CorporateFinancialReporting

Session2:PGP201719
IntroductionandAccountingEquation

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 Session 2:LearningGoals
QuickRevision:
ElementsofFS:Assets,Liabilities,Revenues,Expenses,Stockholders
Equity
Numerical BasicAccountingEquation&Expansion
BasicConcepts:
Assumptions:MoneyMeasurement,SeparateEntity,GoingConcern,
CashVersusAccrual, AccountingPeriod
Principles:CostandFairvalue,FullDisclosure,Conservatism
ConceptualFramework
Qualitativecharacteristics
FundamentalandEnhancingQualities
Constraints:Materiality,CostBenefit
Ethics:SarbanesOxley(SOX),PreventingFraudulentReportingand
Corporategovernance
Assignments
MariaHernandezCase
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 ElementsofFinancialStatements(BS)
ASSETS
A(present)resourcecontrolled byan
entityasaresultofpastevents and
fromwhichfutureeconomicbenefits are
expectedtoflowtotheentity
1. FutureEconomicBenefitisprobable
toflowin(direct/indirectcashinflow)
2. Control:Righttousetheitemtothe
exclusionofothers
3. Resultofapastevent
IsInvestmentinsharesofacompany
whichvanishedafterIPOanasset?
IsSalarypaidtoemployeesanasset?
Isintentiontopurchaseanequipmentan
asset?
Arepatentsownedbyanentityanasset?
Ex:Building,PlantandMachinery,
Inventories,Accountsreceivables,Cash
LIABILITIES
Presentobligationoftheentityarisingfrompast
events,thesettlementofwhichisexpectedto
resultinanoutflowfromtheenterpriseof
resourcesembodyingeconomicbenefits
1. Economicbenefitisexpectedtoflowoutofthe
entitytosettletheliability
Settlementcanoccurthroughpaymentofcash,
transferofasset,replacementwithotherliability
2. Test:Norealisticalternativebuttosettlethe
obligation
3. Resultofpastobligatingevent
Canbe
Contractual(Borrowings,creditors),
Arisingfromoperationoflaw(taxpayable,
penaltyimposed)
Ex:Borrowings,Bonds/Debentures,Advances
fromcustomers,AccountsPayable,Wages
outstanding,Taxespayable 3
 ElementsofFinancialStatements(BS):ShareholdersEquity

SHAREHOLDERSEQUITY:
Theownersfundsinvestedandearnedinthebusiness.
Itistheresidualinterestorclaimsoftheownersintheassetsoftheentity
afterdeductingallitsliabilities
ContributedCapital(Original+New)
+RetainedEarnings(ProfitslessDistributionstoequityholders)
RetainedEarnings:
Measureofundistributedprofitsofabusiness
RetainedEarningsbalance=
(Cumulativesumofprofitsearnedsinceinception)
(Cumulativesumofdividenddistributedsinceinception)
Dividends:Distributiontotheownersoutoftheprofitsearnedbythe
business
Revenues increaseRE,ExpensesandDividendsdecreaseRE.
Increaseinassets withoutanychangeinliabilities>increasesequity
Decreaseinassets withoutanychangeinliabilities>decreasesequity

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 RevenuesandExpenses
Revenues:
Economicresourcesearnedbyanentity
duringagivenaccountingperiod
Theseresultfromcoreoperating(earning)
activitiesorordinaryactivitiesofanentity
It involvesgrossinfloworincreasein
economicbenefits intheformof
Infloworenhancementofassets
(A/R)or
Settlementofliabilitiesor
Acombinationofboth
Example:Foramanufacturer Saleof
goodstocustomers,Forinsurance
company Premiumsfrompolicy
holders,Banks?Lawyers?
TheyresultinincreaseinRE,Equity
CananyincreaseinequitycalledRevenue?
Expenses:
Resourcesconsumedintheprocessof
generatingrevenueduringagivenaccounting
period
Theseareincurredintheprocessofcreating
revenues&involvedecreaseineconomic
benefits intheformof:
Outfloworconsumptionofassetsor
Incurrenceofliabilitiesor
Acombinationofboth
Example:Costofgoods sold,rent expense
TheyresultindecreaseinRE,Equity
CananydecreaseinequitycalledExpense?
So,ifanentityhasRevenues>Expenses,
Ithasmadeaprofitandthesamegoesto
Increaseownersequity
ThisprofitcanbecalledNetincomeor
Netearnings
But,ifRevenues<Expenses,ithasmadea
NetLoss
EXERCISE:CLASSIFICATIONOFFINANCIALSTATEMENTITEMS

Classify the items :

1. Whether it belongs on the Income statement (IS), Balance Sheet (BS)
2. Whether it is a revenue (R ), expense (E ), asset(A), liability(L) or
stockholders equity (SE)
Item Appearsonthe Classifiedas
Cash BS A
1 SalariesExpense IS E
2 Equipment BS A
3 AccountsPayable BS L
4 Membershipfeesearned IS R
5 CapitalStock BS SE
6 AccountsReceivable BS A
7 Buildings BS A
8 Advertisingexpense IS E
9 RetainedEarnings BS SE
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EXERCISE:CLASSIFICATIONOFFINANCIALSTATEMENTITEMS

Classify the items :

1. Whether it belongs on the Income statement (IS), Balance Sheet (BS)
2. Whether it is a revenue (R ), expense (E ), asset(A), liability(L) or
stockholders equity (SE)
Item Appearsonthe Classifiedas
Cash BS A
1 SalariesExpense IS E
2 Equipment BS A
3 AccountsPayable BS L
4 Membershipfeesearned IS R
5 CapitalStock BS SE
6 AccountsReceivable BS A
7 Buildings BS A
8 Advertisingexpense IS E
9 RetainedEarnings BS SE
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 Exercise:THEACCOUNTINGEQUATION

BCstartstheyearwith$100,000inassetsand$80,000in
liabilities.Netincomefortheyearis$25,000anddividends
paidis$5000.Howmuchisownersequityattheendofthe
year?

A = L + SE
Beginning of year$100,000 = $80,000 +$20,000
+ Net income +$25,000
Dividends 5,000
Stockholders equity at end of year $40,000

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 FurtherExercises

Assets = Liabilities + Stockholders' Equity

End: $550,000 = $301,000 + Stockholders' Equity
Beginning: $360,000 = $137,500 + Stockholders' Equity
Net income ?
1.Thestockholdersmadenoinvestmentinthebusiness,nodividendswere
paidduringtheyear
Assets = Liabilities + Stockholders' Equity
End: $550,000 = $301,000 + $249,000
Beginning: $360,000 = $137,500 + 222,500
Net income $ 26,500

2.Thestockholdersmadenoinvestmentinthebusiness,butdividendsof
$55,000werepaidduringtheyear
2.
Change in Stockholders' Equity $26,500
+ Dividends 55,000
Net income $81,500
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 Continuedfrompreviousslide
Assets = Liabilities + Stockholders' Equity
End: $550,000 = $301,000 + $249,000
Beginning: $360,000 = $137,500 + 222,500
26,500
3.Thestockholdersinvested$32,500inthebusiness,andnodividendswere
paidduringtheyear

3.
Change in Stockholders' Equity $26,500
Stockholders' investments 32,500
Net loss ($ 6,000)

4.Thestockholders invested$25,000 inthebusiness,anddividendsof

$58,000werepaidduringtheyear

4.
Change in Stockholders' Equity $26,500
+ Dividends 58,000
$84,500
Stockholders' investments 25,000
Net income $59,500
NetIncome=ChangeinSE NewInvestmentsbySH+Dividends 10
 R BasicAccountingEquation

Assets = Liabilities + Common Stock + Retained Earnings (RE)

Change in Retained earnings during the year ( RE )

= (Revenues t Expenses t Dividends t )
Retained Earnings at the end of the year (REt)
= RE t-1 + RE
= RE t-1 + (Revenues t Expenses t Dividends t )
= (Revenues Expenses Dividends) accum over the life of the entity
Thus,

Assets = Liabilities + Common stock + (Revenues - Expenses - Dividends)

Or re-arranging we can write:

Assets + Expenses + Dividends = Liabilities + Common Stock + Revenues

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 EXERCISE CASE1 CASE2 CASE3 CASE4
Totalassets,endofperiod $40,000 34,000 ? $75,000 $50,000
Totalliabilities,endofperiod 9,000 ? 15,000 25,000 10,000
Capitalstock,endofperiod 10,000 5,000 20,000 15,000
Retainedearnings,beginningofperiod 15,000 8,000 10,000 20,000
Netincomefortheperiod 8,000 7,000 23,000 ? 9,000
Dividendsfortheperiod 2,000 1,000 3,000 4,000 ?

A = L + CS + (Beg.RE + NetIncome Div.)

Case1: 40 = L + 10 + (15+8 2)
Liabilities=9

Case2: A=15+ 5+ (8+7 1)

Assets=34
Case3: 75=25+ 20+ (10+N.Income 3)
Income=23
Case4:50=10+15+ (20+ 9 Div.)
Dividends=4

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 BasicAssumptions
MoneyMeasurement(orMonetaryUnit)
Financialaccountingrecordsonlythoseeventswhichcanbeexpressedin
monetaryterms
Moneyprovidesacommondenominatortoalltransactions
FSpreparedincurrencyofthecountrywhereincorporated(&wherelisted
ifneeded)
Limitations?Qualitativeinformation,Inflation

SeparateEntity(orEconomicEntity)
Business:Separateentity,distinctfromitsowners,creditors,customers
Accountsarekeptforentitiesasdistinguishedfromthepersons
associatedwiththeentities. Itsfinancialrecordsandreportsshouldrefer
tothefinancialaffairsofthebusinessonly.
So,capitalbroughtinbytheownertohisbusinessiskindofan obligation
ofthebusinessentitytoitsowner
Holdsirrespectiveoftheformofthebusinesseveniffromlegalpointof
viewseparateentitydoesnthold(SoleProprietor,Partnership)
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 BasicAssumptions
GoingConcern
Anentitywouldcontinuetooperateinforeseeablefuture,andisnot
goingtobeliquidated
Helpstospreadtheeffectoflongtermtransactionsovertime
MeasurementofAssetsandLiabilitiesonclosingdate
GoingConcernValue>LiquidationValue

AccountingPeriodorPeriodicity
Measurementofincomegeneratedbyanentitycannotbepostponed
indefinitely
sinceanumberofusersneedtohavetheinformationatperiodic
intervalsfortheireconomicdecisions
Intervaloftime,attheendofwhichfinancialstatementsoftheentityare
preparediscalledanAccountingperiod
So,lifeofabusinessisdividedintoartificialtimeperiods/intervals
Theintervalsaregenerallyofequallength,
Usually1yearwhichcanbecalendaryear,Canbepreparedforthe
interimperiod(Quarterly) 14
 BasicAssumptions:AccrualversusCashBasis
LimitationofCashBasisAccounting:
Timingofcashflowscanbedifferentfromthesubstanceofthetransaction
Sellinggoodsoncredit,Receivingmoneyinadvanceforservicestobeprovidedin
thefuture(magazinesubscription)
timeofcashreceiptsmightnotbethesameasthetimeofrevenuebeing
earned(Revenues canbeearnedinaperiodotherthantheoneinwhich
cashisreceived)
thetimeofcashpaymentsmightnotmatchthetimeofexpensebeing
incurred
SupposethatFCpaintsabuildingin2015.In2015,itincurstotalexpenses
(salariesandpaintcosts)of$50,000butpays$40,000during2015.
Itbillsthecustomer$80,000,butreceivespaymentof$20,000until2015.

ThisComplexityisaddressedbyAccrualBasisofAccounting (requiredbyGAAP)
Transactions(likerevenuesandexpenses)arerecordedwhentheyoccur(&
notwhencashisexchanged)andarereportedinFSoftheperiodtowhich
theyrelate
Thisismoreappropriatethancashbasisforcalculationofprofitsbecauseit
leadstomatchingofrevenueswithexpenses
Itinformsusersofnotonlypastcashtransactionsbutalsofuturevenuesof
cashreceipts(A/R)andpayments(A/P,Loanrepayment) 15
 AccountingPrinciples

MeasurementBases:HistoricalCostandFairvalue
Costorhistoricalcostprinciple,dictatesthatcompaniesrecordassets
attheiracquisitioncost(price+coststogettheassetreadyforuse)
FairValue:Indicatesthatassetsandliabilitiesshouldbereportedat
fairvalue(thepricereceivedtosellanassetorsettlealiability)

Fulldisclosure:Requiresthatfinancialstatementsandtheirnotespresent
allinformationrelevanttousers
ExplanatoryNotes/NotestoFS:ClarifyFS&provideadditionaldetails
ExplanationstokeepFSfrombeingmisleading
MandatoryDisclosure:
AccountingPoliciesusedinpreparingFSlikeRevenuerecognition
policy,Depreciationaccounting,InventoryValuation
VoluntaryDisclosure:Judgment
Toomuchdisclosurecancreateclutterandbemisleading

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 ConservatismorPrudence
Conservatism
Whendealingwithmeasurementuncertainties,iftwoestimatesofsome
futureamountsareequallylikely,
thereshouldbepreferenceforthesmallernumber whenmeasuring
assetsandrevenues&
forthelargernumber forliabilitiesandexpenses
Ex:Valuingclosinginventoryatcostormarketvaluewhicheverislower
Anticipatenoprofitsbutprovideforalllosses
SomeprefertocallitPrudence:
Exerciseofcautioninmakingjudgmentswhenarrivingatestimatesunder
conditionsofuncertainty
Seekstopreventoverstatementofprofits
thepossibilityofsuchoverstatedprofitbeingdistributedbywayof
dividend
However,deliberateoverstatementofliabilities/expensesanddeliberate
understatementofassets/incomediscouraged
canbiasthefinancialstatementswithhiddenreserves
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ConceptualFrameworkforFinancialReporting

Ethics
Assumptions,Principles

Qualitative ELEMENTS
Characteristics ofFinancial
ofaccounting Statements
Information

OBJECTIVEofFinancialReporting

Toprovidefinancialinformationthatisusefultoexistingandpotential
investors,lendersandothercreditorsinmakingdecisionsabout
providingresources(capital)totheentity.
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 AdditionalMaterial
ObjectivesofFinancialReporting
TheObjectiveofFinancialReportingis
Toprovidefinancialinformationaboutthereportingentitythatisuseful
topresentandpotentialinvestors,lendersandothercreditors
Tobeusefulformakingdecisionsintheircapacityascapitalproviders

Decisionusefulinformationhelpsusers
1. AssessCashFlowProspects:InformationcanhelpUsersevaluatethe
abilityoftheentitytogeneratefuturecashflows[timing,amount&
risk(variability)associatedwiththecashflows]
2. AssessManagementsStewardshipofentitysresources:Information
ontheassets,liabilitiesandchangesthereincanhelpusersevaluate
theaccountabilityofmanagement

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QualitativeCharacteristics Hierarchy

Consistency
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 FundamentalQualitativeCharacteristics
Relevancemeansthattheinformationhas
theabilitytoinfluencedecisions.
Informationmusthave:
1. Predictivevaluemeansthatithelps
provideaccurateexpectationsabout
future
2. Confirmativevaluemeansthatit
confirmsorcorrectspriorexpectations

FaithfulRepresentationmeansthatthe
informationaccuratelydepictswhatreally
happened.Informationmustbe:
1. Complete includesallinformation
neededforareliabledecision
2. Neutralfreefrombias
3. Freefrommaterialerror meetsa
minimumlevelofaccuracy,doesnot
distortwhattheinformationdepicts
Financialreportinginformationoftenresultsfromapproximateratherthanaccuratemeasures
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 EnhancingQualities:
QualitativeCharacteristicsthatComplementInformationQuality
1. Comparability: Thequalitythatenablesuserstoidentifysimilaritiesand
differences betweentwosetsofeconomicphenomena
Resultswhendifferentcompaniesusesameaccountingprinciples

2. Verifiability:Thequalitythathelpsassure usersthatinformationfaithfully
representswhatitpurportstodepict.
Ifindependentobservers,usingsamemethods,obtainsimilarresults

3. Timeliness: Thequalitythatenablestheusertoreceiveinformationintime
toinfluenceadecision.
Mustbeavailabletodecisionmakersbeforeitlosesitscapacityto
influencedecisions

4. Understandability: Thequalitythatenablesuserstocomprehend the

meaningoftheinformationtheyreceive
Presentation:AggregationandClassification,clearandconcise
Userscapability:ReasonableKnowledge,Willingness
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 EnhancingQualities:
5. Consistency:Onceanentityhasdecideduponaparticularaccounting
methodoutofseveralpossible,
itshouldusethesamemethodforallsubsequenteventsofsame
character,unlessithasfoundasoundreasontochangethemethod
Anychangeifnecessaryneedstobejustified,itseffectonprofits
tobequantified&disclosed
Facilitatescomparisonovertime

Acompanyusessameaccountingprinciplesandmethodsfromyearto
year.

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 ConstraintstoFinancialReporting:

Materiality:
RelativeImportanceorsizeofanitemorevent
Anitemismaterialwhenitsomissionormisstatementislikelyto
influencethedecisionofauseroffinancialstatements:Judgment
Materialityassessedbasedonthemagnitude(valueoftheitemsay
5%ofNetIncome)&nature (Theft,Bribe)
CanbecalledacompanyspecificaspectofRelevance

CostBenefit:
Holdsthatthebenefitsofprovidingaccountinginformation(that
financialstatementuserswillgain)shouldexceedthecosts of
providingit(thecoststhatthecompanieswillincur)
DifficulttoquantifyCostsandBenefits:Judgment

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 Ethics,PreventingFraudulentFinancialReporting
Shareholders:Investsmoneyinsharesofthecompany
elects

Board:Takesmajorpolicydecisions(Loans,Dividends)
Reportsresults appoints

Management:Implementspolicies,Runsdaytodayoperations
CorporateGovernance(CG)includes
Boardsresponsibilityofmonitoringmanagerialactionsandethics
Ethics isacodeofconductthataddresseswhetheractionsarerightorwrong
SarbanesOxleyActof2002(passedinUSafterEnron,Worldcom)tostrengthenCG:
RequiresCEO&CFOtocertifyaccuracyandcompletenessofFinancialStatements
Imposesheavycriminalpenaltiesonviolation
IncreasedBoardOversight:SubcommitteeoftheBoardcalledAuditCommittee(formed
withfinancialexpertsandindependentdirectors)to
Evaluatemanagementperformance,Appointauditors&reviewtheirwork
Ensureexistenceofadequateinternalcontrolsystems
Increasedtheindependenceofexternalauditors 24
ThankYou

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