Key Concept Summary 1: An Introduction to Financial Reporting and Analysis

This reading has presented an overview of financial statements analysis. Among the major
points covered are the following:

The primary purpose of financial reports is to provide information and data about a
companys financial position and performance, including profitability and cash flows.
The information presented in financial reports-including the financial statements,
financial notes and managements discussion and analysis-allows the financial analyst
to assess a companys financial position and performance and trends in that
performance.

The objective of financial reporting:
1. The objective of financial statements is to provide information about the
financial position, performance and changes in financial position of an entity;
this information should be useful to a wide range of users for the purpose of
making economic decisions.
2. 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 attempt to ensure some type of
consistency in these judgments.

Key financial statements that are a primary focus of analysis include the income
statement, balance sheet, cash flow statement and statement of owners equity.

Financial statements should serve investors and government, as well as other users
such as labor unions, and offer information about the amount, timing and uncertainty
of future cash flows.

Accounting statements should be relevant to users, contain reliable figures and be
presented in a timely manner in order to have predictive value for users.

The income statement presents information on the financial results of a companys
business activities over a period of time. The income statement communicates how
much revenue the company generated during a period and what costs it incurred in
connection with generating that revenue. The basic equation underlying the income
statement is Revenue-Expense=Net Income.

The balance sheet discloses what a company owns (assets) and what it owes
(liabilities) at a specific point in time. Owners equity represents the portion belonging
to the owners or shareholders of the business; it is the residual interest in the assets of
 an entity after deducting its liabilities. The three parts of the balance sheet are
formulated in the accounting relationship of Assets = Liabilities +Owners Equity.

Although the income statement and the balance sheet provide a measure of a
companys success, cash and cash flow are also vital to the companys long-term
success. Disclosing the sources and uses of cash in the cash flow statement helps
creditors, investors, and other statement users evaluate the companys liquidity,
solvency and financial flexibility.

The statement of changes in owners equity reflects information about the increases or
decreases to a companys owners equity.

In addition to the financial statements, a company provides other sources of financial
information that are useful to the financial analyst. As part of his or her analysis, the
financial analyst should read and assess the information presented in the companys
financial note disclosures and supplementary schedules as well as the information
contained in the managements discussion and analysis (MD&A). Analysts must also
evaluate footnote disclosures regarding the use of alternative accounting methods,
estimates and assumptions.

A publicly traded company must have an independent audit opinion performed on its
financial statements. The auditors opinion provides some assurance about whether
the financial statements fairly reflect a companys performance and financial position.

The auditors opinion gives evidence of an independent review of the financial
statements that verifies that generally accepted accounting principles (GAAP) were
used and that standard auditing procedures were used to establish that the
statements contain no material errors.

The financial statements analysis framework provides steps that can be followed in
any financial statements analysis project, including the following:
1. articulate the purpose and context of the analysis;
2. collect input data;
3. process data;
4. analyze/interpret the processed data
5. develop and communicate conclusions and recommendations; and
6. follow up.
 Key Concept Summary 2: The Accounting Process
The accounting process is a key component of financial reporting. The mechanics of this
process convert business transactions into records necessary to create periodic reports on a
company. An understanding of these mechanics is useful in evaluating financial statements for
credit and equity analysis purposes and in forecasting future financial statements. Key
concepts are as follows:

Business activities can be classified into three groups: operating activities, investing
activities and financing activities.

Companies classify transactions into common accounts that are components of the
five financial statements elements: assets, liabilities, equity, revenue and expense.

The core of the accounting process is the basic accounting equation:
Assets= Liabilities + Owners Equity.

The expanded accounting equation is Assets = Liabilities + Contributed Capital +
Beginning Retained Earnings + Revenue-Expenses-Dividends.

Business transactions are recorded in an accounting system that is based on the
basic and expanded accounting equations.

The accounting system tracks and summarizes data used to create financial
statements: the balance sheet, income statement, statement of cash flows, and
statement of owners equity. The statement of retained earnings is a component of the
statement of owners equity.

Accruals are a necessary part of the accounting process and are designed to allocate
activity to the proper period for financial reporting purposes.

The results of the accounting process are financial reports that are used by
managers, investors, creditors, analysts and others in making business decisions.
 Key Concept Summary 3: Understanding Income Statement
This reading has presented the elements of income statement analysis. The income statement
presents information on the financial results of a companys business activities over a period
of time. It communicates how much revenue the company generated during a period and
what costs it incurred in connection with generating that revenue. A companys net income
and its components (e.g., gross margin, operating earnings and pretax earnings) are critical
inputs into both the equity and credit analysis processes.

The income statement presents revenue, expenses and net income.

The components of the income statement include: revenue, cost of sales/services,
general and administrative expenses, other operating expenses, non-operating
income and expenses, gains and losses, nonrecurring items, net income and EPS.

The income statement has several components, the most important being net income
from continuing operations as it gives the best indicator of future earnings.

Revenue is recognized in the period it is earned, which may or may not be in the
same period as the related cash collection. Recognition of revenue when earned is a
fundamental principle of accrual accounting.

Revenue is recognized when two conditions are met: (1) the firm has virtually provided
all of the goods or services for which it is to be paid, and (2) the company is able to
estimate the probability of payment.

An analyst should identify differences in companies revenue recognition methods and
adjusted reported revenue where possible to facilitate comparability. Where the
available information does not permit adjustment, an analyst can characterize the
revenue recognition as more or less conservative and thus qualitatively assess how
differences in policies might affect financial ratios and judgments about profitability.

The general principles of expense recognition include the matching principle.
Expenses are matched either to revenue or to the time period in which the
expenditure occurs (period costs) or to the time period of expected benefits of the
expenditures (e.g., depreciation). In other words, the matching principle states that
revenues and the expenses incurred to generate those revenues should be
accounted for in the same time period.

In expense recognition, choice of method (i.e. depreciation method and inventory cost
method), as well as estimates (i.e., uncollectible accounts, warranty expenses, assets
useful life and salvage value) affect a companys reported net income. An analyst
 should identify differences in companies expense recognition methods and adjust
reported financial statements where possible to facilitate comparability. Where the
available information does not permit adjustment, an analyst can characterize the
policies and estimates as more or less conservative and thus qualitatively assess how
differences in policies might affect financial ratios and judgments about companies
performance.

In assess a companys future earnings, it is helpful to separate those prior years items
of income and expense that are likely to continue in the future from those items that
are less likely to continue.

Non-operating items are reported separately from operating items. For example, if a
non-financial service company invests in equity or debt securities issued by another
company, any interest, dividends or profits from sale of these securities will be
showed as non-operating income.

Basic EPS is the amount of income available to common shareholders divided by the
weighted average number of common shares outstanding over a period. The amount
of income available to common shareholders is the amount of net income remaining
after preferred dividends (if any) have been paid.

If a company has a simple capital structure (i.e., one with no potentially dilutive
securities), then its basic EPS is equal to its diluted EPS. If, however, a company has
dilutive securities, its diluted EPS is lower than its basic EPS. On the contrary, a
complex capital structure contains potentially dilutive securities such as options,
warrants or convertible securities.

Dilutive securities are stock options, warrants convertible debt or convertible preferred
stock that decrease EPS if exercised or converted to common stock. Antidilutive
securities are those that would increase EPS if exercised or converted to common
stock.

A company with a complex capital structure must report both basic and diluted EPS.

Common-size analysis of the income statement involves stating each line item on the
income statement as a percentage of sales. Common-size statements facilitate
comparison across time periods and across companies of different sizes.

Comprehensive income includes both net income and other revenue and expense
items that are excluded from the net income calculation.

There are four ways in which management can manipulate earnings:
 1. Classification of good and bad news.
2. Income smoothing.
3. Big bath technique
4. Accounting changes

There are four nonrecurring items in the income statement:
1. Unusual or infrequent items
2. Extraordinary items
3. Income or loss from discontinued operations
4. Cumulative effect of accounting changes
 Key Concept Summary 4: Understanding Balance Sheet
The starting place for analyzing a company is typically the balance sheet. It provides users
such as creditors or investors with information regarding the sources of finance available for
projects and infrastructure. At the same time, it normally provides information about the future
earnings capacity of a companys assets as well as an indication of cash flows implicit in the
receivables and inventories.
The balance sheet has many limitations, especially relating to the measurement of assets and
liabilities. The lack of timely recognition of liabilities and, sometimes, assets coupled with
historical costs as opposed to fair value accounting for all items on the balance sheet, implies
that financial analysts must make numerous judgments to judge the economic net worth of a
company.
The balance sheet discloses what an entity owns (assets) and what it owes (liabilities) at a
specific point in time, which is why it is also referred to as the statement of financial position.
Equity represents the portion belonging to the owners or shareholders of a business. Equity is
the residual interest in the assets of an entity after deducting liabilities. The value of equity is
increased by any generation of new assets by the business itself or by profits made during the
year and is decreased by losses or withdrawals in the form of dividends. Key points include:

The balance sheet should distinguish between current and non-current assets and
between current and non-current liabilities unless a presentation based on liquidity
provides more relevant and reliable information.

Assets expected to be liquidated or used up within one year or one operating cycle of
the business, whichever is greater, are classified as current assets. Assets not
expected to be liquidated or used up within one year or one operating cycle of the
business, whichever is greater, are classified as non-current assets.

Liabilities expected to be settled or paid within one year or one operating cycle of the
business, whichever is greater, are classified as current liabilities. Liabilities not
expected to be settled or paid within one year or one operating cycle of the business,
whichever is greater, are classified as non-current liabilities.

Assets and liabilities values reported on a balance sheet may be measured on the
basis of fair value or historical cost. Historical cost values may be quite different from
economic values. Balance sheets must be evaluated critically in light of accounting
policies applied to answer the question of the values relate to economic reality and to
each other.

The notes to financial statements are an integral part of financial reporting processes.
They provide important required detailed disclosures, as well as other information
provided voluntarily by management. This information can be invaluable when
determining whether the measurement of assets is comparable to other entities being
analyzed.

Tangible assets are long-term assets with physical substance that are used in
company operations.

Intangible assets are amounts paid by a company to acquire certain rights that are
not represented by the possession of physical assets. A company should assess
whether the useful life of an intangible asset is finite or infinite and, if finite, the length
of its life.

Financial instruments are contracts that give rise to both a financial asset of one entity
and a financial liability of another entity. Financial instruments come in a variety of
instruments, including derivatives, hedges and marketable securities.

There are five potential components that comprise the owners equity section of the
balance sheet: contributed capital, minority interest, retained earnings, treasury stock
and accumulated comprehensive income.

The statement of changes in equity reflects information about the increases or
decreases to a companys net assets or wealth.

Ratio analysis is used by analysts and managers to assess company performance
and status. Another valuable analytical technique is common-size (relative analysis),
which is achieved through the conversion of all balance sheet items to a percentage
of total assets.
 Key Concept Summary 5 Understanding Cash Flow Statement
The cash flow statement provides important information about a companys cash receipts and
cash payments during an accounting period as well as information about a companys
operating, investing and financing activities. Information on the sources and use of cash helps
creditors, investors and other statement users evaluate the companys liquidity, solvency and
financial flexibility. Key concepts are as follows:

The primary purpose of the statement of cash flows is to provide information about a
companys cash receipts and payments as well as its sources and uses of cash from
and for investing and financing activities.

Cash flow activities are classified into three categories: operating activities, investing
activities and financing activities. Significant non-cash activities (if present) are
reported by using a supplemental disclosure note to the cash flow statement.

Cash flow from operations represents changes in the working capital accounts and all
items that flow through the income statement.

Cash flow from investing represents the purchase or sale of assets. It is calculated by
classifying each investing activity as a non-cash transaction, a cash inflow (+), or an
outflow (-), and summing the individual items.

Cash flow from financing represents cash expended to pay dividends, repurchase
stock, or make principal payments on debt or taken in from the sale of securities or
borrowing. It is calculated by summing the cash receipts (+) and payments (-) from
each financing source.

Companies can use either the direct or indirect method for reporting their operating
cash flow:
1. The direct method discloses operating cash inflows by source (e.g., cash
received from customers, cash received from investment income) and
operating cash outflows by use (e.g., cash paid to suppliers, cash paid for
interest) in the operating activities section of the cash flow statement.
2. The indirect method reconciles net income to net cash flow from operating
activities by adjusting net income for all non-cash items and the net changes
in the operating working capital accounts.

The cash flow statement is linked to a companys income statement and comparative
balance sheet and is constructed from the data on those statements.
 Key Concept Summary 6 Financial Statement Analysis Techniques
Financial analysis techniques, including common-size and ratio analysis, are useful in
summarizing financial reporting data and evaluating the performance and financial position of
a company. The results of financial analysis techniques provide important inputs into
securities valuation and credit analysis. Key facets of financial analysis include the following:

Common-size financial statements and financial ratios remove the effect of size,
allowing comparisons of a company with peer companies (cross-sectional analysis)
and comparison of a companys results over time (trend or time-series analysis).

Activity ratios measure the efficiency of a companys operations, such as collection of
receivables or management of inventory. Major activity ratios include inventory
turnover, days of inventory on hand, receivables turnover, days of sales outstanding,
payables turnover, number of days of payables, working capital turnover, fixed asset
turnover and total asset turnover.

Liquidity ratios measure the ability of a company to meet short-term obligations. Major
liquidity ratios include the current ratio, quick ratio, cash ratio and defensive interval
ratio.

Solvency ratios measure the ability of a company to meet long-term obligations. Major
solvency ratios include debt ratios (including the debt-to-assets ratio, debt-to-capital
ratio, debt-to-equity ratio and financial leverage ratio) and coverage ratios (including
interest coverage and fixed charge coverage).

Profitability ratios measure the ability of a company to generate profits from revenue
and assets. Major profitability ratios include return on sales ratios (including gross
profit margin, operating profit margin, pretax margin and net profit margin) and return
on investment ratios (including operating ROA, ROA, ROE and return on common
equity).

Growth analysis ratios indicate the companys ability to pay future obligations. The
calculation of the sustainable growth rate is g = RRxROE, where RR = retention rate =
1-(dividend declared/after-tax operating income) and ROE is return on equity.

Financial ratios can also be combined and evaluated as a group to better understand
how they fit together and how efficiency and leverage are tied to profitability.

ROE can be analyzed as the product of net profit margin, asset turnover and financial
leverage.

Ratio analysis is useful in the selection and valuation of debt and equity securities and
is a part of the credit rating process.

Ratios can also be computed for business segments to evaluate how units within a
business are doing.

The results of financial analysis provide valuable inputs into forecasts of future
earnings and cash flow.
 Key Concept Summary 7 Inventories
Inventory cost flow is a major determinant in measuring income for merchandising and
manufacturing companies. In addition, inventories are usually a significant asset on the
balance sheets of these companies. The financial statements and financial notes of a
company provide important information that the analyst needs to correctly assess and
compare financial performance with other companies. Key concepts in this reading are as
follows:

Inventories are a major factor in the analysis of merchandising and manufacturing
companies. Such companies generate their sales and profits through inventory
transactions on a regular basis. An important consideration in determining profits for
these companies is measuring the cost of goods sold when inventories are sold to
business customers.

The cost of inventories comprises all costs of purchase, cost of conversion, and other
costs incurred in bringing the inventories to their present location and condition. Also,
any allocation of fixed production overhead is based on normal capacity levels, with
unallocated production overhead expensed as incurred.

The basic formula for inventory calculation is:
Ending inventory = Beginning inventory + purchases-COGS

Under IFRS, the cost of inventories is assigned by using either the first-in, first-out
(FIFO) or weighted average cost formula. The specific identification method is
required for inventories of items that are not ordinarily interchangeable and for goods
or services produced and segregated for specific projects. A business entity must
use the same cost formula for all inventories having a similar nature and use to the
entity.

When prices are changing, FIFO provides the more useful estimate of inventory
balance and balance sheet information, while LIFO provides the more useful estimate
of COGS (and operating income).

In periods of rising prices and stable or increasing inventory quantities, LIFO and
FIFO result in the following:
 LIFO results in: FIFO results in:
Higher COGS Lower COGS
Lower taxes Higher taxes
Lower net income (EBT and EAT) Higher net income (EBT and EAT)
Lower inventory balances Higher inventory balances
Lower working capital Higher working capital
Higher cash flows (less taxes paid out) Lower cash flows (less taxes paid out)
Lower net and gross margins Higher net and gross margins
Lower current ratio Higher current ratio
Higher inventory turnover Lower inventory turnover
Higher D/A and D/E Lower D/A and D/E

Inventories are measured at the lower of cost or Bnet realizable value.C Net realizable
value is the estimated selling price in the ordinary course of business less the
estimated costs necessary to make the sale. Reversals of write-downs are permissible
under IFRS.

The choice of inventory method impacts the financial statements and any financial
ratios that are derived from them. As a consequence, the analyst must carefully
consider inventory method differences when evaluating a companys performance or
when comparing a company with industry data or industry competitors.

The inventory turnover ratio, number of days of inventory ratio, and gross profit margin
ratio are directly and fully affected by a companys choice of inventory method.
 Key Concept Summary 8 Long-Lived Assets
Key points include the following:

Long-term assets are used to produce items for resale and have a useful life of
greater than one year.

The cost of plant assets includes all expenditures necessary to place the asset into
service that are made prior to placing the asset in service.

The cost of an asset is allocated to over time through depreciation. Three main
methods are straight-line, units-of-production and declining-balance.

Expenditures related to long-lived assets are included as part of the value of assets
on the balance sheet, i.e. capitalized, if they are expected to provide future benefits,
typically beyond one year.

Although capitalizing expenditures, rather than expensing, results in higher reported
profitability in the initial year, it results in lower profitability in subsequent years;
however, if a company continues to purchase similar or increasing amounts of assets
each year, the profitability enhancing effect of capitalizing continues.

Capitalizing an expenditure rather than expensing it results in greater amounts
reported as cash from operations.

Capitalization of outlays, compared to expensing, causes lower variability of net
income, higher net income, higher operating cash flow and lower leverage ratios.
Capitalization causes return on assets (ROA) and return on equity (ROE) to be higher
in the year of capitalization and lower in later years unless capitalized expenditures
are increasing.

Capitalization of interest causes interest expense to be lower, depreciation to be
slightly higher, cash flow from operations to be higher, and the interest coverage ratio
to be higher.

