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Introduction
This paper aims to analyze and expand the statement that “the objective
of financial statements is to provide information about the reporting
entity’s performance and financial position that is useful to a wide range
of users for assessing the stewardship of management and for making
economic decisions”. Such effort will be done by evaluating the financial
reports (FS) of two companies in the same industry regarding their
compliance with international standards and such compliance added value to
users of FS primarily (e.g. equity) investors. It is initially thought
that compliance with international standards increase the added-value FS
provide to users because such standards have universality and incorporates
integration across country preference. This initial idea can also be
checked while reading the paper.
Background
British telecommunications
(BT) is a UK-based company that operates in 170 countries with principal
stakes in networked IT services, telecommunications services and other
broadband/ internet products (BT Annual Report BAR 2005 p.1). On the
other hand, NTL is also a UK-based company and operating in UK soil but is
headquartered and listed in the US (NTL Annual Report NAR 2005 p. 1). Its
businesses are broadband, digital television, telephony, content and
communications services with 50% consumer and 85% business customers
within UK. Due to this, it is expected that there will be size and policy
differences but the focus would on the following policy frameworks. Also,
there is no available 2006 Annual Report for NTL and so the two companies
will be analyzed based on their 2005 FS. But to note, 2005 FS are not yet
based on IAS for both companies that level of compliance would be very
low.
First, IAS 1 lays down the presentation,
structure and other disclosure requirements of entities with regards to
the making of general-purpose FS (IASB 2006). AIS 1 is guided by the
principle of fair presentation by which an entity can achieve after
diligent compliance with international standards. When fairness is deemed
on FS, users of such information can have a useful and pertinent
decision-making platform. Also, AIS 1 ensure that FS of an entity is
comparable historically to itself and to other entities (e.g. product and
capital competitors). With this, AIS 1 sets out guidelines such as basis,
formats and minimum requirements in preparing FS (IASB 2006).
Another, IAS 8 largely deals with
accounting policies and changes to them initiated by the entity. This
guideline is much a complementary to IAS 1 because the fact that an entity
changes, use or defer to use international standards make its FS
incomparable historically to itself and other entities. Fair presentation
is also adversely affected. IAS 8 sets out implications of one’s
accounting policies especially with changes in accounting estimates and
emergence of errors (IASB 2006). Thus, it aspires to protect users
against the risks of misleading forecasts about the past, present and
future financial performance of an entity. The leniency of IAS 8,
however, is eminent in its submission for an entity’s use of managerial
judgment in setting its own policies as last resource.
Body of the Paper and Relevant Discussions
According to IAS 1, minimum content of FS
should include balance sheet (BS), income statement (IS), statement in
changes in equity (SICE), cash flow statement (CFS) and necessary
explanatory notes (EN) (IASB 2006). However, NTL did not have
extra-column for every account that requires further explanation. At the
end of every FS, it merely reminds the reader to “See accompanying notes”
(NAR 2005 p. f3-f10). This can tantamount for users to be annoyed and
de-motivated in searching for a relevant EN. For example, the necessary
notes for the effects of “loss from continuing operations” on average
number of shares outstanding is found in f-20 while such account is
located in Consolidated Statements of Operations in f-5.
On the other hand, BT complied
with such minimum requirements on FS content (BAR 2005 pp. 75-80) avoiding
the mistake of NTL in assuming unique FS titles (e.g. IS is tagged as
Consolidated Statement of Operations). For EN, BT also complied (pp.
75-80) assuring that every aggregated account in each FS titles are
explained and presented to users in a convenient manner. For example,
total turnover under IS is referenced with 2 under notes column which
makes it easy to navigate and refer information regarding the company’s
geographical, product and area that resulted in sales (p. 82). In effect,
users and especially potential investors who are not familiar with the FS
of the entity can assess performance and other components efficiently.
According to IAS 1, all FS
should be presented in accrual basis except the CFS (IASB 2006). However,
NTL accounted for deferred income taxes, deferred finance costs, prepaid
expenses, accounts payable, accounts receivable, accrued expenses and
deferred revenue under its CFS (p. f7). As a result, real cash assets of
the company are not reflected because CFS has elements that are not
recorded under cash basis. The amounts of such accrued accounts are huge
and are material in nature. For example, accrued expenses and deferred
revenue are two of the highest net values that changes operating assets
and liabilities (p. f7). In effect, potential investors are caught under
dim decision framework especially in evaluating liquidity of the company
and its ability to finance day-to-day operations without losing solvency
or face litigation.
In the contrary, BT complied
with CFS exemption from accrual accounting (p. 79). For example, accounts
pertaining to tax deferrals are replaced by taxation paid and further
classified in UK and non-UK obligations. This makes BT’s CFS to fulfill
the promise of this specific FS to guide investors in determining the
certainty and timing of cash flows the firm would expect (IASB 2006). BT
uses indirect method in presenting CFS as well as NTL and both also
classified their CFS according to IAS 1 which is categorizing accounts
into operating, financing and investing activities (IASB 2006).
