FB5810

Financial Reporting Concepts

and Institutional Framework for
Financial Reporting
Financial
Financial Reporting
Reporting Concepts
Concepts
Assumptions in Financial Reporting Illustration 2-18

Monetary Unit Economic Entity

Requires that only those things
States that every economic
that can be expressed in
entity can be separately
money are included in the
identified and accounted for.
accounting records.
Financial
Financial Reporting
Reporting Concepts
Concepts
Assumptions in Financial Reporting Illustration 2-18

Periodicity Going Concern

States that the life of a The business will remain in
business can be divided into operation for the
artificial time periods. foreseeable future.
Financial
Financial Reporting
Reporting Concepts
Concepts
Principles in Financial Reporting
Measurement Principles

Historical Cost Fair Value Full disclosure

Or cost principle, Indicates that Requires that
dictates that assets and companies disclose
companies record liabilities should be all circumstances
assets at their reported at fair and events that
cost. value (the price would make a
received to sell an difference to
asset or settle financial statement
a liability). users.
Financial
Financial Reporting
Reporting Concepts
Concepts
Cost Constraint

Cost Constraint
Accounting standard-setters weigh
the cost that companies will incur to
provide the information against the
benefit that financial statement
users will gain from having the
information available.
Timing
Timing Issues
Issues

Accountants divide the economic life of a business into

artificial time periods (Periodicity Assumption).
.....
Jan. Feb. Mar. Apr. Dec.

 Generally a month, a quarter, or a year.

 Fiscal year vs. calendar year
Timing
Timing Issues
Issues

The Revenue Recognition Principle

Companies recognize
revenue in the accounting
period in which the
performance obligation is
satisfied.
Timing
Timing Issues
Issues

Illustration: Assume Conrad Dry Cleaners cleans clothing

on June 30, but customers do not claim and pay for their
clothes until the first week of July.

Should Conrad Dry Cleaners recognize the service revenue

in June or July?
Timing
Timing Issues
Issues
Illustration 4-1 (Partial)

“Let the expenses follow the revenues.”

Timing
Timing Issues
Issues
Illustration 4-1 GAAP
relationships in revenue
and expense recognition
Timing
Timing Issues
Issues

Accrual versus Cash Basis of Accounting

Accrual-Basis Accounting
► Transactions recorded in the periods in which the
events occur.
► Revenues are recognized when services performed,
even if cash was not received.
► Expenses are recognized when incurred, even if cash
was not paid.
Timing
Timing Issues
Issues

Accrual versus Cash Basis of Accounting

Cash-Basis Accounting
► Revenues are recognized only when cash is received.

► Expenses are recognized only when cash is paid.

► Prohibited under generally accepted accounting

principles (GAAP).
Timing
Timing Issues
Issues
Illustration: Suppose that Fresh Colors paints a large
building in 2013. In 2013, it incurs and pays total expenses
(salaries and paint costs) of $50,000. It bills the customer
$80,000, but does not receive payment until 2014.
Illustration 4-2 (Partial)

2013 2014
The
The Basics
Basics of
of Adjusting
Adjusting Entries
Entries

Adjusting entries
 ensure that the revenue recognition and expense
recognition principles are followed.
 are required every time a company prepares financial
statements.
 includes one income statement account and one
balance sheet account.
 never include cash.
Types
Types of
of Adjusting
Adjusting Entries
Entries

Deferrals:
1. Prepaid expenses: Expenses paid in cash and recorded as
assets before they are used or consumed.
2. Unearned revenues: Cash received before service are
performed.
Accruals:
1. Accrued revenues: Revenues for services performed but not
yet received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in
cash or recorded.
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid Expenses”
Expenses”

Payment of cash, that is recorded as an asset because service or

benefit will be received in the future.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

 insurance  rent
 supplies  equipment
 advertising  buildings
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid Expenses”
Expenses”

Prepaid Expenses
 Costs that expire either with the passage of time or
through use.
 Adjusting entry results in an increase (a debit) to an
expense account and a decrease (a credit) to an asset
account.
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid Expenses”
Expenses”

Depreciation
 Buildings, equipment, and motor vehicles (long-lived
assets) are recorded as assets, rather than an expense,
in the year acquired.
 Companies report a portion of the cost of a long-lived
asset as an expense (depreciation) during each period of
the asset’s useful life.
 Depreciation does not attempt to report the actual
change in the value of the asset.
Adjusting
Adjusting Entries
Entries for
for “Unearned
“Unearned Revenues”
Revenues”