Impact of capitalizing vs. expensing development costs is as below:

Effect on If capitalized///.. If expensed////

Current net income Greater Smaller
Future income (increasing Greater Smaller
capitalized expenditures)
Future income (decreasing Smaller Greater
capitalized expenditures)
Debt-to-equity ratio Smaller Greater
Return on assets (initial) Greater Smaller
Return on assets (future) Smaller Greater
Total cash flow Same Same
Cash flow from operations Greater Smaller
Cash flow from investing Smaller Greater

In general, intangible asset costs are capitalized when the assets are acquired from
an outside entity. In most countries, R&D costs cannot be capitalized; only the legal
fees to obtain a patent or trademark internally can be capitalized, and development
costs for software for external use may be capitalized after technical and economic
feasibility have been established.

If an asset is acquired in a nonmonetary exchange, its cost is based on the fair value
of the asset given up, or the fair value of the asset acquired if it is more reliably
determinable.

Companies must capitalize interest costs associated with acquiring or constructing an
asset that requires a long period of time to prepare for its intended use.

Including capitalized interest in the calculation of interest coverage ratios provides a
better assessment of a companys solvency.

Depreciation methods include the straight-line method, in which the cost of an asset is
allocated in equal amounts over its useful life; accelerated methods, in which the
allocation of cost is greater in earlier year; and units-of-production methods, in which
the allocation of cost corresponds to the actual use of an asset in a particular period.

Compared to straight-line methods, accelerated methods decrease operating
earnings and net income in the early years of assets life and increase them in the
later years.

The choice of depreciation method on the firms financial statements does not affect
the firms cash flow, but the use of accelerated depreciation methods for tax reporting
lowers taxable income and taxes due, increasing the firms cash flow by the reduction
in taxes.

Significant estimates required for depreciation calculations include the useful life of
equipment (or its total lifetime productive capacity) and its expected residual value at
the end of that useful life. A longer useful life and higher expected residual value
 decrease the amount of annual depreciation relative to a shorter useful life and lower
expected residual value.

Intangible assets with finite useful lives are amortized over their useful lives.

Intangible assets without a finite useful life, i.e. with an indefinite useful life, are not
amortized, but are reviewed for impairment whenever changes in events or
circumstances indicate that the carrying amount of an asset may not be recoverable.

For many types of long-lived tangible assets, ownership involves obligations that must
be fulfilled at the end of the assets service life, referred to as asset retirement
obligations (AROs).

The gain or loss on the sale of long-lived assets is computed as the sales proceeds
minus the carrying value of the asset at the time of sale.

In contrast with depreciation and amortization charges, which serve to allocate the
cost of long-lived asset over its useful life, impairment charges reflect a decline in the
fair value of an asset to an amount lower than its carrying value.

Impairment must be recognized when the carrying value of an asset is higher than the
sum of the future cash flows (undiscounted) from their use and disposal. Impairments
will cause income, asset value, deferred taxes, equity and future depreciation to
decline, resulting in an increase in future net income.

Impairment disclosures can provide useful information about a companys expected
cash flows.

When assets are sold or discarded, a realized gain or loss may result. The gain or loss
is equal to sale proceeds minus book (carrying) value.

Intangible assets do not have a physical existence but they do produce benefits to the
assets owners.

IFRS requires capitalization of environmental remediation expenses and for most firms
will lead to higher assets, liabilities, depreciation expense, and interest expense which
will tend to decrease net income. ROA, asset turnover and interest coverage ratios will
decrease, and liabilities-to-equity will increase.
 Key Concept Summary 9 Long-Term Liabilities and Leases
Key points include the following:

The sales proceeds of a bond issue are determined by discounting future cash
payments using the market rate of interest. The reported interest expense on bonds is
based on the market interest rate.

Future cash payments on bonds usually include periodic interest payments (made at
the stated rate) and the principal amount at maturity.

When the market rate of interest is the stated rate for the bonds, the bonds are sold at
par, i.e. at price equal to the face value. When the market rate of interest is higher
than the bonds stated rate, the bonds will sell at a discount. When the market rate of
interest is lower than the bonds stated rate, the bonds will sell at a premium.

An issuer amortizes any issuance discount or premium on bonds over the life of the
bonds.

Debt covenants impose restrictions on borrowers such as limitations on future
borrowing or requirements to maintain a maximum debt-to-equity ratio.

The book value of bonds is based on the face value adjusted for any unamortized
discount or premium, which can differ from its fair value. Such a difference will be due
to the implicit discount rate, established at the time of issue, being different from the
current market rate.

It is useful for an analyst to revalue the firm and compute leverage ratios using the
market value of debt instead of the book value.

Some financial instruments have characteristics of both debt and equity. If the
financial instruments are treated as equity, solvency ratios based on the financial
statements appear stronger. Debt with equity features should be treated for analytical
purposes as having both a debt and equity components.

Accounting standards generally define two types of leases: operating leases or
financial (or capital) leases.

A lease is classified as a financial (or capital) lease by a lessee if any one of the
following holds:
1. If the title is transferred to the lessee at the end of lease period.
2. A bargain purchase option exists.
3. The lease period is at least 75 % of the assets life.
 4. The present value of the lease payments is at least 90 % of the fair value of
the asset.
Otherwise, it is classified as an operating lease.

Capital leases are recorded on the lessees financial statements as assets and
liabilities. The assets are depreciated, whereas the lease payments are split into
principal repayments and interest expense. The recorded liability is amortized over
the life of the lease.

When a lessee reports a lease as an operating lease rather than a finance lease, it
usually appears more profitable in early years of the lease and less so later, and it
appears more solvent over the whole period.

When a lessor reports a lease as a finance lease rather than an operating lease, it
usually appears more profitable in early years of the lease.

Relative to operating leases, capital leases provide a lessor with earlier recognition of
profit, larger assets and lower cash flow from operations.

Relative to operating leases, capital leases provide a lessee with higher assets, higher
liabilities, deferred net income and higher operating cash flow.

When a company has a substantial amount of operating leases, adjusting reported
financials to include the impact of capitalizing these leases better reflects the
companys solvency position.

Various off-balance-sheet financing methods include take-or-pay and throughput
arrangements, sales of receivables, finance subsidiaries and joint ventures.

Off-balance-sheet financing methods make debt balances look artificially low, and
receivables sales and finance subsidiaries make receivables look artificially low. For
analytical purposes, the debt and receivables should be restated before calculating
ratios.
 Key Concept Summary 10 Income taxes
Income taxes are a significant category of expense for profitable companies. Analyzing
income tax expenses is often difficult for the analyst as there are many permanent and
temporary timing differences between the accounting that is used for income tax reporting
and the accounting that is used for financial reporting on company financial statements. The
financial statements and notes to the financial statements of a company provide important
information that the analyst needs to assess financial performance and to compare a
companys financial performance with other companies. Key concepts in this reading are as
follows:

Differences between the recognition of revenue and expenses for tax and accounting
purposes may result in taxable income differing from accounting profit. The
discrepancy is a result of different treatments of certain income and expenditure
items.

Taxable income on the tax return is equivalent to pretax income on the income
statement; taxes payable on the tax return is equivalent to tax expense on the income
statement.

The tax base of an asset is the amount that will be deductible for tax purposes as an
expense in the calculation of taxable income as the company expenses the tax basis
of the asset. If the economic benefit will not be taxable, the tax base of the asset will
be equal to the carrying amount of the asset.

The tax base of a liability is the carrying amount of the liability less any amounts that
will be deductible for tax purposes in the future. With respect to revenue received in
advance, the tax base of such a liability is the carrying amount less any amount of the
revenue that will not be taxable in future.

Temporary differences arise from recognition of differences in the tax base and
carrying amount of assets and liabilities. The creation of a deferred tax asset or
liability as a result of a temporary difference will only be allowed if the difference
reverses itself at some future date and to the extent that it is expected that the
balance sheet item will create future economic benefits for the company.

Permanent differences result in a difference in tax and financial reporting of revenue
(expenses) that will not be reversed at some future date. Because it will not be
reversed at a future date, these differences do not constitute temporary differences
and do not give rise to a deferred tax asset or liability.

Current taxes payable or recoverable are based on the applicable tax rates on the
balance sheet date of an entity; in contrast, deferred taxes should be measured at the
tax rate that is expected to apply when the asset is realized or the liability settled.

All unrecognized deferred tax assets and liabilities must be reassessed on the
appropriate balance sheet date and measured against their probable future economic
benefit.

Deferred tax assets must be assessed for their prospective recoverability. If it is
probable that they will not be recovered at all or partly, the carrying amount should be
reduced through the use of a deferred asset valuation allowance.

Deferred tax assets are balance sheet amounts that result from an excess of taxes
payable over income tax expense that are expected to be recovered from future
operations. Deferred tax liabilities are balance sheet amounts that result from an
excess of income tax expense over taxes payable that are expected to result in future
cash outflows.

Deferred tax assets and liabilities are calculated using the liability method, in which
the assets and liabilities are calculated at any one time to reflect the current tax rate.

A valuation allowance reduces the value of a deferred tax asset when its eventual
recoverability is in doubt.

Deferred tax liabilities that are expected never to reverse, typically due to expected
growth in capital expenditures, should be treated for analytical purposes as equity. If
deferred tax liabilities are expected to reverse, they should be treated for analytical
purposes as liabilities, but calculated at their present value.

Permanent differences between taxable income and pretax income should not create
a deferred asset or liability but should be used to adjust the effective tax rate.

If the tax rate increases, the increase in deferred tax liabilities increases the income
tax expense, and the increase in deferred tax assets decreases the income tax
expense. A tax rate decrease has the opposite effect.
 Key Concept Summary 11 Intercorporate Investments
Intercompany investments play a significant role in business activities and create significant
challenges for the analyst in assessing a company performance. Investments in other
companies can take four basic forms; minority passive investments, minority active
investments, joint ventures and controlling interest investments. Key concepts are as follows:

Minority passive investments are those in which the investor has no significant
influence. They can be designated as: held-to-maturity investments, held-for-
trading securities, or available-for-sale securities. IFRS treats minority passive
investments in a similar manner.
1. Held-to-maturity investments are carried at cost.
2. Held-for-trading securities are carried at fair value: unrealized gains and
losses are reported on the profit and loss (income) statement.
3. Available-for-sale securities are carried at fair value; unrealized gains and
losses are reported as other comprehensive income in the equity section of
the balance sheet.
4. Gains or losses on investments designated as fair value are reported on the
profit and loss (income) statement.

Minority active investments are those in which the investor has significant
influence, but not control, over the investees business activities. As the investor
can exert significant influence over financial and operating policy decisions, the
equity method of accounting provides a more objective basis for reporting
investment income.
1. The equity method requires the investor to recognize income as earned rather
than when dividends are received.
2. The equity investment is carried at cost, plus its share of post-acquisition
income (after adjustments) less dividends received.
3. The equity investment is reported as a single line item on the balance sheet
and on the income statement.

Controlling interests investments can be structured as mergers, acquisitions
or statutory consolidation.

In a statutory merger, two or more companies combine such that only one of
the companies remains in existence. In a statutory consolidation, two or more
 companies are folded into a new entity with the new entity becoming the
surviving company.

An acquisition allows for the legal continuity for each of the combining
companies. Both companies continue as separate entities but are now
affiliated through a parent-subsidiary relationship.

Unlike a statutory merger or consolidation, the acquiring company does not
need to acquire 100 percent of the target. If the acquiring company acquires
less than 100 percent, minority (noncontroling) shareholders interests are
reported on the consolidated financial statements.

Consolidated financial statements are prepared in each reporting period.

Current accounting standards require the purchase method for business
combinations. Fair value is the appropriate measurement for identifiable
assets and liabilities acquired in the business combination.

Under the purchase method, the assets and liabilities of the acquired
company are written up to fair value, any identifiable intangible assets are
recorded, and the excess of the purchase price over the fair value of net
tangible and identifiable intangible assets is recorded as goodwill.

Goodwill is the excess purchase price after recognizing the fair market value
of all tangible and intangible assets acquired. Goodwill has an indefinite life
and is not amortized but evaluated at least annually for impairment.
Impairment losses are reported on the income statement.

Debt securities held-to-maturity are securities the company has a positive
intent and ability to hold to maturity. Available-for-sale securities may be sold
to address the companys liquidity needs. Trading securities are acquired for
the purpose of selling them in the short term.

The unrealized gains and losses of trading securities are reported on the
income statement. The gains and losses of available-for-sale securities are
reported as a component of equity on the balance sheet.

To use the equity method, an investor must exert significant influence over the
investees operations and management (the investor usually owns between 20
% and 50 % of the outstanding shares of the investee.

Under the equity method, the investment is listed at cost on the balance
sheet. Dividends that are paid by the investee increase cash and decrease
 the investment account on the assets side of the balance sheet. In addition,
the investors pro rata share of the investees net income increases the asset
account and is listed as income on the investors income statement.

The equity method differs from the cost method in that when the dividend
payout is not 100 % and the income of the investee is positive, the reported
net income under the equity method will exceed the net income reported
under the cost method (all else the same). Under these same circumstances,
the reported amount in the investment account will be greater for the equity
method than for the cost method. The reported cash flow will not differ
between the two methodologies.

To use consolidation, the parent must control a subsidiary (the investor
usually owns more than 50 % of the subsidiary).

A consolidation will differ from financial statements generated using the equity
method in the following ways. First, the consolidated assets and liabilities will
exceed those listed under the equity method in more cases. Also,
consolidated revenues, expenses and operating income will exceed those
reported under the equity method. Reported equity and net income will be the
same under both methods.

In general, if the subsidiary is profitable, the equity method reports better
results than the consolidation method: ROA and net profit margin will be
greater, and leverage ratios will be lower under the equity method.

A proportionate consolidation will lead to the same results as a normal
consolidation except there is no minority interest computation in a
proportionate consolidation. We simply add the parents proportionate share
of all accounts net of intercorporate transfers. Do not add the equity accounts
together.

A reportable segment is a component of an enterprise that has at least 10 %
of revenues, operating profit or loss, or combined identifiable assets of the
enterprise as a whole.

Reportable segments disclose sales and intersegment sales, operating profit,
assets, depreciation, depletion and amortization expenses and capital
expenditures. Segment data allows an analyst to better understand
companys operations and track trends.

Under the cost method, dividends are recognized as income in the period in
which they are received, impairments are recognized immediately and
reported as a loss, and realized gains and losses are reported when the
securities is sold.

An asset is considered impaired when its fair value is less than the book value
reported on the balance sheet, and the decline in market value is Bother than
temporaryC. Accounting standards require that impaired assets be written
down to fair value on the balance sheet, with the accompanying loss reported
on the income statement as a charge against net income.

Subsequent increases in market value of cost-based investments and
investments held to maturity, however, are not reflected on the balance sheet
as increases in reported value, and no unrealized gain is reported on the
income statement.
 Key Concept Summary 12 Employee Compensation: Postretirement and Share-Based
This summary discusses two different forms of employee compensation: postretirement
benefits and share-based compensation. While different, the two share similarities in that they
are forms of compensation outside the standard salary arrangements. They also involve
complex valuation, accounting and reporting issues. It is important to note that differences in a
countrys social system, laws and regulations can result in differences in a companys pension
and share-based compensation plans that may be reflected in the companys earnings and
financial reports. Key concepts include the following:

Defined-contribution pension plans specify only the amount of contribution to the
plan; the eventual amount of the pension benefit to the employee will depend on the
value of an employees plan assets at the time of retirement. Thus, employees may
bear the short-fall risk.

Defined-benefit pension plans specify the amount of the pension benefit, often
determined by a plan formula, under which the eventual amount of the benefit to the
employee is a function of length of service and final salary. Thus, the company may
bear the short-fall risk.

The accounting for defined benefit plans is much more complicated than for defined
contribution pension plans. In pay-related defined benefit plans, pension benefits are
based on the employees future compensation.

Differences exist in countries regulatory requirements for companies to fund defined-
benefit pension plan regulations.

Defined-benefit pension plan obligations are funded by the sponsoring company
contributing assets to a pension trust, a separate legal entity.

Three measures are used in estimating a defined-benefit pension plans liabilities,
each increasingly more inclusive; the vested benefit obligation, the accumulated
benefit obligation and the projected benefit obligation.

The projected benefit obligation (PBO) is the actuarial present value (at the assumed
discount rate) of all future pension benefits earned to date, based on expected future
salary increases. It measures the value of the obligation assuming the firm is a going
concern and that the employees will continue to work for the firm until they retire.

The accumulated benefit obligation (ABO) is the actuarial present value of all future
pension benefits earned to date based on current salary levels, ignoring future salary
increases.

The vested benefit obligation (VBO) is the amount of ABO to which the employee is
entitled based on the companys vesting schedule.

For analysis, the projected benefit obligation is typically the most appropriate
measure as it recognizes future salary increases.

Balance sheet reporting is less relevant for defined contribution plans as companies
make contributions to defined contribution plans as the expense arises and thus no
liabilities accrue for that type of plan.

IFRS requires companies balance sheets to reflect as a defined benefit liability the
pension obligation minus the fair value of plan assets, with certain adjustments for
actuarial gains or losses, and any past service costs not yet recognized.

Pension expense includes the following components: service cost, interest expense,
prior service cost, actuarial gains and losses and return on plan assets (which
reduces pension expense).

Estimates of the future obligation under defined benefit plans and other
postretirement benefits are sensitive to numerous assumptions, including discount
rates, assumed annual compensation increases, expected return on plan assets and
assumed health care cost inflation.

Employee compensation packages are structured to fulfill varied objectives including
satisfying employees needs for liquidity, retaining employees and providing
incentives to employees.

Common components of employee compensation packages are salary, bonuses and
share-based compensation.

Share-based compensation serves to align employees interest with those of the
shareholders. It includes stocks and stock options.

Share-based compensation has the advantage of requiring no current-period cash
outlays.

Share-based compensation is reported at fair value under IFRS.

The valuation technique, or option pricing model, that the company uses is an
important choice in determining fair value and is disclosed.

Key assumptions and input into option pricing models include items such as exercise
price, stock price volatility, estimated life of each award, estimated number of options
that will be forfeited and the risk-free rate of interest. Certain assumptions are highly
 subjective, such as stock price volatility or the expected life of stock options, and can
greatly change the estimated fair value and thus compensation expense.

Assumptions of high discount rates, low compensation growth rates and high
expected rates of return on plan assets will decrease pension expense, increase
earnings and reduce pension liability. The more aggressive these assumptions are,
the lower the earnings quality of the firm.

