CFA 1 Financial Reporting & Accounting

7/27/2019 CFA 1 Financial Reporting & Accounting

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Financial Reporting and Analysis - I


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Mapping to Curriculum

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Reading 22: Financial Statement Analysis : An Introduction

Reading 23: Financial Reporting Mechanics Reading 24: Financial Reporting Standards Reading 25: Understanding the Income Statement

Expect around 12 questions in the exam from todays lecture


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Key Concepts

Accounting Equation

Auditors Notes

Accruals

SEC Filling

IFRS, US GAAP

Revenue Recognition Methods

Depreciation Methods

Intangible Assets

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Financial Statement Analysis: An Introduction

Role of Financial reporting and Financial Statement Analysis (FSA)

Role of key financial statements in evaluating a company performance Importance of Financial statement notes and supplementary information

Objective of audits of financial statements.

Other sources of information used by analysts.

Steps in FSA framework.

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Roles of Financial reporting and Financial Statement Analysis

Financial reporting: It is the way companies show their performance to outside world

International Accounting Standards Board (IASB)has described the role of financial reporting in itsFramework for the Preparation & Presentation of Financial Statements as:

The objective of financial statements is to provide information about the financial position,performanceand changes infinancial positionof an entity that is useful to a wide range of users inmaking economic decisions

Financial Statement Analysis (FSA): The role of FSA is to use the companys financial statements &other relevant information to make economic decisions

FSA is used to

Evaluate companys past performance and current financial position

Project companys ability to earn profits and future cash flows

So that economic decisions like the following can be taken: Whether to invest in the company's securities

Whether to extend bank credit to the company

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Role of key Financial Statements in evaluating a company'sperformance and financial position

Income statement

Shows financial performance over a particular period of time

Includes following elements

Revenue (inflows) generated from sales of goods or services

Expenses (outflows) incurred to produce the goods or services

Gains/Losses earned from continued or discontinued operations

Balance sheet

Shows financial positionat a particular point of time Includes following elements

Assets: resources owned by company which will produce current or future economic benefit

Liabilities: obligations owed by company which will accrue future economic costs

Owners equity: residual interest remains after deducting liabilities from assets

Fundamental Accounting Equation:Assets = Liabilities + Owners' equity

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Role of key Financial Statements in evaluating acompany's performance and financial position cont

Cash flow Statement:

Reports companys cash receipts & payments over a particular period

Can be classified into:

Operating Cash flows:generated from normal business activity

Investing Cash flows :generated from investments in other firms & acquisitions etc.

Financing Cash flows:generated from financial matters like dividend paid to stockholders, interestpaid

Changes in owners' equity Reports sources and uses of equity investors' investment in the firm over a particular period

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Financial Statement Notes & Supplementary schedules

Financial Statement notes (footnotes):

Provides information about accounting methods, assumptions & estimates used in preparing financial

statements Provide additional information on business segment, related party transactions, acquisitions / disposals,

contingencies, significant customers

Since Company A has many related party transactions, company Bs revenues are more reliable.

Allows users to improve their assessment of amount, timing & uncertainty of estimates reported infinancial statements

All footnotes are required to be audited

Supplementary schedulescontains additional information like:

Operating income or sales by region or business segment Reserves for an oil and gas company

Information about hedging activities and financial instruments

Supplementary schedules are not required to be audited

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Company A Company B

Revenue 100 100

Revenue through related party 500 0

Total Revenue 600 600

Exam Notes: Check the differences between footnotes and supplementary schedules



Management's Discussion and Analysis (MD&A)

Management's Discussion and Analysis (MD&A) provides assessmentof the financial performanceof a firm from managements perspective

In US, public companies are required to disclose following information in MD&A

Result from operations with trends in sales and expense

General business overview based on known trends

Capital resources and liquidity along with trends in cash flows

Discussion on significant events & uncertainties

Additional information, not compulsorilyrequired to be disclosed, under MD&A:

Discussion of effects of known trends on business

Discussion over accounting policies requiring significant judgment

Discussion over issues related to capital structure and liquidity

Information on unusual or infrequent items and extraordinary items etc.

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Exam Notes: You should remember either Compulsory or Non Compulsory but not both



Audits of Financial Statements

Since management itself prepares financial statements, there can biasness involved

thus audits are required to get an independent review of financial statements

Audits are performed by independent auditors

Objective of Audit

To get an independent opinion on fairness and reliability of financial statements

To check whether generally accepted accounting policies (GAAP)were followed

To examine efficiency of accounting & internal control system

To determine financial statements contain no material errors

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Auditors Report Types

On the basis of his analysis, an auditor can issue one of the following three opinions:

Unqualified opinion

Financial statements are free from materialomissions and errors

Qualified Opinion

Statements makeany exceptionto the accounting principles

Auditors must explain these exceptionsin the audit report

Adverse Opinion

Statements are not presented fairlyor are materially non conforming with accounting standards

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Imp


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Question: Auditors Report

If an auditor issues an "adverse opinion" qualification in her opinion, she is referring to the factthat:

A. The firm's financial statements do not fairly represent the company's financial performanceand position.

B. There is considerable uncertainty in the firm's asset-liability valuation, thus causing a concernabout its operational health.

C. The firm has inadequate controls in place and needs an on-going, frequent audit.

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Solution: Auditors Report

A.

The firm's financial statements do not fairly represent the company's financial performance and position.

An adverse opinion is rendered in cases where financial statements are not prepared in accordance withaccepted accounting principles, and this has a material effect on the fair presentation of the statements.

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Auditors Report Explanatory paragraph

Explanatory paragraph

Auditors report contain explanatory paragraph when material loss is probable but the amount cant

be reasonable ascertained

Uncertainties are caused due to issues related to:

Going concern assumptions

Any litigation

Realization of assets values

For example, in the case of British Petroleum oil spill, the auditor would include an explanatoryparagraph on the material loss.

