chapter 1

 This chapter also includes numerous conceptual

discussions that are integral to the topics presented here.

PREVIEW OF CHAPTER 1

As the following opening story indicates, countries are moving

quickly to adopt International Financial Reporting Standards (IFRS).

It is estimated that over 300 of the 500 largest global companies are

using IFRS. However, the accounting profession faces many

challenges in establishing these standards, such as developing a

sound conceptual framework, use of fair value measurements,

proper consolidation of financial results, off-balance-sheet financing,

and proper accounting for leases and pensions. This chapter

discusses the international financial reporting environment and the

many factors affecting it, as follows.

Continuing Evolution of International Financial Reporting

The age of international trade and the interdependence of national

economies continue to evolve. Many of the largest companies in the

world often do more of their business in foreign lands than in their

home countries. Companies now access not only their home country

capital markets for financing, but others as well. With this globalization,

companies are recognizing the need to have one set of financial

reporting standards. For globalization of capital markets to be efficient,

what is reported for a transaction in Beijing should be reported the same

way in Paris, New York, or London.

In the past, many countries used their own sets of accounting standards

or followed standards set by larger countries, such as those used in Europe or in the United States. That protocol has changed through the

adoption of a single set of rules, called International Financial Reporting

Standards (IFRS). As indicated in the following chart, there is broad

acceptance of IFRS around the world.

As indicated, 126 jurisdictions require the use of IFRS by all or most

public companies, with most of the remaining jurisdictions permitting

their use. Indeed, 27,000 of the 49,000 companies listed on the 88

largest securities exchanges in the world use IFRS. IFRS also has appeal

for non-public companies; since its publication, the IFRS for SMEs

(small and medium-sized entities) is required or permitted in 57

percent, or 85 of 150, profiled jurisdictions, while a further 11

jurisdictions are also considering adopting IFRS.

Changing to IFRS does not come without cost and effort. However,

academic research and studies by adopting jurisdictions provide

overwhelming evidence that the use of IFRS has brought the following

net benefits to capital markets:

IFRS was successful in creating a common accounting language for

capital markets (European Commission, 2015).

Evidence suggests that IFRS adoption was largely positive for listed

companies in Australia (Australian Accounting Standards Board,

2016).

IFRS adoption helped to reduce investment risk in domestic firms,

mitigate the “Korea discount,” and attract foreign capital via

overseas shares listing, bond issuance, or mergers and acquisitions

(Korean Accounting Standards Board, 2016).

Some companies also report benefits from being able to use IFRS in

their internal reporting. This improves their ability to compare operating

units in different jurisdictions by reducing the number of different

reporting systems. In Japan, where use of IFRS has been voluntary since

2010, business efficiency, enhanced comparability, and better

communications with international investors have been identified as the

main reasons why many Japanese companies made the choice to adopt

IFRS (Japanese Financial Services Agency). Thus, the international

financial reporting environment has and is continuing to evolve. With

these changes, it is hoped that a more effective system of reporting will

develop, which will benefit all.

Review and Practice

Go to the Review and Practice section at the end of the chapter for

a targeted summary review and practice problem with solution.

Multiple-choice questions with annotated solutions, as well as

additional exercises and practice problem with solutions, are also

available online.

Global Markets

LEARNING OBJECTIVE 1

Describe the global financial markets and their relation to financial

reporting.

World markets are increasingly intertwined. International consumers

drive Japanese cars, wear Italian shoes and Scottish woolens, drink Brazilian coffee and Indian tea, eat Swiss chocolate bars, sit on Danish

furniture, watch U.S. movies, and use Arabian oil. The tremendous

variety and volume of both exported and imported goods indicates the

extensive involvement in international trade—for many companies, the

world is their market.

To provide some indication of the extent of globalization of economic

activity, Illustration 1.1 provides a listing of the top 20 global

companies in terms of sales.

ILLUSTRATION 1.1 Top 20 Global Companies in Terms of

Sales

Source: Data from Global Fortune 500, 2018.

www.fortune.com/global500/2018/search/?revenues=desc.

In addition, due to technological advances and less onerous regulatory

requirements, investors are able to engage in financial transactions

across national borders and to make investment, capital allocation, and financing decisions involving many foreign companies. Also, many

investors, in attempts to diversify their portfolio risk, have invested

more heavily in international markets. As a result, an increasing number

of investors are holding securities of foreign companies. For example,

over a recent seven-year period, estimated investments in foreign equity

securities by U.S. investors doubled, from $3,422 billion to $7,844

billion (OECD, 2018).

