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2. The annual reports under the International Financial Reporting Standards (IFRS)

Annual reports produced under the IFRS normally include, among others, some or all of the following documents:

o Chairman's letter to the shareholders

o Operational review

o Directors' report: business review

o Directors' report: corporate governance

o Financial statements6:

o Accounting policies

o Income statement

o Balance sheet

o Cash flow statement

o Statement of changes in equity

o Notes to the accounts

o Auditors' report

All of these documents must be read and analyzed in combination. The financial statements, on their own, are able to convey only a certain level of information; even considering the amount of disclosure included in the 'accounting policies' and the 'notes to the accounts', interpretation of the figures included in the statements must be supported by the analysis of the intentions of the directors and their considerations on the entity's going concern.

For example the operational review should normally enlighten the reader of the accounts on the reasons behind certain capital expenditures, i.e. investments for maintaining or improving the production and distribution capacity of the entity. These expenses could, for example, seem inexplicably high, in comparison with sector's or competitors' benchmarks, if not seen in the context provided by an operational review, where the directors explain that they are undertaking a business re-engineering process aimed at reducing areas of inefficiency in production or distribution.

Another example is where the strategic considerations provided by the directors in their 'business review' enlighten about, for instance, a sudden expansion of the production volumes with lower gross margin percent; in the context of a highly price competitive environment and with a choice of aggressive market penetration, these results might reflect a sound strategy.

What you should expect to see in each of the sections above mentioned is briefly explained below.

The Chairman's letter to the shareholders is a document from the person, who should bring to the owners of the entity some relatively independent view about its situation and performance. This letter is meant to represent the chairman's opinion and his/her view, i.e. you should not expect objectivity and perhaps even its absolute fairness can, under certain circumstances, be forgone. However, you should assume that the contents of the letter are true and based on true results, i.e. in compliance with one leg of the main accounting principle of 'truth and fairness.

The Operational review widely varies in formats and approaches from industry to industry and from entity to entity. You can normally expect some description of the main product lines and services provided by the entity; their contribution to the overall performance of the entity; the operational point of view of the main innovations embraced during the year. This review often makes references to the results as presented by segments according to the segmental analysis.

The Directors' report is often split in business review and corporate governance. The business review part of the directors' report consists of the analysis and view of the directors on the situation and performance of the entity, as a result of their decisions in the past year. Also, this document contains a prospective view of where the entity is heading; the directors' view of the entity's going concern. The entity's strategy is explained in the context of its competitive market, often with a very dynamic approach encompassing the possible medium and long term scenarios of the broader industry.

Together with the operational review, this report is the main tool the directors can use to convey the image of the entity and the strength of their strategy. It is the opportunity to link the entity's mission statement with the directors' strategic plans, support them with the directors' insight of the relevant environment and with their highlights of the results obtained so far. As per the chairman's statement, this part of the report must be based on true figures and results, but it is very much a subjective interpretation of them, made by those who are at the helm of the entity (and wish to be confirmed in their roles).

The Directors' report more and more often includes a section on Corporate Governance. This is where the directors explain what "process of supervision and control intended to ensure that the entity's management acts in accordance with the interests of shareholders"8 is in place. The message conveyed by this part of the report is aimed at reassuring the investors and the wider public, that the entity's management is bound to certain rules of sound management in the interest of the shareholders and, often, also that the entity has commitments to preserve the business and natural environment in which it operates. This information is relevant to the entity's providers of capital in two ways: firstly it reassures them about the protection they have against the moral hazard temptation of their 'agents', i.e. the entity's management; secondly it reduces the perceived risk the market attaches to the entity, which implies a reduction of the risk premium required by providers of capital of the entity, hence reducing the entity's cost of capital.

The following chapters of this study guide will address in more details the financial statements one-by-one. It is, however, worth highlighting at this stage what you should expect to read in the Accounting policies of section. This is a section filled of 'obvious' material, i.e. many of the policies are in fact dictated by the IFRS and do not leave much room for interpretation. However, there are many notable exceptions, where the corporate policies reflect subjective choices of the directors, which can affect the readers' perception of the validity and reliability of the accounts.

The Notes to the accounts are considered integral part of the financial statements and represent explanatory remarks about how certain figures and values have been obtained and what they represent in more details than it is possible to show on the face of the accounts, i.e. balance sheet, income statements, cash flow statements and statement of changes in equity. These notes often include information that is mandatorily required along side with information provided to fulfill the broader principle of fairness in the representation of the financial situation and performance of the entity.

Finally the Auditors' report represents the opinion that the auditors have stated about the validity of the accounts and their compliance with the relevant IFRS and local legislation.

 
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