unqualified opinion: The auditor believes the financial statements are a fair representation of the financial state of the company.

• A qualified opinion: The auditor was either not provided with enough information to form an opinion about specific amounts, or there are material misstatements relating to specific amounts in the financial statements.

• Adverse opinion: There are various material misstatements in the financial statements, which leads the auditor to believe that they are not a true reflection of the financial state of the company.

• Disclaimer of opinion: The auditor was unable to obtain enough evidence to form an opinion about the financial statements.

Case study – Audit report:

Refer to Pages 84 to 91 in M&S’s annual report to view its audit report.

4. Corporate governance, corporate social responsibility, and ethics An annual report usually includes dedicated sections focused on corporate governance and corporate social responsibility. These sections provide evidence of the ethical conduct of the business.

4.1 Corporate governance Corporate governance refers to how a business is managed and controlled. Listed companies are owned by shareholders who are usually not involved in the day-to-day running of the business. The board of directors and senior management team therefore act as the shareholders’ agents, making decisions on their behalf.

The assumption is that the board and managers will act in the best interest of the shareholders, and protect their investment. However, over the years, several corporate scandals were exposed, during which it transpired that managers acted in an unethical way and not in the best interest of the shareholders or society. Many countries have subsequently implemented corporate governance codes, which listed companies are expected to adhere to. These codes address issues such as risk management, remuneration, and the composition of the board of directors.

The Global Network of Director Institutes issued a paper that summarises the guiding principles of good governance. The codes applicable in different countries are based on these basic principles. The principles are applicable to all businesses, but how these principles are implemented in practice depends on the nature and size of a business.

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Case study – Corporate governance:

Refer to Pages 34 to 53 in M&S’s annual report to view their take on corporate governance.

4.2 Corporate social responsibility Corporate social responsibility means that a business acts responsibly and fairly when dealing with its employees, the community it forms part of, and the environment. For example, it is expected of a manufacturing enterprise to disclose how it deals with any damage it does to the environment during the production process. Watch Video 1 to learn more about the long-term impact that corporate social responsibility may have on the profit of a business.

Video 1: Alex Edmans discusses the long-term impact of corporate social responsibility. (Source: https://www.youtube.com/watch?v=Z5KZhm19EO0&t=431s)

The “triple bottom line”:

In Module 5, you learnt that the net profit of a business is also referred to as the “bottom line”. For a long time, this was regarded as the most important indicator of a business’s performance. However, the amount of profit a business makes does not indicate how the business has contributed to society, or whether its management team is acting in the best interest of its shareholders.

Therefore, it has become standard practice for businesses to report on their economic, social, and environmental achievements, which is referred to as the “triple bottom line”. This term suggests that it is just as important for a business to contribute to society and protect the environment as it is to earn profit.

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5. Qualitative characteristics of financial information for decision-making Financial information should display certain characteristics to make it useful for individuals making business decisions.

5.1 Fundamental qualitative characteristics The two most important characteristics that financial information must display are relevance and faithful representation.

Information is relevant if it is “capable of making a difference in the decisions made by users” (IFRS Foundation, 2010). The amount of profit earned, for example, is relevant to potential investors, as it is an indication of whether buying shares in the business is a good investment. Information is represented faithfully if it is complete and does not contain any errors.

According to the IFRS Foundation (2010) “information must be both relevant and faithfully represented if is to be useful”. Relevant information that is incorrect may result in a user making a wrong decision. For example, if the statements include reference to an asset sold (which is a relevant piece of information), but the profit made during the transaction is calculated incorrectly, it will not be of use to individuals using the statements. Similarly, information that is correct but irrelevant is also of little use when making decisions.

5.2 Enhancing qualitative characteristics In addition to relevance and faithful representation, there are other characteristics that will also enhance the usefulness of financial information.

• Comparability: Information is useful when it can be compared to information from previous periods or other businesses. For example, including the last two years’ figures in the current financial statements allows users to identify trends and establish whether performance has improved from previous years.

• Verifiability: Information is verifiable if different, knowledgeable parties can reach consensus that the information is faithfully represented. For example, two different auditors should be able to reach the same conclusion about the financial statements of a business.

• Timeliness: Information is timely when it is made available to users at a time when it can influence their decisions. The annual report should be released within a reasonable amount of time after the end of the financial year so that users can base their planning and decisions on the information included.