Any changes in assumptions that may have only a small impact in the total pension
obligation itself can still have a large impact on the net pension liability. The same is
true with pension expense; because it is a net amount (service and interest cost net
of expected return on plan assets), relatively minor changes in the assumptions can
have a major impact on reported pension expense.

Pension expense components include:
1. Service cost-increase in the PBO reflecting the pension benefits earned
during the year.
2. Interest cost-increase in PBO resulting from interest owed on the current
benefit obligation.
3. Expected return on plan assets-assumed long run rate of return on plan
assets used to smooth the volatility that would be caused by using actual
returns.
4. Amortization of unrecognized prior service cost-amortized costs for changes
in the PBO that result from amendments to the plan.
5. Amortization and deferral of gains or losses-amortization of gains and losses
caused by changes in actuarial assumptions.
6. Amortization of transition liability or asset-amortized amount caused by
switching to SFAS 87 in 1985.

Expected return on plan assets can differ from the actual return because 1) the
market-related value does not necessarily equal the actual return in any given year.
Changes in the assumed expected rate of return directly affect reported pension
expense; actual returns only indirectly affect reported pension expense to the extent
that these changes are reflected in the market-related value of the plan.

If the ABO exceeds the fair value of plan assets, at least that difference must be
reported on the balance sheet as a liability. If necessary, the existing pension asset or
 liability must be adjusted to this liability value by recording an additional pension
liability called the minimum liability allowance or the additional liability.

Accounting for non-pension postretirement benefits is very similar to accounting for
pension benefits, with the following differences:
1. The APBO is the actuarial present value of the expected postretirement
benefits. It is estimated using the unique discount rate applied
specifically to those benefits.
2. The health care cost trend rate, which is used to estimate the APBO, must
be disclosed.
3. There is no minimum liability adjustment.
4. Many postretirement benefit plans are unfunded, which means there are
no plan assets, employer contributions equal benefits paid, and the
funded status equals the APBO.
5. A lower health care cost trend rate decrease the APBO and
postretirement benefit expense.

The appropriate balance sheet adjustment is to reflect the actual economic status of
the plan (the funded status), rather than the net asset or liability reported on the
financial statements for accounting purposes. The offsetting entry is always to equity:
1. An increase in a pension liability (or a decrease in a pension asset) will
result in an offsetting decline in equity.
2. A decrease in a pension liability (or an increase in a pension asset) will
result in an offsetting increase in equity.

Adjusted pension expense is equal to service cost plus interest cost minus actual
return on plan assets.

Adjusted operating income is equal to reported operating income plus reported
pension expense minus service cost. Adjusted income before taxes is equal to
reported income before taxes plus reported pension expense minus adjusted pension
expense.
 Key Concept Summary 13 Multinational Operations
The translation of foreign currency amounts is an important accounting issue for companies
with multinational operations. Fluctuations in foreign exchange rates cause the functional
currency values of foreign currency assets and liabilities resulting from foreign currency
transactions as well as from foreign subsidiaries to change over time, giving rise to foreign
exchange differences that must be reflected in the financial statements. Determining how to
measure these foreign exchange differences and whether to include them in the calculation of
net income are the major issues in accounting for multinational operations. Key concepts are
as follows:

Flow effects are the impact of changes in the exchange rate on income statement
items such as revenue. Holding gain/loss effects are the impact of changes in the
exchange rate on assets and liabilities on the balance sheet such as cash balances.

Some important definitions:
1. The functional currency is defined as the primary currency of the economic
environment in which the firm operates. This can be the currency in which the
firm operates or some other currency.
2. The reporting currency is the currency in which the multinational firm prepares
its final, consolidated financial statements.
3. The local currency is the currency of the country in which the foreign
subsidiary is located.
4. In foreign currency translation, it is possible to have another foreign currency
that is different from the local currency.
5. The current rate is the exchange rate as of the balance sheet date.
6. The average rate is the average exchange rate over the reporting period.
7. The historical rate is the rate that existed when a particular transaction was
conducted.

The local currency is the national currency of the country where an entity is located.
The functional currency is the currency of the primary economic environment in which
an entity operates. Normally, the local currency is an entitys functional currency. For
accounting purposes, any currency other than an entitys functional currency is a
foreign currency for that entity. The currency in which financial statement amounts are
presented is known as the presentation currency. In most cases, the presentation
currency will be the same as the local currency.

When an export sales (import purchase) on account is denominated in a foreign
currency, the sales revenue (inventory) and foreign currency account receivable
(account payable) are translated into the sellers (buyers) functional currency using
the exchange rate on the transaction date. Any change in the functional currency
value of the foreign currency account receivable (account payable) that occurs from
the transaction date to the settlement date is recognized as a foreign currency
transaction gain or loss in net income.

If a balance sheet date falls between the transaction date and the settlement date, the
foreign currency account receivable (account payable) is translated at the exchange
rate at the balance sheet date. The change in the functional currency value of the
foreign currency account receivable (account payable) is recognized as a foreign
currency transaction gain or loss in income. It is worth noting that these gains and
losses are unrealized at the time they are recognized, and might or might not be
realized when the transactions are settled.

A foreign currency transaction gain arises when an entity has a foreign currency
receivable and the foreign currency strengthens or it has a foreign currency payable
and the foreign currency weakens. A foreign currency transaction loss arises when an
entity has a foreign currency receivable and the foreign currency weakens or it has a
foreign currency payable and the foreign currency strengthens.

Companies must disclose the net foreign currency gain or loss included in income.
They may choose to report foreign currency transaction gains and losses as a
component of operating income or as a component of non-operating income. If two
companies choose to report foreign currency transaction gains and losses differently,
making a direct comparison of operating profit and operating profit margin between
the two companies is questionable.

To prepare consolidated financial statements, foreign currency financial statements of
foreign operations must be translated into the parent companys presentation
currency. The major conceptual issues related to this translation process are what is
the appropriate exchange rate for translating each financial statement item and how
should the resulting translation adjustment be reflected in the consolidated financial
statements. Two different translation methods are used worldwide.

Under the current method, assets and liabilities are translated at the current exchange
rate, equity items are translated at historical exchange rates, and revenues and
 expenses are translated at the exchange rate existed when the underlying transaction
occurred. For practical reasons, an average exchange rate is often used to translate
income items.

Under the temporal method, monetary assets (and nonmonetary assets measured at
current value) and monetary liabilities (and nonmonetary liabilities measured at
current value) are translated at the current exchange rate. Nonmonetary assets and
liabilities not measured at current value and equity items are translated at historical
exchange rates. Revenues and expenses, other than those expenses related to
nonmonetary assets, are translated at the exchange rate that existed when the
underlying transaction occurred. Expenses related to nonmonetary assets are
translated at the exchange rates used for the related assets.

Under IFRS, the functional currency of a foreign operation determines the method to
be used in translating its foreign currency financial statements into the parents
presentation currency and whether the resulting translation adjustment is recognized
in income or as a separate component of equity.

The foreign currency financial statements of a foreign operation that has a foreign
currency as its functional currency are translated using the current rate method and
the translation adjustment is accumulated as a separate component of equity. The
cumulative translation adjustment related to a specific foreign entity is transferred to
net income when that entity is sold or otherwise disposed of. The balance sheet risk
exposure associated with the current rate method is equal to the foreign subsidiarys
net asset position.

The foreign currency financial statements of a foreign operation that has the parents
presentation currency as its functional currency are translated using the temporal
method and the translation adjustment is included as a gain or loss in income. The
balance sheet exposure associated with the temporal method is equal to the foreign
subsidiaryJs net monetary asset/liability position (adjusted for nonmonetary items
measured at current value).

With respect to the translation of foreign currency financial statements of foreign
operations located in a highly inflationary country, under IFRS, the foreign currency
statements are first restated for local inflation and then translated using the current
exchange rate.

Application of the different translation methods for a given foreign operation can result
in very different amounts reported in the parents consolidated financial statements.

Companies must disclose the total amount of translation gain or loss reported in
income and the amount of translation adjustment included in a separate component of
stockholders equity. Companies are not required to separately disclose the
component of translation gain or loss arising from foreign currency transactions and
the component arising from the application of the temporal method.

Under the temporal method, cash, accounts receivable, accounts payable and long-
term debt are translated using the current rate. All other assets and liabilities are
translated at the historical rate. Revenues and expenses are translated at the average
rate. Cost of goods sold and depreciation are translated by applying the historical rate
to inventory and fixed asset purchases. The translation gain or loss is showed on the
income statement.

Under the all-current method, all income statement accounts are translated at the
average rate. All balance sheet accounts are translated at the current exchange rate
except for common stock, which is translated at the appropriate historical rate that
applied when the equity was issued. Dividends are translated at the historical rate that
applied when they were paid. The foreign currency adjustment is included on the
balance sheet in the equity section. Pure balance sheet financial ratios and pure
income statement financial ratios will be unaffected by an all-current method
translation.

The rules that govern the determination of the functional currency under IFRS are:
1. The results of operations, financial position and cash flows of all foreign
operations must be measured in the designated functional currency.
2. Self-contained, independent subsidiaries whose operations are primarily located
in the local market will use the local currency as the functional currency.
3. Subsidiaries whose operations are well integrated with the parent will use the
parents currency as the functional currency.
4. If the subsidiary operates in a highly inflationary environment, use the parents
currency as the functional currency. A high inflation environment is defined as
cumulative inflation that exceeds 100 % over a 3-year period.
5. If the functional currency is the local currency, use the all-current method. The use
of the all-current method under IFRS is called translation.
 6. If the functional currency is the parents currency ($) or some other currency, use
the temporal method. The use of the temporal method under IFRS is called
remeasurement.

Translation gains or losses result from gains or losses related to balance sheet accounts
that are exposed to changes in exchange rates. Rates are in $/LC (local currency).
1. Exposure under the all-current method = shareholders equity
2. Exposure under the temporal method = (cash+accounts receivable)-(accounts
payable+current debt+long-term debt)
3. Flow effect (in $) =change in exposure (in LC)x (ending rate-average rate)
4. Holding gain/loss effect (in $)=beginning exposure (in LC)x(ending rate-
beginning rate)
5. Translation gain/loss (in $) =flow effect+ Holding gain/loss effect

There are three reasons the temporal and all-current methods report significantly different
results:
1. Translation gains/losses appear on the balance sheet with the all-current method
and on the income statement with the temporal method.
2. Realized gains and losses on nonmonetary inventory and fixed assets are
included in cost of goods sold and depreciation expense under the temporal
method.
3. Unrealized gains and losses on inventory and fixed assets are ignored under the
temporal method.

Foreign currency exposure is defined relative to the net asset or net liability exposure of
the firm. Under the temporal method, it is highly probable that the firm will have a net
liability exposure as long-term debt and accounts payable are translated using the current
rate, whereas only cash and accounts receivable are translated at the current rate on the
assets side of the balance sheet. Under the all-current method, you will almost always see
a net asset exposure unless the subsidiary is bankrupt.

A depreciating foreign currency reduces the value of a net asset position in USD terms,
and you will have a foreign exchange loss. Alternatively, a depreciating foreign currency
will increase the value of a net liability position in USD terms, and you will have a foreign
exchange gain.

The statement of cash flows is unaffected by the choice of translation method.

All pure income statement and balance sheet ratios are unaffected by the application of
the all-current method. What we mean by BpureC is that the components of the ratio all
come from the balance sheet, or the components of the ratio all come from the income
statement.

The all-current method of translation results in small changes in ratios combining income
statement and balance sheet data.

The temporal method of translation results in ratios that are materially different from those
measured in local currency units and from ratios measured under the all-current method.

An appreciating (depreciating) local currency creates illusion of higher (lower) sales and
earnings of foreign subsidiaries.

For income statement measures, translated sales are the same under both the all-current
and the temporal methods, SG&A and other expenses are the same under both methods,
COGS, depreciation and net income are not the same under both methods.

For the balance sheet measures, accounts receivable and cash are the same under both
methods, inventory is different, fixed assets are different, debt is the same.
 Key Concept Summary 14 Evaluating Financial Reporting Quality
Financial reporting quality is a broad area with considerable academic and practitioner
research. Among the points in this reading has made are the following:

There are two basic strategies underlying all accounting tricks: (1) inflating earnings
by inflating revenue and/or by deflating expenses and (2) deflating earnings by
deflating revenue and/or by inflating expenses.

There are seven categories of techniques that management has used to distort a
companys reported financial performance and financial condition: (1) recording
revenue prematurely or recording revenue of questionable quality, (2) recording
fictitious revenue. (3) engaging in special, one-time transactions to generate gains,
(4) shifting current-period expenses to an earlier or future period, (5) failure to record
liabilities or improperly reducing liabilities, (6) deferring current revenue to a future
period, and (7) transferring future expenses to the current reporting period as a
special, one-time charge.

Conservative accounting policies include 1) LIFO with rising prices, 2) accelerated
depreciation/short asset lives, 3) later recognition of revenue, 4) rapid amortization,
5) higher estimates of bad debts, 6) accruing losses/establishing loss reserves, and
7) current period expensing rather than capitalization of expenses. The opposite
policies are considered aggressive.

Financial reporting quality relates to the accuracy with which a companys reported
financial statements reflect its operating performance and to their usefulness for
forecasting future cash flows. Understanding the properties of accruals is critical for
understanding and evaluating financial reporting quality.

The application of accrual accounting makes necessary use of judgment and
discretion. On average, accrual accounting provides a superior picture to a cash
basis accounting for forecasting future cash flows.

Sources of accounting discretion include choices related to revenue recognition,
depreciation choices, inventory choices, choices related to goodwill and other
noncurrent assets, choices related to taxes, pension choices, financial asset/liability
valuation and stock option expense estimates.

A framework for detecting financial reporting problems includes examining reported
financials for revenue recognition issues and expense recognition issues.

Revenue recognition issues include overstatement of revenue, acceleration of
revenue and classification of nonrecurring or nonoperating items as operating
revenue.

Expense recognition issues include understating expenses, deferring expenses and
the classification of ordinary expenses as nonrecurring or nonoperating expenses.

Discretion related to off-balance sheet liabilities (e.g., in the accounting for leases)
and the impairment of goodwill can also affect financial reporting quality.
Key Concept: Types of Leases
Leasing takes several different forms, the four most important being (1) operating leases, (2) financial
or capital leases, (3) sale-and-leaseback arrangements, and (4) combination leases.

Operating Leases
Operating leases, sometimes called service leases, generally provide for both financing and
maintenance. Ordinarily, operating leases require the lessor to maintain and service the
leased equipment, and the cost of the maintenance is built into the lease payments.
Another important characteristic of operating leases is the fact that they are not fully
amortized. In other words, the rental payments required under the lease contract are not
sufficient for the lessor to recover the full cost of the asset. However, the lease contract is
written for a period considerably less than the expected economic life of the asset, so the
lessor can expect to recover all costs either by subsequent renewal payments, by re-leasing
the asset to another lessee, or by selling the asset.
A final feature of operating leases is that they often contain a cancellation clause that gives
the lessee the right to cancel the lease and to return the asset before the expiration of the
basic lease agreement. This is an important consideration to the lessee, for it means that the
asset can be returned if it is rendered obsolete by technological developments or is no
longer needed due to a change in the lessee*s business.

Financial or Capital Leases

Financial leases, sometimes called capital leases, are differentiated from operating leases in
that (1) they do not provide for maintenance service, (2) they are not cancelable, and (3)
they are fully amortized (that is, the lessor receives rental payments equal to the full price of
the leased equipment plus a return on invested capital.
In a typical arrangement, the firm that will use the equipment (the lessee) selects the
specific items it requires and negotiates the price with the manufacturer. The user firm then
arranges to have a leasing company (the lessor) buy the equipment from the manufacturer
and simultaneously executes a lease contract.
The terms of the lease generally call for full amortization of the lessor*s investment, plus a
rate of return on the unamortized balance which is close the percentage rate the lessee
would have paid for a secured loan.
The lessee is generally given an option to renew the lease at the reduced rate upon
expiration of the basic lease. Nevertheless, the basic lease usually cannot be cancelled
 unless the lessor is paid in full. As well, the lessee generally pays the property taxes and
insurance on the leased property.
As the lessor receives a return after, or net of, these payments, this type of lease is often
called a -net, net. lease.

Sale-and-Leaseback Arrangements
Under a sale-and-leaseback arrangement, a firm that own land, buildings, or equipment
sells the property to another firm and simultaneously executes an agreement to lease the
property back for a stated period under specific terms. The capital supplier could be an
insurance company, a commercial bank, a specialized leasing company, the finance arm
of an industrial firm, or an individual investor. The sale-and-leaseback plan is an alternative
to a mortgage.
Note that the seller immediately receives the purchase put up by the buyer. At the same
time, the seller-lessee retains the use of the property. The parallel to borrowing is carried
over to the lease payment schedule.
Under a mortgage loan arrangement, the lender would normally receive a series of equal
payments just sufficient to amortize the loan and to provide a specified rate of return on the
outstanding loan balance. Under a sale-and-leaseback arrangement, the lease payments
are set up exactly the same way-the payments are just sufficient to return the full purchase
price to the investor, plus a stated return on the lessor*s investment.
Sale-and-leaseback arrangements are almost the same as financial leases, the major
difference being that the leased equipment is used, not new, and the lessor buys it from
the user-lessee instead of from a manufacturer or a distributor. A sale-and-leaseback may,
then, be thought of as a special type of financial lease.

Combination Leases
Many lessors now offer leases under a wide variety of terms. Therefore, in practice leases
often do not fit exactly into the operating lease or financial lease category, but, rather,
combine some features of each. Such leases are called combination leases.
To illustrate, cancellation clauses are normally associated with operating leases, but many
of today*s financial leases also contain cancellation clauses. However, in financial leases
these clauses generally include prepayment provisions whereby the lessee must make
penalty payments sufficient to enable the lessor to recover the unamortized cost of the
leased property.
The Conceptual Framework for Financial Reporting 2011
The IASB Framework was approved by the IASC Board in April 1989 for publication in
July 1989, and adopted by the IASB in April 2001. In September 2010, as part of a bigger
project to revise the Framework, the IASB revised the objective of general purpose
financial reporting and the qualitative characteristics of useful information. The
remaining of the document from 1989 remains effective.

This Conceptual Framework sets out the concepts that underlie the preparation and
presentation of financial statements for external users.
The Conceptual Framework deals with:
(a) the objective of financial reporting;
(b) the qualitative characteristics of useful financial information;
(c) the definition, recognition and measurement of the elements from which financial
statements are constructed; and
(d) concepts of capital and capital maintenance.

