Friday, May 26, 2017

Financial Statement Analysis Notes: Financial Reporting and CSR

Unit – 3: Financial Reporting and CSR

Meaning of Financial Reporting, its components and objectives
Basically, financial reporting is the process of preparing, presenting and circulating the financial information in various forms to the users which helps in making vigilant planning and decision making by users. The core objective of financial reporting is to present financial information of the business entity which will help in decision making about the resources provided to the reporting entity and in assessing whether the management and the governing board of that entity have made efficient and effective use of the resources provided. Financial reporting is of two types – Internal reporting and external reporting. The financial report made to the management is generally known as internal reporting and the financial report made to the shareholders and creditors is generally known as external reporting. The internal reporting is a part of management information system and they uses MIS reporting for the purpose of analysis and as an aid in decision making process.
 The components of financial reporting are:
a)      The financial statements – Balance Sheet, Profit & loss account, Cash flow statement & Statement of changes in stock holder’s equity
b)      The notes to financial statements
c)       Quarterly & Annual reports (in case of listed companies)
d)      Prospectus (In case of companies going for IPOs)
e)      Management Discussion & Analysis (In case of public companies)

Objectives of Financial Reporting
The following points sum up the objectives & purposes of financial reporting:
a)      Providing information to management of an organization which is used for the purpose of planning, analysis, benchmarking and decision making.
b)      Providing information to investors, promoters, debt provider and creditors which is used to enable them to male rational and prudent decisions regarding investment, credit etc.
c)       Providing information to shareholders & public at large in case of listed companies about various aspects of an organization.
d)      Providing information about the economic resources of an organization, claims to those resources (liabilities & owner’s equity) and how these resources and claims have undergone change over a period of time.
e)      Providing information as to how an organization is procuring & using various resources.
f)       Providing information to various stakeholders regarding performance of management of an organization as to how diligently & ethically they are discharging their fiduciary duties & responsibilities.
g)      Providing information to the statutory auditors which in turn facilitates audit.
h)      Enhancing social welfare by looking into the interest of employees, trade union & Government.
Qualitative Characteristics of Financial Reports
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. The Qualitative characteristics of useful financial reporting identify the types of information which are likely to be most useful to users in making decision about the reporting authority on the basis of information in its financial report. Financial information is useful when it is relevant and presented faithfully. Some of the qualitative characteristics which makes the financial reports useful to its users are given below:
a)      Relevance: Information is relevant if it would potentially affect or make a difference in users’ decisions. A related concept is that of materiality i.e. information is considered to be material if omission or misstatement of the information could influence users’ decisions.
b)      Faithful Representation: This means that the information is ideally complete, neutral, and free from error. The financial information presented reflects the underlying economic reality.
c)       Comparability: This means that the information is presented in a consistent manner over time and across entities which enables users to make comparisons easily.
d)      Materiality: Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or both) of the items to which the information relates in the context of an individual entity's financial report.
e)      Verifiability: This means that different knowledgeable and independent observers would agree that the information presented faithfully represents the economic phenomena it claims to represent.
f)       Timeliness: Timely information is available to decision makers prior to their making a decision.
g)      Understandability: This refers to clear and concise presentation of information. The information should be understandable by users who have a reasonable knowledge of business and economic activities and who are willing to study the information with diligence.
h)      Transparency: This means that users should be able to see the underlying economics of a business reflected clearly in the company’s financial statements.
i)        Comprehensiveness: A framework should encompass the full spectrum of transactions that have financial consequences.
j)        Consistency: Similar transactions should be measured and presented in a similar manner across companies and time periods regardless of industry, company size, geography or other characteristics.
International Financial Reporting Standards (IFRS)
IFRS is a set of international accounting standards stating how particular types of transactions and other events should be reported in financial statements. IFRS are generally principles-based standards and seek to avoid a rule-book mentality. Application of IFRS requires exercise of judgment by the preparer and the auditor in applying principles of accounting on the basis of the economic substance of transactions. IFRS are issued by the International Accounting Standards Board (IASB).
IASB issued only thirteen (13) IFRS which are as follows:
IFRS 1 - First-time adoption of International Financial Reporting Standards
IFRS 2 - Share-based payment
IFRS 3 - Business combinations
IFRS 4 - Insurance contracts
IFRS 5 - Non-current assets held for sale and discontinued operations
IFRS 6 - Exploration for and evaluation of mineral resources
IFRS 7 - Financial instruments: disclosures
IFRS 8 - Operating segments
IFRS 9 - Financial instruments
IFRS 10 - Consolidated financial statements
IFRS 11- Joint arrangements
IFRS 12- Disclosure of interests in other entities
IFRS 13- Fair Value measurement
Need and Importance of IFRS
The goal of IFRS is to provide a global framework for how public companies prepare and disclose their financial statements. IFRS provides general guidance for the preparation of financial statements, rather than setting rules for industry-specific reporting. Having an international standard is especially important for large companies that have subsidiaries in different countries. Adopting a single set of world-wide standards will simplify accounting procedures by allowing a company to use one reporting language throughout. A single standard will also provide investors and auditors with a comprehensive view of finances. 
