IAS 1 Presentation of Financial Statements
Components of financial statements
According to IAS 1 Presentation of Financial Statements, a complete set of financial statements has the following components:
- a statement of financial position
- a statement of profit or loss and other comprehensive income (or statement of profit or loss with a separate statement of other comprehensive income)
- a statement of changes in equity
- a statement of cash flows (discussed in a later chapter)
- accounting policies note and other explanatory notes
- a statement of financial position at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively or corrects an error retrospectively.
Other reports and statements in the annual report (such as a financial review, an environmental report or a social report) are outside the scope of IAS 1.
Statement of financial position
IAS 1 says that an entity must classify an asset as current on the statement of financial position if:
- it is realised or consumed during the entity’s normal trading cycle, or
- it is held for trading, or
- it will be realised within 12 months of the reporting date.
All other assets are classified as non-current.
IAS 1 says that an entity must classify a liability as current on the statement of financial position if:
- it is settled during the entity’s normal trading cycle, or
- it is held for trading, or
- it will be settled within 12 months of the reporting date.
All other liabilities are classified as non-current.
Statement of profit or loss and other comprehensive income
IAS 1 provides the following definitions:
Other comprehensive income (OCI) are incomes and expenses recognised outside of profit or loss, as required by particular IFRS Standards.
Total comprehensive income (TCI) is the total of the entity’s profit or loss and other comprehensive income for the period.
IAS 1 requires that OCI is classified into two groups as follows:
- items that might be reclassified (or recycled) to profit or loss in subsequent accounting periods:
– foreign exchange gains and losses arising on translation of a foreign operation (IAS 21)
– effective parts of cash flow hedging arrangements (IFRS 9)
– Remeasurement of investments in debt instruments that are classified as fair value through OCI (IFRS 9)
- items that will not be reclassified (or recycled) to profit or loss in subsequent accounting periods:
– changes in revaluation surplus (IAS 16 & IAS 38)
– remeasurement components on defined benefit plans (IAS 19)
– remeasurement of investments in equity instruments that are classified as fair value through OCI (IFRS 9)
Entities can prepare one combined statement showing profit or loss for the year and OCI. Alternatively, an entity can prepare a statement of profit or loss and a separate statement of OCI. If the latter option is chosen, the statement of OCI should begin with profit or loss for the year so that there is no duplication or confusion as to which items are included within each statement.
Format one: statement of profit or loss and other comprehensive income
For illustration, one of the recommended formats from the implementation guidance in IAS 1 is as follows:
XYZ Group – Statement of profit or loss and other comprehensive income for the year ended 31 December 20X3
| $000 | ||
| Revenue | X | |
| Cost of sales | (X) | |
| Gross profit | ––– | |
| X | ||
| Other operating income | X | |
| Distribution costs | (X) | |
| Administrative expenses | (X) | |
| Other operating expenses | (X) | |
| Profit from operations | ––– | |
| X | ||
| Finance costs | (X) | |
| Share of profit of associates | X | |
| Profit before tax | ––– | |
| X | ||
| Income tax expense | (X) | |
| Profit or loss for the period | ––– | |
| X | ||
| ––– |
| Other comprehensive income | ||
| Items that will not be reclassified to profit or loss: | ||
| Gains on property revaluation | X | |
| Remeasurement or actuarial gains and losses on defined | (X) | |
| benefit pension plans | ||
| Remeasurement of equity investments designated to be | X | |
| accounted for through OCI | ||
| Income tax relating to items that will not be reclassified | (X) | |
| –– | ||
| Total – items that will not be reclassified to profit or loss net of tax: | X | |
| Items that may be reclassified subsequently to profit or loss: | –– | |
| Cash flow hedges | X | |
| Exchange differences on translating foreign operations | X | |
| Income tax relating to items that may be reclassified | (X) | |
| –– | ||
| Total – items that may be reclassified to profit or loss net of tax: | X | |
| –– | ||
| Total – other comprehensive income net of tax for the year | X | |
| –– | ||
| Total comprehensive income for the year | X | |
| Profit attributable to: | –– | |
| $000 | ||
| Owners of the parent | X | |
| Non-controlling interest | X | |
| ––– | ||
| X | ||
| Total comprehensive income attributable to: | ––– | |
| Owners of the parent | X | |
| Non-controlling interest | X | |
| ––– | ||
| X | ||
| ––– | ||
| Other comprehensive income and related tax | ||
| IAS 1 requires an entity to disclose income tax relating to each | ||
| component of OCI. This may be achieved by either: |
- disclosing each component of OCI net of any related tax effect, or
- disclosing OCI before related tax effects with one amount shown for tax (as shown in the above examples).
