As the main objective of the financial statements to reflect the economic value of a company in order external users make useful economic decision, and due to the last shocking breakthroughs in the financial system, IASB recently has worked on developing high quality set of accounting standers; International financial reporting standards (IFRS). IFRS transition has break out in 90 countries, though other countries are following. Concerning the European Union, The EU has required IFRS for the groups listed on European stock market (EU Regulation 1606/2002).The new set of standers – as any new standers being introduced- has some effects on the financial reporting issues. This study is a literature review of prior studies focusing on the effect of the comprehensive income introduced by IFRS on the financial analysis, specifically one financial technique; ratio analysis. This study is presenting prior studies starting with a literature review in chapter one which is an overview of the comprehensives income discussing the definition of the comprehensive income then examines the pro’s and con’s of the comprehensive income. Chapter two is a literature review where of the financial analysis definition and financial analysis techniques, focusing on ratio analysis technique as the most common technique being used, and as it used part of this study. Chapter three is including the main hypothesis and the core issue of the research of the effect of the comprehensive income on the financial ratios. While Chapter four is a practical example examining the hypothesis mentioned in the previous chapter. Time was one of the major limitations of this study, lack of sufficient data was a second, many studies have examined the effect of IFRS adoption, but few has gone beyond and studied its effects on key financial ratios, where none has clearly stated the direct impact of the comprehensive income on the key financial ratios. This study is an attempt to study this effect.
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Chapter 1: comprehensive income statement overview
1.1. Definition and Presentation of comprehensive income statement
Many studies has declared that Income statement thought to be the most important statements in the financial statements. For inventors; the past income is the most important base for the future predictions and expectation for the cash flows, and so for expecting the share price and dividends. While creditors view the income statement as the borrowers ability to generate future cash flows to fulfill their financial obligations. Yet the comprehensive income statement drove its importance from the income statement importance.
Comprehensive income is not a new concept; it was first introduced by FASB in 1985 in its Framework as “the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources.” Later it was introduced in the Statement of Financial Accounting Standards (SFAS) No. 130, Reporting Comprehensive Income, issued by FASB in 1997, as: “the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners”.
Comprehensive income statement includes the traditional net income plus all revenues, expenses, gains and losses recognized during the period, refereed as other comprehensive income, where “other comprehensive income shall be classified separately into foreign currency items, minimum pension liability adjustments, and unrealized gains and losses on certain investments in debt and equity securities. Additional classifications or additional items within current classifications may result from future accounting standards.” ((SFAS) No. 130,Para 17,1997).
Under IFRS comprehensive income definition has not been changed, but IFRS has modified the rules of income presentation; due to the former rules regarding the classification of other comprehensive income, where these rules has been criticized as some of other comprehensive income items have been recorded in the equity section, while others in the profit and loss statement and others were not recognized at all. A second major reason was the importance recognizing the realized and unrealized gains and losses that might continue into the future as the excepted cash flows in the futures as they are the main drive for share price. IFRS approach of income presentation a mixture of previous income reporting and fair value concept and is being applied on unrealized gains and losses meeting certain criteria.
Regards the presentation of the comprehensive income statement under IAS 1, profit or loss are recognized plus other comprehensive income items, where the income statement has changed from ” net profit and loss” to ” profit and loss”. Entities are allowed to use the most suitable name to describe the totals as long as it give the right meaning, though IAS uses different terms, like ” total comprehensive income”, or ” profit or loss”.
Regarding the presentation of comprehensive income, entities are allowed to choose between the presentation of a single statement, or tow statements where an income statement is including all items of profit and loss, and the second statement shows other comprehensive income items (IAS 1.81). Under IAS 1, all income and expenses should be recognized in the profit and loss, unless there is an exception (AS 1.88), under (IAS 1.89) some of items need to be recognized under other comprehensive income.
IAS has as well identified the items of other comprehensive income, as the following:
Changes in revaluation surplus (IAS 16 property, plant and equipment and IAS 38 intangible assets )
Actuarial gains and losses on defined benefit plans recognized in accordance with (IAS 19 employees benefit )
Gains and losses arising from translating the financial statements of a foreign operation (IAS 21 The Effects of Changes in Foreign Exchange Rates)
Gains and losses on re-measuring available-for-sale financial assets (IAS 39 Financial Instruments: Recognition and Measurement)
The effective portion of gains and losses on hedging instruments in a cash flow hedge (IAS 39 Financial Instruments: Recognition and Measurement).