Merits of IFRS
1. IFRS brings improvement in comparability of financial information and financial performance with global peers and industry standards. This will result in more transparent financial reporting of a company’s activities which will benefit investors, customers and other key stakeholders in India and overseas.
2. The adoption of IFRS is expected to result in better quality of financial reporting due to consistent application of accounting principles and improvement in reliability of financial statements.
3. IFRS provide better access to the capital raised from global capital markets since IFRS are now accepted as a financial reporting framework for companies seeking to raise funds from most capital markets across the globe.
4. IFRS minimize the obstacles faced by Multi-national Corporations by reducing the risk associated with dual filings of accounts.
5. The impact of globalization causes spectacular changes in the development of Multi-national Corporations in India. This has created the need for uniform accounting practices which are more accurate, transparent and which satisfy the needs of the users.
6. Uniform accounting standards (IFRS) enable investors to understand better the investment opportunities as against multiple sets of national accounting standard.
7. With the help of IFRS, investors can increase the ability to secure cross border listing.
Limitations of IFRS
1. The perceived benefits from IFRS’ adoption are based on the experience of IFRS compliant countries in a period of mild economic conditions. Any decline in market confidence in India and overseas coupled with tougher economic conditions may present significant challenges to Indian companies.
2. IFRS requires application of fair value principles in certain situations and this would result in significant differences in financial information currently presented, especially in relation to financial instruments and business combinations.
3. This situation is worsened by the lack of availability of professionals with adequate valuation skills, to assist Indian corporate in arriving at reliable fair value estimates.
4. Although IFRS are principles-based standards, they offer certain accounting policy choices to preparers of financial statements.
5. IFRS are formulated by the International Accounting Standards Board (IASB) which is an international standard body. However, the responsibility for enforcement and providing guidance on implementation vests with local government and accounting and regulatory bodies, such as the ICAI in India. Consequently, there may be differences in interpretation or practical application of IFRS provisions, which could further reduce consistency in financial reporting and comparability with global peers.
Explanation of Some Important IFRS
IFRS 1 – First-time adoption of International Financial Reporting Standards: The IASB issued the IFRS 1 on June 19, 2003. It applies to all those business concerns which are going to converge their accounting statements with IFRS from the first time. The IFRS1 has come into with effect from 1st January 2004. The main purpose of IFRS1 is to set out the basic rules or regulations for preparing and presenting first IFRS financial statements and interim financial statements by business concerns. The IFRS1 applies to first IFRS complied financial statements and each interim  report which is presented under IAS 34 for part of the period is covered by first IFRS financial statements of a business concern
IFRS 2 - Share-based payment: The major objective of this IFRS is to reflect the effect of share based transitions in the financial statements of an entity, including expenses associated with transactions in which share options are granted to employees. It is entailed for an entity to mention all the transactions which are associated with employees or other parties to be settled either in cash or other equity instruments of the business entity.
IFRS 3 - Business combinations: The major objective of this IFRS is to specify all requirements for an entity when it undertakes a business. Business combination means combining two separate entities in to a single economic entity. As a result of this, an enterprise obtains the control over the net assets or operations of other enterprises.
IFRS 4 - Insurance contracts: An insurance contract is that where one party (the insurer) accepts the insurance risk of another party (the policy holder) by agreeing to reimburse the amount of policy to the policy holder if any specified uncertain future events occur and adversely affect the policy holder. The primary objective of this IFRS for an entity is to determine the financial reporting for the issued insurance contracts (described in this IFRS as an insurer) until the Board completes the second phase of its project on insurance contracts.
IFRS 5 - Non-current assets held for sale and discontinued operations: The main purpose of this IFRS is to measure the accounting for the assets held for sale, and the preparation and disclosure of discontinued operations in the financial statements of an entity. Particularly, the IFRS requires those assets which can be categorized as held for sale to be measured at the lower degree of carrying amount and fair value less costs to sell, and the amount of depreciation on such assets to cease.
IFRS 6 - Explorations for and evaluation of mineral resources: The primary objective of this IFRS is to specify the effects of exploration for and evaluation of mineral resources in the financial reporting of an entity. This IFRS state that initially an entity should measure mineral resources assets on cost and subsequently measurement can be at cost or revalued amount. The IFRS demands for an entity to perform an impairment test when there are indications that the carrying amount of exploration and evaluation assets exceeds recoverable amount.
