Financial Accounting And

Analysis
Topic 1

General Purpose
Financial Reporting

2016 John Wiley & Sons Australia, Ltd

 Learning objectives/Outcomes
1. Explain the demand and supply of financial
information in the business context
2. Discuss the impact of financial information on
organisation, society and individuals.
3. Explain and apply the concepts and principles
underlying the recording of accounting information.
4. Describe the Conceptual Framework for Financial
Reporting (the Conceptual Framework).

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 Learning objectives/Outcomes

5. Integrate principles, concepts, standards and the

Conceptual Framework.
6. Identify the elements of each of the four main
financial statements.
7. Describe the financial reporting environment.
8. Appreciate various contemporary issues associated
with corporate reporting (e.g. Accounting for corporate
social responsibility, sustainability reporting).

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 Why Financial Information Are Important ?

Assess the performance and risks (i.e., credit

risk, asset risk)
Provide a comprehensive economic history of a
business entity
Thus, financial statement can be used for
various purposes:
As an analytical tool.
As a management report card.
As an early warning signal.
As a basis for prediction.
As a measure of accountability.
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 Impacts of Financial information

CBA posts record profit

https://www.youtube.com/watch?v=c8NAw54AGGM
Good for Investors?
Good for consumers?
Good for society?
Reaction?
https://www.youtube.com/watch?v=5xwZfG13QRA
https://www.youtube.com/watch?v=8xI25VXyBc4

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 Who are the users of Financial Information ?
Why do they demand financial Information?

Shareholders and investors Managers and employees

1. Investment 1.Performance assessment
decisions/stewardship
2.Compensation contracts
function
3.Employment benefits
2. Proxy contests
Lenders and suppliers
Government and regulatory
1. Lending decisions
agencies
2. Covenant compliance
1.Mandatory reporting
Customers
2.Taxing authorities
1. Suppliers health
3.Regulated industries
2. Repeat purchases
3. Warranties & supports
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 Supply of financial information

Relevant financial information is provided

primarily through financial statements and
related disclosure notes.
Major Financial statements: Balance Sheet,
Income Statement, Statement of Stockholders
Equity and Statement of Cash Flows.
Disclosures in the notes
Other forms of information: Press releases and
management discussions (MD&A).
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 Type of Disclosures:

Mandatory Disclosure (i.e., leases, financial

instruments, etc.): Required by the
Corporation Act and accounting standards.
Voluntary disclosure (i.e., CSR: Guided by
cost/benefit considerations.

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 Disclosure Benefits

The following are benefits arising from voluntary

disclosures :
Increase investors confidence on the quality of
companys equity offerings.
Obtain capital cheaply from the capital markets.
Get better deals from suppliers.

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 Disclosure Costs

The costs which may arise from voluntary

disclosures :
Information collection, processing and
dissemination costs.
Competitive disadvantage costs.
Litigation costs, increase the possibility of
being sued by some stakeholders.
Political costs, more taxes may be imposed
by government.
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 Introduction to accounting

Primary function of accounting is to provide financial

information for decision making.
Management accounting provides information for
decision making within the business.
Financial accounting provides information to assist
external users decision making.

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 Nature of Financial Accounting
Financial accounting measures an entitys performance
over time and its position (status) at a particular point of
time.
The financial statements (largely for the use of people
outside of an enterprise), which are financial accountings
reports, summarise the measurements of performance
and position in standard ways thought to be useful in
evaluating whether the business has done well and is in
good shape.
Financial accounting process, therefore, is concerned with
communicating economic information
Accountants must, therefore, be skilful in conveying the
information concisely and accurately to their chosen
audiences.
 The social setting of financial
Accounting
Financial Accounting for the enterprise operates within and
serves a complex social setting. Financial Accounting-
Helps investors decide whether to buy, sell or hold shares
of companies
Helps banks and other lenders decide whether or not to
lend
Helps managers run enterprise in behalf of owners,
members or citizens
Provides basic financial records for the purpose of day-to-
day management, control, insurance and fraud prevention
Is used by governments in monitoring the actions of
enterprises and in assessing taxes such as income tax and
goods and services tax (GST)
 The financial reporting
environment
Financial reporting is heavily regulated
A number of institutions and groups regulate and
monitor financial reporting in Australia:
Australian Securities and Investments Commission
Financial Reporting Council
Australian Accounting Standards Board
Australian Securities Exchange
Professional Accounting Bodies

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 The accounting process

Accounting is the process of identifying, measuring,

recording and communicating the economic
transactions and events of a business operation.
Transactions are economic activities relevant to a
particular business.
For example:
sale of item to customer
purchase of office stationery from supplier.