Under (IAS 1.82), the minimum items should be included in the comprehensive income are:
Revenues
Finance costs
Share of the profit or loss of associates and joint ventures accounted for using the equity method
Tax expense
Amounts from the discontinued operation include : the post-tax profit or loss and the post-tax gain or loss recognized on the disposal of the assets or disposal group(s)
Profit or loss
Each component of other comprehensive income classified by nature
Share of the other comprehensive income of associates and joint ventures accounted for using the equity method
Total comprehensive income
Under (IAS 1.83) these items must also be disclosed in the statement of comprehensive income as allocations for the period:
Profit or loss for the period attributable to non-controlling interests and owners of the parent
Total comprehensive income attributable to non-controlling interests and owners of the parent
Under (IAS 1.85) additional line items may be needed to fairly present the entity’s results of operations. Under (IAS 1.87) No items may be presented in the statement of comprehensive income (or in the income statement, if separately presented) or in the notes as ‘extraordinary items’.
Under (IAS 1.95) certain items must be disclosed separately either in the statement of comprehensive income or in the notes, if material, including:
Write-downs of inventories to net realizable value or of property, plant and equipment to recoverable amount, as well as reversals of such write-downs
Restructurings of the activities of an entity and reversals of any provisions for the costs of restructuring
Disposals of items of property, plant and equipment
Disposals of investments
Discontinuing operations
Litigation settlements
Other reversals of provisions
Under (IAS 1.99) expenses should be recognized either by nature or by function if an entity categorizes by function, and then additional information on the nature of expenses must be disclosed (IAS 1.104).
Pro’s and con’s of Comprehensive income :
According to prior studies, Investors has the ability to process financial information regardless its location, giving this, the location of the comprehensive income will not affect the quality of information interrupted by investors. On the contrary, policy makers believe it matters, as they think the performance statement presentation is more transparent presentation as comprehensive income serves as better measurement for firm performance, where it includes all changes in net assets.
The immediate recognition and direct reporting of comprehensive income items would transparently present all income flows in one statement in a timely manner, though it can be costly to some companies in certain industries (e.g. insurance industry) as they might try to hide their earning management. Another argued advantage, is comprehensive income shows value creation process and forces managers to consider external factors that affect firm value, not just internal operating ones. On the other hand, as comprehensive income contains a number of passing items possible as future events, this might cause noise and uncertainty and affect decision making process because users may take significant time to sort out temporary or irrelevant components. Following this point, proposing that comprehensive income includes irrelevant components can reduce the ability to uncover long-run performance.
Chapter 2: Financial analysis overview
2.1. Definition of financial analysis and methods
Though IFRS was discussed to be the one is giving more comprehensive information, it dose not include all the financial information needed to reach an excellent financial analysis. Financial statements are the source of information that present the economic value of a company to the external users. Several articles and books has defined the Financial analysis as to combine financial statement, financial notes, with other information, to evaluated the past, current, and future performance and financial position of company for the purpose of making investment, credit, and other economics decision. Financial Analysis is concerned with risk factors that might affect the future performance of a certain company.
Financial analysis is concerned with different aspects of the company, in general financial analysis deals with profitability (ability to generate profit from delivering good and services), cash- flow generating ability (ability to generate cash inflows exceed cash outflows), liquidity (the ability to meet short term obligation), and solvency (the ability to meet long term obligation).
In order to conduct a full, comprehensive analysis, analyst must collect information concerning economy, industry, competitors, company itself. This external information can be found as economics statistics, industry reports, and trade publication. The company provides the internal part of the information which includes the financial statements, and press releases.
Financial analysis is not only about financial data which is the core of the financial analysis and provided in the four major financial statements, that provide the historical and current information; is it about the non-financial data which provide the future information. Regarding the financial data, can be founded in the four major statements: income statement, balance sheet, statement of cash flow, statement of changes in owners’ equity.
The income statement shows how much revenue the company generating during certain period and what its cost incurred. Income statement can be referred as “profit and loss” and it’s prepared on consolidated basis. Revenues, operating income, net income, and earning per share can be driven from the income statement.
The balance sheet or as recently knows as the “statement of financial position”, shows the current financial position of the company by showing company resource (Assets), and what it owes (liability) at a specific point in time.While the (owners equity) shows the excess of assets over the liabilities, analysts could use the information stated in the statement of financial position to answer question regarding improvements concerning liquidity, and solvency, and give the statues of the company compared to its peers in the same industry.
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The cash flow statement classifies the cash flows into of three sections: operating activities which include items determines net income as well as day to day transactions. While investing activities includes the acquisition and disposals of long term assets. The last section is financing activities which contain activities related to obtaining or repaying capital. Cash flow statement provides information related to performance and financial position. While income statement provides the necessary information regarding the company ability to generate profit, cash flow statement provides information regarding the ability of the company to generate cash flow from running the business itself.
Statement of changes in owners’ equity knows as “statement of shareholders equity”, reports the changes in the owners’ investments in the business, and it helps analysts in understanding the changes in the financial position. Beside the four major statements, financial notes and supplementary schedules, management’s discussion and analysis, and auditor’s reports, provide a quite good set of extra information for further analysis.
Financial analysis should be well defined as it could be preformed for different reasons and purposes. Different categories require different financial techniques, but for any purpose data must be gathered and analyzed, and all examining the company ability of generating cash and grow earnings. But as for different focuses, different techniques are used. For example, the most tow common categories are the equity analysis and the credit analysis. Equity analysis is usually preformed by the owner, and focuses on growth while the credit analysis is preformed by the creditors (banker or bond holder) and concentrates on risks associated.
Defining the purpose of the financial analysis is the most important and first step in effective financial analysis as it defines the necessary financial techniques that should be used, and thus defines the type and amount of data to be collected. After defining the purpose of the financial analysis, a suitable technique should be chosen to deliver the purpose of the focus. To reach the best results, a mixture of calculations and interruptions is required. For example, it is not enough just to calculate the financial ratios, further investigation explaining the reasons behind each ratio, what each ratio means, comparing the ratios with other competitors, might give a comprehensive picture.
A comparison is a must in a good evaluation, compare the company with other competitors in the industry is (common size analysis), while evaluate the company through time called (trend analysis), and (ratio analysis) is to express certain number to another in which answers some important question about the true financial position. Common size analysis is to compare a total financial statement – usually income statement, balance sheet, cash flow statement in relation to base like revenues or total assets. Common size analysis for the balance sheet includes: horizontal and vertical common size analysis, where horizontal common size analysis is to compare the increase or decrease in balance sheet items to previous years. Vertical common size analysis involves dividing each item in the same period total assets to come with a percentage, in the case of analyzing the income statement, items usually are divided by revenues. Trend analysis involves comparison of the financial statement of an entity over time, trend analysis usually provide information about the historical performance and growth. Cross sectional analysis compare a specific measurement of a company with the same measurement for another company. The use of graphs and analytical tools could facilities the comparison and highlight the most important facts that the analyst wants to communicate with the management. Statistics like regression analysis are used in more complicated situation where more precise information needed.
Ratio analysis is one of the most famous techniques in the financial analysis where it provides information about the relationships and expectations between the financial accounts. Certain issues should be in mind while conducting ratio analysis; as mentioned before computing the ratio itself is not enough for providing a comprehensive picture about the financial performance, it only indicating what certain issues are but not explaining why they are happening, therefore further investigation going beyond the numbers is required, in compliance with full compression overtime, competitors, and industry. Second issue would be to choose the relevant ratios as ratios used for different purpose and providing certain financial information; for example ROA is an indicator of profitability, where current ratio provides information regards liquidity. Different accounting policies can misrepresent ratios; therefore adjustments across different financial statements for different companies are required for a meaningful analysis.
There are about five main types of financial ratios; profitability, activity, liquidity, solvency, valuation ratios. Profitability ratio is measure the company’s ability to generate profit from its resources, the most famous ratios in this category are: return on assets (ROA) and return on equity (ROE). While activity ratios measure how efficient the company in managing the day to day activities, inventory turnover is one example of the ratios used under this category. Third type is liquidity ratios where it deals with the company ability in meeting short term obligations, can be expressed in current ratio, while solvency ratios deals with long term obligation, debt to asset is one example of solvency ratios. Valuations ratios are used to asses the company equity, P/E ratio is used for this purpose. Ratios could be driven from the financial statements of the company or from specialized websites as Bloomberg, as these kinds of websites provide easy access to the historical data.
Ratio analysis drove its importance from the information that might provide, as it gives an insight to the historical, current and future performance of the company. Though ratio analysis has its own limitation when it deals with a company operates in different industries, as the comparison become more difficult then. Another limitation would be the use of different accounting methods as comparison would be difficult unless adjustments are made, for example one company might consider account for its inventories under the FIFO method while the other account for it under the LIFO method. Using IFRS might overcome these differences if applied.
2.2. The affect of IFRS as new accounting standard on financial Ratios
Financial statements are determined by business strategy, industry, and economics and affected by those as well. The difficulty of understanding the financial statements depending in the accounting procedures and polices chosen by top management. Changes in time frames, company structure, accounting methods and estimates in the company can affect the true economic value of an entity and might affect the financial analysis and thus reflect a distorted image of the company.