IFRS 7 - Financial instruments disclosures: The main purpose of this IFRS is to compel entities to prescribe disclosures that enable financial statements users to measure the significance of financial instruments for the entity’s financial position and performance; the nature and extent of their risk and how the entity manage these risks. This IFRS applies to all type of entities, either that have few financial instruments or those that have many financial instruments. This IFRS does not apply to those financial instruments which are associated with insurance contracts and financial instruments, contracts and obligations under share based payment transactions.
IFRS 8 - Operating segments: The primary objective of this IFRS is to disclose such information that enables the users of financial statements to evaluate the nature and financial effects of the business activities in which it is engaged and the economic environments in which it operates. This IFRS applies to the separate or individual financial statements of an entity and to the consolidated financial statements of a group with a parent whose debt or equity instruments are traded in a public market. If the parent company presents both separate and consolidated financial statement in a single financial report then segment information should be presented only on the basis of consolidated financial statements.
IFRS 9 - Financial instruments: This IFRS is replacement of IAS 39 and its major objective is to set some principles for the financial reporting of financial assets and financial liabilities of an entity’s financial statements and providing useful information to the users of these financial statements so that they can take rational decisions. This IFRS prescribes general guidelines such as how an entity should classify and determine the financial assets and financial liabilities.
Meaning of Corporate Governance
Corporate governance is the system of rules, practices and processes by which a company is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community.
Corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The corporate governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. This article outlines the relationship between corporate governance and corporate social responsibility (CSR). It begins by examining the role of corporate governance in creating value for shareholders. It focuses on the actions of the corporation and the board toward its shareholders and other stakeholders, i.e., how corporate governance serves or fails to serve their interests. It covers the assumptions that underlie theories of corporate governance and the expected outcomes of various board structures and compositions. It then examines the state of corporate democracy, the issue of accountability, and key legislation relative to corporate governance.
James D. Wolfensohn "Corporate Governance is about promoting corporate fairness, transparency and accountability".
In the words of Robert Ian (Bob) Tricker, "Corporate Governance is concerned with the way corporate entities are governed, as distinct from the way business within those companies is managed. Corporate governance addresses the issues facing Board of Directors, such as the interaction with top management and relationships with the owners and others interested in the affairs of the company"
Need and Importance of Corporate Governance
Corporate Governance is integral to the existence of the company. Corporate Governance is needed to create a corporate culture of Transparency, accountability and disclosure. It refers to compliance with all the moral & ethical values, legal framework and voluntarily adopted practices.
a) Corporate Performance: Improved governance structures and processes help ensure quality decision making, encourage effective succession planning for senior management and enhance the long-term prosperity of companies, independent of the type of company and its sources of finance. This can be linked with improved corporate performance- either in terms of share price or profitability.
b) Enhanced Investor Trust: Investors consider corporate Governance as important as financial performance when evaluating companies for investment. Investors who are provided with high levels of disclosure & transparency are likely to invest openly in those companies. The consulting firm McKinsey surveyed and determined that global institutional investors are prepared to pay a premium of up to 40 percent for shares in companies with superior corporate governance practices.
c) Better Access to Global Market: Good corporate governance systems attract investment from global investors, which subsequently leads to greater efficiencies in the financial sector.
d) Combating Corruption: Companies that are transparent, and have sound system that provide full disclosure of accounting and auditing procedures, allow transparency in all business transactions, provide environment where corruption will certainly fade out. Corporate Governance enables a corporation to compete more efficiently and prevent fraud and malpractices within the organization.
e) Easy Finance from Institutions: Several structural changes like increased role of financial intermediaries and institutional investors, size of the enterprises, investment choices available to investors, increased competition, and increased risk exposure have made monitoring the use of capital more complex thereby increasing the need of Good Corporate Governance. Evidence indicates that well-governed companies receive higher market valuations. The credit worthiness of a company can be trusted on the basis of corporate governance practiced in the company.
f) Enhancing Enterprise Valuation: Improved management accountability and operational transparency fulfill investors' expectations and confidence on management and corporations, and return, increase the value of corporations.
g) Reduced Risk of Corporate Crisis and Scandals: Effective Corporate Governance ensures efficient risk mitigation system in place. The transparent and accountable system that Corporate Governance makes the Board of a company aware of all the risks involved in particular strategy, thereby, placing various control systems to monitor the related issues.
h) Accountability: Investor relations' is essential part of good corporate governance. Investors have directly/ indirectly entrusted management of the company for the creating enhanced value for their investment. The company is hence obliged to make timely disclosures on regular basis to all its shareholders in order to maintain good investor‘s relation. Good Corporate Governance practices create the environment where Boards cannot ignore their accountability to these stakeholders.
