Disclosures and Analysis Overview

1. Putting It All Together: Disclosures and Analysis Overview

Trading Has Been Suspended for SEHK: 0940

On December 4, 2015, a Hong Kong-listed animal drug company, China Animal Healthcare Ltd. (SEHK: 0940), announced a delay in the release of its financial statements. The firm alleged that a thief had stolen the truck in which the past five years of the company’s financial records were being transported. The theft was alleged to have occurred during the middle of a forensic audit, when the truck’s driver, who was transporting the original financial documents from the Qingyuan area to Hebel province, stopped and left the truck for a lunch break. The company continues to be embroiled in the forensic accounting investigation, stalled as a result of the missing financial statements now labeled the “Lost Documents.”  As of March 2016, the Hong Kong Stock Exchange suspended the company’s shares trading when the firm missed its deadline for filing the 2014 financial results. The suspension is expected to continue until further notice, while the company continues its search for the stolen documents. This situation has created more than a little angst for 20% shareholder Eli Lilly’s Elanco company, which invested $100 million in the troubled China Animal Health care Ltd. in 2013. These recent events threaten to suspend Elanco’s efforts to expand its presence in China, giving its competition a potential advantage. If the issue is not resolved soon, Elanco may be on the hunt for another China-based partner to give it a stake in one of China’s fastest growing markets for animal health.

Learning Objectives 

After completing this chapter, you should be able to:

LO 1:  Discuss the rationale and methods of full disclosure in corporate reporting.

LO 2:  Identify the issues and disclosure requirements for related parties.

LO 3:  Describe the appropriate accounting and disclosure requirements for events occurring after the reporting period.

LO 4:  Describe the purpose of the audit opinion and the contents of the auditor’s report.

LO 5:  Explain the various financial statement analysis tools and techniques.

LO 6:  Explain the similarities and differences between ASPE and IFRS regarding dis-closures and analysis of financial statements.

Source: Glenn Arnold & Suzanne Kyle, https://lifa1.lyryx.com/textbooks/ARNOLD_2/marketing/ArnoldKyle-IntermFinAcct-Vol2-2020A.pdf
This work is licensed under a Creative Commons Attribution 4.0 License.

2. Introduction

The previous chapters of this text and the previous course text were focused on the individual aspects of financial reporting. For example, the previous intermediate financial accounting text covered how to prepare the basic core financial statements as well as the more complex aspects of current and long-term assets. In contrast, this text has discussed the complex issues regarding current and long-term liabilities and equity such as complex financial instruments, income taxes, pensions, leases, earnings per share,as well as an in-depth look at accounting changes, error analysis, and the direct method for preparing the statement of cash flows. This last chapter will focus on pulling together these individual topics into a cohesive overview of financial statement disclosures and analyses.

Chapter Organization: 

3. Disclosures and Analysis: Overview

The underlying purpose of the financial statements is to tell a story about the operations of a business from its inception to its dissolution. What stories could China Animal Healthcare’s financials tell had they not been stolen, and how might this event affect investor and creditor decisions? Given the complexities in today’s marketplace, decision-making for creditors and investors can be quite challenging. Financial statements only have meaning, and therefore appropriate influence, if they are complete and if users know how to interpret them. Appropriate disclosures and financial statement analysis are an important part of this evaluative process.

To aid users in understanding financial statements, most medium to large businesses prepare extensive disclosures in the notes to the financial statements. In addition, monthly or quarterly interim financial statements are often prepared that provide an early warning system for management and other select users, such as creditors, who monitor debt and compliance with restrictive covenants. Additionally, if business activities are diversified, segmented reporting is another financial report that separates business operations into segments such as geographical operations or various business lines. This allows stake-holders to determine which segments contribute the most to the overall business.

To assist with the task of a thorough financial statement assessment, there are several analytical techniques available to stakeholders. These include ratio, common size, and vertical and trend analysis. Actual results reported in the financial statements can be compared to the business’s own strategic forecast and to industry competitors to see if it is keeping pace, growing, or shrinking.

Understanding a business, however, is more than just analyzing the core financial statements. Business stakeholders need to consider the quality of management, the overall industry climate, as well as projected economic developments. This information comes from many different sources such as the notes to the financial statements and the management discussion and analysis (MD&A) report, which presents information about the operations,  company liquidity, capital resources, economic outlook, and any risks and uncertainties. Independently prepared reports such as auditor’s reports, analysts’ reports,economic reports, and news articles are also an important source of information.

The purpose of this chapter is to focus on the bigger picture of a business’s overall current financial performance through the accurate interpretation of the financial statements and their disclosures.

4. Disclosure Issues

Recall from our previous discussions that the purpose of financial reporting is to provide financial information that is useful to investors, lenders, and other creditors in making decisions about providing resources to the company. In this text, we have focused on the preparation of financial reports to meet the usefulness criteria identified above. However, it is important to keep in mind a fundamental deficiency of financial reporting: it is back-ward looking. That is, financial statements report on events that have already occurred. For investors and creditors, the more relevant consideration is the financial performance in the future, as this is where profits and returns will be made. While the accounting profession has always assumed that historical financial statements are useful in making predictions about the future, users understand that the financial statements are only one of many sources of information required to make well-informed decisions. In this section, we will examine some of the other types of information used by investors, as well as some of the specific disclosures that enhance the financial statements themselves.

4.1. Full Disclosure

The concept of full disclosure is a well-established principle that has been broadly recognized as an essential component of financial reporting models. The principle is derived directly from the economic concept of the efficient securities market. A semi-strong efficient securities market is a market in which securities trade at a price that reflects all the information that is publicly available at the time. Although there have been many studies over the years that question the true level of efficiency in securities markets, strong evidence suggests that share prices do respond quickly to new information. Thus, from the perspective of a financial statement preparer, full and complete information should be disclosed in order to meet the needs of the readers. This will help engender a sense of confidence not only in the individual company, but also in the market as a whole, and will help alleviate the problem of information asymmetry.

One way that accountants contribute to the process of full disclosure is through the presentation of financial statement notes. The notes include additional explanations and details that provide further information about the numbers that appear in the financial statements. This additional information can help readers understand the results more fully, which can lead to better decisions. The notes also contain a description of significant accounting policies. These disclosures are very important to help readers understand how accounting numbers are derived. In making investment decisions, readers may wish to compare one company’s performance to another’s. Because accounting standards sometimes allow choices between alternative accounting treatments, it is important that the readers fully understand which policies have been applied. The concept of the semi-strong efficient market presumes that readers of financial statements can determine the effects of different accounting policy choices, as long as the details of those policy choices are disclosed. The principle of full disclosure also presumes that readers of financial statements have a reasonable knowledge of business methods and accounting conventions. Thus, the accountant is not required to explain the most basic principles of accounting in the note disclosures. As businesses have become more complex over time, note disclosures have become more detailed. The accounting profession is sometimes criticized for presenting overly complicated note disclosures that even knowledgeable readers have difficulty understanding. This criticism is a result of one of the trade-offs that the profession often faces: the need for completeness balanced against the need for understandability.

Most companies will disclose significant accounting policies in the first or second note to the financial statements. A retail company, for example, may disclose an accounting policy note for inventory as follows:

Review the accounting policy notes of Canadian Tire Corporation’s 2015 annual financial statements. 

The significant accounting policy note begins on page 66 of the document and continues for ten pages. Canadian Tire Corporation has fully disclosed all the significant accounting policies to help readers understand the methods used to generate the amounts that appear on the financial statements.

Aside from descriptions of accounting policies, the notes to the financial statements contain further details of balance sheet and income statement amounts. For example, the property and equipment account on Canadian Tire Corporation’s 2015 balance sheet is disclosed as a single item. However, Note 16 (page 86 of the document) contains further details of individual classes of assets and movements within those classes, including opening balances for each class of property and equipment, additions and disposals during the year, reclassification to or from the "held for sale" category, depreciation, impairment, and other changes. This level of disclosure helps readers better understand the asset composition and capital replacement policies of the property and equipment account.