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 The accounting process

Transactions are the basic inputs into the

accounting process.
Identifying Measuring Recording Communication
Taking into Quantifying in Analysing, Preparing
consideration all monetary terms recording, accounting
transactions classifying and reports,
which affect summarising analysing and
business entity transactions interpreting

Commonly referred to as bookkeeping

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Concepts and principles underlying
accounting
 Introduction to the
Conceptual Framework
The Conceptual Framework consists of a set of
concepts to be followed by preparers of financial
statements and standard setters.

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 Conceptual frameworks (CF)
Set of concepts defining the nature, purpose
and content of general-purpose of financial
reporting.
Used by preparers and standard setters.

Impacts the way

we view,
interpret and
report the
economic world.
 The objective of general purpose financial
reporting
Stewardship and accountability objectives:
For entities where there is a separation of
ownership from control, general-purpose financial
reports can support stewardship/accountability
function.
Managers use reports to show owners they are
fulfilling their stewardship function and managing
resources effectively.
Shareholders use reports to check on managers
and make them accountable.

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 The objective of general purpose financial
reporting
Decision-usefulness objective:
The objective of general-purpose is to provide
information to users that is useful for making and
evaluating decisions about allocation of scarce
resources (perspective of Australian CF SAC 2).

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 The objective of general purpose financial
reporting
According to the IASBs preliminary conceptual
framework:
the objective of general-purpose financial reporting
is to provide financial information about the reporting
entity that is useful to existing and potential equity
investors, lenders, and other creditors in making their
decisions about providing resources to the entity
(OB2).

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 Users and uses of financial reports
The Conceptual Framework primary users are
resource providers.

*other creditors must in capacity as resource providers,

otherwise not considered a primary user.
 The reporting entity

Currently Australian business entities and standard

setters still use the definition from the Australian
conceptual framework:
an entity in which it is reasonable to expect the
existence of users who depend on general-
purpose financial reports to enable them to make
economic decisions (SAC 1).

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 The reporting entity

Indicators:
if the entity is managed by individuals who are not
owners of the entity; e.g. public listed companies
if the entity is politically or economically
important; e.g. Australia Post
if the entity is considered large in sales, assets,
borrowings, customers, and employees; e.g. Coles,
Woolworth, BHP Billiton etc.
then the entity is more likely to be a reporting
entity.

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 Qualitative characteristics and constraint on
financial reporting
Fundamental qualitative characteristics:
Relevance:
provides a basis for predictions
confirms or corrects previous expectations.

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 Qualitative characteristics and constraint on
financial reporting
Fundamental qualitative characteristics:
Faithful representation:
complete, neutral and free from material error
depicts the economic substance
unbiased
judgements and estimates reflect best
available information.

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 Qualitative characteristics and
constraint on financial reporting
Enhancing qualitative characteristics:
Qualitative characteristics and constraint on
financial reporting
Constraint on financial reporting:
Costs versus benefits:
Costs of preparing financial reports should
not exceed the benefits to be derived from
the reports.

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 Definition, recognition and measurement of
elements in financial reports
The elements of financial statements include:
assets
liabilities
equity
income
expenses.
The Conceptual Framework defines each element
and sets out the criteria for their recognition.

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 Assets definition

The Framework defines assets as a resource

controlled by the entity as a result of past events and
from which future economic benefits are expected to
flow to the entity (para. 49(a)).
There are 3 essential characteristics:
1. The entity must have control over the asset:
Mostly means ownership, but not always the
case (e.g. in finance lease).

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 Financial Lease

Lessor Equipment Lessee

Substantial Risks and Benefits

Lessee needs to recognize Equipment in its book even

though it is not the owner, it actually CONTROL the
equipment

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 Assets definition

2. The control must be as a result of a past

transaction or event:
i.e. after purchase of asset has taken
place.
Resources to be purchased in the future
are not considered assets until exchange
takes place.

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 Assets definition

3. The resource must be able to provide future

economic benefits or service potential:
e.g. being sold for cash, exchanged for
another asset, used to produce goods and
services.

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 Can a resource be recognized as an assets if meeting
the definition of assets?
https://www.youtube.com/watch?v=Hglw-HhwAFA
Can we put Great Barrier Reef as an asset on
Australian government account?

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 Assets recognition

Items that meet the definition of assets should be

incorporated in the statement of financial position
when:
a) It is probable that the future economic benefits
will flow to the entity:
Refers to the degree of uncertainty.
Use all evidence available to assess probability.
If it is improbable that economic benefits will flow
to the entity beyond current period, the
expenditure is recorded as an expense.

