Financial Reporting CHAPTER 1

and Accounting Standards

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Describe the growing 3. Identify the major policy-
importance of global financial setting bodies and their role
markets and its relation to in the standard-setting
financial reporting. process.
2. Explain the objective of financial 4. Discuss the challenges
reporting. facing financial reporting.

1-1
 Importance of global financial markets and
its relation to Financial Reporting –
Accounting and Capital Allocation

Resources are limited. Efficient use of resources often

determines whether a business thrives.

1-2 LO 1
 Global Markets

High Quality Standards

Globalization demands a single set of high-quality
international accounting standards. Some elements:
1. Single set of high-quality accounting standards established by
a single standard-setting body.
2. Consistency in application and interpretation.
3. Common disclosures.
4. Common high-quality auditing standards and practices.
5. Common approach to regulatory review and enforcement.
6. Education and training of market participants.
(Continued)

1-3 LO 1
 Global Markets

High Quality Standards

Globalization demands a single set of high-quality
international accounting standards. Some elements:
7. Common delivery systems (e.g., eXtensible Business
Reporting Language—XBRL).
8. Common approach to corporate governance and legal
frameworks around the world.

1-4 LO 1
 Objective of
Financial Reporting

Objective: Provide financial information about the reporting

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

► lenders, and

► other creditors

in making decisions about providing resources to the entity.

1-5 LO 2
 Objective of Financial Reporting

General-Purpose Financial Statements

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

Equity Investors and Creditors

► Investors and creditors are the primary user group.

1-6 LO 2
 Objective of Financial Reporting

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

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

1-7 LO 2
 Objective of Financial Reporting

Question & Answer

The objective of financial reporting places most emphasis on:
a. reporting to capital providers.
b. reporting on stewardship.
c. providing specific guidance related to specific needs.
d. providing information to individuals who are experts in
the field.

1-8 LO 2
 Objective of Financial Reporting

Question & Answer

General-purpose financial statements are prepared primarily
for:
a. internal users.
b. external users.
c. auditors.
d. government regulators.

1-9 LO 2
 Identify the major policy-setting bodies and
their role in the standard-setting process.
Standard-Setting Organizations
Main international standard-setting organization:
► International Accounting Standards Board (IASB)
● Issues International Financial Reporting Standards
(IFRS).

● Standards used on most foreign exchanges.

● IFRS used in over 149 countries.

● Two organizations that have a role in international

standard-setting are the International Organization of
Securities Commissions (IOSCO) and the IASB.
1-10 LO 3
 Standard-Setting Organizations

International Organization of Securities

Commissions (IOSCO)
► Does not set accounting standards.

► Dedicated to ensuring that global markets can operate

in an efficient and effective basis.
► Supports the use of IFRS as the single set of
international standards in cross-border offerings and
listings.

http://www.iosco.org/

1-11 LO 3
 Standard-Setting Organizations

International Accounting Standards Board (IASB)

Composed of four organizations—
► IFRS Foundation

► International Accounting Standards Board (IASB)

► IFRS Advisory Council

► IFRS Interpretations Committee

1-12 LO 3
 International Accounting Standards Board

ILLUSTRATION 1.4
International Standard-Setting Structure

1-13 LO 3
 Standard-Setting Organizations

Question & Answer

IFRS stands for:
a. International Federation of Reporting Services.
b. Independent Financial Reporting Standards.
c. International Financial Reporting Standards.
d. Integrated Financial Reporting Services.

1-14 LO 3
 Standard-Setting Organizations

Question & Answer

The major key players on the international side are the:
a. IASB and IFRS Advisory Council.
b. IOSCO and the U.S. SEC.
c. London Stock Exchange and International
Securities Exchange.
d. IASB and IOSCO.

1-15 LO 3
 International Accounting Standards Board

Due Process
The IASB due process has the following elements:
1. Independent standard-setting board;
2. Thorough and systematic process for developing
standards;
3. Engagement with investors, regulators, business leaders,
and the global accountancy profession at every stage of
the process; and
4. Collaborative efforts with the worldwide standard-setting
community.
1-16 LO 3
 ILLUSTRATION 1.5
International Standard-Setting Structure
1-17 LO 3
 International Accounting Standards Board

Types of Pronouncements
► International Financial Reporting Standards.

► Conceptual Framework for Financial Reporting.

► International Financial Reporting Standards Interpretations.

1-18 LO 3
 Standard-Setting Organizations

Hierarchy of IFRS
Companies first look to:
1. International Financial Reporting Standards and IFRS
interpretations originated by the IFRS Interpretations
Committee
2. The Conceptual Framework for Financial Reporting; and
3. Pronouncements of other standard-setting bodies that use a
similar conceptual framework (e.g., U.S. GAAP).

1-19 LO 3
 Standard-Setting Organizations

Question & Answer

IFRS is comprised of:
a. International Financial Reporting Standards and FASB
financial reporting standards.
b. International Financial Reporting Standards,
International Accounting Standards, and International
Accounting Standards Interpretations.
c. International Accounting Standards and International
Accounting Standards Interpretations.
d. FASB financial reporting standards and International
Accounting Standards.
1-20 LO 3
 Financial Reporting Challenges

IFRS in a Political Environment

► Considering the economic consequences of many
accounting rules, special interest groups are expected to
vocalize their reactions to proposed rules.
► The Board should not issue standards that are primarily
politically motivated.
► While paying attention to its constituencies, the Board
should base IFRS on sound research and a conceptual
framework that has its foundation in economic reality.

1-21 LO 4
 IFRS in a Political Environment

1-22 LO 4
 The Expectations Gap
What the public thinks accountants should do and what
accountants think they can do.

Significant Financial Reporting Issues

► Non-financial measurements

► Forward-looking information

► Soft assets

► Timeliness

1-23 LO 4
 Ethics in the Environment of Financial Accounting
► Companies that concentrate on “maximizing the bottom
line,” “facing the challenges of competition,” and
“stressing short-term results” place accountants in an
environment of conflict and pressure.

► IFRS do not always provide an answer.

► Technical competence is not enough when

encountering ethical decisions.

1-24 LO 4
 International Convergence
Examples of how convergence is occurring:
1. China’s goal is to eliminate differences between its standards and
IFRS.
2. Japan now permits the use of IFRS for domestic companies.
3. The IASB and the FASB have spent the last 16 years working to
converge their standards.
4. Malaysia helped amend the accounting for agricultural assets.
5. Italy provided advice and counsel on the accounting for business
combinations under common control.

1-25 LO 4
 Question & Answer
The expectations gap is:
a. what financial information management provides and
what users want.
b. what the public thinks accountants should do and what
accountants think they can do.
c. what the governmental agencies want from standard-
setting and what the standard-setters provide.
d. what the users of financial statements want from the
government and what is provided.

1-26 LO 4
Conceptual Framework CHAPTER 2
for Financial Reporting
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Describe the usefulness of a 3. Review the basic
conceptual framework and the assumptions of accounting.
objective of financial reporting.
4. Explain the application of the
2. Identify the qualitative basic principles of
characteristics of accounting accounting.
information and the basic
elements of financial
statements.

1-27
 Describe the usefulness of a conceptual
framework and the objective of financial
reporting

Conceptual Framework establishes the concepts that

underlie financial reporting.

Need for a Conceptual Framework

► Rule-making should build on and relate to an established
body of concepts.

► Enables IASB to issue more useful and consistent

pronouncements over time.
1-28 LO 1
 Conceptual Framework

Development of a Conceptual Framework

Presently, the Conceptual Framework is comprises of the following.
• Chapter 1: The Objective of General Purpose Financial Reporting
• Chapter 2: The Reporting Entity
• Chapter 3: Qualitative Characteristics of Useful Financial
Information
• Chapter 4: The Framework, comprised of the following:
1. Underlying assumption—the going concern assumption;
2. The elements of financial statements;
3. Recognition of the elements of financial statements;
4. Measurement of the elements of financial statements; and
5. Concepts of capital and capital maintenance.
1-29 LO 1
 Conceptual Framework

Overview of the Conceptual Framework

Three levels:
 First Level = Objectives of Financial Reporting

 Second Level = Qualitative Characteristics and

Elements of Financial Statements

 Third Level = Recognition, Measurement, and

Disclosure Concepts.

1-30 LO 1
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
Third level
3. Monetary unit 3. Expense recognition The "how"—
4. Periodicity 4. Full disclosure implementation
5. Accrual

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

OBJECTIVE
Provide information
about the reporting
entity that is useful First level
ILLUSTRATION 2.7 to present and potential
Conceptual Framework for The "why"—purpose
equity investors,
Financial Reporting of accounting
lenders, and other
creditors in their
capacity as capital
1-31 providers.
 Basic Objective

“To provide financial information about the reporting entity

that is useful to present and potential equity investors,
lenders, and other creditors in making decisions about
providing resources to the entity.
 Provided by issuing general-purpose financial statements.