Aside from the financial statements themselves, companies provide further disclosures in the annual report and in other public communications. Canadian Tire Corporation’s 2015 Report to Shareholders (Canadian Tire Corporation, 2016) is 118 pages long, including the financial statements. Aside from the financial statements, the annual report includes messages from the Chairman and the President/CEO, listings of the Board of Directors and Executive Leadership Team, and a section entitled "Management’s Discussion and Analysis" (MD&A), on pages 3 to 54. The MD&A is required disclosure under Canadian securities regulations. Similar disclosures are required or encouraged in other jurisdictions, although they may bear different names, such as Management Commentary or Business Review. The purpose of MD&A, and similar disclosures, is to provide a narrative explanation from management’s perspective of the year’s results and financial condition, risks, and future plans. The guidelines encourage companies to provide forward-looking information to help investors understand the impact of current results on future prospects. MD&A should help investors further understand the financial statements, discuss information not fully disclosed in the financial statements, discuss risks and trends that could affect future performance, analyze the variability, quality and predictive nature of current earnings, provide information about credit ratings, discuss short- and long-term liquidity, discuss commitments and off balance sheet arrangements, examine trends, risks and uncertainties, review previous forward-looking information, and discuss the risks and potential impact of financial instruments.

The objectives of MD&A are clearly aimed at helping investors link past performance with predictions of future results. Although this type of information is consistent with investors’ needs, there are some limitations with MD&A disclosures. First, although the general elements are defined by securities regulations, companies have some discretion in how they fulfill these requirements. Thus, some companies may provide standardized disclosures that change little from year to year. Although the disclosures may meet the minimum requirements, the usefulness of these boilerplate, or generic and non-specific statements, may be questionable. Second, MD&A disclosures are not directly part of the financial statements, meaning they are not audited. Auditors are required to review the annual report for any significant inconsistencies with the published financial statements, but the lack of any specific assurance on the MD&A may result in investors having less confidence in the disclosures. Third, the MD&A contains more qualitative information than the financial statements does. Although this qualitative information is useful in analyzing past, and predicting future, financial results, it is not as easily verified as the more quantitative disclosures.

One interesting effect of the qualitative nature of MD&A is that companies may either deliberately or inadvertently provide signals to the readers. A number of studies have examined the use of language and the presence of tone in the narrative discussion of the MD&A. Although the research is not always conclusive, there is evidence to suggest that the word choice and grammatical structures present in the reports may provide some predictive function. The language choices may reflect something about management’s more detailed understanding of the business that is not directly disclosed in the information.

Although there are sometimes suggestions of information overload levied against the accounting profession and securities regulators, the continually expanding volume of financial and non-financial disclosures does suggest that there is a demand for this in-formation and that readers are finding some value in the disclosures.

4.2. Related Party Transactions

One area in particular where full disclosure is important is in the case of related parties.The accounting issue with related parties is that transactions with these parties may occur on a non-arms-length basis. Because the transactions may occur in a manner that is not consistent with normal market conditions, it is important that readers are alerted to their presence. IAS 24 provides guidance to the appropriate treatment of related party transactions and balances. IAS 24 provides a detailed definition of related parties, as follows:

The key feature of IAS 24 is that it requires additional disclosures when related parties exist. Specifically, all related party relationships must be disclosed, even if there are no transactions with those parties. When transactions with related parties do occur, the amount of the transactions and outstanding balances must be disclosed, along with a description of the terms and conditions of the transaction, any commitments, security, or guarantees with the related party, the nature of the consideration used to settle the transactions, and the amount of any provision or expense related to bad debts of the related party. Additionally, the standard requires disclosure of details of compensation paid to key management personnel. The disclosure requirements are designed to help readers understand the potential effects of the related party transactions on the entity’s results and financial position.

ASPE takes related party disclosures one step further by also requiring different measurement bases for the transaction, depending on the circumstances. In summary, related party transactions are normally reported at the carrying amount of the item or services transferred in the accounts of the transferor. This means that the transaction may need to be remeasured at a different amount than what was agreed upon by the parties. The only circumstances where the exchange amount (i.e., the amount agreed upon by the related parties, is used to measure the transaction is if the transaction is:

• a monetary exchange in the normal course of operations
• a non-monetary exchange in the normal course of operations which has commercial substance
• an exchange not in the ordinary course of business where there is a substantive change in ownership, the amount is supported by independent evidence, and the transaction is monetary or has commercial substance.

These rules are intended to prevent related parties from reporting transactions at amounts that may not be representative of fair values. By requiring most related party transactions to be reported at the carrying amount, the standard may prevent gains or losses from being reported that represent the result of bargaining between arm’s length parties. Only where the transaction is monetary, has commercial substance, or is the result of a substantial change of ownership interests, can the negotiated price be used.