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Internal controls

US GAAP requires auditor to comment on internal controls followed by company:

Internal controlsare checks and systems which ensures that company uses a proper process to prepare

and present accurate financial statements

Management is required to provide a report on internal control system under the

SarbanesOxley Act that

Management is responsiblefor maintaining the internal control systems

Descriptionon how management evaluates the internal control systems

Statementthat financial statements are presented accurately Assessmentof the effectiveness of most recent year of the internal control systems

Statement from managementthat firms auditors have assessed management internal controls

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Exam Notes: The Management, not the auditor is responsible for internal controls.The auditors job is to comment on the efficacy of the same.


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Other sources of information used by analysts

Corporate reports and press releases

Available on companys website

Quarterly or semi-annual reports

Interim reports may not be necessarily audited

SEC filing

www.sec.gov

8-K : Current Report of any significant event 10-K: annual financial statements

10-Q: quarterly financial statements

Proxy Statements

Issued to shareholders on the matters requiring a shareholder vote

Good source of information about the election of (and qualifications of) board members. compensation,management qualifications, and the issuance of stock options

Company/Industry research reports/ Other broker reports

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http://www.sec.gov/http://www.sec.gov/


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Steps of financial statement analysis

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1. Determinethe Objectiveand Context

2. Gather Data

3. Process theData

4. Analyze andinterpret the

data

5. Report theConclusions or

Recommendations

6. Update theAnalysis


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Questions

1. ABC company faces serious claims under a lawsuit filed against it. An interim judgment if goesagainst ABC can cause a probable material loss but this cannot be quantified at the time of preparingfinancial statements. Which of the following best describes desired action by auditor of ABC?

A. Auditor should issue an explanatory note in audit report

B. Auditor should issue qualify report

C. Auditor should issue an adverse opinion

2. In U.S., which of the following information needs to be compulsorily disclosed under managementdiscussions and analysis?

A. Information on unusual or infrequent items and extraordinary items etc.

B. Capital resources and liquidity along with trends in cash flows

C. Discussion over accounting policies requiring significant judgment

3. A footnote in financial statement is least likely to contain information on:

A. Accounting policies

B. Estimations used

C. Details on actual Capacities

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Questions (Cont)

4. Under Sarbanes Oxley Act

A. Management is required to provide a report on internal controls

B. Auditor is required to provide a report on internal controlsC. Management is required to report that financial statements are their responsibility

5. Which of the following is least likely to be an objective for conducting an audit

A. To get an independent opinion on fairness and reliability of financial statements

B. To judge and examine efficiency of internal control system

C. To uncover any financial frauds

4. An analyst is looking to get information on related party transactions. In which of the section he ismost likely to find out the same

A. Footnotes

B. Supplementary Schedules

C. Management discussion and analysis

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Solutions

1. A.When auditor faces a situation where material loss is probable but the amount cant bereasonable ascertained, he should issue a detailed explanatory note in audit report on suchuncertainties and impact.

2. B. In US, public companies are required to disclose 4 types of information in MD&A out of which oneis - Capital resources and liquidity along with trends in cash flows

3. C. Financial Statement notes (footnotes) includes accounting policies, estimates and assumptionused in preparing Financial statements but not the Details on actual Capacities

4. A. Management is required to provide a report on internal controls under the Sarbanes Oxley Actincluding that management is responsible for maintaining the internal control systems

5. C. Out of four, twoobjectives of an audit are to get an independent opinion on fairness and reliabilityof financial statements & to judge and examine efficiency of internal control system

6. A. Footnotes contain additional information on business segment, related party transactions,acquisitions / disposals, contingencies, significant customers etc.

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Agenda

Reading 22: Financial Statement Analysis : AnIntroduction

Reading 23: Financial Reporting Mechanics Financial Statement Element vs Accounts

Business Activities from Financial Statements

perspective

Assets, Liabilities and Owners Equity

Revenue and Expenses

Accounting equation in its basic and expanded forms Double Entry Accounting

Accruals and other adjustments

Relationship among Financial Statements

Reading 24: Financial Reporting Standards

Reading 25: Understanding the Income Statement

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Financial Reporting Mechanics

Accounts & Financial Statement Elements

Basic and expanded forms of accounting equation

Double entry accounting


Relationship among financial statements

Flow of information in an accounting system

Accounting process and security analysis

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Accounts & Financials Statement Elements

When a transaction happens it is first recorded in its related account

For example we have different account for each expenditures - wages, postage, stationary etc

Contra accountsare used for entries which offset some part of the value of another account

Accounts receivable has contra account as provision for bad debts)

These accounts are grouped into 5 elements of financial statements which are:

Assets

Liabilities Owners equity

Revenue

Expenses

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Assets

Current Assets

Cash and cash equivalents: liquid securities with maturities of < 90 days

Accounts receivable: adjusted for "allowance for bad debt expense" as contra a/c Inventory

Prepaid expenses: items that will be expenses on future income statements.

Financial assets: marketable securities etc.

Long Lived Assets and Other assets

Property, plant, and equipment: includes a contra account as accumulateddepreciation

Intangible assets: economic resources without physical existence such as patents, trademarks,licenses, and goodwill

Investment in affiliates (accounted for using the equity method)

Deferred tax assets

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Liabilities

Current Liabilities

Accounts payable & trade payables

Short-Term notes payable Unearned revenue: Revenue received but not earned (related to future periods)

Income taxes payable

Long Term Liabilities

Long-term debt such as bonds payable

Deferred tax liabilities

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Owners' equity

Capital - Par value of common stock

Additional paid-in capital: proceeds received over par value

Retained earnings - Cumulative net income till date

Other comprehensive income

Changes resulting from foreign currency translation of subsidiary

Minimum pension liability adjustments Unrealized gains and losses on investments.

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Revenue

Sales

Gains: Increases in assets or equity from transactions incidental to day-to- day activities

Gain on sale of assets

Investment income

Interest income

Dividend income

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Expenses

Cost of goods sold (COGS)

=Opening inventory + PurchasesClosing Inventory

Selling, general and administrative expenses (SG&A)

Advertising, management salaries, rent, utilities

Depreciation and amortization

Interest expense

Losses

Decreases in assets / equity from incidental transactions related to normal activities

Tax expense

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Basic and expanded forms of accounting equation

Basic Equation:

Assets = liabilities + owners' equity

Equity can be broken into contributed capital (preferred and common both) and retained earnings:

Assets = Liabilities + Contributed capital + Retained earnings

Retained earnings can be further broken as:

Retained earnings = Beginning retained earnings + Net profits during the yeardividends

Net profits can be broken into:

Net profits = RevenueExpenses

Expanded accounting equation:

Assets = liabilities + contributed capital + opening retained earnings + revenuesexpensesdividends

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Imp

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Double entry accounting

Each transaction effects two accountsso that assets and liabilities are balanced

For example:

A) An increase in an asset account must be balanced by either:

Increase in a liability or owners' equity account

Decrease in another asset account

B) An expenses incurred (causing reduced earning leading to low retained earning to low equityhence lower liability) must be balanced by either:

Reduction in cash (if expenses is incurred in cash)

Increase in liability (if expenses is incurred on credit)

When an asset is increased/decreased and it affects an account on the balance sheet, it either affectsanother asset account or a liability account

When an asset is increased/decreased and it affects the P&L (salary), it affects equity.

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Account 1 Account 2 Example

Asset Asset Purchase inventory with cash

Asset Liability Purchase inventory on credit

Asset Equity Company pays out Salary

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Examples

Purchase furniture for $1,000 cash

Furniture (an asset) increases by $1,000

Cash (an asset) decreases by $1,000.

Both assets and liabilities are balanced


Purchase furniture for $1,000 through raising $1,000 notes

Furniture (an asset) increases by $1,000

Notes (liability) increases by $1,000


Pay $1000 for salary in cash

Salary (expenses) reduces net income, leading to low equity and lower liabilities by $1000

Cash reduces by $1000


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Timing difference between revenues/expenses earned & and cash collected/paid

Accrual concept causes revenues to be recorded when they are earned (instead collected) andexpenses when they are incurred (instead paid)

Accrual concept results into 4 type of accounts:

1. Accrued revenue

2. Unearned revenue

3. Prepaid expenses

4. Accrued expenses

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Example Party 1 Party 2

Airline Tickets Airlines - UnearnedRevenue

CustomerPrepaidExpense

Salary CompanyAccruedExpenses

EmployeeAccruedRevenue

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Accruals and other adjustments (Cont)

Accrued Revenue

Goods or services are sold but cash is not received

Hence revenue increases and accounts receivable (an asset)increases

On receipt of cash, cash increases and accounts receivable decreases

For exampleemployee works in a company for a month & receives the payment on last day ofmonth

Unearned revenue:

Receives cash in advance before it provides goods or render services

Cash increases and unearned revenue (a liability)increases by the same amount When firm provides goods or services, revenue increases and the liability decreases

For example - magazine subscription, payment is done first & then the service is received

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Imp

A l d th dj t t (C t )


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Accruals and other adjustments (Cont)

Prepaid expenses:

Pays cash for expenses before they are incurred

Cash (an asset) decreases and prepaid expense (also an asset)increases When the expense is actually incurred, prepaid expense decreases and expenses increase

For example: advance rent / electricity

Accrued expenses:

Expenses incurred but cash not paid

Expenses increase and a

liability for accrued expensesincreases as well

Liability decreases when the firm pays cash for expenses

For example: companies receives the services of its employees for the complete month & then pays thesalary at the end of the month

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I t t R l ti hi fi i l t t t


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Important Relationships among financial statements

Income Statement and Balance Sheet

Net income(income statement item) is added to retained earnings(balance sheet item)

Retained Earningst+1= Retained Earningst+ Net Income

Cash flow and Balance Sheet

Sum of net cash flow from all three activities must match with the difference between opening and closingcash flows

Casht+1= Casht+ Net Cash Flow

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Fl f i f ti i ti t


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Flow of information in an accounting system

Journal entries

(record every transaction)

General ledger

(sorts the entries in the general journal by account)

Trial balance

(initial trial balance & adjusted trial balance)

Financial statement

(Grouping into various financial line items)

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Question: Accounting System


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Question: Accounting System

Which of the following would you refer to if you wanted the maximum insight into a companys

financial transaction?

A. Financial StatementsB. General Ledger

C. Journal Entries

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Solution: Accounting System


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Solution: Accounting System

C.

The Journal shows every single transaction a company executes. It contains maximum detail.

Financial statements are the most concise form.

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Questions


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Questions

1. ABC Corp is bank operating in UK and receiving dividend income out of the investments it made inequity securities. This activity is most likely to be described as

A. Operating Activity

B. Investing Activity

C. Financing Activity

2. Under an expanded accounting equation;

A. Liabilities = Assets - Contributed capital + Retained earnings

B. Dividends = Beginning retained earnings + Net profits during the year - Closing Retained Earning

C. Contributed capital = AssetsLiabilities + Retained Earnings

3. Under double entry accounting, how a $1000 purchase of trading goods on credit will impact differentaccounts

A. Purchase account will increase by $1000 and Creditors will decrease by $1000

B. Purchase account will increase by $1000 and creditors will increase by $1000

C. Purchase account will increase by $1000 and equity will decrease by $1000

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Questions (Cont )


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4. ABC company pays current months salary to its employee on 1st day of next month, how thistransaction will be reported on financial statement at year end:

A. Report one day salary as outstanding expenses

B. Report one month salary as outstanding expenses

C. Report one day salary as prepaid expenses

5. Kingfisher Airlines, on last day of its financial year, received an amount of $1000 for flights booking innext month. This amount will most likely be reported as:

A. Accrued revenue of $1000 on liability side

B. Advance from customers of $1000 on liabilities side

C. Unearned revenue of $1000 on liability side

6. Value of ABCs investments have declined substantially in the market though ABC company is stillholding these investments while preparing BS, how this will be adjusted in books?

A. Adjust valuation by decreasing assets value and decreasing equity

B. Adjust valuation by decreasing assets value and increasing equityC. No adjustment is needed

Questions (Cont)

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Solutions


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1. A.Since ABC Corp is a bank, doing investments and receiving return on such investments are partof operating activity.

2. B. In an expanded accounting equation,Assets = Liabilities + Contributed capital + Closing Retained earnings;

Closing Retained earnings = Beginning retained earnings + Net profits during the yeardividendshence dividend = Beginning retained earnings + Net profits during the yearClosing retainedearnings

3. B. Here, purchase is on credit, thus an associated expense will increase with associated increase

in creditors (i.e. liability)

4. B. Since company is paying one months salary in arrears, at the year end, it would report this asoutstanding expenses in liabilities.

5. C. Since Kingfisher has received money in advance against its future revenues which is bookedtoday, it will report this as unearned revenue.

6. A. Valuation adjustment requires assets to be valued at its market value and hence investmentsshould be decreased. To maintain the accounting equation, this will decrease owners equity.

Solutions

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Agenda


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Agenda


Reading 23: Financial Reporting Mechanics


Standard Setting Bodies

IASB Goals

Regulatory Authorities and Sec Filings

Barriers to develop a Universal Accounting Standards

IFRS - Recognition and measurement of bases

IFRS DescriptionFinancial Statements Elements

Constraints and Assumptions

Financial Statements requirements-InternationalAccounting Standard-1

Financial Reporting - FASB and IASB framework

Coherent Financial Statements and Barriers to it

Importance of monitoring developments in financialreporting standards


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Financial Reporting Standards


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Financial Reporting Standards

Reporting Standards

Standard setting bodies

Barriers to develop a universal accounting standard

IFRS

FS requirements

Financial Reporting - FASB and IASB framework

Coherent Financial Reporting & Barriers to it

Importance of monitoring developments in financial reporting standards

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Reporting standards


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Reporting standards

If reporting standards didnt exist then financial statements can take any form because of possible

assumptions & estimates

Reporting standards

Makes financial statements much more comparable

Fixes a range onmanagementestimates which otherwise could have substantially varied

Makes Financial statements useful to a wide range of usersincluding security analysts

For e.g.: Depreciation methods, inventory valuation methods, representation of assets at book value etcare made standardized by reporting standards

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Standard - setting bodies & Regulatory authorities


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g g y

Standard-setting bodies: professional organizations of accountants & auditors that establishfinancial reporting standards

Regulatory authorities: government agencies that have the legal authority to enforce compliancewith the reporting standards

Standard-setting bodies:

1. Financial Accounting Standard Board (FASB)

FASB is governing body in U.S.

Sets forth generally accepted accounting principles (GAAP)

2. International Accounting Standard Board (IASB):

Establishes International Financial Reporting Standards (lFRS) outside U.S.

Most of the nations have their own accounting standard bodies

Most of these are now converging and trying to fill the gap with IFRS

3. India (ICAI)

Regulated by SEBI

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Standard - setting bodies & Regulatory authorities(Cont)

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IASB has following 4 goals:

Develop global accounting standardsto bring transparency, comparability, and high quality in financialstatements

Promote useof such global accounting standards

Achieve convergencebetween various national accounting standards and global accounting standards.

Take careof needs of emerging marketsand small firmswhile implementing global accountingstandards

Regulatory authorities established by national governments

Securities and Exchange Commission (SEC) in the United States Financial Services Authority (FSA) in the United Kingdom

Most national authorities belong to International Organization of Securities Commissions (IOSCO) whichhas led three objectives:

Protect Investors

Ensure fairness, efficiency & transparency

Reduce systemic risk

IOSCO goal is to bring uniformity in financial regulation across countries Both SEC and FSA have legally enforceable power

IOSCO does not have legally enforceable power

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SEC Filings


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Form S-1:

Registration statement filed prior to the sale of new securities to the public.

Form 10-K: Disclosure about business and its management , audited financial statements, legal matters etc.

40-F: corresponding form for Canadiancompanies listed on US exchanges

20-F: corresponding form for foreignissuers listed on US exchanges

Form 10-Q:

Quarterly Report: Financial statements may not be audited

6-K:

Non-U.S. companies file for semiannual financial report

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SEC Filings (Cont)


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Form 8-K:

Filed to disclose material event like:

Acquisitions and disposals

Changes in management or corporate governance

Accountants, financial statements, or other related matters

Press Releases

Form DEF-14A:

Proxy statementfor its shareholders (prior to the annual meeting or other shareholder vote)

Form 144:

When a company issues securities to certain Qualified Institutional Buyers (QIB)without registering thesecurities with the SEC

Form 3,4,5

Details on beneficial ownershipof securities by company's officers and directors

Can learn about purchases and salesof company securities by corporate insiders

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Barriers to develop a universal accounting standard


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Accounting standards differ across countries:

Depending upon the economic structure of a nation and prevalent conditions in a particular country

Treatment of a particular item or issue is different in different countries

This is a major barrier for setting up universal accounting standards

Other reasons are:

Political pressures from business groups who will be affected by changes in reporting standards

Pressure from others who will be affected by changes in reporting standards

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IFRSFinancial Statements Objectives


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Ideas on which IASB bases its standards are expressed in the IFRS Framework for Preparation &

Presentation of Financial Statements

According to IFRS, objective of financial statements are:

To provide informationon financial position, performance and changes in the financial position of anentity

Provide information that is useful to a wide variety of users for taking economic decisions

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IFRSFinancial Statement Characteristics Imp


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Financial statements should have following qualitative characteristics:

Comparable:across firms and across time periods

Understandable: users with a basic knowledge should be able to readily understand the information

Relevant: should provide timely and sufficient detailed information without material omissions ormisstatements

Reliable

Faithful representation of all transactions and events in FSs Not biased

Complete (based on materiality limits and costs limits)

Substance matters over form (reflects economic reality)

Prudent and conservative in making estimates

For example, the Quarterly results of a companies are not audited. Here, relevance/timeliness isgiven preference over reliability.

In the case of Annual reports, they are always audited. Here, reliability is given preference overrelevance/timeliness.

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IFRS - Recognition and measurement of bases


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Financial statements should recognize any transaction / item when

Economic benefit / cost is probable

Such benefits / costs can be measured reliably

How to measure benefits / costs:

Historical cost: amount originally paid for an asset

Current cost:current replacement costs

Realizable value:amount which can be realized from selling the asset

Present value:Discounted cash flow of future economic benefit

Fair value:Amount at which two parties willing to enter in an arms length transactions

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IFRS DescriptionFinancial Statements Elements


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IFRS describes the financial statement elements as:

Assets: Resources which are expected to accrue economic benefits in future periods

Liabilities: Obligations which are expected to accrue economic costs in future periods

Equity: Residual interest equal to AssetsLiabilities

Income: Includes revenue and gains; result of past transaction which accrued economic benefitseither by way of increasing assets or decreasing liabilities

Expenses: Includes expenses and losses; result of past transaction which accrued economic costseither by way of decreasing assets or increasing liabilities

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IFRSFinancial Statements Constraints and assumptions


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Constraints:

FSs can directly present only quantitative information but not the non-quantifiable information like brandloyalty, capacity for innovation, etc.

Strike a balance between reliability (free of errors) v/s timeliness

Strike a balance between cost of preparing FSs v/s benefits to users through FSs

Assumptions Accrual basis: financial statements should reflect transactions at the time they actually occur, not

necessarily when cash is paid

Going concern: entity is expected to continue its operations in foreseeable future

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General requirements for financial statements Imp


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International Accounting Standard (IAS) No. 1 states that:

Financial statementsrequired are:

Balance sheet Statement of comprehensive income

Cash flow statement

Statement of changes in ownersequity

explanatory notes, including a summary of accounting policies

Fundamental principles while preparingfinancial statements are:

Fair presentation

Going concern basis

Accrual basis of accounting

Consistency

Materiality (no omissions and misstatements)

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General requirements for financial statements (Cont)


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Fundamental principles while presentingfinancial statements are

No offsettingof assets against liabilities unless specific standard permits it

Aggregationof similar items

Should present a classified balance sheetshowing current & non-current assets & liablities

Minimum informationon the face supported by detailed information in footnotes

Comparative informationwith information on prior periods

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Question: General Requirements for financial statements


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Which of the following is not a principle for preparing financial statements according to theInternational Accounting Standard?

A. Consistency

B. Materiality

C. Accuracy

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Solution: General Requirements for financial statements


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C.

Accuracy is not one of the fundamental principles for preparing financial statements.

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Comparison of FASB and IASB framework Imp


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Differences in Principles:

FASBframework, unlike the IASB framework, is not at top GAAP hierarchy

IASBframework places more emphasis on the going concern assumption

IASB requires management to consider the framework if no explicit standard exists on an issue, butthe FASB does not

FASBpushes for relevanceand reliabilityas primary characteristics

IASBlists comparabilityand understandabilityas primary characteristics

Differences in Financial Elements:

Assets is sourceof economic benefits under IASB and is economic benefit itself under FASB IASB considers income and expenses for performance whereas FASB considers slight differently

through revenue, expenses, gains, losses & comprehensive income

FASB uses words probablefor assets/ liabilities unlike IASB

FASB does not allow values of most assets to be adjusted upwards

Select companies need to report reconciliation between different standards (IASB / FASB) like companylisted in US but incorporated outside US needs to report such statement

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Coherent Financial Reporting & Barriers to it Imp


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Coherent financial reporting framework (CFRF) contains following characteristics:

Comprehensive

Consistent

Transparent framework

There are three barriers to create a CFRF:

1. Valuation: tradeoff between reliability v/s relevance

Historical cost is more reliable but may not be relevant in present context whereas

Fair Value which is more relevant in current context requires more judgment

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Coherent Financial Reporting & Barriers to it (Cont)


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2. Standard Setting: While preparing accounting standards 3 approaches are followed:

Principles-based: relies on broad framework / goals

Rules-based: rule for each transaction

Objectives oriented: blends above two approaches

IFRS is principal based, whereas U.S. GAAP is rules based standard setting approach

3. Measurement:

Two different approaches are followed

None of the approach focuses on all financial statements comprehensively

Approaches are:

Assets and Liability approach - focuses on balance sheet valuation

Revenue and expense approach- focuses more on income statement valuation

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Importance of monitoring developments


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An analyst needs to monitor the developments in financial reporting standards

This will an analyst better equipped to understand the impact on companys performance and financialposition in present and future

An analyst should go through accounting policies as presented in footnotes and managementdiscussion and analysis statement to evaluate the impact on financial statements and makeprojections

An analyst should be cautious on uncertainty caused by not following new standard by managementeven when its required while reporting financial results

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Questions


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1. Which of the following is least likely to be a stated goal of International Accounting Standard Board(IASB)?

A. Develop global accounting standards to bring transparency, comparability, and high quality

B. Promote use of accounting standards with highest quality and transparency

C. Achieve convergence between various national accounting standards and global accountingstandards

2. Which of the following characteristics is most likely cause financial statement (FSs) to becomereliable?

A. FSs must be comparable across firms and across time periodsB. FSs provide timely and sufficient detailed information

C. FSs must provide faithful representation of all transactions and events

3. Which of the following is least likely to be primary assumptions followed while preparing FS underIFRS

A. Accrual basisB. Going concern

C. Materiality

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Questions (Cont)


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4. Which of the following best describes difference between principles followed by FASB and IASB

A. IASB pushes for relevance and reliability while FASB lists comparability and understandability asprimary characteristics

B. IASB framework places more emphasis on the going concern assumption

C. FASB uses word probable for assets/ liabilities unlike IASB

5. Which of the following statement is correct

A. IFRS is principal based whereas U.S. GAAP is rules based standard setting approach

B. IFRS is rule based, whereas U.S. GAAP is principal based standard setting approach

C. There is no difference in standard setting approach between IFRS and US GAAP

6. Which of the following is not a principle for presenting financial statements?

A. Aggregation

B. Comparative Information

C. Materiality

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Solutions


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1. B.IASB promotes use of global accounting standards and brings convergence between national andglobal accounting standards.

2. C. FSs should provide faithful representation of all transactions and events, should not be biased,should be complete, favor to substance over and prudent and conservative in making estimates tobecome reliable

3. C Under IFRS, FSs should follow two primary assumptions like accrual basis and going concern

4. B.IASB framework places more emphasis on the going concern assumption and lists comparabilityand understandability as primary characteristics.

5. A.IFRS is principal based (relies on broad framework) whereas U.S. GAAP is rules based (Specificrule for each transaction) standard setting approach

6. C. Materiality is a principal for preparing not presenting financial statements

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Extra Questions


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1. IASB expresses the objective of financial statements in "Framework for preparation and presentationof financial statements" What is the objective?

A. Financial implications, measurement and changes in assets and liabilities.

B. Financial position, performance and changes in financial position of an entity.

C. Changes in income and expenses, financial position and changes in assets and liabilities.

2. Which of the following is a qualitative characteristic described by the FASB framework:

A. Reliability

B. Transparency

C. Relevance

3. Which of the following is not a feature of preparing financial statement stated in IAS No. 1:

A. Going concern basis

B. Consistency and materiality.

C. Reporting frequency must be at least quarterly.

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Extra Questions (cont)


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4. On analyzing a balance sheet, it has been observed revenue recognition has been accounted as aliability for the large cash received for future airline travel. In accrual accounting, it is termed as:

A. Unearned or deferred revenue.

B. Unbilled or accrued revenue.

C. Accounts payable.

5. In recording accounting entries on accrual basis, for cash movement prior to accounting recognition,adjusting entry will consider for Unearned (Deferred) Revenue

A. Reducing the liability while recording revenue.

B. Increasing the liability while recording revenue.

C. Eliminate the receivable on cash collection.

6. Which of the following actions was least likely a warning signs of earnings manipulation?

A. Decrease in discount rate used in pension liability assumptions

B. Aggressive revenue recognition by using bill and hold strategy

C. Extending the useful lives of long term assets

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Solutions


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1. B.

2. C.

3. B.

4. A.

5. A.

6. A.

Decrease in the discount rate results in the increase in liability, therefore it is not a warning sign forearnings manipulation.

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Agenda


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Reading 23: Financial Reporting Mechanics



Understanding the Income statement

Revenue Recognization

Expenses Recognization

Methods of Depriciation & Depreciation of long-term assets

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Income Statement


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Understanding the Income statement

Revenue Recognization

Expenses Recognization

Methods of Depriciation & Depreciation of long-term assets

Operating and Non-operating income

Unusual or infrequent items

EPS

Diluative and antidilutive securities

Financial Ratios

Other comprehensive income includes

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Understanding The Income Statement


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Income statement is also known as:

Statement of operations,/ statement of earnings,/ "profit and loss statement (P&L)

An income statement equation:

Revenues - Expenses = Net Income (gains/loss)

Revenue

Gross Revenue

Net Revenue : Gross revenue adjusted for estimated returns & allowance

Expensescan be grouped based on their function / nature:

By Function

Manufacturing Expenses: Raw material, labor and direct expenses related to manufacturing areincluded in cost of goods sold

Selling and General & Administrative expenses

By Nature

Depreciation: Both on assets in manufacturing and administration are combined together based onnature

Research and development expenses

Estimated Gains/ Losses from discontinued operations:

Gain or loss which are not related to their normal business activities

For ex. Gain (Loss) on sale of fixed assets (difference between book valuesale vale)

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Understanding The Income Statement (Cont)


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Presentation formats of Income Statements:

1. Single-step

Revenue less Expenses : all items are grouped together as revenue or expenses

2. Multi-step

Shows detailed presentation including calculation of gross profit, operating profit & net income

Gross profit / loss: RevenueCost of Good Sold (direct costs of producing a product / service)

Operating profit / loss (EBIT): Gross profit Other Operating expenses (including selling, general. andadministrative & depreciation expenses )

Income from continuing operations: Operating profit - Interest expense - Income taxes

Net Income = Income from continuing operations + Earnings/ loss from discontinued operations

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Understanding The Income Statement (Cont)


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www.edupristine.com Neev Knowledge Management Pristine 73

Single Step Multi-Step

Revenue 3855.38Revenue 3855.38

Expenses 3318.29COGS 2590.99

Profit 537.09Other Operating Expenses 362.86

Depreciation 80.65

Operating Profit 820.88

Interest 10.29

Earnings Before Tax 810.59

Tax 273.5

Profit After Tax 537.09

Revenue Recognition: IASB/FASB definition of the term income

A di t th IASB th t "i i l d d i


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According to the IASB, the term "incomeincludes revenue and gains:

Income is defined as increases in economic benefits during the accounting period in the form ofinflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than

those relating to contributions from equity participants

According to the FASB, revenue is recognized in the income statement when:

It is realized or realizable or

It is earned

IASB GUIDELINESFOR REVENUE RECOGNITION:Following conditions must be satisfied:

1. Transfer of ownershipsrisk and rewards to buyer

2. Reliable Measurement of Revenues

3. Reliable Measurement of associated costs

Probable that economic benefits on sale will flow to the entity

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Income is broad concept and includes gains / losses from non operating activities as well.

SEC guidelines for revenue recognition

Agreement delivery price determination and surety of collection are SEC criteria to recognize

Imp


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Agreement, delivery, price determination and surety of collectionare SEC criteria to recognizerevenue

There is evidence of an arrangement between the buyer and seller

The product has been delivered or the service has been rendered

The price is determined or determinable

The seller is reasonably sure of collecting money.

Specific Revenue Recognition Applications:

Revenue is usually recognized at delivery using the revenue recognition criteria previously discussed

However, in some cases, revenue may be recognized before delivery occurs

Long Term Contracts:Generally for the entities engaged in construction projects

Methods for revenue recognition:

Percentage of completion method

Completed-contract method

Equal recognition: In some cases involving service contracts or licensing agreements, the firm may simplyrecognize revenue equally over the term of the contract or agreement

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Revenue - Recognition methods

Percentage of completion method:

Imp


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Percentage of completion method:

Appropriate when the project's cost and revenuecan be reliably estimated

Amount of revenueto be recognized =

Total contract value x total costincurred to date / total expected costof the project

Accordingly, revenue, expense, and therefore profit, are recognized based on the % completed

Completed Contract Method:

Used when the outcome of a project cannot be reliably measuredor

The project is short-term

Revenue, expense, and profit are recognized only when the contract is completed But, if a loss is expected, the loss must be recognized immediately (Principal of conservatism)

Comparedto completed contract method, percentage of completion method:

Recognizes revenue early hence it is more aggressive

Requires estimation of total costs hence subjectivity is involved

Provides smoother earningsand results in better matching of revenues and expenses over time

No impact on Cash flow: cash flows is same under both methods

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Installment Sales

Occurs when a firm finances a sale and amount is collected over an specified extended time period


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Occurs when a firm finances a sale and amount is collected over an specified extended time period

Revenue recognition can be of following types:

If collectability is certain: Recognize revenue at time of sale using normal revenue recognition criteria

If collectability cant be reasonably estimated: Recognize revenue using installment method

If collectability is highly uncertain: Recognize revenue using cost recovery method

Installment method: Profit is recognized as cash is collected

Profit = Cash collected during the period x Total expected profit / Total Sales

Used in limited circumstances, usually involving the sale of real estate or other firm assets

Cost Recovery Method: Book profits after recovering costs

Profit is recognized when cash collected exceeds costs (costs + interest) incurred

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There is no difference when installment sales and cash sales from revenue recognition point of view ifcollections are certain but if they are not, an installment or cost recovery method is used to recognizerevenue.`

IFRS guidelines on revenue recognition :

IFRS guideless for long-term contracts:


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IFRS guideless for long-term contracts:

If the firm cannot reliably measure the outcome of the project,

Revenue is recognized to the extent of contract costs

Costs are expensed when incurred (actual costs)

Profit is recognized only at completion

IFRS treatment of installment sales:

Installment sale treatment is appropriate for certain real estate transactions

Risks and rewards of ownership are not transferred (as seller remains involved in the property)

Buyers acquire a vested interest in the assets on the date which is different from the date of title transfer

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Barter transactions

Two parties exchange goods or services without exchanging cash


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Two parties exchange goods or services without exchanging cash

Issues like fair value of transaction arises

Dealt differently in US GAAP & IFRS

US GAAP

Recognized revenue at fair value based on historical transactions/ experience

But when firm has historically received cash payments for such goods

IFRS

Recognized revenue at fair value based on similar non barter transactionswith unrelated parties

E.g. Advertising space on internet companies

Note: Give special attention to difference in treatments given by US GAAP & IFRS to various transactions

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Gross or net revenue

An ecommerce company selling goods on portal what should be revenue?


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An ecommerce companyselling goods on portal what should be revenue?

Equal to total value of goods sold

Equal to commissions on total valueof such sales

If following criteria are met, revenue should equal to total value

Entity bears inventory risk and customer credit risksrelated to payments

Can choose supplierswith reasonable freedom to establish prices

E.g.: Big Bazaar

Otherwise, revenue should be recognized on net basismeaning equal to commissions E.g.: Agent selling flight tickets of Air India, makemytrip.com, amazon.com

Implications for Financial Analysis:

Firms disclose revenue recognition policies at financial statement footnotes

Analysis shows whether a firm is aggressive or conservative

Analysis also shows extent to which firms policies rely on judgment or estimates

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Revenue Calculation

Example:


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p

Mountain Infrastructure Ltd has a contract spanning over the next 3 years. The total revenue earnedby the contract is $20 Million. The total estimated costs are $10 Million. What is the revenue to be

recognized in year 2 using the percentage of completion method? What is the revenue recognized inyear 2 by the completed contract method? The costs projection for the contract are as of the tablebelow.

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Project Costs

Year 1 $6 Million

Year 2 $3 Million

Year 3 $1 Million

Revenue Calculation

Solution:Percent of Revenue


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In case of the completed contract method, since the project completed in year 3, no revenue isrecognized in year 2.

Project CostsPercent of

Total ProjectRevenueEarned

Year 1 $6 Million 60% $12 Million

Year 2 $3 Million 30% $6 MillionYear 3 $1 Million 10% $2 Million

Total $ 10 Million 100% $20 Million

Question: Installment and Cost Recovery Method

ABC Inc. purchases land at $400 million. It sells it to company XYZ for $600. The payment is to be


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collected over a period of three years. Below is the payment schedule to ABC Inc.

Which of the following is the profit recognized in year 2 by both installment sales method and by costrecovery method:

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Year Payment to ABC (in $ million)

Year 1 200

Year 2 200

Year 3 200

Total 600

Installment Sales Cost Recovery

A 66 66

B 0 66

C 66 0

Solution: Installment and Cost Recovery Method

By Installment Sales Method:


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Profit = Cash collected during the period x Total expected profit / Total Sales

= 200 * 200 / 600

= 66

By Cost Recovery Method

Profit is recognized when cash collected exceeds costs incurred.In this case, a profit is not observed till year 3, since all costs are recovered in year 2.