The purpose of this is to provide users with tax information relating to these components, as they often have tax rates different from those applied to profit or loss.
Statement of changes in equity
IAS 1 requires all changes in equity arising from transactions with owners in their capacity as owners to be presented separately from non-owner changes in equity. This would include:
- Issues of shares
Total comprehensive income is shown in aggregate only for the purposes of reconciling opening to closing equity.
XYZ Group – Statement of changes in equity for the year ended 31 December 20X3
| Equity | Ret’d | Transl’n of | Financial | Cash | Reval’n | Total | ||||||
| capt’l | earng’s | for’gn | assets thru’ | flow | surplus | |||||||
| operations | OCI | hdg’s | ||||||||||
| $000 | $000 | $000 | $000 | $000 | $000 | $000 | ||||||
| Balance at 1 Jan | X | X | (X) | X | X | – | X | |||||
| 20X3 | ||||||||||||
| Changes in | – | X | – | – | – | – | X | |||||
| accounting policy | ||||||||||||
| Restated balance | X | X | X | X | X | X | X | |||||
| Changes in equity | ||||||||||||
| for 20X3 | ||||||||||||
| Dividends | – | (X) | – | – | – | – | (X) | |||||
| Issue of equity | X | – | – | – | – | – | X | |||||
| capital | ||||||||||||
| Total comprehensive | – | X | X | X | X | X | X | |||||
| income for year | ||||||||||||
| Transfer to retained | – | X | – | – | – | (X) | – | |||||
| earnings | ||||||||||||
| Balance at 31 | X | X | X | X | X | X | X | |||||
| December 20X3 | ||||||||||||
In addition to these columns, there should be columns headed:
- Non-controlling interest
- Total equity
A comparative statement for the prior period must also be published.
General features of financial statements
Going concern
Once management have assessed that there are no material uncertainties as to the ability of an entity to continue for the foreseeable future, the financial statements should be prepared on the assumption that the entity will in fact continue. In other words, the financial statements will be prepared on a going concern basis.
Accruals basis of accounting
The accruals basis of accounting means that transactions and events are recognised when they occur, not when cash is received or paid for them.
Consistency of presentation
The presentation and classification of items in the financial statements should be retained from one period to the next unless:
- it is clear that a change will result in a more appropriate presentation, or
- a change is required by an IFRS or IAS Standard.
Materiality and aggregation
An item is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. This could be based on the size or nature of an omission or misstatement.
When assessing materiality, entities should consider the characteristics of the users of its financial statements. It can be assumed that these users have a knowledge of business and accounting.
To aid user understanding, financial statements should show material classes of items separately.
Immaterial items may be aggregated with amounts of a similar nature, as long as this does not reduce understandability.
Offsetting
IAS 1 says that assets and liabilities, and income and expenses, should only be offset when required or permitted by an IFRS standard.
Comparative information
Comparative information for the previous period should be disclosed.
Disclosures
Disclosure note presentation
IAS 1 says that entities must present their disclosure notes in a systematic order. This might mean:
- Giving prominence to the most relevant areas
- Grouping items measured in similar ways, such as assets held at fair value
- Following the order in which items are presented in the statement of profit or loss and the statement of financial position.
Compliance with IFRS Standards
Entities should make an explicit and unreserved statement that their financial statements comply with IFRS Standards.