The objective of general purpose 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. Those
decisions involve buying, selling or holding equity and debt instruments, and providing or
settling loans and other forms of credit. Many existing and potential investors, lenders
and other creditors cannot require reporting entities to provide information directly to
them and must rely on general purpose financial reports for much of the financial
information they need. Consequently, they are the primary users to whom general purpose
financial reports are directed.

General purpose financial reports do not and cannot provide all of the information that
existing and potential investors, lenders and other creditors need. Therefore those users
need to consider pertinent information from other sources. Other parties, such as
regulators and members of the public other than investors, lenders and other creditors,
may also find general purpose financial reports useful. However, those reports are not
primarily directed to these other groups.

In order to meet their objectives, financial statements are prepared on the accrual basis of
accounting. Accrual accounting depicts the effects of transactions and other events and
circumstances on a reporting entitys economic resources and claims in the periods in
which those effects occur, even if the resulting cash receipts and payments occur in a
different period. This is important because information about a reporting entitys
economic resources and claims and changes in its economic resources and claims during
a period provides a better basis for assessing the entitys past and future performance than
information solely about cash receipts and payments during that period.

The financial statements are normally prepared on the assumption that an entity is a going
concern and will continue in operation for the foreseeable future. Qualitative
characteristics identify the types of information that are likely to be most useful to the
existing and potential investors, lenders and other creditors for making decisions about
the reporting entity on the basis of information in its financial report (financial
information). If financial information is to be useful, it must be relevant (i.e. must have
predictive value and confirmatory value, based on the nature or magnitude, or both, of
the item to which the information relates in the context of an individual entitys financial
report) and faithfully represents what it purports to represent (ie information must be
complete, neutral and free from error). The usefulness of financial information is
enhanced if it is comparable, verifiable, timely and understandable. The
IASB acknowledges that cost may be a constraint on preparing useful financial
information.

The elements directly related to the measurement of financial position are assets,
liabilities and equity. These are defined as follows:
(a) An asset is a resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity.
(b) A liability is a present obligation of the entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources embodying
economic benefits.
(c) Equity is the residual interest in the assets of the entity after deducting all its liabilities.
The elements of income and expenses are defined as follows:

(a) Income is increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in increases in
equity, other than those relating to contributions from equity participants.
(b) Expenses are decreases in economic benefits during the accounting period in the form
of outflows or depletions of assets or incurrence of liabilities that result in decreases
in equity, other than those relating to distributions to equity participants.

An item that meets the definition of an element should be recognized if:

(a) it is probable that any future economic benefit associated with the item will flow to or
from the entity; and
(b) the item has a cost or value that can be measured with reliability.

Measurement is the process of determining the monetary amounts at which the elements
of the financial statements are to be recognized and carried in the balance sheet and
income statement. This involves the selection of the particular basis of measurement.
The concept of capital maintenance is concerned with how an entity defines the capital
that it seeks to maintain. It provides the linkage between the concepts of capital and the
concepts of profit because it provides the point of reference by which profit is measured;
it is a prerequisite for distinguishing between an entitys return on capital and its return of
capital; only inflows of assets in excess of amounts needed to maintain capital may be
regarded as profit and therefore as a return on capital. Hence, profit is the residual amount
that remains after expenses (including capital maintenance adjustments, where
appropriate) have been deducted from income. If expenses exceed income the residual
amount is a loss.

The Board recognizes that in a limited number of cases there may be a conflict between
the Conceptual Framework and an IFRS. In those cases where there is a conflict, the
requirements of the IFRS prevail over those of the Conceptual Framework. As, however,
the Board will be guided by the Conceptual Framework in the development of future
IFRSs and in its review of existing IFRSs, the number of cases of conflict between
the Conceptual Framework and IFRSs will diminish through time. The Conceptual
Framework will be revised from time to time on the basis of the IASBs experience of
working with it
IFRS 3 Business Combinations
The objective of the IFRS is to enhance the relevance, reliability and comparability of the
information that a reporting entity provides in its financial statements about a business
combination and its effects. It does that by establishing principles and requirements for
how an acquirer:

(a) recognizes and measures in its financial statements the identifiable assets acquired, the
liabilities assumed and any non-controlling interest in the acquiree;
(b) recognises and measures the goodwill acquired in the business combination or a gain
from a bargain purchase; and
(c) determines what information to disclose to enable users of the financial statements to
evaluate the nature and financial effects of the business combination.

Core Principle
An acquirer of a business recognises the assets acquired and liabilities assumed at their
acquisition-date fair values and discloses information that enables users to evaluate the
nature and financial effects of the acquisition.

Applying the acquisition method

A business combination must be accounted for by applying the acquisition method, unless
it is a combination involving entities or businesses under common control. One of the
parties to a business combination can always be identified as the acquirer, being the entity
that obtains control of the other business (the acquiree).
Formations of a joint venture or the acquisition of an asset or a group of assets that does
not constitute a business are not business combinations.

The IFRS establishes principles for recognizing and measuring the identifiable assets
acquired, the liabilities assumed and any non-controlling interest in the acquiree. Any
classifications or designations made in recognizing these items must be made in
accordance with the contractual terms, economic conditions, acquirers operating or
accounting policies and other factors that exist at the acquisition date.

Each identifiable asset and liability is measured at its acquisition-date fair value. Any
non-controlling interest in an acquiree is measured at fair value or as the non-controlling
interests proportionate share of the acquirees net identifiable assets.

The IFRS provides limited exceptions to these recognition and measurement principles:
(a) Leases and insurance contracts are required to be classified on the basis of the
contractual terms and other factors at the inception of the contract (or when the terms
have changed) rather than on the basis of the factors that exist at the acquisition date.
(b) Only those contingent liabilities assumed in a business combination that are a present
obligation and can be measured reliably are recognized.
(c) Some assets and liabilities are required to be recognized or measured in accordance
with other IFRSs, rather than at fair value. The assets and liabilities affected are those
falling within the scope of IAS 12 Income Taxes, IAS 19 Employee Benefits, IFRS 2
Share-based Payment and IFRS 5 Non-current Assets Held for Sale and Discontinued
Operations.
(d) There are special requirements for measuring a reacquired right.
(e) Indemnification assets are recognized and measured on a basis that is consistent with
the item that is subject to the indemnification, even if that measure is not fair value.
The IFRS requires the acquirer, having recognized the identifiable assets, the liabilities
and any non-controlling interests, to identify any difference between:
(a) the aggregate of the consideration transferred, any non-controlling interest in the
acquiree and, in a business combination achieved in stages, the acquisition-date fair
value of the acquirers previously held equity interest in the acquiree; and
(b) the net identifiable assets acquired.

The difference will, generally, be recognised as goodwill. If the acquirer has made a gain
from a bargain purchase that gain is recognised in profit or loss. The consideration
transferred in a business combination (including any contingent consideration) is
measured at fair value. In general, an acquirer measures and accounts for assets acquired
and liabilities assumed or incurred in a business combination after the business
combination has been completed in accordance with other applicable IFRSs. However,
the IFRS provides accounting requirements for reacquired rights, contingent liabilities,
contingent consideration and indemnification assets.

Disclosure
The IFRS requires the acquirer to disclose information that enables users of its financial
statements to evaluate the nature and financial effect of business combinations that
occurred during the current reporting period or after the reporting date but before the
financial statements are authorized for issue. After a business combination, the acquirer
must disclose any adjustments recognised in the current reporting period that relate
to business combinations that occurred in the current or previous reporting periods.
IFRS 10 Consolidated Financial Statements
The objective of this IFRS is to establish principles for the presentation and preparation of
consolidated financial statements when an entity controls one or more other entities. To
meet the objective, this IFRS:

(a) requires an entity (the parent) that controls one or more other entities (subsidiaries) to
present consolidated financial statements;
(b) defines the principle of control, and establishes control as the basis for consolidation;
(c) sets out how to apply the principle of control to identify whether an investor controls
an investee and therefore must consolidate the investee; and
(d) sets out the accounting requirements for the preparation of consolidated financial
statements.

Consolidated financial statements are the financial statements of a group in which the
assets, liabilities, equity, income, expenses and cash flows of the parent and its
subsidiaries are presented as those of a single economic entity.

Presentation of consolidated financial statements

The IFRS requires an entity that is a parent to present consolidated financial statements.
A limited exemption is available to some entities. The IFRS defines the principle of
control and establishes control as the basis for determining which entities are consolidated
in the consolidated financial statements.

An investor controls an investee when it is exposed, or has rights, to variable returns from
its involvement with the investee and has the ability to affect those returns through its
power over the investee.

The IFRS sets out requirements on how to apply the control principle:
(a) in circumstances when voting rights or similar rights give an investor power, including
situations where the investor holds less than a majority of voting rights and in
circumstances involving potential voting rights.
(b) in circumstances when an investee is designed so that voting rights are not the
dominant factor in deciding who controls the investee, such as when any voting rights
relate to administrative tasks only and the relevant activities are directed by means of
contractual arrangements.
(c) in circumstances involving agency relationships.
(d) in circumstances when the investor has control over specified assets of an investee.

Consolidation procedures
When preparing consolidated financial statements, an entity must use uniform accounting
policies for reporting like transactions and other events in similar circumstances.
Intragroup balances and transactions must be eliminated. Non-controlling interests in
subsidiaries must be presented in the consolidated statement of financial position within
equity, separately from the equity of the owners of the parent.

Changes in the ownership interests

Changes in a parents ownership interest in a subsidiary that do not result in the parent
losing control of the subsidiary are equity transactions (i.e. transactions with owners in
their capacity as owners).
Loss of control
If a parent loses control of a subsidiary, the parent:
(a) derecognises the assets and liabilities of the former subsidiary from the consolidated
statement of financial position.
(b) recognises any investment retained in the former subsidiary at its fair value when
control is lost and subsequently accounts for it and for any amounts owed by or to the
former subsidiary in accordance with relevant IFRSs. That fair value shall be
regarded as the fair value on initial recognition of a financial asset in accordance with
IFRS 9 or, when appropriate, the cost on initial recognition of an investment in an
associate or joint venture.
(c) recognises the gain or loss associated with the loss of control attributable to the former
controlling interest.

Disclosure
The disclosure requirements for interests in subsidiaries are specified in IFRS 12 Disclosure of
Interests in Other Entities.
IFRS 13 Fair Value Measurement
IFRS 13:
(a) defines fair value;
(b) sets out in a single IFRS a framework for measuring fair value; and
(c) requires disclosures about fair value measurements.

The IFRS applies to IFRSs that require or permit fair value measurements or disclosures
about fair value measurements (and measurements, such as fair value less costs to sell,
based on fair value or disclosures about those measurements), except in specified
circumstances.

The measurement and disclosure requirements of the IFRS do not apply to the following:
(a) share-based payment transactions within the scope of IFRS 2 Share-based Payment;
(b) leasing transactions within the scope of IAS 17 Leases; and
(c) measurements that have some similarities to fair value but are not fair value, such as
net realizable value in IAS 2 Inventories or value in use in IAS 36 Impairment of
Assets.

The disclosures required by the IFRS are not required for the following:
(a) plan assets measured at fair value in accordance with IAS 19 Employee Benefits;
(b) retirement benefit plan investments measured at fair value in accordance with IAS 26
Accounting and Reporting by Retirement Benefit Plans; and
(c) assets for which recoverable amount is fair value less costs of disposal in accordance
with IAS 36.

IFRS 13 defines fair value as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the
measurement date (i.e. an exit price). That definition of fair value emphasizes that fair
value is a market-based measurement, not an entity-specific measurement.

When measuring fair value, an entity uses the assumptions that market participants would
use when pricing the asset or liability under current market conditions, including
assumptions about risk. As a result, an entitys intention to hold an asset or to settle or
otherwise fulfill a liability is not relevant when measuring fair value.

The IFRS explains that a fair value measurement requires an entity to determine the
following:
(a) the particular asset or liability being measured;
(b) for a non-financial asset, the highest and best use of the asset and whether the asset is
used in combination with other assets or on a stand-alone basis;
(c) the market in which an orderly transaction would take place for the asset or liability;
and
(d) the appropriate valuation technique(s) to use when measuring fair value. The
valuation technique(s) used should maximize the use of relevant observable inputs
and minimize unobservable inputs. Those inputs should be consistent with the inputs
a market participant would use when pricing the asset or liability.

Application to liabilities and an entitys own equity instruments

A fair value measurement assumes that a financial or non-financial liability or an entitys
own equity instrument (e.g. equity interests issued as consideration in a business
combination) is transferred to a market participant at the measurement date. The transfer
of a liability or an entitys own equity instrument assumes the following:
(a) A liability would remain outstanding and the market participant transferee would be
required to fulfill the obligation. The liability would not be settled with the
counterparty or otherwise extinguished on the measurement date.
(b) An entitys own equity instrument would remain outstanding and the market
participant transferee would take on the rights and responsibilities associated with the
instrument. The instrument would not be cancelled or otherwise extinguished on the
measurement date.

Fair value hierarchy

To increase consistency and comparability in fair value measurements and related
disclosures, the IFRS establishes a fair value hierarchy that categorizes into three levels
the inputs to valuation techniques used to measure fair value. The fair value hierarchy
gives the highest priority to quoted prices (unadjusted) in active markets for identical
assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level
3 inputs). Level 1 inputs are quoted prices (unadjusted) in active markets for identical
assets or liabilities that the entity can access at the measurement date. Level 2 inputs are
inputs other than quoted prices included within Level 1 that are observable for the asset or
liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset
or liability.

Disclosure
An entity shall disclose information that helps users of its financial statements assess both
of the following:
(a) for assets and liabilities that are measured at fair value on a recurring or non-recurring
basis in the statement of financial position after initial recognition, the valuation
techniques and inputs used to develop those measurements.
(b) for recurring fair value measurements using significant unobservable inputs (Level 3),
the effect of the measurements on profit or loss or other comprehensive income for the
period
IFRS 7 Financial Instruments: Disclosures
The objective of this IFRS is to require entities to provide disclosures in their financial
statements that enable users to evaluate:

(a) the significance of financial instruments for the entitys financial position and
performance; and
(b) the nature and extent of risks arising from financial instruments to which the entity is
exposed during the period and at the end of the reporting period, and how the entity
manages those risks. The qualitative disclosures describe managements objectives,
policies and processes for managing those risks. The quantitative disclosures provide
information about the extent to which the entity is exposed to risk, based on
information provided internally to the entitys key management personnel. Together,
these disclosures provide an overview of the entitys use of financial instruments and
the exposures to risks they create.

The IFRS applies to all entities, including entities that have few financial instruments (e.g.
a manufacturer whose only financial instruments are accounts receivable and accounts
payable) and those that have many financial instruments (e.g. a financial institution most
of whose assets and liabilities are financial instruments). When this IFRS requires
disclosures by class of financial instrument, an entity shall group financial instruments
into classes that are appropriate to the nature of the information disclosed and that take
into account the characteristics of those financial instruments. An entity shall provide
sufficient information to permit reconciliation to the line items presented in the statement
of financial position. The principles in this IFRS complement the principles for
recognizing, measuring and presenting financial assets and financial liabilities in IAS 32
Financial Instruments: Presentation and IFRS 9 FinancialInstruments.
 AN OVERVIEW OF FINANCIAL REPORTING
WITHIN THE SCOPE OF
IFRS 7 FINANCIAL INSTRUMENTS: DISCLOSURES

0. INTRODUCTION

Financial instruments which have significant effects on an entitys financial statements while
reporting on their performance and financial position, have been defined as being any contract
which gives rise to a financial asset for one entity, whilst giving rise to another entitys
financial liability or equity instrument. Financial instruments consist of financial assets,
financial liabilities (debts) and contracts that include a right or a commitment on the financial
assets and financial liabilities (derivatives). Within the scope of the International Financial
Reporting Standards, there are 3 (three) standards which relate to financial instruments: IAS
32: Financial Instruments: Presentation, IAS 39: Financial Instruments: Recognition and
Measurements, IFRS 7: Financial Instruments: Disclosures. IAS 32 used to contain the
presentation and disclosure of financial instruments. However the disclosure of financial
instruments has been removed from IAS 32 as a result of the issuing of IFRS 7 on 1.1.2007.
Therefore in reference to the disclosure requirements, IFRS 7 has superseded IAS 32 and IAS
30: Disclosures in the Financial Statements of Banks and Similar Financial Institutions.

Whilst taking into account the presentation requirements of IAS 32 and the recognition and
measurement requirements of financial instruments according to IAS 39, the purpose of this
study is to examine the disclosure requirements of financial instruments according to IFRS 7.

1. IFRS AND FINANCIAL REPORTING

The aim of the International Financial Reporting Standards (IFRS) is to make all entities
present their financial performance and financial position fairly. The following modes of
financial reporting fall under the remit of the IFRS and must be disclosed (IAS 1: paragraph
8):

Balance Sheet (Financial Position Statement)

Income Statement

1

Cash Flow Statement

Statement of Change in Equity

Notes

Both financial reporting and activity reporting are significant when reporting on and
establishing an entitys value. As shown in Figure 1, financial reporting is one of the two
basic components used to establish an entitys value.

Enterprise Value
Reporting

Financial Reporting Operational Reporting

Balance Sheet (Financial Position Table)

A Statement of Changes in Equity

(Financial Performance Table)

Traditional Operational
Disclosures and Notes

Intellectual Capital
Cash Flow Statement

Reporting Reporting
Income Statement

IFRS

Figure 11: Components of Enterprise Value Reporting

There are two critical points concerning financial reporting according to the IFRS. One of
them is the technical language of the IFRS (SANCHEZ: 2006). This technical language
makes it difficult for non-expert financial statement users to reach the IFRS's financial
reporting standards. The other critical point is the immense challenge of understanding the
presentation and measurement principles of the IFRS unless the technical elements are fully
explained. (DAMANT: 2003:9).

1
Burgman, Roland; Roos Gran: The Importance of Intellectual Capital Reporting: Evidence and
Implication, Journal of Intellectual Capital, Vol 8, No 2, 2007, p.29 was utilized while preparing this figure.