One of the most trends that might affect the financial analysis is changing of the accounting standers, as different accounting standers might use different methods. IFRS as a new set of international accounting standers has some effects, as the adoption process is costly, complex, Although IFRS believed to improve transparency and comparability of financial statements. Besides these effects IFRS has effect on the financial statements. To understand the effects of IFRS, one should understand the major differences between IFRS standers and local GAAP standers.
Several studies will be mentioned in this section, which will clarify the effect of IFRS adoption in Europe. According to Impact of International Financial Reporting Standard Adoption on key financial ratio, which has studied the effect of IFRS adaption on Europe continent represented by Finland; major differences in IFRS and Domestic accounting standers were found in the following areas: for employee benefits obligations (IAS 19), it is required to be measure at present value, where in countries like (Belgium, Denmark, Finland) such rules are do not exist, and in countries like (e.g. Austria and Germany) calculations follow tax regulations.
Concerning deferred tax (IAS 12), a deferred tax liability should be recognized for all taxable temporary differences, where in countries like (Greece, Luxembourg) rules concerning the treatment of deferred tax are missing, and in countries like (France, Germany) the deferred tax is be calculated on the basis of timing differences rather than temporary differences. In addition, deferred tax assets are not required to be recognized (Austria, Belgium) , while IAS 12 requires a deferred tax asset to be recognized for all deductible temporary differences to the extent that is probable that the deductible temporary difference can be utilized .
For intangible assets (IAS 38), state that an asset can be recognized when it will probably generate future benefits and when the cost of the asset can be reliably measured. For this reason, research expenditures cannot be capitalized. However, in many countries like (Germany, Italy, and Spain) research costs are allowed to be capitalized. Moreover, countries like (Finland) emphasize capitalization of development expenditures.
Construction contracts (IAS 11), requires the costs and revenues of construction contracts to be recognized on a stage of completion basis, compared to countered like (Finland, Greece), recognition by the stage of completion is optional.
Inventories (IAS 2), requires inventory to be measured at the lower of cost and net realizable value, (Austria, Portugal and Spain) allows inventories to be measured at the replacement cost instead of net realizable value. Moreover, according to (Germany, Luxembourg), inventories can be valued without the production overheads, IAS 2 requires inventory to be valued at full cost.
The major difference is that IFRS requires that assets impairments (IAS 36), most financial instruments (IAS 39), biological assets (IAS41), tangible and intangible fixed assets that have been acquired in a business combination (IFRS 3), pension assets (IAS 19) and share-based payment liabilities (IFRS 2) and investment property and property, plant and equipment (IAS 16) after initial recognition to be measured at fair value. On the contrary accounting practices in continental European countries have been based on historical costs but required downward valuations for permanent impairments of long-term assets.
Beside fair value, depreciation of assets in accordance with continental European countries differs from that required by IFRS. As IFRS has put large weight on the presenting balance sheets at fair value, therefore it requires assets with definite useful life to be depreciated or amortized periodically and assets with indefinite useful life to be assed for impairment. However, the continental European countries also require assets with indefinite useful life to be amortized. Therefore, while IFRS requires goodwill to be assessed annually for impairment, continental European countries requires goodwill to be amortized systematically (Finland, France) or allows goodwill to be deducted immediately against equity (Germany, Greece).
The study has also indicates the impact of these changes on the accounting figures. The study has indicating that the adoption of fair value accounting will probably increase the balance sheet items, and as the impairment accounting rules of continental European countries differ from those of IFRS these differences could lead to different accounting figures. As a consequence, the impact of fair value accounting adoption on accounting figures is also an empirical question since it is impossible to predict the exact impact of the adoption on accounting figures.
Other studies where more specific and handled one country by itself. One of the studies titles Adoption of IFRS in Spain: Effect on the comparability and relevance of financial reporting has indicated the effect of IFRS implementation on the balance sheet, as one of the study results has indicated that on the liability side, important differences were found due to the change of debt valuation rules and a new direction for consolidation. While the major difference in the equity side was due to direct adjustments and to the indirect effect of the adjustments. Fixed assets and inventories were the only items that did not change significantly as fixed assets were valued under traditional valuation method (acquisition cost). The reason behind insignificant differences in the inventory was that Spanish usually didn’t apply LIFO method which is not permitted under IFRS.