Accounting policies
Entities must produce an accounting policies disclosure note that details:
- the measurement basis (or bases) used in preparing the financial statements (e.g. historical cost, fair value, etc)
- each significant accounting policy.
Sources of uncertainty
An entity should disclose information about the key sources of estimation uncertainty that may cause a material adjustment to assets and liabilities within the next year, e.g. key assumptions about the future.
Reclassification adjustments
Reclassification adjustments are amounts ‘recycled’ from other comprehensive income to profit or loss.
IAS 1 requires that reclassification adjustments are disclosed, either on the face of the statement of profit or loss and other comprehensive income or in the notes.
Dividends
Distributions to equity holders are disclosed in the statement of changes.
This requirement is in line with separate disclosure of owner and non-owner changes in equity discussed earlier.
Problems with IAS 1
The accounting treatment and guidance with respect to other comprehensive income (OCI) has been criticised in recent years. Some of these criticisms are as follows:
- There is no consistent basis across IFRS Standards for determining when a gain or loss is recognised in profit or loss and when it is recognised in OCI. This often means that the OCI is not fully understood by the users of the financial statements.
- Many users ignore OCI, since the gains and losses reported there are not related to the operating flows of an entity. As a result, material losses presented in OCI may not be given the attention that they require.
- The notion of recycling gains and losses from OCI is unclear, particularly with regards to which items are recycled and when. Moreover this recycling results in profits or losses being recorded in a different period from the change in the related asset or liability, thus contradicting the Conceptual Framework’s definition of incomes and expenses.
- There are differences between IFRS Standards and US GAAP in respect of OCI. This reduces the comparability of profit-based performance measures.
Current issues: liabilities
The following exposure draft is an examinable document for P2.
ED/2015/1: Classification of Liabilities
The Board proposes to amend IAS 1 to clarify that the classification of a liability as current or non-current is based on rights as at the reporting date.
2 IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
Discontinued operations
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations says that a discontinued operation is a component of an entity that has been sold, or which is classified as held for sale, and which is:
- a separate line of business (either in terms of operations or location)
- part of a plan to dispose of a separate line of business, or
- a subsidiary acquired solely for the purpose of resale.
An operation is held for sale if its carrying amount will not be recovered principally by continuing use. To be classified as held for sale (and therefore to be a discontinued operation) at the reporting date, it must meet the following criteria.
- The operation is available for sale immediately in its current condition.
- The sale is highly probable and is expected to be completed within one year.
- Management is committed to the sale.
- The operation is being actively marketed.
- The operation is being offered for sale at a reasonable price in relation to its current fair value.
- It is unlikely that the plan will change or be withdrawn.
Presentation
Users of the financial statements are more interested in future profits than past profits. They are able to make a better assessment of future profits if they are informed about operations that have been discontinued during the period.
IFRS 5 requires information about discontinued operations to be presented in the financial statements.
- A single amount should be presented on the face of the statement of profit or loss and other comprehensive income that is comprised of:
– the total of the post-tax profit or loss of discontinued operations
– the post-tax gain or loss on the measurement to fair value less costs to sell or on the disposal of the discontinued operation.
- An analysis of the single amount described above should be provided. This can be presented on the face of the statement of profit or loss and other comprehensive income or in the notes to the financial statements.
- If a decision to sell an operation is taken after the year-end but before the accounts are approved, this is treated as a non-adjusting event after the reporting date and disclosed in the notes. The operation does not qualify as a discontinued operation at the reporting date and separate presentation is not appropriate.
- In the comparative figures the operations are also shown as discontinued (even though they were not classified as such at the end of the previous year).
Example presentation
Statement of profit or loss (showing discontinued operations as a single amount, with analysis in the notes)
| 20X2 | 20X1 | |
| $m | $m | |
| Revenue | 100 | 90 |
| Operating expenses | (60) | (65) |
| –––– | –––– | |
| Profit from operations | 40 | 25 |
| Finance cost | (20) | (10) |
| –––– | –––– | |
| Profit before tax | 20 | 15 |
| Income tax expense | (6) | (7) |
| –––– | –––– | |
| Profit from continuing operations | 14 | 8 |
| Discontinued operations | ||
| Loss from discontinued operations* | (25) | (1) |
| –––– | –––– | |
| Profit/(loss) for the year | (11) | 7 |
| –––– | –––– |
The entity did not recognise any components of other comprehensive income in the periods presented.