However, both companies failed to
disclose the maturity of their investments to confirm that they are
cash-earners (BAR p. 79; NAR pp. f7-f8). IAS 1 requires CFS accounts to
be consisted of investment which have maturity not exceeding three months
from the date of acquisition (IASB 2006). But this provision cannot be
determined without the entity disclosing related information about the
nature and background of a related investment recorded in CFS. BT, which
is confirmed earlier as having the upper hand in EN, also failed to
explain the nature of CFS components. The lacking is much for NTL. BT
includes mere three EN, compared to substantial EN in IS, and the maturity
of “returns from investments and servicing finance” is not indicated in
either of the notes (p. 79 and p. 88).
In terms of materiality and
aggregation coinciding with IAS 1, NTL seemingly outperforms BT as the
former indicated separation of accounts in the face of IS (p. f5). The
latter, although referenced its aggregation with corresponding EN, IAS 1
is clear that similar items that are material should be separated while
dissimilar items can be aggregated if immaterial (IASB 2006). For
example, NTL readily specified the components of costs and expenses like
operating costs, selling expenses, administrative expenditures,
depreciation and amortization (p. f5). On the other hand, BT aggregated
operating costs (p. 75) amounting to at least three-fourths of its
turnover. Also, it is noticeable that corresponding EN is not available
for “other operating income” and “profit from the sale of fixed asset
investments” which are far above the share of minority interests in the
bottom-line (e.g. meaning they are material).
Failure to provide ready
information about the components of a certain material and aggregated
account can post decision problems to potential and current investors.
For the former, it would not have clear data in which the company is
spending too much or too less and if a significant corporate assets (e.g.
trademark on technologies) is executed. Such scenario would have change
the current impression and future outlook of the incumbent investor. But
since individual elements are not stated or rather located in EN, the
company seemingly escapes an adverse investor reaction. For the latter,
the given unfamiliarity of corporate operations deepens the ambiguity on
what present investors are experiencing.
The above investor adversaries
may as well take effect when both companies included in there are accounts
which have a face name of “extra ordinary” (IASB 2006). In the contrary,
both companies did not aggravate this situation because all transactions
that affects IS are disclosed may it be gains from foreign currency
trading (e.g. for NTL on p. f5) or interest receivable (e.g. for BT on p.
77). In the contrary, going intensive to the scope of IAS 1, NTL fell
behind the requirement that in using functional IS (e.g. cost of sales,
selling, administrative), the minimum requirement is to indicate
depreciation, amortization and staff cost (IASB 2006). Staff costs is not
reflected in its IS (p. f5). Investor ambiguity is confronted with added
pressure.
According to IAS 1, the
following should be complied in the FS of the entities; namely, separation
of enterprise and company, consistent reporting period and similarity of
face values of FS across annual reports (IASB 2006). All are intended to
maintain comparative stances of FS internally (e.g. historic accounts) and
externally (e.g. competitor’s FS). The first prerequisite is denied by
NTL which clearly stated in every FS that the information contained is for
“NTL Incorporated and Subsidiaries” (pp. f4-f10). The third prerequisite
is also tarnished in which NTL under SICE included a dollar amount (e.g.
$) to determine the par value of its common stock even if the total amount
is in pound sterling (e.g. £). In the contrary, BT did not commit the
same mistake. There is no problem for the second prerequisite as both
companies either restated or show performances from 2003 to 2005.
The problem of incomparability
is the cornerstone of why AIS 1 is created and so the failure of entities
to make their FS comparable supersedes the idea that they entirely break
down goals and provisions of AIS 1. As a result of incomparability, FS
become unfair to its users and their decision-making abilities are not
supported, or if ever FS is used, being misled. For potential investors,
they can be easily trapped in the inability of an entity’s FS to compare
historically and against other entities which can be more eligible for
investor’s resources. If this happens, they cannot maximize their
investments and also may loose their chance to help their communities
through their corporations. For current investors, they can be ensnared
in sub-optimal promises and outlooks of the entity (e.g. sub-optimal
within industry standards) due to incomparability.
It is also eminent that BT
does include SICE explicitly together with other FS in the initial part of
its FS. Its SICE is rather located in the EN (p. 96) that is incompliance
with format set forth by IAS 1. IAS 1 requires entities to present SICE
as a separate component of their FS and not as a negligible FS component (IASB
2006) that SICE should not be located in EN. On the other hand, NTL have
SICE in the location which BT failed to comply (pp. f9-f10). It can be
said that BT is hiding something which can cause negative impressions from
current investors. In their respective SICE, it is noticeable that their
formats and contents vary which is an indication that comparability cannot
be held and that one is not diligently coinciding with international
standards. In addition, both did not fulfill the need of the SICE results
to reflect minority and equity holder interest which is against IAS 1.
Investors are uncertain on how much they have stake in both companies that
can polish their holding gain targets.
With regards to IAS 8, both
companies complied with the provision that accounting policy being applied
should be disclosed (IASB 2006). For BT, it stated that it used Companies
Act of 1985 (p. 72) while NTL disclosed US GAAP as basis for FS
preparation (p. f12). Although international standards are not applied by
both companies, the mere fact that they made explicit the framework used
in their FS is already compliance with IAS 8. As a result, potential
investors that is new to capital markets can get an accountant or analyst
that is qualified in a certain accounting policy. In addition, current
investors will be aware if there are any changes in accounting policies
which may require change of allocation decisions or hiring of capital
market assistants.