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 Assets recognition

b) The asset has a cost or value that can be

measured with reliability:
e.g. purchase price.
Could also be an estimated value, for
example for items such donated assets

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 Liabilities definition

The Conceptual Framework defines liabilities as a

present obligation of the entity arising from past
events, the settlement of which is expected to result
in an outflow from the entity of resources
embodying economic benefits (para. 49(b)).

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 Liabilities definition

There are 3 essential characteristics:

1. The entity must have a present obligation:
A duty to act or perform in the future, e.g.
providing goods/services, delivering cash
repayments.
e.g. receive a customers purchase deposit
of AUS$ 1,400 for a new Iphone 7
e.g. Purchased inventories but not yet
paid, Accounts payable

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 Liabilities definition

2. The obligation must be as a result of a past

transaction or event:
e.g. after purchase of assets has taken place.
An intention to buy an asset is not a present
obligation.

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 Liabilities definition

3. A liability must result in an outflow of resources

or economic benefits:
Outflow of economic benefits will reduce
the entitys future cash flows, e.g. paying
cash, providing goods/services, or issuing
another liability.

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 Liabilities recognition

A liability is recognised in the statement of financial position

when:
a) It is probable that an outflow of resources embodying
result from the settlement of a present obligation:
Not dependent upon occurrence of certain
events outside the entitys control.
e.g. You owe $10,000 to your friend, you think
what if he may have an accident tomorrow??
b) The amount at which the settlement will take place
can be measured reliably.

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 Liabilities recognition

Liabilities that do not satisfy recognition criteria are

classified as contingent liabilities:
e.g. unresolved lawsuits, potential liability from
a tax audit in progress.
Contingent liabilities are not recognised in the
financial statements, but they must be disclosed in
the notes to the financial statements if considered to
be material.

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 Equity definition

Equity is defined in the Framework as the residual

interest in the assets of the entity after deducting all its
liabilities (para. 49(c)):
Cannot be independently defined (residual).
From basic accounting equation:
Equity = Assets Liabilities

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 Equity definition

Transactions/events that affect equity:

gains/losses
owners activities (capital investments, drawings,
dividends).

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 Income definition

Definition of income in the Framework: increases in

economic benefits during the accounting period in
the form of inflows or enhancements of assets or
decreases of liabilities that result in increases of
equity, other than those relating to contributions
from equity participants (para. 70(a)).
Definition of income is linked to the definition of
assets and liabilities.

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 Income definition

Income includes:
1. Revenue:
Increases in economic benefits arising in the
course of ordinary activities.
e.g. sales revenue, rent, dividends.
2. Gains:
Other increases in economic benefits that do
not arise from ordinary course of business.
e.g. gains from the sale of non-current assets.
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 Income recognition

Income is recognised when an increase in future

economic benefits related to an increase in an asset or
a decrease of a liability has arisen that can be
measured reliably.
This means that income recognition occurs
simultaneously with the recognition of increases in
assets or decreases in liabilities.
Common practice: recognise revenue when it is
earned.

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 Income recognition

Revenue recognition criteria on the sale of goods (AASB

118 Revenue para.14):
a) The entity has transferred to the buyer the
significant risks and rewards of ownership of the
goods;
b) The entity retains neither continuing managerial
involvement to the degree usually associated with
ownership nor effective control over the goods sold;

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 Income recognition

Revenue recognition criteria on the sale of goods

(AASB 118 Revenue para.14):
c) The amount of revenue can be measured
reliably;
d) It is probable that the economic benefits of the
revenue will flow to the entity; and
e) The associated costs can be measured reliably.

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 Income recognition

Revenue recognition criteria for provision of services

(AASB 118 Revenue para. 20):
a) The amount of revenue can be measured reliably;
b) It is probable that the economic benefits
associated with the transaction will flow to the
entity;
c) The stage of completion of the transaction at the
reporting date can be measured reliably; and

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 Income recognition

Revenue recognition criteria for provision of services

(AASB 118 Revenue para. 20):
d) The costs incurred for the transaction and the
costs to complete the transaction can be
measured reliably
Note that a new standard for revenue recognition
was released in May 2014 and is mandatory for
reporting periods from 1 January 2017.

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 Expenses definition

The Framework defines expenses as decreases in

economic benefits during the accounting period in
the form of outflows or depletions of assets or
incurrences of liabilities that result in decreases in
equity, other than those relating to distributions to
equity participants.
Like the definition of income, definition of expenses
is also linked to the definition of assets and liabilities.

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 Expenses definition

Expenses include:
1. Expenses:
Decreases in economic benefits that arise in
the ordinary activities of the entity.
e.g. cost of sales, salaries.
2. Losses:
Expenses that do not necessarily arise in the
ordinary course of business.
e.g. loss from natural disasters.
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 Expenses recognition

Expenses are recognised when a decrease in future

economic benefits related to a decrease in an asset or
an increase of a liability has arisen that can be
measured reliably.
Matching principle: when resulting directly or jointly
from the same transaction as revenues, expenses
should be recognised on the basis of a direct
association with revenues.

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Expenses recognition
 Measurement of the elements of
financial reports
Measurement: the process of determining the
monetary amounts at which the elements of the
financial statements are to be recognised and carried
in the statement of financial position and income
statement.
Four measurement bases are outlined in the existing
Conceptual Framework but the IASB intends to
provide further guidance as to which measurement
should be used in the revised Conceptual
Framework.
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 Measurement of the elements of
financial reports
The existing Framework outlines 4 measurement
bases:
1. Historical cost:
Assets are recorded at the amount paid or
consideration given at the time of
acquisition.
Liabilities are recorded at the amounts of
expected to be paid to satisfy the liability
in the normal course of business.

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 Measurement of the elements of
financial reports
2. Current cost:
Assets are carried at the amount that would
have to be paid if the same asset was
acquired currently.
Liabilities are carried at the undiscounted
amount that would be required to settle the
obligation currently.

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 Measurement of the elements of
financial reports
3. Realisable (settlement) value
Assets are carried at the amount that could
currently be obtained by selling the asset in
an orderly disposal.
Liabilities are carried at settlement value.

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 Measurement of the elements of
financial reports
4. Present value:
Assets are carried at the present discounted
value of future net cash inflows that is
expected to be generated in the normal course
of business.
Liabilities are carried at present discounted
value of the future net cash outflows required
to settle liabilities in the normal course of
business.

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 Measurement of the elements of financial
reports
Suppose you purchased a computer 1 year ago, cost you
$2,000
Historical cost: $2,000
You want to replace it with the same model and
functions, Price is $1,500
Current cost $1,500
If you sell the old computer, you only can get $1,350
Realisable (settlement) value $1,350
If you keep the old computer it can generate $1,100 in a
year (discount rate is 10%)
Present value $1,000
 Integrating GAAP

Generally accepted accounting principles (GAAP) are a

set of rules and practices, having substantial
authoritative support, that are recognised as a general
guidance for financial reporting purposes.
GAAP consists of:
Statutory rules (standards) and interpretations.
Concepts and principles developed over time.

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 Integrating GAAP

Order of applying GAAP:

Corporations Act accounting standards &
interpretations conceptual framework
concepts & principles.

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 Integrating GAAP

Interrelationships among various aspects of GAAP:

Reporting entities (SAC 1) are required to prepare
general purpose financial reports that are useful for
decision making by the resource providers and the
usefulness is dependent upon the informations
qualitative characteristics.
Accounting period concept and revenue and expense
recognition criteria are interrelated.
The definitions of assets, liabilities, equity, income
and expenses are linked.
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 Financial statements

The Conceptual Framework defines the

elements of financial statements.
Statement of Statement of Statement of Statement of
Profit or Loss Changes in Equity Financial Position Cash Flows

Reports revenues Reports total Reports assets, Reports

less expenses for comprehensive liabilities and information
a particular period income for the equity at a regarding cash
of time. period and other particular point in receipts and cash
changes in equity. time. payments for a
particular period
of time.

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Statement of profit or loss

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Statement of changes in equity

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Statement of financial position

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Statement of cash flows

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 Interrelationships between the
statements
The financial statements are interrelated:
The statement of financial position is linked to the
statement of profit or loss and the statement of
changes in equity by the ending retained earnings
balance.
The statement of cash flows is linked to the
statement of financial position by the ending cash
balance.

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 Future developments in
financial reporting
Sustainability Reporting:
Social Dimension focuses on impact of business
activities on individuals as well as communities.
Environmental Dimension focuses on impact of
business activities on the environment.
These disclosures are currently voluntary but there
are increasing pressures on companies to measure,
report, and reduce environmental impact.

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 Sustainability reporting

Sustainability: making sure the social, economic and

environmental needs of our community are met and
kept healthy for future generations.
Concerned with 3 main areas:
economic
environmental
social.
Currently social and environmental disclosures are
voluntary.

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