* The analysis of this loss would be given in a note to the accounts.
Illustration – Discontinued operations
The Portugal group of companies has a financial year-end of 30 June 20X4. The financial statements were authorised three months later. The group is disposing of many of its subsidiaries, each of which is a separate major line of business or geographical area.
- A subsidiary, England, was sold on 1 January 20X4.
- On 1 January 20X4, an announcement was made that there were advanced negotiations to sell subsidiary Switzerland and that, subject to regulatory approval, this was expected to be completed by 31 October 20X4.
- The board has also decided to sell a subsidiary called France. Agents have been appointed to find a suitable buyer but none have yet emerged. The agent’s advice is that potential buyers are deterred by the expected price that Portugal hopes to achieve.
- On 10 July 20X4, an announcement was made that another subsidiary, Croatia, was for sale. It was sold on 10 September 20X4.
Required:
Explain whether each of these subsidiaries meets the definition of a ‘discontinued operation’ as defined by IFRS 5.
Solution
England has been sold during the year. It is a discontinued operation per IFRS 5.
Switzerland is a discontinued operation per IFRS 5. There is clear intention to sell, and the sale is highly probable within 12 months.
France is not a discontinued operation per IFRS 5. It does not seem that France is being offered for sale at a reasonable price in relation to its current fair value. The sale does not seem to be highly probable within 12 months.
Croatia is not a discontinued operation per IFRS 5. The conditions for classification as held for sale were not met until after the year end.
3 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
Policies, estimates and errors
Accounting policies
Accounting policies are the principles and rules applied by an entity which specify how transactions are reflected in the financial statements.
Where a standard exists in respect of a transaction, the accounting policy is determined by applying that standard.
Where there is no applicable standard or interpretation, management must use its judgement to develop and apply an accounting policy. The accounting policy selected must result in information that is relevant and reliable. Management should refer to :
- standards dealing with similar and related issues
- the Framework.
Provided they do not conflict with the sources above, management may also consider:
- pronouncements from other standard-setting bodies, as long as they use a similar conceptual framework
- other accepted industry practices.
Changes in accounting policies
An entity should only change its accounting policies if required by a standard, or if it results in more reliable and relevant information.
New accounting standards normally include transitional arrangements on how to deal with any resulting changes in accounting policy.
If there are no transitional arrangements, changes in accounting policy should be applied retrospectively. The entity adjusts the opening
balance of each affected component of equity, and the comparative figures are presented as if the new policy had always been applied.
Where a change is applied retrospectively, IAS 1 revised requires an entity to include in its financial statements a statement of financial position at the beginning of the earliest comparative period. In practice this will result in 3 statements of financial position
- at the reporting date
- at the start of the current reporting period
- at the start of the previous reporting period.
Changes in accounting estimates
Making estimates is an essential part of the preparation of financial statements. For example, preparers have to estimate allowances for financial assets, inventory obsolescence and the useful lives of property, plant and equipment.
A change in an accounting estimate is not a change in accounting policy.
According to IAS 8, a change in accounting estimate must be recognised prospectively by including it in the statement of profit or loss and other
comprehensive income for the current period and any future periods that are also affected.
Prior period errors
Prior period errors are mis-statements and omissions in the financial statements of prior periods as a result of not using reliable information that should have been available.
IAS 8 says that material prior period errors should be corrected retrospectively in the first set of financial statements authorised for
issue after their discovery. Opening balances of equity, and the comparative figures, should be adjusted to correct the error.
IAS 1 also requires that where a prior period error is corrected retrospectively, a statement of financial position is provided at the beginning of the earliest comparative period.
Problems with IAS 8
It has been argued that the requirements of IAS 8 to adjust prior period errors retrospectively may lead to earnings management. By adjusting prior period errors through opening reserves, the impact is never shown within a current period statement of profit or loss.