2
As we can understand from disclosures, financial reporting is a tool that is used for
transferring an entitys financial information to the users of financial statements. As shown in
Figure 2, financial reports serve the users of financial statements:

USERS OF FINANCIAL STATEMENTS

INVESTORS

PUBLIC EMPLOYEES

Users
of
Financial
Statements
GOVERNMENT CREDITORS

CUSTOMERS SUPPLIERS

Figure 2: Users of Financial Statements

Financial reporting today focuses on the presentation, measurement and recognition of

financial events and also on the disclosure of these events to financial information users.
Therefore, financial reporting - which is primarily required to focus on the needs of the
financial information users - must continue to be improved especially on the subjects related
to the disclosures and notes. (MUNTER and ROBINSON: 1999: 8,9).

2. FINANCIAL INSTRUMENTS UNDER THE SCOPE OF THE IFRS

Financial Instruments Standard is a project which was developed in 1989 by a common study
group consisting of the International Accounting Standards Committee2 (IASC) and the
Canadian Institute of Chartered Accountants (CICA). Two draft copies of this study were
issued, and as a result of the reviews received on the last draft, it was decided that the project

2
The current name of International Accounting Standards Committee (IASC) is International Accounting
Standards Board (IASB).

3
would be separated into two different standards. As a result of this, IAS 32 Financial
Instruments: Presentation and Disclosures standard was issued in June 1995 and IAS 39
Financial Instruments: Recognition and Measurement standard was issued in December 1998.
Afterwards, following some amendments, IAS 32 and IAS 39s final scope was determined in
December 2003. (MISIRLIOLU: 2005: 3).

Due to these developments, the IASB removed the disclosures of financial instruments from
the scope of IAS 32 (IAS 30 for banks and similar financial institutions) and managed to
relocate them within another standard. IFRS 7 Financial Instruments: Disclosures standard
was effective from 1.1.2007 (IFRS 7: IN 8). Thus there are effectively 3 standards for the
reporting of financial instruments in financial statements:

IAS 32 Financial Instruments: Presentation

IAS 39 Financial Instruments: Recognition and Measurements

IFRS 7 Financial Instruments: Disclosures

Due to the IFRS's regulations concerning presentation, recognition and disclosures of

financial instruments, some basic changes are required for existing applications in the
countries of the European Union. These basic changes focus not only on the hedge accounting
applications, but also on the risk management of entities in order to successfully apply hedge
accounting. (MOORE: 2002: 22).

Financial instruments under the scope of the IFRS are shown in Figure 3:

4
 BALANCE SHEET AS OF
31.12.....
Active Passive

FINANCIAL ASSETS FINANCIAL LIABILITIES

Cash in Hand Financial Liabilities

Banks Trade Payables
Cheques Received Marketable Securities Issued
Customers Deposits (for Banks)
Notes Receivable
Marketable Securities
Loans (for Banks)

DERIVATIVES

Forward Contracts
Options Contracts
Futures Contracts
Swap Contracts
Commodity Contracts

Figure 3: Financial Instruments

Financial instruments are defined in IAS 32 as follows: Any contract that gives rise to a
financial asset of one entity and a financial liability or equity instrument of another entity.
As the definition implies, financial instruments are not only recognised instruments but they
can also cover some unrecognised contracts which contain certain conditions (DYCKMAN ve
dierleri: 1998: 674). Unrecognised financial instruments include those that do not fall under
the scope of IAS 39 but under that of the IFRS (eg, loan contracts) (EBSTEIN ve
JERMAKOWICZ: 2007: 165).

Example: Because of the positive conditions (eg. the pre-determined interest rate is less than
the interest rate on the date of maturity) a bank could have issued a letter of credit that
obligates cash payment to a customer. In this situation, although the letter of credit is not
recognised as a receivable for the entitys assets or as a debt to the entitys liabilities, it must
be evaluated as a financial instrument.

5
In parallel with the development of financial markets, the amount of these kinds of financial
instruments is increasing. Interest rate exchange contracts and maturity contracts, which have
been used frequently in recent years, are classed as these type of financial instruments.
The scope of financial instruments in the IFRS is quite wide. Any asset, liability and
derivative that is appropriate to the definition of a financial instrument is recognised and
reported according to IAS 32, IAS 39 and IFRS 7.

Table 13: Financial instruments within and out of the scope of IAS 32, IAS 39 and IFRS 7
Within the scope of IAS 32, IAS 39 and IFRS 7 Out of scope
Investment in subsidiaries (IAS 27)
Debt and equity investments Investments in associates (IAS 28)
Joint ventures (IAS 31)
Loans and receivables
Tax balances(IAS 12)
Own debt
Employee benefits (IAS 19)
Cash and cash equivalents
Derivatives for example:

Forward Contracts

Options Contracts

Futures Contracts
Own use commodity contracts

Swap Contracts

Commodity Contracts

Credit Derivatives

Derivatives on subsidiaries, associates and joint ventures

Embedded derivatives
Loan commitments held for trading Other loan commitments

Financial guarantees Insurance contracts (IFRS 4)

2.1. FINANCIAL ASSETS

2.1.1. Definition of Financial Assets

A financial asset that falls within the scope of IAS 32 is any asset that is either; cash, an
equity instrument of another entity, a contractual right to exchange financial instruments with
another entity or a contract that will or may be settled in the entitys own equity instruments
(IAS 32: paragraph 11).
3
This table was prepared by using the information in PRICEWATERHOUSECOOPERS: Financial
Instruments Under UFRS , 2006, p.4,5 .

6

Cash: Entitys cash in hand and in banks.
Cash in hand
Banks

An Equity Instrument of Another Entity: A contract that gives an entity the right to buy
the financial instruments of another entity, is defined as a financial asset. This kind of
financial asset is not classed as assets or liabilities of an entity, but as derecognised financial
assets that are called derivatives.

Generally, it is not difficult for entities to assess whether or not a financial asset should be
derecognised. But in some cases the derecognition decision for financial assets can be less
obvious. For example; if an entity sells its portfolio of trade receivables in order to earn
financial gain, then it would be less obvious whether or not those financial assets should be
derecognised (PWC: 2006: 14).

A Contractual Right to Exchange Financial Instruments With Another Entity: This

can be a contractual right which allows an entity to receive cash or another financial asset
from another company, or it can be the right to exchange financial assets and financial
liabilities with another entity under conditions which are potentially favourable to the entity.

A Contract That Will or May Be Settled In The Entitys Own Equity Instruments: A
contractual right for one entity to buy another entitys equity instruments. Common stock is
the most common of these financial instruments. Other than common stock, preferred stocks
issued by an entity are also a financial asset (MISIRLIOLU: 2005 : 4).

2.1.2. Classification and Measurement of Financial Assets

IAS 39 classifies financial assets into four groups (IAS 39: paragraph 9). The financial assets
that are defined in IAS 39 can be called passive investments. Passive investments are
financial investments upon which investors do not exert any effect (EPSTEIN and MIRZA:
2003).

7

Fair Value Through Profit or Loss: These are evaluated by fair value and the
difference of the fair value is reported on the income statement.

Held-To-Maturity Investments : These are evaluated by amortised cost.

Loans and Receivables : These are evaluated by amortised cost.

Available-For-Sale Finacial Assets : These are evaluated by fair value and the
difference of the fair value is reported on the equity.

2.2. FINANCIAL LIABILITIES

2.2.1. Definition of Financial Liabilities

Within the scope of IAS 32, a financial liability is a contractual obligation to deliver cash or
another financial asset to another entity. It could also be a contract that will or may be settled
in the entitys own equity instruments (IAS 32: paragraph 11).

A Contractual Obligation to Deliver Cash or a Financial Asset: A contract that

gives an entity the right to pay its debt by delivering cash or financial asset to another
entity. The instruments that are in the short and long-term liabilities are as follows:
Financial Liabilities
Trade Payables

Equity Instrument: A contract that shows a residual interest in the assets of an entity
after deducting all of its liabilities (IAS 32: paragraph 11).

2.2.2. Classification and Measurement of Financial Liabilities

IAS 32 establishes principles for distinguishing between liability and equity. An instrument is
a liability when the issuer is, or can be, required to deliver either cash or another financial
asset to the holder. This is the critical feature that distinguishes a liability from an equity. All
relevant features need to be considered when classifying a financial instrument. For example:
(PWC: 2006: 6).

8

If the issuer can, or will, be forced to redeem the instrument, classification as a
liability is appropriate.

If the choice of settling a financial instrument in cash or otherwise is contingent on the
outcome of circumstances beyond the control of both the issuer and the holder, the
instrument is a liability as the issuer does not have an unconditional right to avoid
settlement.

An instrument which includes an option for the holder to give the inherent rights in
that instrument back to the issuer for cash or another financial instrument is a liability.

In addition, the treatment of interest, dividends, losses and gains in the income statement
follows the classification of the related instrument.

Not all instruments can be classified as either debt or equity. Some, known as compound
instruments, contain elements of both in a single contract. For example bonds, which are
convertible into equity shares either mandatorily or at the option of the holder, must be split
into liability and equity components. Each is then accounted for separately. The liability
element is determined first, by a fair valuation of the cash flow excluding any equity
component, and the residual is assigned to equity (IAS 32: paragraph 28).

Table 2 illustrates the decision process which determines whether an instrument is a financial
liability or equity instrument:

9
Table 24: Determining if a Financial Instrument is a Financial Liability or Not
Cash
Cash Settlement
obligation for
Instrument obligation for in fixed number Classification
coupon/
principal of shares
dividends

Ordinary shares Equity

_ _ n/a

Redeemable
preference shares
with fixed
dividend each
Liability
year subject to + + _
availability of
distributable
profits

Redeemable Liability for

preference shares principal and
with discretionary + + _ equity for
dividends dividends

Convertible bond
Liability for bond
which converts
and equity for
into fixed number + + +
conversion option
of shares

Convertible bond
which converts
into shares to Liability
+ + _
the value of the
liability

Financial liabilities are classified and evaluated as follows:

Fair Value Through Profit or Loss : These are evaluated by fair value and the
difference of fair value is reported on the income statement.

Held-To-Maturity Financial Liabilities : These are evaluated by amortised cost.

2.3. DERIVATIVE FINANCIAL INSTRUMENTS

2.3.1. Definition of Derivative Financial Instruments

Derivative financial instruments serve to create rights and obligations which permit the
transference (between the parties and the instrument) of one or more of the financial risks

4
This table was prepared by using the information in PRICEWATERHOUSECOOPERS: Financial
Instruments Under UFRS , 2006, p.7.

10
inherent in an underlying primary financial instrument (IAS 32: AG 15-16). When a
derivative financial instrument gives one party a choice over how it should be settled, it is
classed as a financial asset or a financial liability, unless all of the settlement alternatives
would result in it being an equity instrument (IAS 32: paragraph 26).

The most common derivative financial instruments can be defined as follows:

Forward Contract : When an entity buys a forward contract, it writes a contract on that day at
a stated price but pays no cash for a promised future delivery of the underlying asset at a
specified time and place in the future. At the time of delivery the entity receives the asset
purchased and pays the contract price. The entitys profit (or loss) on the delivery date is the
difference between the market value of the asset and the contract price (COPELAND and
WESTON: 1992: 300, 301).

Futures Contracts: Forward and futures contracts are similar. The only difference is the daily
settled price of futures contracts. In fact, forward and futures contracts are very common in
daily life. For example, when an entity buys a car that will be delivered in six months, the
entity is in effect buying a future contract (COPELAND and WESTON: 1992: 301).

Swap Contracts: Swap contracts are the contracts used to exchange interest or foreign
currency between firms. An interest rate swap is a contract between firms in which interest
payments are based on a notational principle amount that is itself never paid or received
(COPELAND and WESTON: 1992: 656). Foreign currency swap is a contract between firms
in which foreign currencies are exchanged according to a settled rate and conditions
(COPELAND and WESTON: 1992: 301).

Commodity Contracts : A contractual obligation to buy or sell a commodity at a certain price

on a pre-determined future date (http://www.kobifinans.com.tr/bilgi_merkezi/0217/9778; 30
March 2007).

2.3.2. Classification and Measurement of Derivative Financial Instruments

A derivative financial instrument must have all three of the following characteristics (IAS 39:
paragraph 9):

11

A financial instrument contracts value changes in response to certain parameters. The
parameters that provide value changes in the contract are; financial instrument price,
commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index etc.

When buying a contract of derivative financial instruments, initial net investment is

not usually required or, if an initial net investment is required, it will be lower than
would be required for other types of contracts.

Contracts of derivative financial instruments are settled at a future date.

As derivative financial instruments are the contracts that are held to achieve profit, they
should be characterized as financial instruments held for trading. Therefore they are evaluated
by fair value.

3. DISCLOSURES AND NOTES

It is necessary for entities to provide information to their shareholders and to disclose

information by applying some specific regulatory authority. Moreover, listed companies tend
to disclose more than the legally required amount of information in their annual reports by
considering the positive effect that this may have on their image and company name.

However, there is some information that companies do not want to disclose. This concerns
the trade secrecy. Basically, trade secrecy is based on the assumption that exposing certain
information will be disadvantageous for the company. For example, a company does not want
its rivals to have detailed information about a new product that will be put on the market in
the future. Similarly, a company also does not want its customers to learn the unit cost of its
products and as a result the company's profit (BENDREY and others: 2005: 22).

In order to present financial statements in a fair manner, the IFRS requires that the
presentation of financial statements includes additional information, disclosures and the
exposition of some qualitative information. According to the IFRS, the disclosures relating to
the financial statements of entities are disclosed through the notes section.

12
Due to the IFRS, 'notes' contain additional information relating to the balance sheet, the
income statement, the statement of change in equity and the cash flow statement. These 'notes'
provide narrative descriptions or disaggregations of items disclosed in those statements and
gives information about items which does not qualify for recognition in those statements (IAS
1: paragraph 11).

4. IFRS 7 FINANCIAL INSTRUMENTS: DISCLOSURES

IFRS 7 incorporates the disclosures relating to the financial instruments within the scope of
IAS 32 Financial Instruments: Disclosures and Presentation and replaces IAS 30 Disclosures
in the Financial Statements of Banks and Similar Financial Institutions. Thus the disclosures
of all financial instruments and for all types of entities are located in a single standard. The
disclosure requirements contained in IFRS 7 are less prescriptive than those for banks which
are found in IAS 30 and there are no longer any bank-specific disclosure requirements.

All the disclosures of IFRS 7, except the risk disclosures, must be a part of the financial
instruments according to the minimum disclosure requirement of the materiality concept of
IAS 1 Presentation of Financial Statements. The qualitative and quantitative risk disclosures
required by IFRS 7 may be provided in the financial statements or incorporated by reference
from the financial statements to another statement.

IFRS 7 basically presents the following information: (McDONNELL: 2006: 24):

Required balance sheet and income statement disclosures by categories (eg.

instruments held for trading or held-to-maturity)

Information relating to the provisions of impared assets

Additional information about fair value of collateral and other credit enhancements
used to manage credit risk

Market risk sensitivity analyses

13
4.1. SCOPE OF IFRS 7

IFRS 7 takes into consideration all risks arising from all financial instruments, including those
instruments that are not recognised on a balance sheet. However there are no exceptions for
small and medium sized entities in IFRS 7 and the IASB also considers this issue in reference
to the financial reporting project for small and medium sized entities (PACKER: 2006).

IFRS 7 disclosures must be presented based on the accounting policies that are harmonious
with the IFRS including consolidation adjustments. Internal information which is required for
risk management purposes cannot be prepared using these accounting policies. Thus it must
be amended accordingly.

IFRS 7 does not cover the following issues (other than the exceptions in the standard) (IFRS
7: paragraph 3):

Interest in subsidiaries, associates and joint ventures that are recognised within the
scope of IAS 27 Consolidated and Separate Financial Statements, IAS 28 Investments
in Associates and IAS 31 Interest in Joint Ventures,

Employees' rights and obligations arising from employee benefits plans within the
scope of IAS 19 Employee Benefits,

Contracts for contingent payments in business combinations,

Insurance contracts as defined in IFRS 4 Insurance Contracts,

Financial instruments, contracts and obligations under share-based payment
transactions to which IFRS 2 Share-Based Payment applies, except that this IFRS does
apply to contracts within the scope of paragraphs 57 of IAS 39.

4.2. BALANCE SHEET DISCLOSURES OF IFRS 7

IFRS 7 does not prescribe the location of the required balance sheet disclosures. An entity can
either present the required disclosures on the face of the balance sheet or in the notes for
financial statements. According to IFRS 7, an entity is permitted to classify financial
instruments which are appropriate to the nature of the information disclosed and the
characteristics of the instruments.

14
IFRS 7 requires additional detailed information for each of the financial asset and liability
categories.

4.2.1. Loans and Receivables at Fair Value Through Profit or Loss

As a result of the IAS 39 fair value option amendment, IFRS 7 includes disclosure
requirements for loans and receivables at fair value through profit or loss, as introduced in
IAS 32. These include the maximum credit exposure, the impact of credit derivatives on the
credit exposure, the change in the fair value of the loan and receivable, and any related credit
derivatives due to changes in credit risk, both during the period and cumulatively since
designation (IFRS 7: paragraph 9).

4.2.2. Financial Liabilities at Fair Value Through Profit or Loss

IFRS 7 contains the requirement from IAS 32 that disclosures concerning the change of the
fair value of a financial liability due to credit risk must be included, as introduced as part of
the amendment to IAS 39 for the fair value option. In addition, IFRS 7 also requires the
disclosure of the particular method used in order to determine the change in the fair value due
to credit risk. Unless an alternative method gives a better approximation, entities are required
to use the methodology described in IFRS 7 (IFRS 7: paragraph 10).

4.2.3. Other Miscellaneous Balance Sheet Disclosures

Derecognition: Certain information is required when all or a part of the transferred

financial assets do not qualifiy for derecognition.

Collateral given: In addition to the terms and conditions of financial assets pledged as
collateral, disclosure relating to the carrying amount is also required.

Collateral received: An entity must disclose the fair value, terms and conditions of
assets received as collateral which the entity has right to sell or repledge in the absence
of default.

15

Allowance for credit losses: While IAS 30 requires only disclosure of loans and
advances, IFRS 7 requires disclosure of reconciliation of the allowances for credit
losses for all financial assets.

Compound financial instruments with multiple embedded derivatives: Disclosure must

consist of the existence of multiple embedded derivatives whose values are
interdependent (eg, callable convertible debt)

Defaults and breaches: Disclosure is required for the details and carrying amounts of
liabilities that are in default.

4.3. INCOME STATEMENT DISCLOSURES OF IFRS 7

Similar to the balance sheet disclosures, an entity is permitted to present the required
disclosures either on the face of the income statement or in the notes for the financial
statements. Although the income statement disclosures that are required by IFRS 7 are not
detailed as the requirements of IAS 30, they are more prescriptive than those required in IAS
32. For example, IAS 32 only requires a separate disclosure of the net gains or net losses of
financial instruments carried at fair value through profit or loss, whereas IFRS 7 requires the
disclosure of this information for all categories of financial assets and financial liabilities.

4.3.1. Income Statement Disclosures Defined by IFRS 7

IFRS 7 basically contains the following income statement disclosures (IFRS 7: paragraph 20):

Net profit or loss for each category of financial assets and liabilities

Impairment losses for each category of financial assets

Total interest income and total interest expense (calculated using the effective interest
method) for financial assets and liabilities not measured at fair value through profit or
loss

Fee income and expense arising from trust and other fiduciary activities that result in
the holding or investing of assets on behalf of individuals, trusts, retirement benefit
plans, and other institutions.

16
4.3.2. Other Income Statement Disclosures Defined by IFRS 7

4.3.2.1. Accounting policies

IAS 1 requires a disclosure for certain accounting policies of an entity. But IFRS 7 requires
specific disclosures of certain policies relating to financial instruments. IFRS 7's application
guide provides more specific guidelines for the required accounting policies. IFRS 7 presents
disclosures based on the criteria of the following issues:

Designating financial assets and financial liabilities according to fair value through
profit or loss,

Designating financial assets as held-for-sale

Using an allowance account (eg, bad debt reserve).

4.3.2.2.Hedge Accounting

IFRS 7 expands the scope of the required disclosures relating to the gain or loss on a hedging
instrument. IFRS 7 also presents the disclosures of the amount of ineffectiveness recognised
in profit or loss for cash flow hedges, hedges of net investments in foreign operations, and the
gain or loss on the hedging instrument and hedged item attributable to hedged risk for fair
value hedges (IFRS 7: paragraph 22, 23, 24).

Table 3 designates the hedge accounting disclosure requirements of IFRS 7:

Table 3: Hedge Accounting Disclosure Requirements of IFRS 7 (ERNST & YOUNG : 2006:
3).
Net
Fair Value Cash Flow
Disclosure Investments
Hedges Hedges
Hedges
Description of the hedged risk and hedging instrument with
X X X
related fair values
When hedged cash flows are expected to occur X
Forecast transaction no longer expected to occur X
Gain or loss recognized in equity and reclassifications to P&L X
Gain or loss from hedging instrument and hedged risk X
Ineffectiveness recognized in P&L (Profit and Loss) X X

17
4.3.2.3. Fair Value

IFRS 7 contains disclosures from IAS 32 relating to the methods and certain assumptions
used to determine a fair value for different categories of financial assets and financial
liabilities. Required disclosures must contain the following elements:

Whether fair value is based on a quoted price or a valuation method,

Whether fair value is based on a valuation method that includes assumptions not
supported by market prices or rates and the amount of profit recognised,

The effect of possible alternative assumptions that are used in a valuation method.

Although those can be answered with a qualitative analysis, it is agreed that a quantitative
analysis will be required for the value analysis of different categories of financial instruments
(ERNST & YOUNG : 2006: 3).

IAS 32 requires disclosure of the nature and carrying amount of financial assets whose fair
value cannot be realiably measured as well as the disclosure of the reason behind this
situation. IFRS 7 expands the IAS 32 requirement to include the way in which the entity
intends to dispose of such financial instruments.

4.4. RISKS ARISING FROM FINANCIAL INSTRUMENTS AND THEIR

DISCLOSURES

On the reporting date entities must disclose the quality and level of the risks arising from
financial instruments towards the users of financial statement. This information must be
presented appropriately so that the users may evaluate it. IFRS 7 focuses on those risks (credit
risk, liquidity risk, market risk) arising from financial instruments and requires the disclosure
of how an entity manages those risks (MIRZA and others: 2007: 376).

4.4.1. Risk Disclosures

4.4.1.1. Qualitative Risk Disclosures

IFRS 7 demands qualitative disclosures, also required by IAS 32, relating to the risks (credit
risk, liquidity risk, market risk) and also requires information on the objectives and policies

18
for managing such risks at a senior level within the company. IFRS 7 expands the required
disclosures in order to demand information on the methods used to manage and measure risk
by an entity (MIRZA and others: 2007: 377).

4.4.1.2. Quantitative Risk Disclosures

IFRS 7 expands the quantitative disclosures of IAS 32 which are based on the information
available to key management personnel of an entity which is disclosed to risk (IFRS 7:
paragraph 34). IFRS 7 requires the disclosure of the total of all risks (eg, location, currency,
economic condition etc.) and also demands to know how an entity determines those risks.

4.4.2. Risk Types

4.4.2.1. Credit Risk

IFRS 7 requires disclosure of the credit position of each financial instrument class before a
consideration of collateral or other credit enhancements received, disclosure of net value of
each impairment loss and the description of collateral or other credit enhancements available.
IFRS 7 considers the maximum credit exposure for loans and receivables, deposits placed and
derivative financial instruments that are evaluated by fair value (IFRS 7: paragraph 36). The
credit risk disclosures of IFRS 7 contain (IFRS 7: paragraph 37):

Information relating to the credit quality of overdue or impaired financial assets,

Definition and fair value of collateral held by the entity as security and other credit
enhancements,

Collateral of which the entity has taken control.

Disclosure of financial assets that are overdue at the reporting date but that are not impaired is
very important for many entities. Overdue information may not be readily available or it may
not be captured by an entitys credit system until such time that it becomes overdue by a
critical amount of time (ERNST & YOUNG : 2006: 4).

19
4.4.2.2. Liquidity Risk

Although IAS 30 requires banks to disclose contractual maturity information relating to both
financial assets and financial liabilities, IFRS 7 does not require the disclosure of contractual
maturity information of financial assets because it is less prescriptive (IFRS 7: paragraph 39).
Financial liabilities must be disclosed by contractual maturity based on undiscounted cash
flows that may or may not be consistent with the internal information available for
management. One of the difficulties of the preparation of maturity analysis is the derivative
financial instruments that normally involves a series of cash flows. The application guidance
in IFRS 7 determines that net amounts must be included in the analysis for pay float/receive
fixed interest rate swaps for each contractual maturity category when gross cash flows are
exchanged. Therefore, contractual amounts to be exchanged in a derivative financial
instrument (eg. currency swap) should be included in the maturity analysis that is based on
gross cash flows (IFRS 7: B 14).

The application guidance in IFRS 7 recommends that time frames should be used while
preparing a contractual maturity analysis for financial liabilities. IFRS 7 expands the liquidity
risk disclosures by including the description of how liquidity risks are managed (MIRZA and
others: 2007: 377).

4.4.2.3. Market Risk

An entity should present disclosures relating to sensitivity analysis of its market risk. Those
disclosures should include the effect of risk on the financial statements, techniques and
assumptions used in sensitivity analysis (EBSTEIN and JERMAKOWICZ: 2007: 171). IFRS
7 requires the disclosure of market risk sensitivity analysis and demands the addition of the
effects of reasonably possible changes in risk variables on the balance sheet date and also
information on the techniques and assumptions used in analysis (IFRS 7: paragraph 40).
Market risk is defined as the chance that the fair value or future cash flows of financial
instruments will fluctuate because of changes in market prices and this includes interest rate
risk, foreign currency risk and other price risk (IFRS 7: Appendix A). IFRS 7s application
guide provides information relating to reasonably possible change and contains the following
information:

20

Economic environment in which the entity operates

Reasonably possible changes over the next reporting period

Market risk contains three types of risk (EBSTEIN and JERMAKOWICZ: 2007: 154):

Currency (foreign exchange) risk: The risk arises on the value of financial instruments due
to the effect of reasonably possible changes in foreign currency

Interest rate risk: The risk arises on the value of financial instruments due to the effect of
reasonably possible changes in market interest rates

Price risk: The risk arises on the value of financial instruments due to the effect of marketable
security transactions in similar markets and other factors.

5. CONCLUSION

Classification, measurement, recognition and disclosures of financial instruments are

comprehensive and detailed subjects of the IFRS. The standards related to the financial
instruments within the scope of the International Financial Reporting Standards are; IAS 32:
Financial Instruments: Presentation, IAS 39: Financial Instruments: Recognition and
Measurements, IFRS 7: Financial Instruments: Disclosures. IFRS 7 Financial Instruments:
Disclosures is the only standard that arranges the disclosures relating to financial instruments
but it would not be sufficient to research only this standard and not take into consideration the
classification, measurement and recognition of financial instruments. Therefore this study has
considered the subject of financial instruments as a whole and all the standards which relate to
financial instruments were summarized as simply as possible.

IFRS 7 superseded the disclosure requirements of IAS 32 and IAS 30: Disclosures in The
Financial Statements of Banks and Similar Financial Institutions on 1.1.2007. Financial
instruments consist of financial assets, financial liabilities and derivative financial
instruments. The purpose of the IFRS is to guide the preparation of financial statements and
notes in order to present all the information needed by the users of financial statements
(information). In the same way, the requirements of IFRS 7 are concentrated on the
information relating to financial instruments in order to make it more evident.

21
Financial instruments have an important place within the assets and liabilities of an entity as
well as in its income statement. An entity's related parties require detailed disclosures on
classification and measurement of financial instruments, risks that may arise from them, how
the entity manages those risks and the specific types of risks. This information is necessary
because the purpose of an entity's related parties is to evaluate not only the quantitative risks
but also the qualitative risks, and ultimately make the correct decisions about the entity.

Difficulties occur in the measurement of financial instruments rather than in their

classification. Those difficulties arise from the measurement of the fair value of the
instruments. A measurement of fair value requires some calculations for those financial
instruments that do not have an active market and the entity should disclose its accounting
policies and assumptions relating to measurement methods in accordance with the IFRS.

As IFRS 7 has only been effective since the beginning of 2007, criticism concerning the
difficulties and the complicated elements of the standard is possible. However, it is apparent
that those difficulties and problems can be solved by combining academic information and
practical experiences.

22
6. REFERENCES

AKDOAN, Nalan; SEVLENGL, Orhan: Trkiye Muhasebe Standartlar ile Uyumlu

Tekdzen Muhasebe Sistemi Uygulamas, SMMMO Yayn No:83, 13. Bask, 2007

AKDOAN, Nalan: IAS 39 Nolu Standart Hkmlerine Gre Menkul Kymetler ve

Finansal Duran Varlk lemlerinde Uygulanacak Muhasebe Politikalar, Gazi
niversitesi BF Dergisi, 3/2001

BENDREY, Mike; HUSSEY Roger; WEST, Colston: Essentials of Financial Accounting in

Business, Thomson Learning, London 2005

BURGMAN, Roland; ROOS Gran: The Importance of Intellectual Capital Reporting:

Evidence and Implication, Journal of Intellectual Capital, Vol 8, No 2, 2007

COPELAND, Thomas E.; WESTON, J. Fred: Financial Theory and Corporate Policy,
Addison-Wesley Publishing Company, 1992

DAMANT, David: Accounting Standards-A New Era, Balance Sheet, Vol 11, No 1, 2003

DELOITTE : IFRS 7 Financial Instruments: Disclosures A Disclosure Checklist, 2006

DYCKMAN , Thomas R.; DUKES, Ronald E.; DAVIS Charles J.: Intermediate
Accounting, Mc Graw-Hill, International Edition, 1998

EPSTEIN, Bary J.; JERMAKOWICZ, Eva K.: IFRS 2007: Interpretation and Application
of International Financial Reporting Standards, John Wiley & Sons Editions, 2007

EPSTEIN, Barry J.; MIRZA, Ali Abbas : IAS 2003: Interpretation and Application of
International Accounting Standards , John Wiley & Sons Editions, 2003

ERNST & YOUNG : IFRS 7 Financial Instruments: Disclosures, 2006

McDONNELL, John: IFRS-a step towards Basel II and Solvency II Implementation,

Accountancy Ireland, ABI/INFORM Global, 38-1, 2006

23
MIRZA, Ali Abbas; HOLT, Graham J.; ORRELL, Magnus: International Financial
Reporting Standards- Workbook and Guide, John Wiley & Sons Editions, 2007

MISIRLIOLU, Ufuk: Finansal Aralarn Finansal Tablolara Alnmas ve

Deerlemesine likin Temel lkeler, Muhasebe Bilim Dnyas Dergisi (MDAV), Mart
2005

MOORE, Richard: Accounting for Financial Instruments Under UMS (TMS): The
European Dimension, Balance Sheet, (http://www.emeraldinsight.com/0965-7667.htm)

MUNTER, Paul; ROBINSON, Thomas: Financial Reporting in the Twentieth Century:

Where Have We Been, and Where Are We Going?, The Journal of Corporate Accounting
and Finance/Autumn 1999

PACTER, Paul: Accounting Standards for SMEs, 17.World Congress of Accountants,

November 2006

PRICEWATERHOUSECOOPERS: Financial Instruments Under UFRS (TFRS), 2006

SANCHEZ-Y-MADRID, Manuel : International Standards Implementation: Challenges

and Solutions, 17.World Congress of Accountants, November 2006

TRKYE MUHASEBE STANDARTLARI: Uluslararas Finansal Raporlama

Standartlar (IFRS/IAS) ile Uyumlu Trkiye Muhasebe Standartlar, Trkiye Muhasebe
Standartlar Kurulu Yaynlar, 2006

24
International Financial Reporting Standards

International Financial Reporting Standards (IFRS) are principles-based standards, interpretations

and the framework (1989) adopted by the International Accounting Standards Board (IASB). Many of
the standards forming part of IFRS are known by the older name of International Accounting
Standards (IAS). IAS was issued between 1973 and 2001 by the Board of the International
Accounting Standards Committee (IASC). On April 1, 2001, the new IASB took over from the IASC
the responsibility for setting International Accounting Standards. During its first meeting the new
Board adopted existing IAS and Standing Interpretations Committee standards (SICs). The IASB has
continued to develop standards calling the new standards IFRS.

Structure of IFRS

IFRS are considered a "principles based" set of standards in that they establish broad rules as well
as dictating specific treatments.

International Financial Reporting Standards comprise:

International Financial Reporting Standards (IFRS)2 standards issued after 2001

International Accounting Standards (IAS)2 standards issued before 2001
Standing Interpretations Committee (SIC)2 issued before 2001
Conceptual Framework for Financial Reporting (2010)

IAS 8 Par. 11

"In making the judgment described in paragraph 10, management shall refer to, and consider the
applicability of, the following sources in descending order:

(a) the requirements and guidance in Standards and Interpretations dealing with similar and related
issues; and

(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and
expenses in the Framework."

Framework

The Framework for the Preparation and Presentation of Financial Statements states basic principles
for IFRS. (The framework provided in this link is a version issued by Australia, and is partly out-of-
date.)
The IASB and FASB Frameworks are in the process of being updated and converged. The Joint
Conceptual Framework project aims to update and refine the existing concepts to reflect the
changes in markets, business practices and the economic environment that have occurred in the two
or more decades since the concepts were first developed.

Role of framework

In the absence of a Standard or an Interpretation that specifically applies to a transaction,

management must use its judgment in developing and applying an accounting policy that results in
information that is relevant and reliable. In making that judgment, IAS 8.11 requires management to
consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income,
and expenses in the Framework. This elevation of the importance of the Framework was added in the
2003 revisions to IAS 8.

Objective of financial statements

A financial statement should reflect true and fair view of the business affairs of the organization. As
these statements are used by various constituents of the society / regulators, they need to reflect true
view of the financial position of the organization. It is very helpful to check the financial position of the
business for a specific period.

IFRS authorize three basic accounting models:

I. Current Cost Accounting, under Physical Capital Maintenance at all levels of inflation and deflation
under the Historical Cost paradigm as well as the Capital Maintenance in Units of Constant
Purchasing Power paradigm. (See the Conceptual Framework, Par. 4.59 (b).)

II. Financial capital maintenance in nominal monetary units, i.e., globally implemented Historical cost
accounting during low inflation and deflation only under the traditional Historical Cost
paradigm.(See the original Framework (1989), Par 104 (a))[now Conceptual Framework (2010), Par.
4.59 (a)].

III. Financial capital maintenance in units of constant purchasing power, i.e., Constant Item
Purchasing Power Accounting @ CIPPA @ in terms of a Daily Consumer Price Index or daily rate at
all levels of inflation and deflation (see the original Framework (1989), Par 104 (a)) [now
Conceptual Framework (2010), Par. 4.59 (a)] under the Capital Maintenance in Units of Constant
Purchasing Power paradigm and Constant Purchasing Power Accounting @ CPPA @ (see IAS 29)
during hyperinflation under the Historical Cost paradigm.
The following are the three underlying assumptions in IFRS:

1. Going concern: an entity will continue for the foreseeable future under the Historical Cost
paradigm as well as under the Capital Maintenance in Units of Constant Purchasing Power
paradigm. (See Conceptual Framework, Par. 4.1)

2. Stable measuring unit assumption: financial capital maintenance in nominal monetary units or
traditional Historical cost accounting only under the traditional Historical Cost paradigm; i.e.,
accountants consider changes in the purchasing power of the functional currency up to but
excluding 26% per annum for three years in a row (which would be 100% cumulative inflation
over three years or hyperinflation as defined in IAS 29) as immaterial or not sufficiently
important for them to choose Capital Maintenance in units of constant purchasing power in
terms of a Daily Consumer Price Index or daily rate Constant Item Purchasing Power
Accounting at all levels of inflation and deflation as authorized in IFRS in the original
Framework(1989), Par 104 (a) [now Conceptual Framework (2010), Par. 4.59 (a)].

Accountants implementing the stable measuring unit assumption (traditional Historical Cost
Accounting) during annual inflation of 25% for 3 years in a row would erode 100% of the real value of
all constant real value non-monetary items not maintained constant under the Historical Cost
paradigm.

3. Units of constant purchasing power: capital maintenance in units of constant purchasing

power at all levels of inflation and deflation in terms of a Daily Consumer Price Index or daily
rate (Constant Item Purchasing Power Accounting) only under the Capital Maintenance in
Units of Constant Purchasing Power paradigm; i.e. the total rejection of the stable measuring
unit assumption at all levels of inflation and deflation. See The Framework (1989), Paragraph
104 (a) [now Conceptual Framework (2010), Par. 4.59 (a)]. Capital maintenance in units of
constant purchasing power under Constant Item Purchasing Power Accounting in terms of a
Daily Consumer Price Index or daily rate of all constant real value non-monetary items in all
entities that at least break even in real value at all levels of inflation and deflation - ceteris
paribus - remedies for an indefinite period of time the erosion caused by Historical Cost
Accounting of the real values of constant real value non-monetary items never maintained
constant as a result of the implementation of the stable measuring unit assumption at all levels
of inflation and deflation under HCA.