Meaning of Corporate Social Responsibility (CSR)
Corporate social responsibility (CSR) is a business approach that contributes to sustainable development by delivering economic, social and environmental benefits for all stakeholders. CSR is a concept with many definitions and practices. Corporate social responsibility (CSR) promotes a vision of business accountability to a wide range of stakeholders, besides shareholders and investors. Key areas of concern are environmental protection and the wellbeing of employees, the community and civil society in general, both now and in the future.
The concept of CSR is underpinned by the idea that corporations can no longer act as isolated economic entities operating in detachment from broader society. Traditional views about competitiveness, survival and profitability are being swept away.
Difference between CSR and Corporate Governance
In very simple terms, Corporate Social Responsibility is expression of the commitment a corporate has with the society/environment in which it exists, whereas Corporate Governance is the way a corporate governs itself in a responsible way.
As far as inter-relationship between the two is concerned - it can be said that Corporate Social Responsibility is a subset of Corporate Governance in the Indian Context. In the international arena Corporate Governance would become a sub-set of Corporate Social Responsibility.
This difference is due to a conceptual difference in understanding of CSR. In India CSR generally excludes anything and everything that is not voluntary and also that is concerned with employees. In global perspective, anything that is done to bring in a positive impact on society gets covered under the umbrella of CSR, irrespective of of it being for the employees or for outsiders.
Need and Importance of CSR
Some of the drivers pushing business towards CSR include:
1. The shrinking role of government: In the past, governments have relied on legislation and regulation to deliver social and environmental objectives in the business sector. Shrinking government resources, coupled with a distrust of regulations, has led to the exploration of voluntary and non-regulatory initiatives instead.
2. Demands for greater disclosure: There is a growing demand for corporate disclosure from stakeholders, including customers, suppliers, employees, communities, investors, and activist organizations.
3. Increased customer interest: There is evidence that the ethical conduct of companies exerts a growing influence on the purchasing decisions of customers. In a recent survey by Environics International, more than one in five consumers reported having either rewarded or punished companies based on their perceived social performance.
4. Growing investor pressure: Investors are changing the way they assess companies' performance, and are making decisions based on criteria that include ethical concerns. The Social Investment Forum reports that in INDIA in, 2016 there was more than $1 trillion worth of assets invested in portfolios that used screens linked to the environment and social responsibility.
5. Competitive labour markets: Employees are increasingly looking beyond paychecks and benefits, and seeking out whose philosophies and operating practices match their own principles. In order to hire and retain skilled employees, companies are being forced to improve working conditions.
6. Supplier relations: As stakeholders are becoming increasingly interested in business affairs, many companies are taking steps to ensure that their partners conduct themselves in a socially responsible manner. Some are introducing codes of conduct for their suppliers, to ensure that other companies' policies or practices do not tarnish their reputation.
Benefits of CSR
Corporate Social Responsibility has many benefits that can be applied to any business, in any region, and at a minimal cost:
a) Improved financial performance: A recent longitudinal Harvard University study has found that “stakeholder balanced” companies showed four times the growth rate and eight times employment growth when compared to companies that focused only on shareholders and profit maximization.
b) Enhanced brand image & reputation: A company considered socially responsible can benefit -both by its enhanced reputation with the public, as well as its reputation within the business community, increasing a company’s ability to attract capital and trading partners. For example, a 1997 study by two Boston College management professors found that excellent employee, customer and community relations are more important than strong shareholder returns in earning corporations a place an Fortune magazine’s annual “Most Admired Companies” list.
c) Increased sales and customer loyalty: A number of studies have suggested a large and growing market for the products and services of companies perceived to be socially responsible. While businesses must first satisfy customers’ key buying criteria – such as price, quality, appearance, taste, availability, safety and convenience. Studies also show a growing desire to buy based on other value-based criteria, such as ” sweatshop-free” and “child labor-free” clothing, products with smaller environmental impact, and absence of genetically modified materials or ingredients.
d) Increased ability to attract and retain employees: Companies perceived to have strong CSR commitments often find it easier to recruit employees, particularly in tight labor markets. Retention levels may be higher too, resulting in a reduction in turnover and associated recruitment and training costs. Tight labor markets as well the trend toward multiple jobs for shorter periods of time are challenging companies to develop ways to generate a return on the consideration resources invested in recruiting, hiring, and training.
e) Reduced regulatory oversight: Companies that demonstrate that they are engaging in practices that satisfy and go beyond regulatory compliance requirements are being given less scrutiny and freer reign by both national and local government entities. In many cases, such companies are subject to fewer inspections and paperwork, and may be given preference or “fast-track” treatment when applying for operating permits, zoning variances or other forms of governmental permission.

f) Easier access to capital: Companies addressing ethical, social, and environmental responsibilities have rapidly growing access to capital that might not otherwise have been available.

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