4 IAS 33 Earnings per Share
Earnings per share
Scope
IAS 33 Earnings per Share applies to listed entities. If private entities choose to disclose an earnings per share figure, it must have been calculated in accordance with IAS 33.
The basic calculation
The actual earnings per share (EPS) for the period is called the basic
EPS and is calculated as:
Profit or loss for the period attributable to equity shareholders —————————————————————————————— Weighted average number of ordinary shares outstanding in the period
Profit for the period must be reduced (or a loss for the period must be increased) for any irredeemable preference dividends paid during the period.
If an entity prepares consolidated financial statements, then EPS will be based on the consolidated profit for the period attributable to the equity shareholders of the parent company (i.e. total consolidated profit less the profit attributable to the non-controlling interest).
The weighted average number of shares takes into account the timing of share issues during the year.
Illustration – Basic EPS
An entity issued 200,000 shares at full market price on 1 July 20X8.
| Relevant information | ||
| 20X8 | 20X7 | |
| Profit attributable to the ordinary | ||
| shareholders for the year ending 31 Dec | $550,000 | $460,000 |
| Number of ordinary shares in issue at 31 Dec | 1,000,000 | 800,000 |
Required:
Calculate basic EPS for the years ended 31 December 20X7 and 20X8.
Solution
Calculation of earnings per share
20X7 = $460,000/800,000 = 57.5c
20X8 = $550,000/900,000 (W1) = 61.1c
(W1) Weighted average number of shares in 20X8
| 800,000 × 6/12 = | 400,000 |
| 1,000,000 × 6/12 = | 500,000 |
–––––––
900,000
Since the additional 200,000 shares were issued at full market price but have only contributed finance for half a year, a weighted average number of shares must be calculated. The earnings figure is not adjusted.
Bonus issues
If an entity makes a bonus issue of shares then share capital increases. However, no cash has been received and therefore there is no impact on earnings. This means that a bonus issue reduces EPS.
For the purpose of calculating basic EPS, the bonus issue shares are treated as if they have always been in issue. The easiest way to do this is multiply the number of shares outstanding before the bonus issue by the bonus fraction.
The bonus fraction is calculated as follows:
Number of shares after bonus issue
————————————————
Number of shares before bonus issue
EPS for the comparative period must be restated. The easiest way to achieve this is to multiply the EPS figure from the prior year’s financial statements by the inverse of the bonus fraction.
Illustration – Bonus issue
An entity made a bonus issue of one new share for every five existing shares held on 1 July 20X8.
| Relevant information | ||
| 20X8 | 20X7 | |
| Profit attributable to the ordinary | ||
| shareholders for the year ending 31 Dec | $550,000 | $460,000 |
| Number of ordinary shares in issue at 31 Dec | 1,200,000 | 1,000,000 |
Required:
- Calculate basic EPS for the year ended 31 December 20X8.
- Calculate the prior year comparative EPS figure as it would appear in the financial statements for the year ended 31 December 20X8.
Solution
(a) EPS = $550,000/1,200,000 (W1) = 45.8c
| (W1) Weighted average number of shares | |
| 1,000,000 × 6/12 × 6/5 (W2) | 600,000 |
| 1,200,000 × 6/12 | 600,000 |
| –––––––– | |
| Weighted average number of shares | 1,200,000 |
| –––––––– |
(W2) Bonus fraction
It was a one for five bonus issue.
A shareholder who had five shares before the bonus issue would have six shares after the bonus issue.
The bonus fraction is therefore 6/5.
- EPS in the financial statements for the year ended 31 December 20X7 would have been 46.0c ($460,000/1,000,000).
This is re-stated in the financial statements for the year ended 31 December 20X8 by multiplying it by the inverse of the bonus fraction.
The restated comparative is therefore 38.3c (46.0c × 5/6).
Rights issues
A rights issue of shares is normally made at less than the full market price. A rights issue therefore combines the characteristics of an issue at full market price with those of a bonus issue.
