Financial Accounting

Concepts and Principles

Objectives of
Accounting Information
The objective of financial reporting is to
provide financial information about the
reporting entity that is useful to existing
and potential investors, lenders, and
other creditors in making decisions about
providing resources to the entity.
Types of Decisions
• Investment and credit decisions
• Assessing cash flows
• Enterprise assets and claims on those
assets
Preparation of Financial
Statements
Should be prepared under the accruals
method.

Alternative method is the cash method.

Qualitative Characteristics of Accounting
Information
Two fundamental qualitative characteristics:
1. Relevance, and
2. Faithful representation
Four enhancing qualitative characteristics:
A. Comparability,
B. Verifiability,
C. Timeliness, and
D. Understandability
1. Relevant
Information that is capable of making a difference in
the decisions made by users.
Financial information is capable of making a
difference
• if it has predictive value (it can be used to predict
future outcomes),
• if it has confirmatory value (it provides feedback
that confirms or changes previous evaluations), or
• if it has both predictive and confirmatory value.
2. Faithful Representation
To be useful, financial information must
faithfully represent the economic phenomena
that it purports to represent. Faithful
representation has three characteristics:
• The financial information is complete.
• The financial information is neutral.
• The financial information is free from
error.
A. Comparability
Financial information has comparability if it
has the following traits.
• It can be compared with similar
information about other entities, or
• It can be compared with similar
information about the same entity for
another period or on another date.
B. Verifiability
Different observers could reach a
consensus that a particular depiction of an
event is a faithful representation.
C. Timeliness
The information is available to decision-
makers in time to be useful in influencing
their decisions.
D. Understandability
Information that is understandable has
been classified, characterized, and
presented clearly and concisely.
Going Concern Assumption
Financial statements are normally
prepared under the assumption that the
entity is a going concern and will continue
in operation for the foreseeable future.
The Cost Constraint
In providing financial information to users,
firms must keep in mind the costs of
preparing and providing the information,
referred to as the cost-benefit relationship.
 Elements of the
Financial Statements and
Recognition of
Financial Statements
Elements of the Financial
Statements
The elements are the building blocks of
the financial statements, and it is
these elements that make up the
financial statements of an enterprise.
There are five elements of the financial
statements.
Elements of the Balance Sheet
• Assets
• Liabilities
• Equity or Net Assets
Elements of the Income
Statement
Income
• Revenues
• Gains

Expenses
• Expenses
• Losses
Recognition in Financial Statements
Recognition is the process of recording an
event or transaction in the accounting
records.
1. There must be a probable future
economic flow either to or from the
company.
2. It must be measurable with sufficient
reliability.
Measuring Elements of
the Financial Statements
The measurement bases employed include
the following:
• Historical cost
• Current cost
• Realizable or settlement value
• Present value
• Fair value
Capital and Capital Maintenance
The concept of capital adopted by an entity
depends on the needs of the users of its
financial statements.
• Under a financial concept of capital,
“capital” means net assets or equity of the
entity.
• Under a physical concept of capital,
“capital” is the productive capacity of the
entity such as units of output per day.
 External
Financial Statements

Statement of Financial Position

and Statement of Profit or Loss
Complete Financial Statements
1. A statement of financial position as of the end
of the period (a balance sheet)
2. A statement of profit or loss and other
comprehensive income for the period
3. A statement of changes in equity for the period
4. A statement of cash flows for the period
5. Notes to the financial statements, comprising a
summary of significant accounting policies and
other explanatory information
 1. The Statement of Financial Position
(Balance Sheet)
Provides information about an entity’s assets,
liabilities and owners’ equity as well as
their relationships to each other at a point
in time.