An indication of the significance of these international investment

opportunities can be found when examining the number of foreign

registrations on various securities exchanges. As shown in Illustration

1.2, a significant number of foreign companies are found on national

exchanges.

As indicated, capital markets are increasingly integrated and companies

have greater flexibility in deciding where to raise capital. In the absence

of market integration, there can be company-specific factors that make it

cheaper to raise capital and list/trade securities in one location versus

another. With the integration of capital markets, the automatic linkage

between the location of the company and the location of the capital

market is loosening. As a result, companies have expanded choices of

where to raise capital, either equity or debt. The move toward adoption

of global accounting standards has and will continue to facilitate this

trend.

The World Federation of Exchanges.

Financial Statements and Financial Reporting

Accounting is the universal language of business. One noted economist

and politician indicated that the single most important innovation

shaping capital markets was the development of sound accounting

principles. The essential characteristics of accounting are (1) the

identification, measurement, and communication of financial

information about (2) economic entities to (3) interested parties.

Financial accounting is the process that culminates in the

preparation of financial reports on the enterprise for use by both

internal and external parties. Users of these financial reports include

investors, creditors, managers, unions, and government agencies. In

contrast, managerial accounting is the process of identifying,

measuring, analyzing, and communicating financial information needed

by management to plan, control, and evaluate a company’s operations.

Financial statements are the principal means through which a company

communicates its financial information to those outside the business.

These statements provide a company’s history quantified in money

terms. The financial statements most frequently provided are (1) the

statement of financial position, (2) the income statement (or statementof comprehensive income), (3) the statement of cash flows, and (4) the

statement of changes in equity. Note disclosures are an integral part of

each financial statement.

Some financial information is better provided, or can be provided only,

by means of financial reporting other than formal financial

statements. Examples include the president’s letter or supplementary

schedules in the company annual report, prospectuses, reports filed with

government agencies, news releases, management’s forecasts, and social

or environmental impact statements. Companies may need to provide

such information because of authoritative pronouncements and

regulatory rules, or custom. Or, they may supply it because management

wishes to disclose it voluntarily.

In this textbook, we focus on the development of two types of financial

information: (1) the basic financial statements and (2) related

disclosures.

Accounting and Capital Allocation

Resources are limited. As a result, people try to conserve them and

ensure that they are used effectively. Efficient use of resources often

determines whether a business thrives. This fact places a substantial

burden on the accounting profession.

Accountants must measure performance accurately and fairly on a

timely basis, so that the right managers and companies are able to

attract investment capital. For example, relevant financial information

that faithfully represents financial results allows investors and creditors

to compare the income and assets employed by such companies as

Nokia (FIN), McDonald’s (USA), Air China Ltd. (CHN), and Toyota

Motor Company (JPN). Because these users can assess the relative

return and risks associated with investment opportunities, they channel

resources more effectively. Illustration 1.3 shows how this process of

capital allocation works. 

ILLUSTRATION 1.3 Capital Allocation Process

An effective process of capital allocation is critical to a healthy economy.

It promotes productivity, encourages innovation, and provides an

efficient and liquid market for buying and selling securities and

obtaining and granting credit. Unreliable and irrelevant information

leads to poor capital allocation, which adversely affects the securities

markets.

High-Quality Standards

To facilitate efficient capital allocation, investors need relevant

information and a faithful representation of that information to enable

them to make comparisons across borders. For example, assume that

you were interested in investing in the telecommunications industry.

Four of the largest telecommunications companies in the world are

Nippon Telegraph and Telephone (JPN), Deutsche Telekom

(DEU), Telefonica (ESP and PRT), and AT&T (USA). How do you

decide in which of these telecommunications companies to invest, if

any? How do you compare, for example, a Japanese company like

Nippon Telegraph and Telephone with a German company like Deutsche

Telekom?

A single, widely accepted set of high-quality accounting standards is a

necessity to ensure adequate comparability. Investors are able to make 

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better investment decisions if they receive financial information from

Nippon Telegraph and Telephone that is comparable to information

from Deutsche Telekom. Globalization demands a single set of high-

quality international accounting standards. But how is this to be

achieved? Here are some elements: