Basic

Accounting
Concept 1
Textbook & Other references:

•Kieso, D., Weygandt, J., and Warfield, T.

Intermediate Accounting (IFRS Edition) (3 rd or 4th
Edition) Wiley

•Pincus, M., S. Rajgopal, and M. Venkatachalam. 2007. The accrual anomaly:

International evidence. The Accounting Review 82 (1):169-203.
•Bernard, V. L., and J. K. Thomas. 1989. Post-earnings-announcement drift - Delayed
price response or risk premium. Journal of Accounting Research 27:1-36.
•Ball, R., and P. Brown. 1968. Empirical Evaluation of Accounting Income Numbers.
Journal of Accounting Research 6 (2):159-178.
2
Importance of this course
• Business Language
• Most prevalent structured big data for business
analysis
• Accurate
• Relevant
• Useful
• Standardized
• Legitimate
• Fewer biases and less uncertainty
• …

3
Importance of this course-Accounting
Income

From Ball, R., and P. Brown. 1968 (JAR)

4
Importance of this course-Better understand accounting
income

From Bernard, V. L., and J. K. Thomas. 1989.

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 Financial Reporting
and Accounting Standards

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Financial Reporting
Economic Entity Financial Statements Additional Information

Financial • Statement of • President’s letter

Information Financial Position • Prospectuses
Accounting? • Income Statement • Reports filed with
or Statement of governmental
Identify
Comprehensive agencies
and Income
• News releases
Measure • Statement of Cash
and Flows • Forecasts

Communicate • Statement of • Environmental

Changes in Equity impact statements
• Note Disclosures
• Etc.
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Objective of Financial Reporting

Objective: Provide financial information about the reporting

entity that is useful to
► present and potential equity investors,

► lenders, and

► other creditors

in making decisions about providing resources to the entity.

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Objective of Financial Reporting

General-Purpose Financial Statements

► Provide financial reporting information to a wide
variety of users.
► Provide the most useful information possible at the
least cost.

Equity Investors and Creditors

► Investors and creditors are the primary user group.

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Objective of Financial Reporting

Entity Perspective
► Companies viewed as separate and distinct from their
owners (shareholders).

Decision-Usefulness
► Investors are interested in assessing
1. the company’s ability to generate net cash inflows and
2. management’s ability to protect and enhance the
capital providers’ investments.

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Standard-Setting Organizations

Main international standard-setting organization:

• International Accounting Standards Board (IASB)
• Issues International Financial Reporting Standards
(IFRS).
• Standards used on most foreign exchanges.
• IFRS used in over 149 countries.
• Two organizations that have a role in international standard-
setting are the International Organization of Securities
Commissions (IOSCO) and the IASB.
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 International Accounting Standards Board

ILLUSTRATION 1.4
International Standard-Setting Structure

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International Accounting Standards Board

Types of Pronouncements
► International Financial Reporting Standards.

► Conceptual Framework for Financial Reporting.

► International Financial Reporting Standards Interpretations.

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Conceptual Framework
Overview of the Conceptual Framework
Three levels:
 First Level = Objectives of Financial Reporting
 Second Level = Qualitative Characteristics and
Elements of Financial Statements
 Third Level = Recognition, Measurement, and
Disclosure Concepts.

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 ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
Third level
3. Monetary unit 3. Expense recognition
The "how"—
4. Periodicity 4. Full disclosure implementation
5. Accrual

QUALITATIVE
CHARACTERISTICS ELEMENTS
1. Fundamental 1. Assets
qualities 2. Liabilities
Second level
3. Equity Bridge between
2. Enhancing
qualities 4. Income levels 1 and 3
5. Expenses

OBJECTIVE
Provide information
about the reporting
entity that is useful First level
ILLUSTRATION 2.7 to present and potential
Conceptual Framework for The "why"—purpose
equity investors,
Financial Reporting of accounting
lenders, and other
creditors in their
capacity as capital
providers. 15
 Basic Objective

“To provide financial information about the reporting entity that

is useful to present and potential equity investors, lenders, and
other creditors in making decisions about providing resources to
the entity.
 Provided by issuing general-purpose financial statements.
 Assumption is that users need reasonable knowledge of business
and financial accounting matters to understand the information.

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Qualitative Characteristics

ILLUSTRATION 2.2
Hierarchy of Accounting
Qualities

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 Relevance
Relevance

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

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18 LO 2
Qualitative Characteristics

Fundamental Quality—Relevance

To be relevant, accounting information must be capable of making

a difference in a decision.

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 Amazon 's Record Profit Streak Ends --- Company's profit rose 3.6% in quarter after posting four
quarters of best-ever results

By Dana Mattioli
950 words
26 J uly 2019
The Wall Street J ournal
J
A1
English
Copyright 2019 Dow J ones & Company, Inc. All Rights Reserved.

Amazon.com Inc.'s record quarterly profit streak has ended, as the online retailer faced higher shipping
costs, slowing growth from its cloud-computing business and a steeper loss in its overseas retail
business.

The company's second-quarter profit rose 3.6% from a year ago to $2.63 billion after more than doubling
in the previous quarter. It missed analysts' consensus estimate. Amazon had posted its best-ever profit
the previous four quarters.

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 Faithful
Faithful Representation
Representation

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

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21 LO 2
Qualitative Characteristics
Fundamental Quality—Faithful Representation

Faithful representation means that the numbers and descriptions match

what really existed or happened.

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Qualitative Characteristics

Enhancing Qualities

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Exercise 2-1 (Identify which qualitative characteristic of accounting
information is best described in each of the following items)

a. The annual reports of Amazon.com are audited by external auditors

(certified public accountants)
Verifiability
b. Starbucks has used the same method to estimate depreciation expense
(straight-line depreciation) since it began operations
Consistency
(Comparability)
c. Heineken Holdings (NLD) issues its quarterly reports immediately after
each quarter ends
Timeliness
d. Nokia and Motorola both use the same inventory cost flow assumption
for their inventory accounting.
Comparability

uReply Testing: https://polyu.ureply.mobi

https://ed2.polyu.edu.hk/ 24
 Basic
Basic Elements
Elements

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

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25 LO 2
 Basic Elements
Elements of Financial Statements

Asset A resource controlled by the entity as a

result of past events and from which
future economic benefits are expected to
Liability flow to the entity.

Equity

Income

Expenses
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 Basic Elements
Elements of Financial Statements

Asset
A present obligation of the entity arising
from past events, the settlement of which
Liability
is expected to result in an outflow from the
entity of resources embodying economic
Equity benefits.

Income

Expenses
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 Basic Elements
Elements of Financial Statements

Asset

Liability

Equity The residual interest in the assets of the

entity after deducting all its liabilities.

Income

Expenses
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 Basic Elements
Elements of Financial Statements

Asset

Liability

Equity Increases in economic benefits during the

accounting period in the form of inflows or
enhancements of assets or decreases of
Income
liabilities that result in increases in equity,
other than those relating to contributions
Expenses from equity participants.
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 Basic Elements
Elements of Financial Statements

Asset

Liability

Equity Decreases in economic benefits during the

accounting period in the form of outflows
Income or depletions of assets or incurrences of
liabilities that result in decreases in equity,
other than those relating to distributions to
Expenses
equity participants.
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 Exercise 2-2 (For each item below, indicate to which category
of elements of financial statements it belongs)

a. Land Assets

b. Inventory Assets
Expenses
c. R&D expenses
Assets
d. Prepaid insurance ((to an insurance company)
Income
e. Sales
Liabilities
f. Bank loan payable
Equity
g. Dividends
Assets
h. Brand
Assets
i. Patents

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 Recognition, Measurement, and
Disclosure Concepts

These concepts explain how companies should recognize,

measure, and report financial elements and events.

Recognition, Measurement, and Disclosure Concepts

ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
3. Monetary unit 3. Expense recognition
4. Periodicity 4. Full disclosure
5. Accrual

ILLUSTRATION 2.7
Conceptual Framework for Financial Reporting
51
 Assumptions

Economic Entity – company keeps its activity separate from

its owners and other business unit.

Going Concern - company to last long enough to fulfill

objectives and commitments.

Monetary Unit - money is the common denominator.

Periodicity - company can divide its economic activities into
time periods.

Accrual Basis of Accounting – transactions are recorded

in the periods in which the events occur.

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 Assumptions

Exercise 2.3: Identify which basic assumption of accounting

is best described in each item below.
(a) The economic activities of FedEx Corporation
(USA) are divided into 12-month periods for the Periodicity
purpose of issuing annual reports.
(b) Total S.A. (FRA) does not adjust amounts in its Monetary
financial statements for the effects of inflation. Unit
(c) Barclays (GBR) reports current and non-current
classifications in its statement of financial Going Concern
position.
(d) The economic activities of Tokai Rubber
Industries (JPN) and its subsidiaries are Economic
merged for accounting and reporting purposes. Entity
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 Basic Principles of Accounting

Measurement Principles
 Historical Cost is generally thought to be a faithful
representation of the amount paid for a given item.

 Fair value is defined as “the price that would be received to

sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement
date.”

IASB has given companies the option to use fair value as the
basis for measurement of financial assets and financial liabilities.
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 Basic Principles of Accounting

Measurement Principles
IASB established a fair value hierarchy that provides insight into
the priority of valuation techniques to use to determine fair value.

ILLUSTRATION 2.4

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 Basic Principles of Accounting

Revenue Recognition Principle

When a company agrees to perform a service or sell a product to
a customer, it has a performance obligation.

Requires that companies recognize revenue in the accounting

period in which the performance obligation is satisfied.

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Basic
Principles
of
Accounting
Illustration: Assume
the Airbus (DEU) signs
a contract to sell
airplanes to British
Airways (GRB) for
€100 million. To
determine when to
recognize revenue,
Airbus uses the five
steps for revenue
recognition shown at
right.

ILLUSTRATION 2.5
57 The Five Steps of
Revenue Recognition
 Basic Principles of Accounting

Expense Recognition - Outflows or “using up” of assets

or incurring of liabilities during a period as a result of delivering
or producing goods and/or rendering services.

ILLUSTRATION 2.6
Expense Recognition Procedures for Product and Period Costs

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 Basic Principles of Accounting

Full Disclosure Principle

Providing information that is of sufficient importance to
influence the judgment and decisions of an informed user.
Provided through:
 Financial Statements
 Notes to the Financial Statements
 Supplementary information

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 Basic Principles of Accounting

Exercise 2-4: Identify which basic principle of accounting

is best described in each item below.
(a) Parmalat (ITA) reports revenue in its income Revenue
statement when it delivered goods instead of when Recognition
the cash is collected.
(b) Google (USA) recognizes depreciation expense for Expense
a machine over the 2-year period during which that
Recognition
machine helps the company earn revenue.
(c) KC Corp. (USA) reports information about pending
Full
lawsuits in the notes to its financial statements.
Disclosure
(d) Fuji Film (JPN) reports land on its statement of
financial position at the amount paid to acquire it,
even though the estimated fair market value is Measurement
greater.
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 Cost Constraint

Companies must weigh the costs of providing the information

against the benefits that can be derived from using it.
 Rule-making bodies and governmental agencies use cost-
benefit analysis before making final their informational
requirements.
 In order to justify requiring a particular measurement or
disclosure, the benefits perceived to be derived from it
must exceed the costs perceived to be associated with
it.

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 Cost Constraint

Exercise 2-5: Determine whether you would classify these

transactions as material.
(a) Blair Co. has reported a positive trend in
earnings over the last 3 years. In the current Material
year, it reduces its bad debt expense to ensure
another positive earnings year. The impact of
this adjustment is equal to 3% of net income. b.
(b) Hindi SE has a gain of €3.1 million on the sale of
plant assets and a €3.3 million loss on the sale
Material
of investments. It decides to net the gain and
loss because the net effect is considered
immaterial. Hindi SE’s income for the current
62 year was €10 million.
 Cost Constraint

2-5: Determine whether you would classify these transactions

as material.
(c) Damon SpA expenses all capital equipment
Likely not
under €2,500 on the basis that it is immaterial. material
The company has followed this practice for a
number of years.

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Summary of
the Structure

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

64 45 LO 2