As already seen, the easiest way to deal with the bonus element is to calculate the bonus fraction and to apply this to all shares outstanding before the rights issue.
The bonus fraction for a rights issue is calculated as follows:
Market price per share before rights issue ——————————————————––––––––––– Theoretical market price per share after the rights issue
EPS for the comparative period must be restated. The easiest way to achieve this is to multiply the EPS figure from the prior year’s financial statements by the inverse of the bonus fraction.
Illustration – Rights issue
An entity issued one new share for every two existing shares at $1.50 per share on 1 July 20X8. The pre-issue market price was $3.00 per share.
| Relevant information | 20X8 | 20X7 | |
| Profit attributable to the ordinary | |||
| shareholders for the year ending 31 Dec | $550,000 | $460,000 | |
| Number of ordinary shares in issue at 31 Dec | 1,200,000 | 800,000 |
Required:
- Calculate basic EPS for the year ended 31 December 20X8.
- Calculate the prior year comparative EPS figure as it would appear in the financial statements for the year ended 31 December 20X8.
Solution
(a) EPS = $550,000/1,080,000 (W1) = 50.9c
| (W1) Weighted average number of shares | |
| 800,000 × 6/12 × 3.00/2.50 (W2) | 480,000 |
| 1,200,000 × 6/12 | 600,000 |
| –––––––– | |
| Weighted average number of shares | 1,080,000 |
––––––––
(W2) Bonus fraction
The bonus fraction is calculated as:
Share price before rights issue/Theoretical share price after rights issue.
The bonus fraction is $3.00/$2.50 (W3).
(W3) Theoretical share price after rights issue
| No. shares | Price per | Market | ||
| share | capitalisation | |||
| $ | $ | |||
| Before | 800,000 | 3.00 | 2,400,000 | |
| rights | ||||
| issue | ||||
| Rights | 400,000 | 1.50 | 600,000 | |
| issue | ––––––––– | ––––––––– | ||
| 1,200,000 | 3,000,000 | |||
| ––––––––– | ––––––––– |
The theoretical price per share after the rights issue is $2.50 ($3,000,000/1,200,000).
- EPS in the financial statements for the year ended 31 December 20X7 would have been 57.5c ($460,000/800,000).
This is restated in the financial statements for the year ended 31 December 20X8 by multiplying it by the inverse of the bonus fraction.
The restated comparative is therefore 47.9c (57.5c × 2.50/3.00).
Diluted earnings per share
Many companies issue convertible instruments, options and warrants that entitle their holders to purchase shares in the future at below the market price. When these shares are eventually issued, the interests of the original shareholders will be diluted. The dilution occurs because these shares will have been issued at below market price.
The Examiner has indicated that diluted earnings per share will not be examined in detail. However, students should have awareness of the topic as summarised below:
- Shares and other instruments that may dilute the interests of the existing shareholders are called potential ordinary shares.
- Examples of potential ordinary shares include:
– debt and other instruments, including preference shares, that are convertible into ordinary shares
– share warrants and options (instruments that give the holder the right to purchase ordinary shares)
– employee plans that allow employees to receive ordinary shares as part of their remuneration and other share purchase plans
– contingently issuable shares (i.e. shares issuable if certain conditions are met).
- Where there are dilutive potential ordinary shares in issue, the diluted EPS must be disclosed as well as the basic EPS. This provides relevant information to current and potential investors.
- When calculating diluted EPS, the profit used in the basic EPS calculation is adjusted for any expenses that would no longer be paid if the convertible instrument were converted into shares, e.g. preference dividends, loan interest.
- When calculating diluted EPS, the weighted average number of shares used in the basic EPS calculation is adjusted for the conversion of the potential ordinary shares.
Presentation
An entity should present basic and diluted earnings per share on the face of the statement of profit or loss and other comprehensive income for each class of ordinary shares that has a different right to share in the net profit for the period. IAS 33 notes the following:
- An entity should present basic and diluted earnings per share with equal prominence for all periods presented
- If an entity has discontinued operations, it should also present basic and diluted EPS from continuing operations
- Basic and diluted losses per share, if applicable, must be disclosed.
Disclosure
An entity should disclose the following.
- The earnings used for basic and diluted EPS. These earnings should be reconciled to the net profit or loss for the period.
- The weighted average number of ordinary shares used to calculate basic and diluted EPS. The two averages should be reconciled to each other.
EPS as a performance measure
The EPS figure is used to compute the major stock market indicator of performance, the Price/Earnings ratio (P/E ratio). Rightly or wrongly, the stock market places great emphasis on the earnings per share figure and the P/E ratio. IAS 33 sets out a standard method of calculating EPS, which enhances the comparability of the figure.
However, EPS has limited usefulness as a performance measure:
- An entity’s earnings are affected by its choice of accounting policies. Therefore, it may not always be appropriate to compare the EPS of different companies.
- EPS does not take account of inflation. Apparent growth in earnings may not be true growth.
- EPS does not provide predictive value. High earnings and growth in earnings may be achieved at the expense of investment, which would have generated increased earnings in the future.
- In theory, diluted EPS serves as a warning to equity shareholders that the return on their investment may fall in future periods. However, diluted EPS as currently required by IAS 33 is not intended to be forward-looking but is an additional past performance measure. Diluted EPS is based on current earnings, not forecast earnings. Therefore, diluted EPS is only of limited use as a prediction of future EPS.
- EPS is a measure of profitability. Profitability is only one aspect of performance. Concentration on earnings per share and ‘the bottom line’ arguably detracts from other important aspects of an entity’s affairs, such as cash flow and stewardship of assets.
5 IAS 34 Interim Financial Reporting
Interim reporting
Interim financial reports are prepared for a period shorter than a full financial year. Entities may be required to prepare interim financial reports under local law or listing regulations.
IAS 34 does not require the preparation of interim reports, but sets out the principles that should be followed if they are prepared and specifies their minimum content. An interim financial report should include, as a minimum, the following components:
- condensed statement of financial position as at the end of the current interim period, with a comparative statement of financial position as at the end of the previous financial year
- condensed statement of profit or loss and other comprehensive income for the current interim period and cumulatively for the current financial year to date (if, for example the entity reports quarterly), with comparatives for the interim periods (current and year to date) of the preceding financial year
- condensed statement showing changes in equity. This statement should show changes in equity cumulatively for the current year with comparatives for the corresponding period of the preceding financial year
- condensed statement of cash flows cumulatively for the year to date, with a comparative statement to the same date in the previous year
- selected explanatory notes
- basic and diluted EPS should be presented on the face of interim statements of profit or loss and other comprehensive income for those entities within the scope of IAS 33.
6 Assessing financial performance and position
Ratio analysis
In your previous studies, you will have learned a number of ratios that can be used to interpret an entity’s financial statements.
A selection of the key ratios are provided below:
Profitability
Gross profit margin:
Gross profit
–––––––––––––– × 100%
Revenue
An increase in gross profit margin may be a result of:
- higher selling prices
- lower purchase prices (perhaps resulting from bulk-buy discounts)
- a change in the sales mix.
Operating profit margin:
Operating profit
–––––––––––––– × 100%
Revenue
Operating profit margin is affected by more factors than gross profit margin. Many operating costs are fixed and therefore do not necessarily increase or decrease with revenue. This means that operating profit margin may be more volatile year-on-year than gross profit margin.
Be aware that many operating costs, such as depreciation and impairment losses, are heavily reliant on management judgement. This may hinder the ability to compare the operating profit margin of one company with another company.
Return on capital employed (ROCE):
Operating profit
–––––––––––––––– × 100%
Capital employed
Capital employed is equity plus interest bearing finance.
ROCE is a measure of how efficiently an entity is using its resources. It should be compared to:
- previous years’ figures
- the target ROCE
- the ROCE of competitors
- the cost of borrowing.
