Financial Reporting

2-1

and Analysis

2
CHAPTER
 2-2

Financial Reporting
And Analysis

Nature & Purpose Accruals –

Accounting of Cornerstones of
Rules & Accounting Accounting
Guidelines

Fair
value
Accounting
Parties involved
In
Financial Reporting Accounting
Analysis
 2-3

Financial Reporting
And Analysis

Accounting
Rules &
Guidelines
 2-4

GAAP
Types of Accounting rules and guidelines
USA
o Statements of Financial Accounting Standards
o APB Opinions.
o Accounting Research Bulletins (ARB).
o AICPA pronouncements.
o EITF Bulletins.
o Industry practices.

Malaysia
o Company Act 1967
o MASBs ?
o IAS
o FRS
 2-5

Financial Reporting
And Analysis

Accounting
Rules &
Guidelines

Parties involved
In
Financial Reporting
 2-6

Environmental Factors
 2-7

Environmental Factors
Parties Involved (Malaysia)
o MIA (Malaysia Institute of Accountant)
o SC (Securities Commission)
o Professional Bodies (ACCA, CPA, ICAEW..)
o Government / Politician
o Investors
o Association ?
 2-8

Environmental Factors
Managers of Companies
o Primary responsibility for fair & accurate
reports
o Accounting reporting to reflect business
activities
o Managerial discretion is necessary in
accounting
 2-9

Auditing

1Investors Appoint
2Shareholders/owners

3
Appoint Shares 1

Auditors
Sell

Check

Financial
Directors Statements
4

2 $$
Prepare
Management
 2-10

Environmental Factors : Auditing

o SEC (USA)/ MROC, KLSE, SC requires Audit Report
o Audit opinion can be:
1) clean (fairly presented):
Standard Unqualified Report – Standard wordings
2) qualified (Overall considered fairly presented, except
for certain matter)
Qualified Report – Except for
3) disclaimer (no opinion)
Disclaimer report – no opinion
4) adverse (no truth and fair)
Adverse report – no truth and fair
o Check Auditor quality & independence
 2-11

Environmental Factors
Corporate Governance

o Board of directors oversight

o Audit committee of the board
o oversee accounting process
o oversee internal control
o oversee internal/external audit
o Internal Auditor
 2-12

BOD (BL)

BOD
Chairman

EDs
Monitor NEDs

Via
Management
• I Audit committee, Risk committee, etc
 2-13

Environmental Factors
Internal Users External Users
 2-14

Financial Reporting
And Analysis

Nature & Purpose

Accounting of
Rules & Accounting
Guidelines

Parties involved
In
Financial Reporting
 2-15

Desirable Qualities of Accounting

Information
 2-16

Financial Accounting
Important Accounting Principles
o Historical Cost - fair & objective values from arm’s-length
bargaining
o Accrual Accounting - recognize revenues when earned,
expenses when incurred
o Materiality - threshold when information impacts decision
making
o Conservatism - reporting or disclosing the least optimistic
information about uncertain events and transactions
 2-17

Financial Accounting
Limitations of Accounting Information
o Timeliness - periodic disclosure, not real-time
basis

o Frequency - quarterly and annually

o Forward Looking - limited prospective

information
 2-18

Financial Reporting
And Analysis

Nature & Purpose

Accounting of Accruals –
Rules & Accounting Cornerstones of
Guidelines Accounting

Parties involved
In
Financial Reporting
 2-19

Accruals-The Cornerstone
Illustration - Case Facts
o Establish company and invest $700 equity
o Purchase plain 100T-shirts for $5 each

o Fixed screen cost of $100

o Variable print cost of $0.75 per T-shirt

o Sold 25 T-shirts at $10 each for cash

o Sold 25 T-shirts at $10 each on credit

 2-20

Accruals- The Cornerstone

Case Illustration – Cash Accounting

Statement of Cash Flows Balance Sheet (Cash basis)

Receipts Assets
T-Shirt sales $250 Cash $275  
(25@ $10)
Payments
T-Shirt purchases $500 (100@$5) Equity
Screen purchase 100 Beginning Equity $700
Printing charges 75 (100@$.75) Less net cash outflow (425)
Total payments $(675) Total equity $275
Net cash outflow $(425)
 2-21

Accruals-The Cornerstone
Case Illustration – Accrual Accounting
Income Statement Balance Sheet (Accrual basis)

Revenues Assets
T-Shirt sales $500.00 Cash $275.00
(25@ $10) cash
(25@ $10) credit
50@ $10 T-Shirt inventory $337.50
337.50
Expenses Receivables 250.00
T-Shirts costs $250.00 (50@$5) