1. Financial Reporting Environment PDF

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Lecturer: Glenn Rechtschaffen
Course taken: 2016

Use these notes and you will have no difficulty understanding Acctg102....

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MODULE 1. FINANCIAL REPORTING ENVIRONMENT LEARNING OBJECTIVES: 1. 2. 3. 4. 5. 6.

Describe the financial reporting environment and generally accepted accounting practice. Discuss the Conceptual Framework’s objective of financial reporting. Discuss the Conceptual Framework’s qualitative characteristics of financial information. Discuss the Conceptual Framework’s definitions and recognition criteria for financial statement elements. Discuss the Conceptual Framework’s assumptions and measurement bases. Using a residual analysis, be able to discuss the effects of economic events on the accounting equation and be able to show how basic financial statements can be prepared from the summarized data.

LO 1: WHAT IS ACCOUNTING? 

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The purpose of accounting is: to identify, record and communicate the economic events of an organisation (entity  ie sole trader) to interested users  To identify economic events, a company selects the economic events relevant to its business  Once economic events are identified, the company records those events in order to provide a history of financial activities  After identification, the firm communicates the collected information to interested users by means of accounting reports (ie financial statements) In total, accounting involves the entire process of identifying, recording and communication economic events.

WHO USES ACCOUNTING DATA?

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Internal users of accounting information are those individuals inside a company who plan, organise and run the business  Includes: marketing managers, production supervisors, finance directors and company officers  In a running business, internal users must answer many important questions  Managerial accounting provides internal reports to help users make decisions about their companies

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External users are individuals and companies outside a company who want financial information about the company  Two types: investors and creditors  Investors (owners) use accounting information to make decisions to buy, hold or sell ownership shares of a company  Creditors (such as suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending money  Financial accounting answers these questions – provides economic and financial information for investors, creditors and other external users

LO 1: THE FINANCIAL REPORTING ENVIRONMENT 

NZ Law: Financial Reporting Act (FRA) of 1993

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Who is involved in the rule-setting process? (The players)

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Replaced by the FRA of 2013

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Effective in April 2014

International Accounting Standards Board (IASB) – 15 members NZ External Reporting Board (XRB) – 9 members NZ Accounting Standards Board (NZASB) – 10 members (committee of XRB)  The XRB is responsible for setting auditing and accounting standards.

The Current International Standard Setting Process: 

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IASB  Researches topics/Discussion Papers  Due Process  Exposure Drafts (ED)  Due process  Standard issued if 9 of 15 members approve NZASB  Receives IASB standard  Submits standard to XRB approval The XRB and Financial Reporting Standards

In order to be issued as IFRS, this process needs to be followed

GAAP (generally accepted accounting practice) ** GAAP includes IFRS, IASB interpretations of IFRS, NZ-specific FRS **  Under the FRA, private sector “for profit” entities must follow GAAP  When the FRB becomes law, only those of the above that are “publicly accountable” or “large” will have to follow GAAP.  Publicly accountable: for the most part, means that the entity’s debt or equity instruments are traded on exchanges.  Sources finances from public (ie shares, debentures)  Large (for NZ companies):  > $30 mill in revenue or  > $60 mill in assets.  Large  could be completely private company, absolutely not publically accountable, but the size of the revenue or assets could lead the firm to follow GAAP  Firms that are not large or publically accountable, they do not need to follow GAAP – but can if they want to  When the FRB becomes law, an entity, if not publicly accountable or large, legally will be required only to prepare special purpose tax reports. 

GAAP in NZ  International financial reporting standards  IFRS and IAS  IASB interpretations of IFRS and IAS  Financial reporting standards (FRS)

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GAAP: but what if there is no standard?  Analogies  NZ Framework for the Preparation and Presentation of Financial Statements (known as the “Conceptual Framework”)

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GAAP compliance and “true and fair view” of financial status and financial affairs  “True and fair view”  what is ACTUALLY going on  By following GAAP, it is presumed you have a true and fair view  If not, must follow standard and have footnotes explaining why it is not true and fair

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Regarding “for profit” entities, NZ is moving toward a two tier GAAP regime  Tier 1: full IFRS for publicly accountable entities (ie publically accountable and/ or large) 

Tier 2: reduced disclosure IFRS for non-publicly accountable entities (ie neither publicly accountable or large) // (Note: Tier 2 must be elected by those that qualify)

LO 2~5: THE CONCEPTUAL FRAMEWORK ** The Conceptual Framework is like the backbone of the IFRS – but the framework is not a standard; it is only a set of guidelines **  The three levels: First level = Basic objective (ie to achieve a true & fair view)  but this is quite  ambiguous and may have different meanings to different users, so… Second level = Qualitative characteristics of accounting information; and  definitions and recognition criteria for financial statement elements  it gives is specific definition to help clear out the ambiguity Third level = Underlying assumptions (explicit and implicit) and measurement  concepts

THE CONCEPTUAL FRAMEWORK - OBJECTIVE (LO2)  To provide general purpose (for majority of external users) financial reporting about the reporting entity that is decision-useful to primary users of the entity’s financial reports  Important to note that ‘primary users’ don not necessarily have to be the shareholders or management – it can be the government THE CONCEPTUAL FRAMEWORK – QUALITATIVE CHARACTERISTICS (LO3)  Fundamental QC’s  the “must haves”

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Characteristic of relevance: Since the purpose of presenting accounting information in financial statements is to provide information to users for making economic decisions, it is important that this information is relevant to users for decision-making. Relevance means that the information can influence the economic decisions made by users.  For example, the information may help users to predict future events, such as future cash flows, from the alternative courses of action under consideration. Furthermore, information is relevant if it is able to help decision makers evaluate past decisions. The information may confirm that a previous decision was correct, or it could show that the results of a previous decision were undesirable and that a new decision is necessary to correct or minimize the mistakes of the past. Thus, information that is relevant is said to have a predictive role and a confirmatory or feedback role.

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Characteristic of faithful representation (reliability):  Reliability means that the user is assured that the information presented represents faithfully, without bias or undue error, the underlying transactions and events being reported in the financial statements To be useful in making investment, credit and similar resource allocation decisions, information must be a faithful representation of the real-world economic phenomena that it purports to represent. The phenomena represented in financial reports are economic resources and obligations and the transactions and other events and circumstances that change them. To be a faithful representation of those economic phenomena, information must be neutral and complete

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Enhancing QC’s  the “nice to haves”

Characteristic of comparability: Quality of information that enables users to identify similarities in and differences between two sets of economic data. Consistency refers to use of the same accounting policies and procedures, either from period to period within an entity or in a single period across entities. Characteristic of understandability: Quality of information that enables users who have a reasonable knowledge of business and economic activities

and financial accounting, and who study the information with reasonable diligence, to comprehend its meaning. THE CONCEPTUAL FRAMEWORK – ELEMENTS (LO4)  ASSETS – an asset is recognised on the BS of an entity if:  Because of a past event  The entity controls a resource  That provides probable future economic benefits  That can be measured reliably 

LIABILITIES – a liability is recognised in the BS of an entity if:  An obligating event (ie past event) causes a present obligation  Whose settlement probably will result in an outflow of resources  That can be measured reliably.

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EQUITY  Definition: Residual interest in assets after deducting all liabilities (E = A – L)  Amount is dependent on the measurement of assets and liabilities  Income increases and expenses decrease equity.

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INCOME  Income is recognised if, during the period,  There are increases in economic benefits  Either from increases to total assets or decreases to total liabilities  That cause an increase in equity, other than owner contributions (ie IPO)  Amount is dependent on the measurement of assets and liabilities

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EXPENSES  Expenses are recognised if, during the period  There are decreases in economic benefits  Either from decreases to total assets or increases to total liabilities  That cause a decrease in equity, other than owner distributions (ie dividends, drawings)  Amount is dependent on the measurement of assets and liabilities.

THE CONCEPTUAL FRAMEWORK – ASSUMPTIONS (LO5)  Explicit assumption underlying financial reporting:  Going concern assumption states that  the business will continue to operate into the foreseeable future  This is important because of the effect on the valuation of assets (ie future economic benefits) – if not going concern (ie business does not operate into foreseeable future [blackberry], the valuation of assets will be affected)

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Implicit assumption underlying financial reporting:  Periodicity assumption states that  life of the business can be divided into periods of equal length – ie consistency = promotes comparability, verifiability, timeliness and understability

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Accrual accounting:  No longer an explicit and not necessary as an implicit assumption…why?  Accrual accounting = transactions recognised or recorded when there has been economic benefits (whether or not cash has been exchanged) *Accrual accounting is more robust because we live in a credit based society*  Under the accrual basis the effects of all transactions and events are recognised in accounting records when they occur, and not when the cash is received or paid. Hence, financial statements report not only on cash transactions but also on obligations to pay cash in the future and on resources that represent receivables of cash in future.

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Cash accounting = transactions only recognised or recorded when cash has been exchanged (whether or not economic benefit has been performed)

THE CONCEPTUAL FRAMEWORK – MEASUREMENT BASES (LO5)  Historical cost (cost principle):  Dictates that companies record assets at their cost.  Issues:  Reported at cost when purchased and also over the time the asset is held.  Cost easily verified, market value is often subjective.  Fair value information may be more useful.  Fair value:  Indicates that assets and liabilities should be reported at fair value (ie the price received to sell an asset or settle a liability)  In determining which measurement principle to use, companies weigh the factual nature of cost figures versus the relevance of fair value.  Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied (sell the asset under current market conditions)  Present value:  Time value of money

LO 6: USING THE ACCOUNTING EQUATION ECONOMIC EVENT ANALYSIS

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Economic events are not all recorded  Accounting Transactions: exchanges of something of value between the accounting entity and another entity.  Companies carry on many activities that do not represent business transactions – eg. hiring employees, answering the telephone etc…  Each transaction must have dual effect on the accounting equation  Some economic events, though not accounting transactions, still might be recorded in the accounting records.  The company must analyse each event to find out if it affects the components of the accounting equation – if it does, the company will record the transaction  Eg. law suit/ suing a company  this is an economic event, but not an accounting transaction – but still recorded because of 50/50 chance of win or lose  ie might affect the components of the accounting equation 

Accounting standards and concepts play a role

RESIDUAL ANALYSIS 

A residual analysis uses the Conceptual Framework to identify if an economic event has affected the accounting equation.  Remember, the accounting equation must ALWAYS balance.

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A residual analysis begins with assets  Asset(s) increased? See definition.  Asset(s) decreased?  Does accounting equation balance? If yes, stop and record. If not, go to liabilities. The residual analysis continues with an analysis of liabilities.  Liability or liabilities increased? See definition.  Liability or liabilities decreased?  Does accounting equation balance? If yes, stop and record. If not, go to equity.

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The residual analysis finishes with equity. If you have reached this point there must have been an overall net increase or decrease to A – L An increase to A – L (called “net assets”) means equity must increase correspondingly:  Ask first: from an owner contribution?  If not, recognize income. A decrease to net assets means equity must decrease correspondingly:  Ask first: from an owner distribution?  If not, recognize an expense.

LO 6: FINANCIAL STATEMENTS

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Financial Statements  The users of financial statements make decisions about whether or not to provide resources to the entity in the form of invested funds, loans or other forms of credit  Users may be interested in three types of information contained in financial statements to inform them about the entity: its financial performance, its financial position and its cash movements  Financial Performance: the ability of the entity to utilise its assets efficiently and effectively to generate cash flows in the conduct of its activities, whether for profit or not for profit  Financial Position: deals with the economic resources controlled by an entity, its financial structure, its capacity to adapt to changes in its environment, and its liquidity and solvency. This information is useful in predicting the ability of the entity to generate cash flows in the future, and to meet its financial commitments as and when they fall due.

 Cash Movements: are made up of cash inflows and outflows. Information about the entity’s cash flows is useful in order to assess the entity’s operating, investing and financing activities. This provides a basis for assessing the ability of the entity to generate cash in the future to meet its objectives. 

Statement of Comprehensive Income (Income Statement)  Reports the results of financial performance for a specific time period such as a month, half-year or year.  Profit for the period is the excess of income over expenses for that time. If expenses for the period exceed income, a loss is incurred.   

Bottom line: - If there is no CI: Profit and comprehensive income If there is CI: Profit, then total comprehensive income Other comprehensive income affects other reserves, not retained earnings

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Income: Represents an increase in the wealth of the owner(s). Income is defined in the Conceptual Framework as 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 in equity, other than those relating to contributions from equity participants  Although income often is measured by the cash received, it may be measured by the receipt of other assets, such as promises by customers to pay in the future (accounts receivable, also called debtors) or the receipt of property from a customer.

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Expenses: 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

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Because income results in an increase in equity and expenses result in a decrease in equity, the difference between the two (where income exceeds expenses) — profit — must represent a net increase in equity. Similarly, a loss represents decrease in equity. A loss arises where expenses exceed income.

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Statement of Changes in Equity (Retained earnings statement) The statement of changes in equity serves as a connecting link between the  balance sheet and the income statement, and explains the changes that took place in equity during the period.

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Statement of Financial Position (Balance Sheet)  Reports the financial position of an entity at a specific point in time. The financial position is reflected by the assets of the entity, its liabilities or debts owed, and the equity of its owners.  The heading of the balance sheet indicates the name of the entity, the name of the statement and the date. The basic statement is divided into three main sections: assets, liabilities and equity.  Current assets, non-current assets, total assets  Current liabilities, non-current liabilities, equity, total liabilities & equity

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Assets: Resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. They are economic resources which may be tangible (having physical characteristics, such as land, buildings and equipment) or intangible (assets without physical existence, such as legal claims or patent rights).

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Liabilities: Present obligations of an entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.  They are the debts owed by an entity to outside parties called creditors and include amounts owed to suppliers for goods or services purchased on credit (accounts payable), amounts borrowed from banks or other lenders (loans payable and mortgages payable) and amounts owed to employees for wages and salaries that have not yet been paid (wages and salaries payable).

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Equity: May be thought of as the owner’s claim to (or the residual interest in) the assets of the entity after deducting all its liabilities.  Assets – Liabilities = Equity  Net Assets = Equity

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Statement of Cash Flows  Prepared to report on the cash flows in and out of the entity. It is particularly useful in helping users to assess t...