Helps users to assess the liquidity, financial

flexibility, solvency, and risk of a company.
Components of Balance Sheet
A. Assets
B. Owners’ equity
C. Liabilities
A. 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.
• Operational assets
• Contract assets
• Investments
• Current assets
• Valuation accounts
B. Owners’ Equity
• Capital contributed by owners
• Retained earnings
• Other Comprehensive Income items
C. Liabilities
Liabilities are present obligations 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.
• Non-current liabilities
• Current liabilities
• Contract liabilities
2. Statement of Profit or Loss
and Other Comprehensive Income
A summary of all of the transactions that a
company was involved in during a period of
time except for transactions with the
owners of the company (shareholders).
Matching Expenses and
Revenues
Expenses should be recognized in the same
period as the revenues are recognized that
were generated by those expenses.
Other Comprehensive Income
• Gains and losses from translating the financial statements of a
foreign operation.
• Gains and losses from investments in equity instruments
designated at fair value through other comprehensive income.
• Gains and losses on financial assets measured at fair value
through other comprehensive income.
• The effective portion of gains and losses on hedging instruments
in a cash flow hedge and gains and losses on hedging
instruments that hedge investments in equity instruments
measured at fair value through other comprehensive income.
• Increases in revaluation surplus from gains on property
revaluations.
• Remeasurements of defined benefit pension plans.
Revenue Recognition
The steps in revenue recognition are:
1. Identify the contract(s) with the customer
2. Identify the performance obligations in the contract, which are
promises to transfer to a customer distinct goods or services
3. Determine the transaction price, or the amount of consideration
the entity expects to be entitled to receive in exchange for
transferring the promised goods or services to the customer
4. Allocate the transaction price to the performance obligations in
the contract on the basis of the relative standalone selling prices
of each distinct good or service promised in the contract
5. Recognize revenue when a performance obligation is satisfied
by transferring a promised good or service to a customer.
Extraordinary Items
A reporting entity is specifically prohibited
from presenting any items of income or
expense as extraordinary items in the
statements of profit or loss and other
comprehensive income or in the notes to the
financial statements.
However, when items of income or expense are
material, their nature and amount are to be
disclosed separately, as a separate line item.
Example: Arsenal International is a holding company that has full
ownership in a manufacturing company that experienced
significant property damage due to a hurricane. This damage
resulted in a 500,000 net loss on the 20X8 financials.
Based on IFRS, the manufacturing company would report this
material loss separately from other gains and losses, in the
following manner.
Income (loss) from operations 1,250,000
Non-operating gains and losses
Net loss from hurricane (500,000)
Gain from sale of equipment 50,000
Total non-operating gains and losses (450,000)
Income before taxes 800,000
Discontinued Operations
A discontinued operation arises when a
company decides to sell a significant and
identifiable part of its business.

Must disclose results of discontinued

operations separately on the income
statement.
 External
Financial Statements

Statement of Changes in Equity,

Statement of Cash Flows and Notes
3. Statement of Changes in
Equity
For each component of equity, a
reconciliation between the carrying
amount at the beginning of the period and
at the end of the period, disclosing changes
resulting from:
• Profit or loss
• Other comprehensive income
• Transactions with owners.
4. Statement of Cash Flows
The primary purpose of the SCF is to
provide information regarding receipts
and uses of cash for the company during a
specified period of time.
Classification of Activities
Every cash transaction is classified as one
of these three categories of activities:
A. Operating
B. Investing
C. Financing
A. Operating Activities
• Cash receipts from the sale of goods or rendering of services.
• Cash receipts from royalties, fees, commissions and other revenue.
• Cash payments to suppliers for goods and other services.
• Cash payments to and on behalf of employees.
• Cash payments to the government for income taxes and cash received
back as tax refunds.
• Cash receipts and payments from contracts held for dealing or trading
purposes, including securities and loans.
• Interest paid on bonds and other debt (loans, leases, mortgages, etc.)
may be classified as operating activities but may also be classified under
financing activities.
• Interest received and dividends received from debt and equity
investments may be classified as operating activities but may also be
classified as investing activities.
B. Investing Activities
Activities that the company undertakes to generate a
future profit, or return.
• Cash payments for purchasing and cash receipts from
sales of property, plant, and equipment, intangibles,
and other long-term assets.
• Making and collecting loans to other parties.
• Acquiring and disposing of stock of other companies.
• Acquiring and disposing of debt instruments.
• Cash payments and cash receipts for futures contracts,
forward contracts, option contracts, and swap
contracts.
C. Financing Activities
Activities that a company undertakes to raise capital
to finance the business.
• Cash proceeds from issuance of shares and other
equity instruments.
• Cash payments to owners to acquire or redeem
the entity’s shares.
• Paying interest and dividends.
• Issuing debt (bonds) and the repayment of debt
obligations.
• Obtaining and repaying a loan.
Cash Equivalents
In the preparation of the statement of cash
flows, cash and cash equivalents on the
balance sheet are both considered to be
cash.
Non-Cash Investing and
Financing
These events are shown below the SCF.
Methods of Preparing SCF
There are two methods for preparing the
Operating Activities section of the SCF.
A. Direct method – adjust each line of the
IS
B. Indirect method – make all of the same
adjustments to net income
5. Notes to Financial Statements
Provide explanations of the principles of
accounting applied, and the methods
used to determine the amounts reported
in the financial statements.
Also provide further breakdown and
analysis of certain accounts that are
deemed important.
Common Notes
Notes can be financial or non-financial.
• Accounting principles
• Contingent liabilities
• Inventory
• Capital stock disclosures
• Changes in the accounting policies
• Pension plans
• Investments in affiliated companies
• Related party transactions
The Financial Statements
1. A statement of financial position as of
the end of the period
2. A statement of profit or loss and other
comprehensive income for the period
3. A statement of changes in equity for the
period
4. A statement of cash flows for the period
5. Notes to the financial statements
Financial Accounting Topics
Financial Accounting Topics
1. Bonds
2. Leases
3. Pensions
4. Intangible assets
5. Research and development
1. Bonds
Bonds are a means of financing in which a
company borrows money by selling debt
securities (bonds) to investors.
Selling Price
The PV of all future cash flows:
A. Payment of interest
B. Payment of face amount of bond at
maturity
Interest Expense
Interest expense is recognized each period
based on the remaining amount of the
bond liability.
Bond Discount and Premium
Bond sold at price lower than face value
sells at a discount.