Receipt of cash recorded as a liability before services are

performed.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

 rent  magazine subscriptions
 airline tickets  customer deposits
Adjusting
Adjusting Entries
Entries for
for “Unearned
“Unearned Revenues”
Revenues”

Unearned Revenues
 Adjusting entry to record the revenue that has been
earned and to show the liability that remains.
 Adjusting entry results in a decrease (a debit) to a
liability account and an increase (a credit) to a revenue
account.
Adjusting
Adjusting Entries
Entries for
for Accruals
Accruals

Made to record:
 Revenues earned and

OR
 Expenses incurred

in the current accounting period that have not been

recognized through daily entries.
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued Revenues”
Revenues”

Revenues for services performed but not yet received in cash or recorded.

Adjusting entry results in:

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

 rent
 interest
 services performed
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued Revenues”
Revenues”

Accrued Revenues
An adjusting entry serves two purposes:

(1) Shows the receivable that exists, and

(2) Records the revenues for services performed.

Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued Expenses”
Expenses”

Expenses incurred but not yet paid in cash or recorded.

Adjusting entry results in:

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

 rent  taxes
 interest  salaries
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued Expenses”
Expenses”

Accrued Expenses
An adjusting entry serves two purposes:

(1) Records the obligations, and

(2) Recognizes the expenses.

Summary
Summary of
of Basic
Basic Relationships
Relationships
Financial
Financial Reporting
Reporting Concepts
Concepts
Qualities of Useful Information
According to the FASB, useful information should possess two
fundamental qualities, relevance and faithful representation.
 Relevance Accounting information has relevance if it would
make a difference in a business decision. Information is
considered relevant if it provides information that has
predictive value, that is, helps provide accurate expectations
about the future, and has confirmatory value, that is,
confirms or corrects prior expectations. Materiality is a
company-specific aspect of relevance. An item is material
when its size makes it likely to influence the decision of an
investor or creditor.
LO 7
Financial
Financial Reporting
Reporting Concepts
Concepts
Qualities of Useful Information
According to the FASB, useful information should possess two
fundamental qualities, relevance and faithful representation.
 Faithful Representation Faithful representation means
that information accurately depicts what really happened. To
provide a faithful representation, information must be
complete (nothing important has been omitted), neutral (is
not biased toward one position or another), and free from
error.
Financial
Financial Reporting
Reporting Concepts
Concepts
Qualities of Useful Information
Enhancing Qualities

Comparability Information is Information has the

results when verifiable if quality of
different companies independent understandability
use the same observers, using the if it is presented in a
accounting same methods, obtain clear and concise
principles. similar results. fashion.

Consistency means
that a company uses For accounting information to
the same accounting have relevance, it must be
principles and methods timely.
from year to year.
Financial
Financial Reporting
Reporting Concepts
Concepts
Review Question
What is the primary criterion by which accounting
information can be judged?
a. Consistency.
b. Predictive value.
c. Usefulness for decision making.
d. Comparability.
 The following items guide the FASB when it creates accounting
standards.
Relevance Periodicity assumption
Faithful representation Going concern assumption
Comparability Historical cost principle
Consistency Full disclosure principle
Monetary unit assumption Materiality
Economic entity assumption

Match each item above with a description below.

1. Ability to easily evaluate one company’s results
relative to another’s.
2. Belief that a company will continue to operate for the
foreseeable future.
3. The judgment concerning whether an item is large
enough to matter to decision-makers.
 The following items guide the FASB when it creates accounting
standards.
Relevance Periodicity assumption
Faithful representation Going concern assumption
Comparability Historical cost principle
Consistency Full disclosure principle
Monetary unit assumption Materiality
Economic entity assumption

Match each item above with a description below.

4. The reporting of all information that would make a
difference to financial statement users.
5. The practice of preparing financial statements at
regular intervals.
6. The quality of information that indicates the
information makes a difference in a decision.
 The following items guide the FASB when it creates accounting
standards.
Relevance Periodicity assumption
Faithful representation Going concern assumption
Comparability Historical cost principle
Consistency Full disclosure principle
Monetary unit assumption Materiality
Economic entity assumption

Match each item above with a description below.

7. Belief that items should be reported on the balance
sheet at the price that was paid to acquire the item.
8. A company’s use of the same accounting principles
and methods from year to year.
9. Tracing accounting events to particular companies.
 The following items guide the FASB when it creates accounting
standards.
Relevance Periodicity assumption
Faithful representation Going concern assumption
Comparability Historical cost principle
Consistency Full disclosure principle
Monetary unit assumption Materiality
Economic entity assumption

Match each item above with a description below.

10. The desire to minimize errors and bias in financial
statements.
11. Reporting only those things that can be measured in
dollars.
 From business activities to financial
statements

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environment activities s
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Accounting Accountin Accounti
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2-37
From business activities to financial statements
From business activities to financial statements

• Financial statements measure and summarize the

economic consequences of business activities.

• Accounting systems facilitate information quality,

conditional on various institutional features:
– Feature 1: The role of accrual accounting.
– Feature 2: The need for accounting conventions and
standards.
– Feature 3: Managers’ accounting choices and strategies.
– Feature 4: Auditing, legal liability, and public enforcement.
 Feature 1: Accrual accounting

• Financial reports are prepared using accrual accounting.

• IFRS Standards define the following financial statement
elements:
– Assets: Economic resources with measurable future benefits.
– Liabilities: Unavoidable and enforceable economic
obligations arising from past benefits.
– Equity: Assets minus liabilities.
– Income or Revenue: Earned economic resources and settled
obligations.
– Expenses: Used economic resources and created obligations.
– Profit or Loss: Income or revenue minus expenses.
 Feature 2: International Financial Reporting
Standards (IFRS Standards)

• The EU and other countries have relied on the IASB to set accounting
standards (IFRS Standards); many countries have endorsement
procedures.

• IFRS Standards allow for consistency in reporting between firms, and

over different time periods for the same firm.

• Regulators make a trade-off:

– Uniform accounting standards minimize managers’ ability to manipulate
financial statement information.
– However, rigid accounting rules may be dysfunctional; calls for principles-
based accounting standards.
 Feature 3: Management’s responsibility for
reporting financial information
• Accrual accounting requires estimates. For example:
– Expected customer defaults.
– Post-employment plan obligations.
– Revenue allocation across elements of bundled sales transactions.

• Applying accounting principles is the responsibility of management,

who has superior knowledge of a firm’s business.

• However, incentives exist for management to distort accounting

numbers in their favor:
– Contracts.
– Reputation.
 Feature 4: External auditing of financial
statements
• Required for publicly traded companies; also required for
some private firms within the EU. Mandatory for all
companies incorporated under Hong Kong Companies
Ordinance
• Conducted according to standards:
– EU: minimum standards set by the Revised Statutory Audit
Directive and Regulation (US: Sarbanes-Oxley Act).
– International Standards of Auditing (US: GAAS).

• Auditing has its limitations; it is backed up by legal liability and

public enforcement.
 Feature 4 (cont.): Public enforcement
• Most countries have public enforcement bodies to review
compliance and take actions to correct noncompliance.

• Public enforcement cannot ensure full compliance because

enforcement bodies work:
– Proactively on a sampling basis.
– On a complaint basis.

• There is international diversity in enforcement quality; the ESMA

(European Securities and Markets Authority) coordinates
enforcement activities in the EU, Accounting and Financial Reporting
Council (AFRC) in Hong Kong; China Securities Regulatory
Commission (CSRC) in China.
Factors influencing accounting quality
• It is necessary to allow managers some
discretion in applying accounting standards.

• As a result, three potential sources of noise

and bias in accounting data include:
1. Noise from accounting rules.
2. Forecast errors.
3. Managers’ accounting choices.
Noise from accounting rules and forecast errors

• The fit between accounting standards and the nature

of the firm’s transactions may introduce some
distortion in the reported financial statements.
– For example: Off-balance sheet intangibles such as research
or customer acquisition investments.

• Management’s estimates may result in accounting

forecasting errors (or bias) reflected in the financial
statements.
Discussion Questions

• Why we need to have uniform financial

reporting standards?

• What are the pros and cons of having uniform

financial reporting standards?
International Financial Reporting
Standards

• IFRS allows for consistency in reporting between firms

and over different time periods of the same firm.

• Uniform accounting standards minimize manager’s

ability to manipulate financial statement information.

• Rigid accounting rules may be dysfunctional; calls for

principles-based accounting standards.
Exercise

• Fred argues: “The standards that I like most are the

ones that eliminate all management discretion in
reporting – that way I get uniform numbers across
all companies and don’t have to worry about doing
accounting analysis”

• Do you agree? Why or why not?

Exercise

• Bill Simon says: “We should get rid of IASB, IFRS and
EU Accounting and Auditing Directives, since free
market forces will make sure that companies report
reliable information.”

• Do you agree? Why or why not?