IFRS adoption in Europe: the case of Germany, has stated that IFRS adoption has resulted in higher retained earning in the first year of IFRS adaption because of the conservative approach of the German GAAP (HGB). The study has also indicated that IFRS effects vary with the industry:”… in the chemical and pharmaceutical industry effects on non-current assets and liabilities were relatively more important, whereas in the fashion industry the effects were mostly on working capital…”
While IFRS Adoption and Financial Statement Effects: The UK Case, has indicated that the IFRS implantation has a positive affect on the financial performance and post. IFRS implementation for the company as profitability and growth attend to be higher under IFRS. It also indicated that IFRS as high quality standers has reduced risk and improved the credibility and the borrowing bargain power of firms. It also stated that: “…IFRS adoption is likely to introduce volatility in income statement and balance sheet figures. Despite the higher volatility, adopters’ interest cover ratio has not been adversely affected, implying that IFRS adoption would not lead to debt covenant violation or financial distress …”
Chapter 3: The Impact of Comprehensive income on the financial ratios
As mentioned earlier the impact of IFRS on accounting figures differs with the country that IFRS is applied in, as different countries have different accounting standers, different impacts resulted. In this section a comparison between US GAAP and IFRS will be mentioned as Deutsche bank (the particle example) mentioned later was using US GAAP. First differences of reporting comprehensive income under IFRS and different accounting standers will be mentioned followed by differences of reporting comprehensive income under IFRS and US GAAP.
In the study titled Comprehensive income in Europe: valuation, prediction and conservative issues, has argued that the concept of comprehensive income does not recognize different income concepts in different industry or different firms. And financial analyst has taken into consideration these limitations and used total and unrealized asset valuations and foreign exchange to fill in the gabs.
In the study titled analyzing brokers’ expertise: did analysts fully anticipate the impact of IFRS adoption on earnings? The European evidence Has reached to a conclusion that “…analysts were not able to correctly anticipate the effect of IFRS adoption on earnings, forecast errors being significantly associated with differences in earnings changes resulting from the compliance with the new financial reporting standards…”.
While in Adoption of IFRS in Spain: Effect on the comparability and relevance of financial reporting the study has studied IFRS effects on the income statement. Major differences were found due to major differences between Spanish GAAP (SAS) or IFRS in classifying revenues and expenses for example the classification of R&D expenses. Another difference is the treatment of extraordinary income, as certain extraordinary items under (SAS) were classified as operating income under IFRS reclassify under (SAS) as operating income under IFRS. The study has indicated those Cash, solvency and indebtedness ratios, as well as the return on assets and returns on equity, has varied significantly as a result of the changes in the balance sheet and income statement.
In Effects Of Comprehensive Income On ROE In A Context Of Crisis: Empirical Evidence For IBEX-35 Listed Companies (2004-2008), when calculating ROE under comprehensive income compared to ROE calculated under net income, statistically significant differences were founded, which means that ROE calculated under comprehensive income, shows the market impact much more clearly and thus provide better information for users and particularly for investors. The study has also indicated that comprehensive income is an “alternative measurements of corporate performance” and “is much more in tune with the market reality than the traditional net income.”
According to IAS plus report which was issued by Deloitte in 2004, the major differences between IFRS and US GAAP are listed here: As in IAS 1(reporting ‘comprehensive income’) IFRS requires the statement of changes in equity. The total of ‘comprehensive income’ is permitted but not required. And define Comprehensive income as the net income plus gains and losses that are recognized directly in equity rather than in net income. While in the US GAAP requires the presentation of the total ‘comprehensive income’. Gains and losses can be presented in the income statement, statement of comprehensive income, or statement of changes in equity. Under IFRS Extraordinary items is prohibited while in US GAAP Extraordinary items are permitted but restricted to infrequent, unusual, and rare items that affect profit and loss. This act by IFRS increase transparency and limit manipulation. And that would lead to an increase in the reported income and therefore might have a significant effect of the financial ratios dealing with profitability.
Dealing with inventory IAS2, LIFO method under IFRS is prohibited while under US GAAP is permitted. When using LIFO revaluation for inventory needed, this could result in major tax liabilities.
For property, plant, and equipment (IAS 16), under IFRS revalued amount or historical cost might be used where revalued amount is fair value at date of revaluation less subsequent accumulated depreciation and impairment losses where under US GAAP it is generally required to use historical cost. Which lead to increase in book values under IFRS.
Chapter 4: Practical example (the case of the Deutsche bank)
In Deutsche bank transition report, (Transition Report,2006 IFRS Comparatives), The Deutsche bank net income under IFRS was € 6,070 million for the year ended December 31, 2006, an increase of € 84 million compared with € 5,986 million under U.S. GAAP. While shareholders’ equity under IFRS was € 32,666 million, a decrease of € 142 million as at December 31, 2006 compared to U.S. GAAP, according to the transition report.
Conducting small ratio analysis limited only to the three major profitably ratios, a res
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