Bond sold at price higher than face value

sells at a premium.
2. Leases
An agreement between a lessor (the owner
of an asset) and a lessee (the entity that is
going to use the asset) that conveys the
right to use specific property for a stated
period of time in exchange for a stated
payment.
A. A finance lease
B. An operating lease
Finance Lease for Lessee
Recognizes a right-of-use asset—its right to use
the leased item for the lease term—and a lease
liability—its obligation to make lease payments.
The asset and the liability are measured at the
present value of the lease payments.
The right-of-use asset is depreciated over its
useful life.
Each payment has an amount of interest and an
amount by which the lease liability is reduced.
Operating Lease for Lessee
A lessee may elect to report short-term
leases and leases of low-value assets as
operating leases without recognizing a
right-of-use asset or lease liability in its
statement of financial position.
The lessee recognizes the lease payments
associated with operating leases as
expenses.
Finance Lease for Lessor
A finance lease transfers to the lessee substantially
all the risks and rewards of ownership of the asset.
At each lease’s inception date, a lessor that is
providing financing only recognizes a lease
receivable for each asset leased under a finance
lease.
Each payment will be partially interest and partially a
reduction of the lease receivable.
A manufacturer or dealer lessor also recognizes
profit or loss on the sale.
Operating Lease for Lessor
The lessor recognizes the asset on its
statement of financial position and
depreciates it consistent with its normal
depreciation policy for similar assets.

The lessor recognizes lease payment

revenue from operating leases as
income.
3. Pensions
This is deferred compensation for an
employee.
The terms of the pension plan determine
how much.
Types of Pension Plans
Defined contribution plan

Defined benefit plan

The Pension Expense
The company must recognize an expense
each period for the present value of the
estimated future pension benefits that the
employee earned that period.
Example: In a pension plan that pays a pension equal to 2% of the
employee’s highest salary for each year that they work, the company
make the following estimates:
• The employee’s highest salary will be $50,000,
• The employee will retire when they are 65, and
• The employees will die when they are 85.

To calculate the pension expense to recognize in the period when the

employee is 50 years old, the company will
• calculate the present value of $1,000 (the amount that is expected
to have been earned by the employee working this year),
• being paid for 20 years (how long the company expects to pay the
pension),
• starting in 15 years (when the employee is expected to retire).
Reporting Pensions on
Statement of Financial Position
The employer records a liability on the balance
sheet to recognize in the financial statements
the obligation to pay future benefits.
Usually, the company will choose to make
contributions to its pension plan each period so
that it can build up the value of the plan assets
to be able to pay the pensions when employees
retire.
The amount the company owes for pensions is
called the Projected Benefit Obligation (PBO).
4. Intangible Assets
IAS 38, defines it as an “identifiable, non-
monetary asset without physical
substance.”
Typical Intangible Assets
• Licenses
• Patent rights
• Franchises
• Trademarks and trade names
• Copyrights
• Customer lists
Purchased Intangibles
Measured at cost, which includes the initial
purchase price and any directly attributable
expenditures to prepare the asset for its
intended use by the purchaser, such as
legal fees.
Internally Generated Intangibles
Generally, internally generated intangible
assets are not recognized on the balance
sheet because they are not able to be
measured.
Purchased Goodwill
Goodwill is defined by IFRS 3 as “future
economic benefits arising from assets that are
not capable of being individually identified and
separately recognized.”
Goodwill must be reported as a separate line
item on the balance sheet.
Cost of acquisition X
- Fair value of net assets acquired (X)
= Goodwill XX
Bargain Purchase
If the purchase price is less than the value of
the net identifiable assets acquired, the
acquirer has a bargain purchase.
The bargain purchase amount should be
reported as a gain on the consolidated
statement of profit or loss as of the acquisition
date. The gain is attributed to the acquirer.
The amount of a bargain purchase cannot be
shown on the balance sheet.
Amortization and Impairment of
Intangible Assets
An intangible asset with an indefinite useful
life is not amortized, but reviewed for
impairment every year.