Thus the correct option is C

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Expenses Recognization: IASB definition of expense

According to the IASB:


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Expenses are decreases in economic benefitsduring the accounting period in the form ofoutflows or depletions of assets or incurrence of liabilitiesthat result in decreases in equity other

than those relating to distributions to equity participants

Just opposite of income definition

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Matching concept: Accrual accounting, PeriodCosts and Depreciation

Both revenue and associated expenses are matched and recognized in same period

Imp


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Matching concept requires expenses to be recognized in the same period when revenues arerecognizedfor which expenses were incurred

E.g. inventory is purchased Q4, 2008 and Q1 2009, using the matching principle, both the revenue andthe cost of goods sold are recognized in Q1 2009

Period Costs: expenses are recognized in the period they are incurred

Meaning Electricity Bills of Q1,09 must be recognized in Q1, 09 even if revenue generated is very lesscompared to other quarters

Administrative costs, rent are period costs

Depreciation:

Long-lived assets provide economic benefits beyond one accounting period hence their cost must bematched with revenues of more than one accounting period

Depreciation is a charge for allocation of cost of long lived assets over their economic lives

It is the cost of using long-lived assets in business matched with revenues

Hence it requires to estimate the life as well as the rate of depreciation

Depreciation is charged for assets like plant and equipments whereas amortization is charged forintangible assets like patents / copyrights

Land is the fixed asset which is not depreciated

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Matching concept: Warranty expense, Provision for baddebt

Method Used for


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Warranty expense:

If a firm provides a warranty to the customer, the matching principle :

Requires the firm to estimate warranty expense

Recognize these expenses in the period of sale to match these expenses with revenues rather than alater period when these are actually incurred

Provision for Bad Debt:

If firm is selling goods or services on credit, they may not be able to collect the whole money as some ofthe customers default

Hence the matching principle requires:

Firms to estimate bad debt expense and Recognize these expenses in the period of the sale rather than a later period when these are actually

incurred

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Depreciation Tangible Fixed Assets

Amortization Intangible Fixed Assets with finite lives

Impairment Intangible Fixed Assets with infinite lives

Implications for Financial Analysis - Expense

Like revenue recognition, expense recognition requires a number of estimates

Imp


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Ex. Depreciation (estimate of rate and period); Bad debts & Warranty (rate)

Judgment comes for estimation giving management a tool to delay or accelerate the recognitionof expensesand fluctuate the earnings

Aggressive policy: delaying the expenses thereby increasing net income

Conservative: Accounts expenses early

Analysts roleprobe management estimates

Must understand the reasons for a change in an expense estimate Changes in rate of bad debts / depreciation / warranty or any other

For example, if a firm's bad debt expense has recently decreased

Is this the result of better collection practices / experience

Is the expense decreased to manipulate net income

Compare a firm's estimates with those of other firms within the firm's industry to understand the trends forsuch changes

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Depreciation Methods

1. Straight-line depreciation

SL D ti (C t R id l l ) / U f l lif


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SL Deprecation expense = (Cost - Residual value) / Useful life

Requires significant estimate for residual value and useful life

2. Units of production method

(Assets Value X Units produced in a particular period / Total units to be produced during assets economiclife)

3. Accelerated method of depreciation:

Allocates high depreciation in early period of assets life Most important method of depreciation

Works on the principal that the maintenance expense in lower in beginning year compared to later years.Thus, by having more depreciation in beginning year it tries to maintain the overall expense constant overthe years

Declining balance method is one of these methods

Applies a constant rate of depreciation to a declining book value

Double-declining balance method DDB depreciation = ( 2 / useful life) * (costaccumulated depreciation)

DB does not explicitly use the asset's residual value in the calculations, but depreciation ends once theestimated residual value has been reached.

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Depreciation Methods (Cont)

Example of double-declining method:

S hi i h d t $10000 & it id l l i $3000 & t d lif i 5

Imp


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Suppose a machine is purchased at $10000 & its residual value is $3000 & expected life is 5 years

Depreciation expense for :

Year 1 = (2/5) * 10000 = $4000 Year 2 = (2/5) * (10000-4000) = $2400

Year 3 = (2/5) * (10000 - 6400) = $1440

Comparison / Analysis:

In early periods: Higher profitsusing straight-line method compared to an accelerated method(because of low depreciation)

In later periods: Opposite occurs

Accelerated method is conservativemethod because of low net income in early periods

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Intangible assets

Amortizationexpense is a depreciation charge for intangible assets with limited lives

Goodwill and other intangible assets with indefinite lives are not amortized


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Goodwill and other intangible assetswith indefinite lives are not amortized

The expense should match the proportion of the asset's economic benefits used during the period.

Most firms use the straight-line method for financial reporting

Goodwill:

Intangible assets with indefinite lives (e.g., goodwill) are not amortized.

Must be tested for impairment (check whether goodwill has or lost its value) at least annually

In such test, the cost of goodwill (as appearing in BS) is compared with the estimated value of goodwill

If the estimated value is less than the value appearing in BS The asset value is said to be impaired, an expense equal to such difference is recognized on the

income statement

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Five Minute Recap

Auditors Reports Opinion:Unqualified opinion : Free from materialomissions and errors

Key Financial Statements:Income statement : Financial performance over aparticular period of time.

FS qualitativecharacteristics : Comparable

U d t d bl


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Qualified Opinion : make any exception tothe accounting principlesAdverse Opinion :Financial Statementsare not presented fairly or are materially nonconforming with accounting standards

p pBalance Sheet: Financial positionat a particular pointof time.

Expanded accounting equation:Assets = liabilities + contributed capital + opening retainedearnings + revenues expensesdividends

Fundamental principles while preparingfinancial statements are :

Fair presentation Going concern basis Accrual basis of accounting Consistency Materiality

Understandable Relevant Reliable

Revenue Recognition Methods:Installment method: Profit is recognized as cashis collected. Profit= Cash collected during the period x Total

expected profit / Total Sales

Cost Recovery Method: Book profits afterrecovering costs Profit is recognized when cash collected

exceeds costs (costs + interest) incurred

Revenue- Recognitionmethods: Percentage of

completion method: Completed Contract

Method

Relationships among financial statements :

Income Statement and Balance Sheet :Retained Earningst+1= Retained Earningst+ Net IncomeCash flow and Balance SheetCasht+1= Casht+ Net Cash Flow

Method Used for

Depreciation Tangible Fixed Assets

Amortization Intangible Fixed Assets withfinite lives

Impairment Intangible Fixed Assets withinfinite lives

Accruals and other adjustments Accrued Revenue Unearned revenue: Prepaid expenses: Accrued expenses:

Depreciation Method:1. Straight-line

depreciation2. Units of production

method3. Accelerated method

CFA 1 Financial Reporting & Accounting

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