Financial Statements

Public companies have a variety of stakeholders, such as shareholders, bondholders, bankers, suppliers, employees, and management. All these stakeholders need to monitor the firm and to ensure that their interests are being served. They rely on the company’s financial statements to provide the necessary information. Public companies in the United States report to their shareholders quarterly and annually. The annual financial statements are filed with the SEC on form 10-K and the quarterly statements are filed on form 10-Q. Therefore you often hear financial analysts refer loosely to the company’s “10-K” or its “10-Q.”

When reviewing a company’s financial statements, it is important to remember that accountants still have a fair degree of leeway in reporting earnings and book values. For example, they have discretion in the choice of depreciation method and the speed at which the firm’s assets are written off.

FINANCE IN PRACTICE The Rise and Stall of Convergence in Accounting Standards

The International Financial Reporting Standards (IFRS), which are set by the London-based International Accounting Standards Board (IASB), aim to harmonize financial reporting around the world. They are the basis for reporting by listed firms throughout the European Union. In addition, some 100 other countries, such as Australia, Canada, Brazil, and India have adopted them or plan to do so, while China has modified its account­ing standards to be largely in line with IFRS.

For some years, the SEC has worked to bring U.S. accounting standards more in line with international rules. For example, until 2007, foreign companies that traded on U.S. stock exchanges were required to show how their accounts differed from U.S. GAAP. This was a very expensive exercise that cost some companies millions of dollars annually and caused many to delist their stocks. These companies can now simply report results using international accounting standards. Sub­sequently, in August 2008, the SEC released its plans to allow some large U.S. multinationals, representing approximately $2.5 trillion in market capitalization, to eventually use IFRS for financial statements.

This shift from GAAP to IFRS would involve a major change in the way that accountants in the United States approach their task. IFRS tend to be “principles based,” which means that there are no hard-and-fast codes to follow. Instead, companies must be ready to defend their accounting practices in light of the gen­eral principles laid out in the IFRS. By contrast, in the United States, GAAP are accompanied by thousands of pages of prescriptive regulatory guidance and interpre­tations from auditors and accounting groups. For exam­ple, more than 160 pieces of authoritative literature relate to how and when companies record revenue. This leaves less room for judgment, but detailed rules rapidly become out of date, and unscrupulous companies have been able to structure transactions so that they keep to the letter but not the spirit of the rules.

By 2014, it had become clear that the SEC’s plan to move to IFRS was effectively dead and that, while the SEC and IASB would continue to collaborate on accounting rules, there was little prospect of any agree­ment over a single global standard that included the United States.

Although accountants around the world are working toward common practices, there are still considerable variations in the accounting rules of different countries. For investors and multinational companies these variations in accounting rules can be irksome. Accounting bodies have therefore been getting together to see whether they can iron out some of the dif­ferences. It is not a simple task, as the nearby box illustrates.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.