An intangible asset with a definite useful

life should be amortized over its useful
life (presumed to be no more than 20
years).
5. Research and Development
Research is an “original and planned investigation
undertaken to gain new scientific knowledge and
understanding.”
Research is expensed as it is incurred.
Development is the “application of research findings
or other knowledge to a plan or design for the
production of new or substantially improved
products, processes, systems or services before
the start of commercial production or use.”
Development is usually expensed as it is incurred.
Advanced Accounting
Topics: Fair Value,
Combinations and
Investments
Advanced Concepts
1. Fair value
2. Business combinations and
consolidations
3. Investments in financial instruments
4. Investments in associates
1. Fair Value (IFRS 13)
A fair value measurement assumes that the
sale or transfer takes place either
• In the principal market for the asset or
liability, or
• In the absence of a principal market, in
the most advantageous market for the
asset or liability.
Subjective Measurement
Fair value estimates can be subjective if, for
instance, an active market does not exist
for a financial asset or liability.

The IASB has established a fair value

hierarchy to provide priority for fair
value valuation techniques to be used.
Fair Value Hierarchy
Level 1: Quoted prices in active markets, such as
a closing stock price, that the entity can access
at the measurement date.
Level 2: Observable inputs other than quoted
prices for the asset or liability, including quoted
prices for similar assets or liabilities in active
markets or in markets that are not active.
Level 3: Unobservable inputs such as a
company’s own data or assumptions.
2. Business Combinations
A business combination occurs when an
acquirer obtains control of one or more
businesses.

The method used under IFRS and US GAAP

to account for a business combination is
the acquisition method.
Basic Principles
• An acquirer of a business measures the cost of the
acquisition at the fair value of the consideration paid.
• The acquirer allocates the cost to the identifiable
assets and liabilities acquired on the basis of their fair
values.
• Any consideration paid over and above the fair value
of the net assets acquired is allocated to goodwill.
• If the consideration paid is less than the fair value of
the net assets acquired, the excess is recognized
immediately as a gain in the statement of profit or
loss.
Recording Assets and Liabilities
The acquired identifiable assets and
liabilities are recorded at the fair values of
the assets acquired and the liabilities
assumed.
Recording Income and Equity
The income or loss of the combined company is
calculated by including the income or the loss
of the purchased company only for the period
after the purchase.
The retained earnings of the acquired company
are eliminated from the consolidated
financial statements along with the rest of
the acquiree’s equity by an offset with the
investment account of the acquiring company.
Consolidations (IFRS 10)
When one company has control over
another company, the controlling
company must prepare consolidated
financial statements.
The parent company will present the
financial statements of the consolidated
companies as if the two, or more,
companies were a single economic
entity.
Control by Investor
An investor controls an investee if and only
if the investor has all of the following:
• Power over the investee
• Exposure, or rights, to variable returns
from its involvement with the investee
• The ability to use its power over the
investee to affect the amount of the
investor’s returns
Eliminations in Consolidation
Intercompany transactions must be
eliminated.
• The elimination of intercompany
receivables and payables.
• The elimination of the effect of
intercompany sales of inventory.
• The elimination of the effect of
intercompany sales of fixed assets.
Non-Controlling Interests
Non-controlling interests are the claims to
the assets of the subsidiary that are held
by parties other than the parent company.
The parent will add 100% of each of the
individual assets and liabilities and then
set up an account called Non-controlling
Interests that represents the claims on the
subsidiary assets by the minority
shareholders.
3. Investments in Financial Instruments
(IFRS 9)
Applies to investments in financial
instruments including debt and equity
securities where the holder does not have
significant influence or control.
Three Methods of Accounting
1. Amortized cost – debt
2. Fair value through OCI – debt
3. Fair value through profit or loss – equity
4. Investments in Associates (IAS 28)
When there is significant influence (usually
owning 20-50% of the company’s voting
shares), the equity method is used.
Acquisition of Equity Investment
Initially recorded at the cost of the
investment.
Post-Acquisition Events
The investor’s share of the profit of the
investee increases the investment account.