Other disclosure requirements under ASPE for related parties are similar to those of IFRS, except ASPE does not specifically require the disclosure of key management compensation.

4.3. Subsequent Events – After the Reporting Period

Financial statements are defined very precisely in terms of time periods. Whereas balance sheets report financial position as at a specific date, income and cash flow statements report results for a period of time ending on a specific date. It would be understandable to think that events occurring after the reporting period are not relevant, as they do not occur within the precisely defined period covered by the financial statements.However, remember that investors and other readers often use financial statements to make predictions about the future. As such, if an event occurs after the reporting date,but before the financial statements are issued, and if the event could have a material impact on the future operations of the business, it is reasonable to expect that investors would want to know about it. For this reason, IAS 10 takes into account the reporting requirements where material events occur after the reporting period.

IAS 10 specifically defines the relevant reporting period as the time between the reporting date and the date when the financial statements are authorized for issue. Although the date of authorization will depend on the legal and corporate structure relevant to the entity, a common scenario is that the financial statements are authorized for issue when the board of directors approves them for distribution to the shareholders. This may be several weeks or even months after the reporting date.

The treatment of events after the reporting period will depend on whether they are adjusting or non-adjusting events. While adjusting events are those that provide further evidence of conditions that existed at the reporting date, non-adjusting events are those that are indicative of conditions that arose after the reporting date. As suggested by the nomenclature, when adjusting events occur, the accounts should be adjusted to reflect the effect of those events, while non-adjusting events will not result in any adjustments to the accounts.

The logic of this treatment is clear. If the event after the reporting date provides further evidence of a condition that existed at the reporting date, then the amount should be adjusted to reflect all available information. If the event only provides evidence of a new condition that arose after the reporting date, then adjustment would not be appropriate,as the condition didn’t exist at the reporting date.

In many cases, the appropriate treatment will be obvious. For example, if a provision for an unsettled lawsuit was included in current liabilities on the reporting date, but the lawsuit was later settled for a different amount before the approval of the financial statements, it makes sense to adjust the provision to the actual settlement amount. Similarly, if an error in the accounts is subsequently discovered before the financial statements are approved, then the error should be corrected.

In some cases the treatment of non-adjusting events is clear. For example, if the company’s warehouse burns to the ground after the reporting period, this is clearly not indicative of a condition that existed at the reporting date, and no adjustment should be made.

In other cases, however, the treatment is less clear. For example, if a significant customer goes bankrupt after the year-end, and no provision had been made for any bad debts, should the accounts be adjusted? Although the customer’s bankruptcy occurred after the reporting date, there may have been prior evidence of the customer’s financial difficulties. One would need to look at account aging, payment patterns, and other evidence that would have been available at the reporting date to determine if the condition existed. If the balance of evidence suggests that the customer’s financial troubles already existed at the reporting date, then an adjustment would be appropriate. In cases like these, the accountant will need to apply sound judgment in evaluating all the evidence.

Even when an event is determined to be a non-adjusting event, disclosure may still be appropriate if the event is anticipated to have a material effect on future economic decisions. In our previous example, the destruction of a company’s warehouse may have a serious impact on the company’s future ability to deliver products and to earn profits. Thus, disclosure of the nature of the event, and the estimated financial effect of the event on future results, should be made.

In rare cases, a company’s financial condition may deteriorate so quickly after the reporting period that it may be impossible for the company to continue operating. Although events after the reporting period may not necessarily provide evidence of conditions that existed at the reporting date, the going concern assumption will override the normal procedure. Because financial statements are presumed to be prepared on a going concern basis, any change in this fundamental assumption would create the need for a complete change in the basis of accounting. This would obviously have a profound effect on all aspects of the financial statements.

The guidance in IAS 10 provides another example of how the principle of full disclosure is employed to help financial statement readers make more informed decisions.

5. Auditor’s Reports

So far we have focused on the role that the accountants and management play in providing useful information to investors. Another important component of a company’s financial statements is the audit opinion. Audit opinions are prepared by firms of independent and professionally trained auditors whose job is to examine a company’s financial statements and disclosures, internal control systems, and all other relevant data in order to express an opinion on the fairness of their financial statements. Audit opinions are required for any company that wants to trade its shares publicly; in some jurisdictions they may also be required of private companies.