 Assumption is that users need reasonable knowledge of

business and financial accounting matters to understand
the information.

1-32 LO 1
 Qualitative Characteristics of Accounting
Information

IASB identified the Qualitative Characteristics of accounting

information that distinguish better (more useful) information
from inferior (less useful) information for decision-making
purposes.

1-33 LO 2
 Qualitative Characteristics

1-34 LO 2
 Qualitative Characteristics

Fundamental Quality—Relevance

To be relevant, accounting information must be capable of making a

difference in a decision.

1-35 LO 2
 Qualitative Characteristics

Fundamental Quality—Relevance

Financial information has predictive value if it has value as an input to

predictive processes used by investors to form their own expectations
about the future.

1-36 LO 2
 Qualitative Characteristics

Fundamental Quality—Relevance

Relevant information also helps users confirm or correct prior

expectations.

1-37 LO 2
 Qualitative Characteristics

Fundamental Quality—Relevance

Information is material if omitting it or misstating it could influence

decisions that users make on the basis of the reported financial
information.

1-38 LO 2
 Qualitative Characteristics

Fundamental Quality—Faithful Representation

Faithful representation means that the numbers and descriptions

match what really existed or happened.

1-39 LO 2
 Qualitative Characteristics

Fundamental Quality—Faithful Representation

Completeness means that all the information that is necessary for

faithful representation is provided.

1-40 LO 2
 Qualitative Characteristics

Fundamental Quality—Faithful Representation

Neutrality means that a company cannot select information to favor one

set of interested parties over another.

1-41 LO 2
 Qualitative Characteristics

Fundamental Quality—Faithful Representation

An information item that is free from error will be a more accurate

(faithful) representation of a financial item.

1-42 LO 2
 Qualitative Characteristics

Enhancing Qualities

Information that is measured and reported in a similar manner for

different companies is considered comparable.

1-43 LO 2
 Qualitative Characteristics

Enhancing Qualities

Verifiability occurs when independent measurers, using the same

methods, obtain similar results.

1-44 LO 2
 Qualitative Characteristics

Enhancing Qualities

Timeliness means having information available to decision-makers

before it loses its capacity to influence decisions.

1-45 LO 2
 Qualitative Characteristics

Enhancing Qualities

Understandability is the quality of information that lets reasonably

informed users see its significance.

1-46 LO 2
 Basic Elements

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

1-47 LO 2
 Basic Elements
Elements of Financial Statements

Asset A resource controlled by the entity as a

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

Equity

Income

Expenses

1-48 LO 2
 Basic Elements
Elements of Financial Statements

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

Income

Expenses

1-49 LO 2
 Basic Elements
Elements of Financial Statements

Asset

Liability

The residual interest in the assets of the

Equity
entity after deducting all its liabilities.

Income

Expenses

1-50 LO 2
 Basic Elements
Elements of Financial Statements

Asset

Liability

Equity Increases in economic benefits during the

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

1-51 LO 2
 Basic Elements
Elements of Financial Statements

Asset

Liability

Equity Decreases in economic benefits during the

accounting period in the form of outflows
Income or depletions of assets or incurrences of
liabilities that result in decreases in equity,
other than those relating to distributions to
Expenses
equity participants.
1-52 LO 2
 EXAMPLE : Qualitative Characteristics
Identify the qualitative characteristic(s) to be used given the
information provided. Characteristics
(a) Qualitative characteristic being Relevance
displayed when companies in the Faithful representation
same industry are using the same Predictive value
accounting principles.
Confirmatory value
(b) Quality of information that confirms Neutrality
users’ earlier expectations.
Materiality
(c) Imperative for providing comparisons Timeliness
of a company from period to period.
Verifiability
(d) Ignores the economic consequences Understandability
of a standard or rule. Comparability
1-53 LO 2
 Identify the qualitative characteristic(s) to be used given the
information provided. Characteristics
(e) Requires a high degree of consensus Relevance
among individuals on a given Faithful representation
measurement. Predictive value
(f) Predictive value is an ingredient of this Confirmatory value
fundamental quality of information. Neutrality
(g) Four qualitative characteristics that Materiality
enhance both relevance and faithful Timeliness
representation.
Verifiability
(h) An item is not reported because its Understandability
effect on income would not change a Comparability
decision.
1-54 LO 2
 Identify the qualitative characteristic(s) to be used given the
information provided. Characteristics
(i) Neutrality is a key ingredient of this Relevance
fundamental quality of accounting Faithful representation
information. Predictive value
(j) Two fundamental qualities that make Confirmatory value
accounting information useful for Neutrality
decision-making purposes.
Materiality
(k) Issuance of interim reports is an Timeliness
example of what enhancing
Verifiability
ingredient?
Understandability
Comparability
1-55 LO 2
 Recognition, Measurement, and Disclosure
Concepts

These concepts explain how companies should recognize,

measure, and report financial elements and events.

