Lucubrate Magazine, Issue 33, July 20th, 2018
This article is an awful lot of schematics and charts. We will go down to gross profit before expenses. In the same vein, most line items reflecting expenses are easily auditable and supported by documentation.
- Accounting Series – article No: 14
- Accounting Theory – Advanced Part 4
By Peter Welch, Georgia, CEO GlobalCfo.LLC.
As we ended, let’s discuss ‘Operating activities’ and the options for disclosure/presentation, the direct vs indirect method.
The IASB on occasions allows options that default to management. Neither option is necessarily better or worse than the other and thus management is left to decide which version they would prefer. On the other hand, as with IAS 1, presentation of financial statements, the by function approach, traditional measures such as gross profit and other line items remain to be recognized. The by nature approach, on the other hand, though totally correct leaves the reader with comparability and reconciliation issues.
By Function Approach
Courtesy of IFRSbox
The approach used in this IAS 7 article, and yes an awful lot of schematics and charts, but if you ‘look’ carefully they’re all connected. An option and the recommended approach is the ‘by function’ that references familiar benchmarks and cross-references to other ‘accrual-based’ financial statements. We’ve also added ‘Grant Thornton’ illustrative model financial statements to strengthen the visual cross-referencing. The ‘by function’ approach will always reference ‘gross-profit’ and ‘changes in the working capital’. For example (statement of profit or loss by function), below, Profit before tax is 22,392. Now look at the ‘consolidated statement of cash flows’ with the first-line being 22,392, it’s all connected. The note (#29) included also shows the line-items that are included in ‘net changes in the working capital’ and ‘non-cash adjustments.
Organizing the statement of profit or loss by the function of expenses.
Acknowledgement Grant Thornton (Reporting under IFRSs. Example consolidated financial statements 2016 and guidance notes.
The same observations, it can be said, apply to IAS 7. The direct method one might argue is more appropriate because it targets cash only and removes any need to adjust for accruals. However, we know that the balance sheet, correctly reflecting accruals, is inadequate from the perspective of analyzing cash uses and sources. Thus, the statement of cash flows is designed to fill that void. It would seem logical therefore that the indirect method starting with the net income per the financial statements and adjusted for non-cash transactions, such as depreciation, is more appropriate.
Let’s now analyze accounts receivables, I promised we’d eventually get there. Accounts receivables, being cash due to the corporation for sales transactions not yet paid are the bricks and mortar underlying the credibility of the income statement. But what is meant by this statement? Consider the key lines on any income statement ultimately resulting in net income before taxes. From a manipulation perspective, definitely not faithful representation, revenue is a primary target.
We have already discussed under IAS 2 the cost of sales; what it comprises and how it is matched against the units sold. It should also be clear that each component of cost of sales can be matched easily against invoices that in turn can be cross-referenced to either cash paid or accounts payable that were previously very thoroughly covered. We are now down to gross profit before expenses. In the same vein, most line items reflecting expenses are easily auditable and supported by documentation. For example, administrative expenses mostly payroll is very straightforward.
Another relatively large ticket item is depreciation that rolls forward year to year until it is fully consumed i.e. written off. Certainly also the income statement will reflect accrual items and provisions that need to be recognized. When all the above is taken in aggregate, from an income statement perspective, we are at the net income before taxes. There is no question that the controlling line item as to how large is the net income defaults to be revenue net of cost of sales adjustments. In a manufacturing company in which most products have a relatively high markup, it can be very apparent on a unit basis how net income can be manipulated. To complete our discussion, two other areas that can manipulate net income are legal fees and pension costs. However, provision for legal fees require disclosures in the notes to the financials that can trigger stakeholder questions. As to pension costs, they are driven very significantly by the credited interest rate and like legal fees are open to scrutiny. At this juncture, it should be no surprise that revenue is frequently the target of financial shenanigans.
Now let’s revisit the presentation format options of IAS 7 we covered at the end last week. Remember also that information, to be of value has to convey a message. If that message creates just nothing more than “that’s interesting” then perhaps it needs to be revisited. On the other hand, when information triggers “what’s going on here” then any financial analyst is likely to seek additional information cross-checking between the balance sheet and the notes to the financials. Often times the notes to the financials, in between the lines, can convey issues that need to be investigated or implications verified. Or in other words, as discussed previously, the application of due diligence. We have now finally reached the point where we need to discuss ”working capital”, I said we would get there eventually.
Consolidated statement of cash flows
Indirect Method (Net change in Working Capital). Organizing the statement of profit or loss by a function of expenses (i.e., Profit before tax 22,392, accrual-based).
Acknowledgement Grant Thornton (Reporting under IFRSs.)
Example consolidated financial statements 2016 and guidance notes. Indirect Method (Net change in Working Capital).
Acknowledgement Grant Thornton (Reporting under IFRSs Example consolidated financial statements 2016 and guidance notes.
Courtesy of IFRSbox
Next week, investing, financing and targeting revenue Shenanigans.
IFRS Workbook 2017 Inventory. The set of books provides a book for every standard. Our acknowledgment to Mr. Prof. Robin Joyce.
Grant Thornton (Reporting under IFRSs Example consolidated financial statements 2016 and guidance notes
Thanks also to IFRSbox and Silvia for her valuable contribution as a reference source. Ms. Silvia Mahútová runs the website www.ifrsbox.com dedicated to helping people understand and learn IFRS in an easy way. In 2018, her website has over 130 000 visits per month and students come from more than 130 countries around the world.
(Photo on top: Ella Pix)
Lucubrate Magazine, Issue 33, July 20th, 2018