The investor’s share of the loss of the investee

decreases the investment account.

Distributions (dividends) received decrease

the investment account.
 Advanced Accounting
Topics: Partnerships and
Foreign Currency
Transactions
Partnerships
A partnership consists of two or more
individuals or entities, formed to carry
on a business with the goal of earning a
profit.

A partnership is governed by the terms of

its partnership agreement.
Partnership Taxation
The partnership does not pay income
taxes.

The income of the partnership is allocated

to the partners and the individual
partners pay the income taxes on their
share of the partnership income.
Partnership Equity Accounts
Each partner will have their own equity
account(s).
Foreign Denominated Transactions
Foreign currency transactions are
individual transactions that are
denominated in a currency other than the
currency that the company uses for its
accounting records.
Date of Entering the Contract
Should record the payable or receivable
and expense or revenue using the current
exchange rate on that date.
Every Balance Sheet Date
The balance in the payable or receivable
account should be adjusted to the
current exchange rate on the balance
sheet date.
The exchange rate gain or loss should be
recorded in the statement of profit or
loss as part of income from continuing
operations.
On Settlement Date
A gain or loss needs to be recognized to
bring the receivable up to its current
value on that date.

The receivable or payable is written-off

with the cash received or paid.
Example: A U.S. company makes a sale for £10,000 to a U.K. company
denominated in British pounds. The U.S. company issues the invoice in the
amount of £10,000. However, the functional currency of the U.S. company
is U.S. dollars, so the invoice will be recorded in the U.S. company’s
accounting records at the equivalent amount of U.S. dollars. Assuming the
U.S. company has not hedged the transaction using a foreign exchange
forward or futures contract, the transaction is treated as follows.
On the date the customer is billed and the revenue is recognized, the spot
exchange rate between British pounds and U.S. dollars is £1 = $1.38. The
U.S. company records the revenue and the receivable in its functional
currency (U.S. dollars) using the currency exchange spot rate on that date.
The equivalent amount in U.S. dollars converted at the spot rate is the
amount of U.S. dollars the U.S. company would receive if the foreign
receivable amount were settled that day in pounds and then converted into
U.S. dollars at that day’s spot rate. At a spot rate of £1 = $1.38, £10,000
equals $13,800 US.
On every financial statement date prior to settlement of the receivable,
the U.S. company adjusts the balance in its receivable account to the
functional currency equivalent of the 10,000 British pounds receivable
at the closing spot exchange rate on the statement date. The
exchange rate gain or loss is recorded in the current period statement
of profit or loss. The foreign currency gain or loss will be equal to the
amount of change in the receivable as a result of the change in the
spot rate since the last statement date (or, on the first statement date
following the sale, the amount of change in the receivable due to
change in the spot rate since the date of the sale).
On the first financial statement date following the sale, the spot rate is
£1 = $1.40. The U.S. dollar value of the sale is now 10,000 × $1.40, or
$14,000. The U.S. company records a gain of $200 and increases its
account receivable in U.S. dollars from $13,800 to $14,000.
The British customer pays the invoice 10 days following the first
financial statement date following the sale. On that date, the spot
exchange rate is £1 = $1.36. On the date payment is received,
the U.S. company uses the £10,000 it receives to buy U.S.
dollars at the spot rate. The U.S. company receives $13,600 for
the £10,000 (10,000 × $1.36). The value of the receivable has
decreased from $14,000 at the last statement date to $13,600, a
$400 decrease. The U.S. company records a $400 loss in the
current period and decreases the balance of the receivable from
$14,000 US to $13,600 US. The U.S. company then applies the
U.S. dollars received to the receivable by debiting cash for
$13,600 and crediting the receivable for $13,600.
The U.S. company’s net currency exchange loss has been $200:
a $200 gain less a $400 loss.