• Understandability: Information is understandable if it is clear and concise. However, the assumption is made that the users of financial statements have some business background and knowledge, and will take time to analyse the information

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correctly. Complex information should therefore not be excluded from the statements just to make it more understandable.

Compiling financial statements using certain standards is one way of ensuring that the information included in the statements is useful for decision makers.

6. Financial reporting standards Most countries have standards that accountants must follow when compiling financial statements. This ensures that financial statements meet the requirements of the end users, and that consistency is achieved across different industries. Financial reporting standards differ from country to country.

However, globalisation and the interaction between businesses situated in different countries created a need for global accounting standards to be used when compiling financial statements. If businesses in different countries and in different industries use their own formats and methods to compile financial statements, it might become near impossible to compare results. Many countries now require, or at least encourage, listed companies to adhere to these global standards when compiling their financial statements.

6.1 The regulatory framework The International Accounting Standards Board (IASB) issued a framework to use when compiling financial statements to ensure that the information contained in these statements is reliable and relevant. This framework includes the following sections:

• Objectives of financial reporting

• Underlying assumptions made when financial reports are compiled (such as the going concern assumption, which means that a business reports its financial position with the assumption that it will continue to do business and operate as usual in future)

• Qualitative characteristics of financial information

• Elements of financial statements

• Recognition of elements of financial statements

• Measurement of elements of financial statements

(IFRS Foundation, 2010)

You can read a summary of the Conceptual Framework for Financial Reporting, which highlights the most important concepts included in the framework.

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6.2 International Accounting Standards (IAS) The Conceptual Framework for Financial Reporting provides high-level guidance to accountants compiling financial statements. The IASB also issues standards that address specific matters, such as when and how to record revenue, and how to present consolidated financial statements.

These standards are referred to as International Accounting Standards (IAS) if issued before or during 2001, or International Financial Reporting Standards (IFRS) if issued after 2001. If there is no standard to address a problem a company is experiencing when compiling financial statements, the Conceptual Framework is used as guidance. Visit the IFRS Foundation’s website to read more about the standard-setting process and view a list of all the global accounting standards that have been issued thus far.

As a business manager, it is not usually expected of you to have an in-depth understanding of accounting standards, as this typically falls in the domain of accountants and auditors. However, it is useful to be aware of these standards should it come up when you are involved in finance-related discussions.

7. Conclusion The annual report is a comprehensive document that serves as a source of information for various parties that have an interest in a listed company, including employees, creditors, and investors. An annual report must include an overview of the financial year’s business activities and the steps directors took to increase shareholder wealth. It should also include comprehensive financial statements that are compiled in line with the International Accounting Standards and audited by an external, independent auditor.

It has become common practice to include sections relating to corporate governance, corporate social responsibility, and environmental responsibility in the annual report. This provides stakeholders with information about the steps the company has taken to balance its pursuit of profit with the well-being of the community and environment it operates in.

In Unit 2, you will discover how the information included in the annual report (and specifically the financial statements) can be analysed to identify the strengths and weaknesses of a business, and which steps can be taken to improve the business’s performance if it becomes necessary.

8. Bibliography Auditor-General of South Africa. n.d. Audit terminology. Available:

https://www.agsa.co.za/Auditinformation/Auditterminology.aspx [2017, October 17].

Edmans, A. 2015. The social responsibility of business [Video file]. Available: https://www.youtube.com/watch?v=Z5KZhm19EO0&t=431s [2017, October 17].

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EduPristine. 2015. Financial reporting. [Blog, 2 December]. Available: http://www.edupristine.com/blog/financial-reporting [2017, October 17].

IFRS Foundation. 2010. The conceptual framework for financial reporting 2010. Available: https://dart.deloitte.com/resource/1/7036afd8-3f7e-11e6-95db-2d5b01548a21 [2017, October 17].

Maynard, J. 2017. Financial accounting, reporting & analysis. 2nd ed. Oxford: Oxford University Press.

Melville, A. 2017. International financial reporting: A practical guide. 6th ed. Edinburgh Gate: Pearson Education Limited.

The Economist Newspaper Limited. 2009. Triple bottom line. Available: http://www.economist.com/node/14301663 [2017, October 2017].