Recognition, Measurement, and Disclosure Concepts

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

1-56 LO 3
 Assumptions

Economic Entity – company keeps its activity separate from its

owners and other business unit.

Going Concern - company to last long enough to fulfill

objectives and commitments.

Monetary Unit - money is the common denominator.

Periodicity - company can divide its economic activities into

time periods.

Accrual Basis of Accounting – transactions are recorded in

the periods in which the events occur.

1-57 LO 3
 Assumptions
BE2.8: Identify which basic assumption of accounting is best
described in each item below.
(a) The economic activities of FedEx Corporation
(USA) are divided into 12-month periods for the Periodicity
purpose of issuing annual reports.
(b) Total S.A. (FRA) does not adjust amounts in its Monetary
financial statements for the effects of inflation. Unit
(c) Barclays (GBR) reports current and non-current
classifications in its statement of financial Going Concern
position.
(d) The economic activities of Tokai Rubber
Industries (JPN) and its subsidiaries are merged Economic
for accounting and reporting purposes. Entity

1-58 LO 3
 Principles

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

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

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

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

1-59 LO 4
 Measurement Principles
IASB established a fair value hierarchy that provides insight into the
priority of valuation techniques to use to determine fair value.

ILLUSTRATION 2.4

1-60 LO 4
 Revenue Recognition
When a company agrees to perform a service or sell a product to
a customer, it has a performance obligation.

Requires that companies recognize revenue in the accounting

period in which the performance obligation is satisfied.

1-61 LO 4
 Illustration: Assume the
Airbus (DEU) signs a
contract to sell airplanes
to British Airways (GRB)
for €100 million. To
determine when to
recognize revenue,
Airbus uses the five
steps for revenue
recognition shown at
right.

ILLUSTRATION 2.5
The Five Steps of
1-62 Revenue Recognition
 Expense Recognition
Outflows or “using up” of assets or incurring of liabilities during a
period as a result of delivering or producing goods and/or
rendering services.

1-63 LO 4
 Full Disclosure
Providing information that is of sufficient importance to
influence the judgment and decisions of an informed user.

Provided through:
 Financial Statements

 Notes to the Financial Statements

 Supplementary information

1-64 LO 4
 EXAMPLE: Principles
Identify which basic principle of accounting is best
described in each item below.
(a) Parmalat (ITA) reports revenue in its income Revenue
statement when it delivered goods instead of when Recognition
the cash is collected.
(b) Google (USA) recognizes depreciation expense for Expense
a machine over the 2-year period during which that Recognition
machine helps the company earn revenue.
(c) KC Corp. (USA) reports information about pending Full
lawsuits in the notes to its financial statements. Disclosure
(d) Fuji Film (JPN) reports land on its statement of
financial position at the amount paid to acquire it,
even though the estimated fair market value is Measurement
greater.
1-65 LO 4
 Cost Constraint

Companies must weigh the costs of providing the information

against the benefits that can be derived from using it.

 Rule-making bodies and governmental agencies use cost-

benefit analysis before making final their informational
requirements.

 In order to justify requiring a particular measurement or

disclosure, the benefits perceived to be derived from it
must exceed the costs perceived to be associated with it.

1-66 LO 4
 EXAMPLE : Cost Constraint

Determine whether you would classify these transactions as

material.
(a) Blair Co. has reported a positive trend in
earnings over the last 3 years. In the current Material
year, it reduces its bad debt expense to ensure
another positive earnings year. The impact of
this adjustment is equal to 3% of net income. b.
(b) Hindi SE has a gain of €3.1 million on the sale of
plant assets and a €3.3 million loss on the sale
Material
of investments. It decides to net the gain and
loss because the net effect is considered
immaterial. Hindi SE’s income for the current
year was €10 million.
1-67 LO 4
 EXAMPLE : Cost Constraint

BE2-11: Determine whether you would classify these

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

1-68 LO 4