IAS 8 also set forth the
limitations of managerial judgment in setting the entity’s accounting
policies for certain accounts (IASB 2006). The general limitation is that
an entity can use managerial judgment if international standards,
interpretations and recent pronouncements are lacking which means such
kind of judgment is a mere last resource (IASB 2006). However, BT
prepared its FS for some accounts such as doubtful debts, long-term
contracts and pension costs within managerial judgment without reference
to either international or other local standards (p. 72). This is
especially true in accounting estimates. In the contrary, BT disclosed
the nature and amount of change of estimating certain accounts such as
pension costs in EN (pp. 97-99).
Managerial judgment should
least be applied in material accounts and material accounts should not be
encapsulated in aggregate items. This is what IAS 8 is implicitly
notifying concerned entities (IASB 2006). But BT and NTL exercise
managerial judgments to substantial accounts without even preventing the
impression of manipulation from investors. Such impression can deter
motivation to invest funds due to the fear of sub-optimal returns even the
company is at its “peak”. When managerial judgment is excessive,
accounting standards either international or local can be easily ignored
because subjective biases of internal managers have a likely tendency for
image and performance building. In effect, the need of investors for fair
FS is dimmed.
The intention of BT in showing
the consequences of changes in accounting estimates is clearly to guide
investor decision-making especially current investors who analyze their
allocation based on, say, previously determined market values of certain
financial instruments. In the contrary, BT presented and explained
changes during 1999-2002 and the year in question is 2005 (p. 98). Due to
this, consolation to BT’s effort is only appropriate as investors would be
provided by inferior data. Investors are entitled to total disclosure
because they are capital providers of the company. However, with this
win-loss scenario they are facing due to inability to gather sufficient
information, their need to estimate the level of their expected wealth is
not supported rather undermined.
On the part of NTL, since it
adopted a single-entity FS (e.g. all Group no Company/ subsidiary as
opposed to BT), its accounting policy also departed from international
standards. As a result, excessive managerial judgment determined such
consolidation. Due to incompliance to IAS 8 regarding accounting polices,
IAS 1 is also adversely affected. In effect, the performance from the
core/ major activities of the firm will not be determined by investors
that may hinder analysis of the quality of stewardship of major
position-holders within NTL. Also, the use of accounting estimates is in
accordance to US GAAP but this reference is a partial departure from
international standards. For example, changes in estimating pension plans
do not have explanations on them (p. f37) like BT that means investors are
not guided and complex computations and analysis are required. The
information needs of users are not achieved.
With regards to IAS 8
provision on disclosing and correcting errors through retrospection (IASB
2006), both companies exemplified compliance. For example, FS of NTL and
BT had conducted retrospection for its errors from 2003 through 2005 (pp.
f3-f10; pp. 75-80) executed through restatements. This is a far-reaching
effort since IAS 8 only demands retrospection from the most immediate
annual report (e.g. 2004 for both companies). However, they included 2003
as well. Such effort can increase the historical comparability of an
entity’s performance which indicates that investors can forecast more
accurately since the inputs of previous operations are adjusted to
accounting policies of present and future transactions.
In the contrary, both
companies failed to disclose the nature of prior period error and the
procedure used to correct such error (IASB 2006). Such statements could
be hiding in other pages which the author is unsuccessful to browse.
However, if the company would really want to disclose such information it
would have included it in EN. However, both of the companies merely
stated that they have adjusted previous reports to coincide with the
effects of present changes in accounting standards that they are using
(BAR p.72; NAR p. f12-f13). As a result, investors are supplied with
retrospective data without knowing why the operational implications of
such changes. It should be remembered that merely saying that their
retrospection policy is consistent with authority regulations is a given
fact and investors want elaboration.
Conclusions
The above analysis contains the most significant inconsistencies of BT
and NTL’s accounting policies against international standards. Small
issues such as failure to split accounts especially in the BS or failure
to change accounting terms (e.g. delete “net” from the bottom-line of IS)
are not discussed. The methodology behind this is the fact that both the
2005 Annual Reports of both companies being analyzed does not yet embrace
IAS or other international standards. For example, the 2006 Annual Report
of BT includes IAS provisions because that year is its debut in adopting
IFRS or by International Financial Reporting Standards. The discussion
merely wants to emphasize the implications to investors both potential and
current of the inability of FS to embrace international standards.
As a conclusion, failure to
use international standards such as IAS provisions makes an entity’s FS
less useful to wide range of users. FS based on some other accounting
policies and subjective judgment cannot be used for comparability
especially to global and well-known companies who already adopted IFRS.
This can lead to loss-loss situation for companies and investors. The
former cannot assure financing not because of inferior performance within
the industry but primarily due in its failure to have comparable FS to the
leader in such industry. The latter cannot diversify the risk of its
portfolio because it is concentrated to firms that have comparable FS. As
a result, there is a need for every growing and competitive firm to adopt
IAS provisions to remain in such state or face the problems of internal
funding. |