Liquidity and working capital
Current ratio:
Current assets
––––––––––––––– : 1
Current liabilities
The current ratio measures whether an entity has sufficient current assets to meet its short-term obligations. The higher the ratio, the more financially secure the entity is. However, if the ratio is too high then it may suggest inefficiencies in working capital management.
Inventory turnover period:
Inventories
––––––––––––– × 365 days
Cost of sales
A high inventory turnover period may suggest:
- lack of demand for the entity’s goods
- poor inventory control.
Receivables collection period:
Trade receivables
––––––––––––– × 365 days
Credit sales
An increase in the receivables collection period may suggest a lack of credit control, which could lead to irrecoverable debts.
Payables payment period:
Trade payables
––––––––––––– × 365 days
Credit purchases
This represents the credit period taken by the company from its suppliers. A long credit period can be a good sign because it is a free source of finance. However, if an entity is taking too long to pay its suppliers then there is a risk that credit facilities could be reduced or withdrawn.
Long-term financial stability
Gearing:
Debt Debt
––––––––– or ––––––––––
Equity Debt + equity
Gearing indicates the risk attached to the entity’s finance. Highly geared entities have a greater risk of insolvency.
Interest cover:
Operating profit
–––––––––––––
Finance costs
Interest cover indicates the ability of an entity to pay interest out of the profits generated. A low interest cover suggests that an entity may have difficulty financing its debts if profits fall.
Investor ratios
P/E ratio:
Current share price
––––––––––––––––
EPS
The P/E ratio represents the market’s view of the future prospects of an entity’s shares. A high P/E ratio suggests that growth is expected.
Limitations of financial information and its analysis
Limitations of financial information
Ratio analysis generally relies on the published financial statements of an entity. However, many user groups have become increasingly aware of the limitations of traditional financial reporting.
- Preparing financial statements involves a substantial degree of classification and aggregation. There is always a risk that essential information will either not be given sufficient prominence or will be lost completely.
- Financial statements focus on the financial effects of transactions and other events and do not focus to any significant extent on their non-financial effects or on non-financial information in general.
- Published financial statements provide information that is largely historical. They do not reflect future events or transactions, nor do they anticipate the impact of potential changes to an entity. This means that it is not always possible to use them to predict future performance.
- There is often a time interval of several months between the year-end and the publication of the financial statements. Most financial information is out of date by the time it is actually published.
Limitations of financial analysis
Ratio analysis is a useful means of identifying significant relationships between different figures, but it also has many limitations.
- Profit is highly dependent on the accounting policies and estimates adopted by an entity.
- Many businesses produce financial statements to a date on which there are relatively low amounts of trading activity. As a result the items on a statement of financial position are not typical of the items throughout the reporting period.
- Ratios based on historical costs do not give a true picture of trends from year to year. An apparent increase in profit may not be a ‘true’ increase, because of the effects of inflation.
- Comparing the financial statements of similar businesses can be misleading for a number of reasons, including the effect of size differences and of operating in different markets.
- There are particular problems in comparing the financial statements of similar businesses that operate in different countries. There can be significant differences in accounting policies, terminology and presentation.
Impact of accounting policies and choices
Accounting policies can significantly affect the view presented by financial statements, and the ratios computed by reference to them, without affecting a business’s core ability to generate profits and cash.
The potential impact of accounting policies is especially important where:
- accounting standards permit a choice between a cost model or a fair value model
- judgement is needed in making accounting estimates, such as with depreciation and provisions
- there is no relevant accounting standard (although this is now extremely rare).
The impact of accounting policy choices on the financial statements will be highlighted throughout this text.
Non-financial performance measures
Ratio analysis and other interpretation techniques based on the financial statements cannot measure all aspects of performance. As a result, non-financial performance measures are becoming increasingly important to management, the shareholders and other interested parties external to an entity.
Examples of non-financial performance measures are:
- the number of instances of environmental spillage per year
- the reduction in CO2 emissions during the year
- the amount of waste (kg) arising from packaging on each $1,000 of products
- employee turnover
- training time per employee
- lost time injury frequency rate (relating to employees).
You will learn more about types of non-financial reporting later in this text.