It is not inflation doing the eroding. Inflation and deflation have no effect on the real value of non-
monetary items.[3] It is the implementation of the stable measuring unit assumption, i.e., traditional
HCA which erodes the real value of constant real value non-monetary items never maintained
constant in a double entry basic accounting model.

Constant real value non-monetary items are non-monetary items with constant real values over time
whose values within an entity are not generally determined in a market on a daily basis.

Examples include borrowing costs, comprehensive income, interest paid, interest received, bank
charges, royalties, fees, short term employee benefits, pensions, salaries, wages, rentals, all other
income statement items, issued share capital, share premium accounts, share discount accounts,
retained earnings, retained losses, capital reserves, revaluation surpluses, all accounted profits and
losses, all other items in shareholders equity, trade debtors, trade creditors, dividends payable,
dividends receivable, deferred tax assets, deferred tax liabilities, all taxes payable, all taxes
receivable, all other non-monetary payables, all other non-monetary receivables, provisions, etc.

All constant real value non-monetary items are always and everywhere measured in units of constant
purchasing power at all levels of inflation and deflation under CIPPA in terms of a Daily CPI or daily
rate under the Capital Maintenance in Units of Constant Purchasing Power paradigm. The constant
item gain or loss is calculated when current period constant items are not measured in units of
constant purchasing power.

Monetary items are units of money held and items with an underlying monetary nature which are
substitutes for units of money held.

Examples of units of money held are bank notes and coins of the fiat currency created within an
economy by means of fractional reserve banking. Examples of items with an underlying monetary
nature which are substitutes of money held include the capital amount of: bank loans, bank savings,
credit card loans, car loans, home loans, student loans, consumer loans, commercial and
government bonds, Treasury Bills, all capital and money market investments, notes payable, notes
receivable, etc. when these items are not in the form of money held.

Historic and current period monetary items are required to be inflation-adjusted on a daily basis in
terms of a daily index or rate under the Capital Maintenance in Units of Constant Purchasing Power
paradigm. The net monetary loss or gain as defined in IAS 29 is required to be calculated and
accounted when they are not inflation-adjusted on a daily basis during the current financial period.
Inflation-adjusting the total money supply (excluding bank notes and coins of the fiat functional
currency created by means of fractional reserve banking within an economy) in terms of a daily index
or rate under complete co-ordination would result in zero cost of inflation (not zero inflation) in only
the entire money supply (as qualified) in an economy.

Variable real value non-monetary items are non-monetary items with variable real values over time.
Examples include quoted and unquoted shares, property, plant, equipment, inventory, intellectual
property, goodwill, foreign exchange, finished goods, raw material, etc.

Current period variable real value non-monetary items are required to be measured on a daily basis
in terms of IFRS excluding the stable measuring unit assumption and the cost model in the valuation
of property, plant, equipment and investment property after recognition under the Capital
Maintenance in Units of Constant Purchasing Power paradigm. When they are not valued on a daily
basis, then they as well as historic variable real value non-monetary items are required to be updated
daily in terms of a daily rate as indicated above. Current period impairment losses in variable real
value non-monetary items are required to be treated in terms of IFRS. They are constant real value
non-monetary items once they are accounted. All accounted losses and profits are constant real
value non-monetary items.

Under the Capital Maintenance in Units of Constant Purchasing Power paradigm daily measurement
is required of all items in terms of

(a) a Daily Consumer Price Index or monetized daily indexed unit of account, e.g. the Unidad de
Fomento in Chile, during low inflation, high inflation and deflation and

(b) in terms of a relatively stable foreign currency parallel rate (normally the US Dollar daily parallel
rate) or a Brazilian-style Unidade Real de Valor daily index during hyperinflation. Hyperinflation is
defined in IAS 29 as cumulative inflation being equal to or approaching 100 per cent over three years,
i.e. 26 per cent annual inflation for three years in a row.

Qualitative characteristics of financial statements

Qualitative characteristics of financial statements include:

Relevance (Materiality)
Faithful representation

Enhancing qualitative characteristics include:

Comparability
 Verifiability
Timeliness
Understandability

Elements of financial statements (IAS 1 article 10)

The financial position of an enterprise is primarily provided in the Statement of Financial

Position. The elements include:
o Asset: An asset is a resource controlled by the enterprise as a result of past events
from which future economic benefits are expected to flow to the enterprise.
o Liability: A liability is a present obligation of the enterprise arising from the past
events, the settlement of which is expected to result in an outflow from the
enterprise' resources, i.e., assets.
o Equity: Equity is the residual interest in the assets of the enterprise after deducting
all the liabilities under the Historical Cost Accounting model. Equity is also known
as owner's equity. Under the units of constant purchasing power model equity is
the constant real value of shareholders equity.
The financial performance of an enterprise is primarily provided in the Statement of
Comprehensive Income (income statement or profit and loss account). The elements of an
income statement or the elements that measure the financial performance are as follows:
o Revenues: increases in economic benefit during an accounting period in the form
of inflows or enhancements of assets, or decrease of liabilities that result in
increases in equity. However, it does not include the contributions made by the
equity participants, i.e., proprietor, partners and shareholders.
o Expenses: decreases in economic benefits during an accounting period in the form
of outflows, or depletions of assets or incurrences of liabilities that result in
decreases in equity.

Revenues and expenses are measured in nominal monetary units under the Historical Cost
Accounting model and in units of constant purchasing power (inflation-adjusted) under the
Units of Constant Purchasing Power model.

Statement of Changes in Equity

Statement of Cash Flows
Notes to the Financial Statements
Recognition of elements of financial statements

An item is recognized in the financial statements when:

it is probable future economic benefit will flow to or from an entity.

the resource can be reliably measured @ otherwise the stable measuring unit assumption is
applied under the Historical Cost Accounting model: i.e. it is assumed that the monetary unit
of account (the functional currency) is perfectly stable (zero inflation or deflation); it is simply
assumed that there is no inflation or deflation ever, and items are stated at their original
nominal Historical Cost from any prior date: 1 month, 1 year, 10 or 100 or 200 or more years
before; i.e. the stable measuring unit assumption is applied to items such as issued share
capital, retained earnings, capital reserves, all other items in shareholders equity, all items
in the Statement of Comprehensive Income (except salaries, wages, rentals, etc., which are
inflation-adjusted annually), etc.

Under the Units of Constant Purchasing Power model, all constant real value non-monetary items are
inflation-adjusted during low inflation and deflation; i.e. all items in the Statement of Comprehensive
Income, all items in shareholders equity, Accounts Receivables, Accounts Payables, all non-
monetary payables, all non-monetary receivables, provisions, etc.

Measurement of the elements of financial statements

Par. 99. Measurement is the process of determining the monetary amounts at which the elements of
the financial statements are to be recognized and carried in the balance sheet and income statement.
This involves the selection of the particular basis of measurement.

Par. 100. A number of different measurement bases are employed to different degrees and in varying
combinations in financial statements. They include the following:

(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair
value of the consideration given to acquire them at the time of their acquisition. Liabilities are
recorded at the amount of proceeds received in exchange for the obligation, or in some
circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to
be paid to satisfy the liability in the normal course of business.

(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be
paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the
undiscounted amount of cash or cash equivalents that would be required to settle the obligation
currently.

(c) Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents that
could currently be obtained by selling the asset in an orderly disposal. Assets are carried at the
present discounted value of the future net cash inflows that the item is expected to generate in the
normal course of business. Liabilities are carried at the present discounted value of the future net
cash outflows that are expected to be required to settle the liabilities in the normal course of business.

Par. 101. The measurement basis most commonly adopted by entities in preparing their financial
statements is historical cost. This is usually combined with other measurement bases. For example,
inventories are usually carried at the lower of cost and net realizable value, marketable securities
may be carried at market value and pension liabilities are carried at their present value. Furthermore,
some entities use the current cost basis as a response to the inability of the historical cost
accounting model to deal with the effects of changing prices of non-monetary assets.

Concepts of capital and capital maintenance

A major difference between US GAAP and IFRS is the fact that three fundamentally different
concepts of capital and capital maintenance are authorized in IFRS while US GAAP only authorize
two capital and capital maintenance concepts during low inflation and deflation: (1) physical capital
maintenance and (2) financial capital maintenance in nominal monetary units (traditional Historical
Cost Accounting) as stated in Par 45 to 48 in the FASB Conceptual Statement N 5. US GAAP does
not recognize the third concept of capital and capital maintenance during low inflation and deflation,
namely, financial capital maintenance in units of constant purchasing power as authorized in IFRS in
the Framework, Par 104 (a) in 1989.

Concepts of capital

Par. 102. A financial concept of capital is adopted by most entities in preparing their financial
statements. Under a financial concept of capital, such as invested money or invested purchasing
power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of
capital, such as operating capability, capital is regarded as the productive capacity of the entity
based on, for example, units of output per day.

Par. 103. The selection of the appropriate concept of capital by an entity should be based on the
needs of the users of its financial statements. Thus, a financial concept of capital should be adopted
if the users of financial statements are primarily concerned with the maintenance of nominal invested
capital or the purchasing power of invested capital. If, however, the main concern of users is with the
operating capability of the entity, a physical concept of capital should be used. The concept chosen
indicates the goal to be attained in determining profit, even though there may be some measurement
difficulties in making the concept operational.

Concepts of capital maintenance and the determination of profit

Par. 104. The concepts of capital in paragraph 102 give rise to the following two concepts of capital
maintenance:

(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or
money) amount of the net assets at the end of the period exceeds the financial (or money) amount of
net assets at the beginning of the period, after excluding any distributions to, and contributions from,
owners during the period. Financial capital maintenance can be measured in either nominal
monetary units or units of constant purchasing power.

(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive
capacity (or operating capability) of the entity (or the resources or funds needed to achieve that
capacity) at the end of the period exceeds the physical productive capacity at the beginning of the
period, after excluding any distributions to, and contributions from, owners during the period.

The concepts of capital in paragraph 102 give rise to the following three concepts of capital during
low inflation and deflation:

(A) Physical capital. See paragraph 102&103

(B) Nominal financial capital. See paragraph 104.[4]
(C) Constant purchasing power financial capital. See paragraph 104.[5]

The concepts of capital in paragraph 102 give rise to the following three concepts of capital
maintenance during low inflation and deflation:

(1) Physical capital maintenance: optional during low inflation and deflation. Current Cost
Accounting model prescribed by IFRS. See Par 106.
(2) Financial capital maintenance in nominal monetary units (Historical cost accounting):
authorized by IFRS but not prescribed2optional during low inflation and deflation. See Par
104 (a) Historical cost accounting. Financial capital maintenance in nominal monetary units
per se during inflation and deflation is a fallacy: it is impossible to maintain the real value of
 financial capital constant with measurement in nominal monetary units per se during inflation
and deflation.
(3) Financial capital maintenance in units of constant purchasing power (Constant Item
Purchasing Power Accounting): authorized by IFRS but not prescribed2optional during low
inflation and deflation. See Par 104(a). IAS 29 is prescribed [6] during hyperinflation: i.e. the
restatement of Historical Cost or Current Cost period-end financial statements in terms of the
period-end monthly published Consumer Price Index.[7] Only financial capital maintenance
in units of constant purchasing power (CIPPA) per se can automatically maintain the real
value of financial capital constant at all levels of inflation and deflation in all entities that at
least break even in real value2ceteris paribus2for an indefinite period of time. This would
happen whether these entities own revaluable fixed assets or not and without the
requirement of more capital or additional retained profits to simply maintain the existing
constant real value of existing shareholders equity constant. Financial capital maintenance
in units of constant purchasing power requires the calculation and accounting of net
monetary losses and gains from holding monetary items during low inflation and deflation.
The calculation and accounting of net monetary losses and gains during low inflation and
deflation have thus been authorized in IFRS since 1989.

Par. 105. The concept of capital maintenance is concerned with how an entity defines the capital that
it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of
profit because it provides the point of reference by which profit is measured; it is a prerequisite for
distinguishing between an entityNs return on capital and its return of capital; only inflows of assets in
excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on
capital. Hence, profit is the residual amount that remains after expenses (including capital
maintenance adjustments, where appropriate) have been deducted from income. If expenses
exceed income the residual amount is a loss.

Par. 106. The physical capital maintenance concept requires the adoption of the current cost basis of
measurement. The financial capital maintenance concept, however, does not require the use of a
particular basis of measurement. Selection of the basis under this concept is dependent on the type
of financial capital that the entity is seeking to maintain.

Par. 107. The principal difference between the two concepts of capital maintenance is the treatment
of the effects of changes in the prices of assets and liabilities of the entity. In general terms, an entity
has maintained its capital if it has as much capital at the end of the period as it had at the beginning
of the period. Any amount over and above that required to maintain the capital at the beginning of
the period is profit.

Par. 108. Under the concept of financial capital maintenance where capital is defined in terms of
nominal monetary units, profit represents the increase in nominal money capital over the period. Thus,
increases in the prices of assets held over the period, conventionally referred to as holding gains, are,
conceptually, profits. They may not be recognised as such, however, until the assets are disposed of
in an exchange transaction. When the concept of financial capital maintenance is defined in terms of
constant purchasing power units, profit represents the increase in invested purchasing power over
the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the
general level of prices is regarded as profit. The rest of the increase is treated as a capital
maintenance adjustment and, hence, as part of equity.

Par. 109. Under the concept of physical capital maintenance when capital is defined in terms of the
physical productive capacity, profit represents the increase in that capital over the period. All price
changes affecting the assets and liabilities of the entity are viewed as changes in the measurement
of the physical productive capacity of the entity; hence, they are treated as capital maintenance
adjustments that are part of equity and not as profit.

Par. 110. The selection of the measurement bases and concept of capital maintenance will determine
the accounting model used in the preparation of the financial statements. Different accounting
models exhibit different degrees of relevance and reliability and, as in other areas, management
must seek a balance between relevance and reliability. This Framework is applicable to a range of
accounting models and provides guidance on preparing and presenting the financial statements
constructed under the chosen model. At the present time, it is not the intention of the Board of IASC
to prescribe a particular model other than in exceptional circumstances, such as for those entities
reporting in the currency of a hyperinflationary economy. This intention will, however, be reviewed in
the light of world developments.[8]

[edit] Requirements of IFRS

See Requirements of IFRS. IFRS financial statements consist of (IAS1.8)

a Statement of Financial Position

a Statement of Comprehensive Income separate statements comprising an Income
Statement and separately a Statement of Comprehensive Income, which reconciles Profit or
Loss on the Income statement to total comprehensive income
 a Statement of Changes in Equity (SOCE)
a Cash Flow Statement or Statement of Cash Flows
notes, including a summary of the significant accounting policies

Comparative information is required for the prior reporting period (IAS 1.36). An entity preparing IFRS
accounts for the first time must apply IFRS in full for the current and comparative period although
there are transitional exemptions (IFRS1.7).

On 6 September 2007, the IASB issued a revised IAS 1 Presentation of Financial Statements. The
main changes from the previous version are to require that an entity must:

present all non-owner changes in equity (that is, 'comprehensive income' ) either in one
Statement of comprehensive income or in two statements (a separate income statement and
a statement of comprehensive income). Components of comprehensive income may not be
presented in the Statement of changes in equity.
present a statement of financial position (balance sheet) as at the beginning of the earliest
comparative period in a complete set of financial statements when the entity applies the new
standatd.
present a statement of cash flow.
make necessary disclosure by the way of a note.

The revised IAS 1 is effective for annual periods beginning on or after 1 January 2009. Early adoption
is permitted.

IASB current projects

Much of its work is LEAD TO convergence with US GAAP.

Adoption of IFRS

IFRS are used in many parts of the world, including the European Union, India, Hong Kong, Australia,
Malaysia, Pakistan, GCC countries, Russia, South Africa, Singapore and Turkey. As of August 2008,
more than 113 countries around the world, including all of Europe, currently require or permit IFRS
reporting and 85 require IFRS reporting for all domestic, listed companies, according to the U.S.
Securities and Exchange Commission.

It is generally expected that IFRS adoption worldwide will be beneficial to investors and other users
of financial statements, by reducing the costs of comparing alternative investments and increasing
the quality of information.[11] Companies are also expected to benefit, as investors will be more willing
to provide financing.[11] Companies that have high levels of international activities are among the
group that would benefit from a switch to IFRS. Companies that are involved in foreign activities and
investing benefit from the switch due to the increased comparability of a set accounting standard.[12]
However, Ray J. Ball has expressed some skepticism of the overall cost of the international standard;
he argues that the enforcement of the standards could be lax, and the regional differences in
accounting could become obscured behind a label. He also expressed concerns about the fair value
emphasis of IFRS and the influence of accountants from non-common-law regions, where losses
have been recognized in a less timely manner.[11]

For a current overview see PwC's map of countries that apply IFRS.

Australia

The Australian Accounting Standards Board (AASB) has issued 'Australian equivalents to IFRS' (A-
IFRS), numbering IFRS standards as AASB 1@8 and IAS standards as AASB 101@141. Australian
equivalents to SIC and IFRIC Interpretations have also been issued, along with a number of
'domestic' standards and interpretations. These pronouncements replaced previous Australian
generally accepted accounting principles with effect from annual reporting periods beginning on or
after 1 January 2005 (i.e. 30 June 2006 was the first report prepared under IFRS-equivalent
standards for June year ends). To this end, Australia, along with Europe and a few other countries,
was one of the initial adopters of IFRS for domestic purposes (in the developed world). It must be
acknowledged, however, that IFRS and primarily IAS have been part and parcel of accounting
standard package in the developing world for many years since the relevant accounting bodies were
more open to adoption of international standards for many reasons including that of capability.

The AASB has made certain amendments to the IASB pronouncements in making A-IFRS, however
these generally have the effect of eliminating an option under IFRS, introducing additional
disclosures or implementing requirements for not-for-profit entities, rather than departing from IFRS
for Australian entities. Accordingly, for-profit entities that prepare financial statements in accordance
with A-IFRS are able to make an unreserved statement of compliance with IFRS.

The AASB continues to mirror changes made by the IASB as local pronouncements. In addition, over
recent years, the AASB has issued so-called 'Amending Standards' to reverse some of the initial
changes made to the IFRS text for local terminology differences, to reinstate options and eliminate
some Australian-specific disclosure. There are some calls for Australia to simply adopt IFRS without
'Australianising' them and this has resulted in the AASB itself looking at alternative ways of adopting
IFRS in Australia

Canada

The use of IFRS became a requirement for Canadian publicly accountable profit-oriented enterprises
for financial periods beginning on or after 1 January 2011. This includes public companies and other
Pprofit-oriented enterprises that are responsible to large or diverse groups of shareholders.Q[13]

European Union

All listed EU companies have been required to use IFRS since 2005.

In order to be approved for use in the EU, standards must be endorsed by the Accounting
Regulatory Committee (ARC), which includes representatives of member state governments and is
advised by a group of accounting experts known as the European Financial Reporting Advisory
Group. As a result IFRS as applied in the EU may differ from that used elsewhere.

Parts of the standard IAS 39: Financial Instruments: Recognition and Measurement were not
originally approved by the ARC. IAS 39 was subsequently amended, removing the option to record
financial liabilities at fair value, and the ARC approved the amended version. The IASB is working
with the EU to find an acceptable way to remove a remaining anomaly in respect of hedge
accounting. The World Bank Centre for Financial Reporting Reform is working with countries in the
ECA region to facilitate the adoption of IFRS and IFRS for SMEs.

India

The Institute of Chartered Accountants of India (ICAI) has announced that IFRS will be mandatory in
India for financial statements for the periods beginning on or after 1 April 2012. This will be done by
revising existing accounting standards to make them compatible with IFRS.

Reserve Bank of India has stated that financial statements of banks need to be IFRS-compliant for
periods beginning on or after 1 April 2011.

The ICAI has also stated that IFRS will be applied to companies above INR 1000 crore (INR 10
billion) from April 2011. Phase wise applicability details for different companies in India:
Phase 1: Opening balance sheet as at 1 April 2011*
i. Companies which are part of NSE Index @ Nifty 50
ii. Companies which are part of BSE Sensex @ BSE 30

a. Companies whose shares or other securities are listed on a stock exchange outside India

b. Companies, whether listed or not, having net worth of more than INR 1000 crore (INR 10 billion)

Phase 2: Opening balance sheet as at 1 April 2012*

Companies not covered in phase 1 and having net worth exceeding INR 500 crore (INR 5 billion)

Phase 3: Opening balance sheet as at 1 April 2014*

Listed companies not covered in the earlier phases * If the financial year of a company commences
at a date other than 1 April, then it shall prepare its opening balance sheet at the commencement of
immediately following financial year.

On January 22, 2010, the Ministry of Corporate Affairs issued the road map for transition to IFRS. It is
clear that India has deferred transition to IFRS by a year. In the first phase, companies included in
Nifty 50 or BSE Sensex, and companies whose securities are listed on stock exchanges outside India
and all other companies having net worth of INR 1000 core will prepare and present financial
statements using Indian Accounting Standards converged with IFRS. According to the press note
issued by the government, those companies will convert their first balance sheet as at April 1, 2011,
applying accounting standards convergent with IFRS if the accounting year ends on March 31. This
implies that the transition date will be April 1, 2011. According to the earlier plan, the transition date
was fixed at April 1, 2010.

The press note does not clarify whether the full set of financial statements for the year 2011@12 will
be prepared by applying accounting standards convergent with IFRS. The deferment of the transition
may make companies happy, but it will undermine IndiaNs position. Presumably, lack of
preparedness of Indian companies has led to the decision to defer the adoption of IFRS for a year.
This is unfortunate that India, which boasts for its IT and accounting skills, could not prepare itself for
the transition to IFRS over last four years. But that might be the ground reality. Transition in phases
Companies, whether listed or not, having net worth of more than INR 500 core will convert their
opening balance sheet as at April 1, 2013. Listed companies having net worth of INR 500 core or
less will convert their opening balance sheet as at April 1, 2014. Un-listed companies having net
worth of Rs 500 core or less will continue to apply existing accounting standards, which might be
modified from time to time. Transition to IFRS in phases is a smart move. The transition cost for
smaller companies will be much lower because large companies will bear the initial cost of learning
and smaller companies will not be required to reinvent the wheel. However, this will happen only if a
significant number of large companies engage Indian accounting firms to provide them support in
their transition to IFRS. If, most large companies, which will comply with Indian accounting standards
convergent with IFRS in the first phase, choose one of the international firms, Indian accounting firms
and smaller companies will not benefit from the learning in the first phase of the transition to IFRS. It
is likely that international firms will protect their learning to retain their competitive advantage.
Therefore, it is for the benefit of the country that each company makes judicious choice of the
accounting firm as its partner without limiting its choice to international accounting firms. Public
sector companies should take the lead and the Institute of Chartered Accountants of India (ICAI)
should develop a clear strategy to diffuse the learning. The government has decided to measure the
size of companies in terms of net worth. This is not the ideal unit to measure the size of a company.
Net worth in the balance sheet is determined by accounting principles and methods. Therefore, it
does not include the value of intangible assets. Moreover, as most assets and liabilities are
measured at historical cost, the net worth does not reflect the current value of those assets and
liabilities. Market capitalization is a better measure of the size of a company. But it is difficult to
estimate market capitalization or fundamental value of unlisted companies. This might be the reason
that the government has decided to use Snet worthN to measure size of companies. Some companies,
which are large in terms of fundamental value or which intend to attract foreign capital, might prefer
to use Indian accounting standards convergent with IFRS earlier than required under the road map
presented by the government. The government should provide that choice. Conclusion The
government will come up with a separate road map for banking and ice companies by February 28,
2010. Let us hope that transition in case of those companies will not be deferred further.

Taiwan

Adoption scope and timetable

(1) Phase I companies: listed companies and financial institutions supervised by the FSC, except for
credit cooperatives, credit card companies and insurance intermediaries:

A. They will be required to prepare financial statements in accordance with Taiwan-IFRS starting from
January 1, 2013.

B. Early optional adoption: Firms that have already issued securities overseas, or have registered an
overseas securities issuance with the FSC, or have a market capitalization of greater than NT$10
billion, will be permitted to prepare additional consolidated financial statements1 in accordance with
Taiwan-IFRS starting from January 1, 2012. If a company without subsidiaries is not required to
prepare consolidated financial statements, it will be permitted to prepare additional individual
financial statements on the above conditions.

(2) Phase II companies: unlisted public companies, credit cooperatives and credit card companies:

A. They will be required to prepare financial statements in accordance with Taiwan-IFRS starting from
January 1, 2019 B. They will be permitted to apply Taiwan-IFRS starting from January. 1, 2013.

(3) Pre-disclosure about the IFRS adoption plan, and the impact of adoption To prepare properly for
IFRS adoption, domestic companies should propose an IFRS adoption plan and establish a specific
taskforce. They should also disclose the related information from 2 years prior to adoption, as follows:

A. Phase I companies: (A) They will be required to disclose the adoption plan, and the impact of
adoption, in 2011 annual financial statements, and in 2012 interim and annual financial statements.
(B) Early optional adoption: a. Companies adopting IFRS early will be required to disclose the
adoption plan, and the impact of adoption, in 2010 annual financial statements, and in 2011 interim
and annual financial statements. b. If a company opts for early adoption of Taiwan-IFRS after January
1, 2011, it will be required to disclose the adoption plan, and the impact of adoption, in 2011 interim
and annual financial statements commencing on the decision date.

B. Phase II companies will be required to disclose the related information from 2 years prior to
adoption, as stated above.

Year Work Plan

2008 Establishment of IFRS Taskforce

2009~2011

Acquisition of authorization to translate IFRS

Translation, review, and issuance of IFRS
Analysis of possible IFRS implementation problems, and resolution thereof
Proposal for modification of the related regulations and supervisory mechanisms
Enhancement of related publicity and training activities
2012

IFRS application permitted for Phase I companies

Study on possible IFRS implementation problems, and resolution thereof
Completion of amendments to the related regulations and supervisory mechanisms
Enhancement of the related publicity and training activities

2013

Application of IFRS required for Phase I companies, and permitted for Phase II companies
Follow-up analysis of the status of IFRS adoption, and of the impact

2014

Follow-up analysis of the status of IFRS adoption, and of the impact

2015 8Applications of IFRS required for Phase II companies

Expected benefits

(1) More efficient formulation of domestic accounting standards, improvement of their international
image, and enhancement of the global rankings and international competitiveness of our local capital
markets;

(2) Better comparability between the financial statements of local and foreign companies;

(3) No need for restatement of financial statements when local companies wish to issue overseas
securities, resulting in reduction in the cost of raising capital overseas;

(4) For local companies with investments overseas, use of a single set of accounting standards will
reduce the cost of account conversions and improve corporate efficiency.

Quote from Accounting Research and Development Foundation

Japan

The minister for Financial Services in Japan announced in late June 2011 that mandatory application
of the IFRS should not take place from fiscal year-ending March 2015; five to seven years should be
required for preparation if mandatory application is decided; and to permit the use of U.S. GAAP
beyond the fiscal year ending March 31, 2016.[14]

Pakistan

All listed companies must follow all issued IAS/IFRS except the following:
IAS 39 and IAS 40: Implementation of these standards has been held in abeyance by State Bank of
Pakistan for Banks and DFIs
IFRS-1: Effective for the annual periods beginning on or after January 1, 2004. This IFRS is being
considered for adoption for all companies other than banks and DFIs.
IFRS-9: Under consideration of the relevant Committee of the Institute (ICAP). This IFRS will be
effective for the annual periods beginning on or after 1 January 2013.

Russia

The government of Russia has been implementing a program to harmonize its national accounting
standards with IFRS since 1998. Since then twenty new accounting standards were issued by the
Ministry of Finance of the Russian Federation aiming to align accounting practices with IFRS. Despite
these efforts essential differences between Russian accounting standards and IFRS remain. Since
2004 all commercial banks have been obliged to prepare financial statements in accordance with
both Russian accounting standards and IFRS. Full transition to IFRS is delayed and is expected to
take place from 2011.

Singapore

In Singapore the Accounting Standards Committee (ASC) is in charge of standard setting. Singapore
closely models its Financial Reporting Standards (FRS) according to the IFRS, with appropriate
changes made to suit the Singapore context. Before a standard is enacted, consultations with the
IASB are made to ensure consistency of core principles.

South Africa

All companies listed on the Johannesburg Stock Exchange have been required to comply with the
requirements of International Financial Reporting Standards since 1 January 2005.

The IFRS for SMEs may be applied by 'limited interest companies', as defined in the South African
Corporate Laws Amendment Act of 2006 (that is, they are not 'widely held'), if they do not have
public accountability (that is, not listed and not a financial institution). Alternatively, the company may
choose to apply full South African Statements of GAAP or IFRS.

South African Statements of GAAP are entirely consistent with IFRS, although there may be a delay
between issuance of an IFRS and the equivalent SA Statement of GAAP (can affect voluntary early
adoption).

Turkey

Turkish Accounting Standards Board translated IFRS into Turkish in 2005. Since 2005 Turkish
companies listed in Istanbul Stock Exchange are required to prepare IFRS reports.
IFRS 8 Operating Segments
Core principleAn entity shall disclose information to enable users of its financial
statements to evaluate the nature and financial effects of the business activities in which it
engages and the economic environments in which it operates.

This IFRS shall apply to:

(a) the separate or individual financial statements of an entity:
(i) whose debt or equity instruments are traded in a public market (a domestic or foreign
stock exchange or an over-the-counter market, including local and regional markets), or
(ii) that files, or is in the process of filing, its financial statements with a securities
commission or other regulatory organization for the purpose of issuing any class of
instruments in a public market; and
(b) the consolidated financial statements of a group with a parent:
(i) whose debt or equity instruments are traded in a public market (a domestic or foreign stock
exchange or an over-the-counter market, including local and regional markets), or
(ii) that files, or is in the process of filing, the consolidated financial statements with a
securities commission or other regulatory organization for the purpose of issuing any
class of instruments in a public market.

The IFRS specifies how an entity should report information about its operating segments
in annual financial statements and, as a consequential amendment to IAS 34 Interim
Financial Reporting, requires an entity to report selected information about its operating
segments in interim financial reports. It also sets out requirements for related disclosures
about products and services, geographical areas and major customers.

The IFRS requires an entity to report financial and descriptive information about its
reportable segments. Reportable segments are operating segments or aggregations of
operating segments that meet specified criteria. Operating segments are components of an
entity about which separate financial information is available that is
evaluated regularly by the chief operating decision maker in deciding how to allocate
resources and in assessing performance. Generally, financial information is required to be
reported on the same basis as is used internally for evaluating operating segment
performance and deciding how to allocate resources to operating
segments.

The IFRS requires an entity to report a measure of operating segment profit or loss and of
segment assets. It also requires an entity to report a measure of segment liabilities and
particular income and expense items if such measures are regularly provided to the chief
operating decision maker. It requires reconciliations of total reportable segment revenues,
total profit or loss, total assets, liabilities and other amounts disclosed for reportable
segments to corresponding amounts in the entitys financial statements.

The IFRS requires an entity to report information about the revenues derived from its
products or services (or groups of similar products and services), about the countries in
which it earns revenues and holds assets, and about major customers, regardless of
whether that information is used by management in making operating decisions.

However, the IFRS does not require an entity to report information that is not prepared
for internal use if the necessary information is not available and the cost to develop it
would be excessive. The IFRS also requires an entity to give descriptive information
about the way the operating segments were determined, the products and services
provided by the segments, differences between the measurements used in reporting
segment information and those used in the entitys financial statements, and changes in
the measurement of segment amounts from period to period.
IFRS 2 Share-based Payment
The objective of this IFRS is to specify the financial reporting by an entity when it
undertakes a share-based payment transaction. In particular, it requires an entity to reflect
in its profit or loss and financial position the effects of share-based payment transactions,
including expenses associated with transactions in which share options are granted to
employees.

The IFRS requires an entity to recognize share-based payment transactions in its financial
statements, including transactions with employees or other parties to be settled in cash,
other assets, or equity instruments of the entity. There are no exceptions to the IFRS,
other than for transactions to which other Standards apply. This also applies to transfers
of equity instruments of the entitys parent, or equity instruments of another entity
in the same group as the entity, to parties that have supplied goods or services to the
entity.

The IFRS sets out measurement principles and specific requirements for three types of
share-based payment transactions:
(a) equity-settled share-based payment transactions, in which the entity receives goods or
services as consideration for equity instruments of the entity (including shares or
share options);
(b) cash-settled share-based payment transactions, in which the entity acquires goods or
services by incurring liabilities to the supplier of those goods or services for amounts
that are based on the price (or value) of the entitys shares or other equity instruments
of the entity; and
(c) transactions in which the entity receives or acquires goods or services and the terms of
the arrangement provide either the entity or the supplier of those goods or services
with a choice of whether the entity settles the transaction in cash or by issuing equity
instruments.

For equity-settled share-based payment transactions, the IFRS requires an entity to

measure the goods or services received, and the corresponding increase in equity, directly,
at the fair value of the goods or services received, unless that fair value cannot be
estimated reliably. If the entity cannot estimate reliably the fair value of the goods or
services received, the entity is required to measure their value, and the corresponding
increase in equity, indirectly, by reference to the fair value of the equity instruments
granted. Furthermore:

(a) for transactions with employees and others providing similar services, the entity is
required to measure the fair value of the equity instruments granted, because it is
typically not possible to estimate reliably the fair value of employee services received.
The fair value of the equity instruments granted is measured at grant date.
(b) for transactions with parties other than employees (and those providing similar
services), there is a rebuttable presumption that the fair value of the goods or services
received can be estimated reliably. That fair value is measured at the date the entity
obtains the goods or the counterparty renders service. In rare cases, if the presumption
is rebutted, the transaction is measured by reference to the fair value of the equity
instruments granted, measured at the date the entity obtains the goods or the
counterparty renders service.
(c) for goods or services measured by reference to the fair value of the equity instruments
granted, the IFRS specifies that vesting conditions, other than market conditions, are
not taken into account when estimating the fair value of the shares or options at the
relevant measurement date (as specified above). Instead, vesting conditions are taken
 into account by adjusting the number of equity instruments included in the
measurement of the transaction amount so that, ultimately, the amount recognized for
goods or services received as consideration for the equity instruments granted is based
on the number of equity instruments that eventually vest. Hence, on a cumulative
basis, no amount is recognized for goods or services received if the equity instruments
granted do not vest because of failure to satisfy a vesting condition (other than a
market condition).
(d) the IFRS requires the fair value of equity instruments granted to be based on market
prices, if available, and to take into account the terms and conditions upon which
those equity instruments were granted. In the absence of market prices, fair value is
estimated, using a valuation technique to estimate what the price of those equity
instruments would have been on the measurement date in an arms length transaction
between knowledgeable, willing parties.
(e) the IFRS also sets out requirements if the terms and conditions of an option or share
grant are modified (e.g. an option is repriced) or if a grant is cancelled, repurchased or
replaced with another grant of equity instruments. For example, irrespective of any
modification, cancellation or settlement of a grant of equity instruments to employees,
the IFRS generally requires the entity to recognize, as a minimum, the services
received measured at the grant date fair value of the equity instruments granted.

For cash-settled share-based payment transactions, the IFRS requires an entity to measure
the goods or services acquired and the liability incurred at the fair value of the liability.
Until the liability is settled, the entity is required to remeasure the fair value of the
liability at each reporting date and at the date of settlement, with any changes in value
recognised in profit or loss for the period.

For share-based payment transactions in which the terms of the arrangement provide
either the entity or the supplier of goods or services with a choice of whether the entity
settles the transaction in cash or by issuing equity instruments, the entity is required to
account for that transaction, or the components of that transaction, as a cash-settled share-
based payment transaction if, and to the extent that, the entity has incurred a liability to
settle in cash (or other assets), or as an equity-settled share-based payment transaction if,
and to the extent that no such liability has been incurred.

The IFRS prescribes various disclosure requirements to enable users of financial

statements to understand:
(a) the nature and extent of share-based payment arrangements that existed during the
period;
(b) how the fair value of the goods or services received, or the fair value of the equity
instruments granted, during the period was determined; and
(c) the effect of share-based payment transactions on the entitys profit or loss for the
period and on its financial position.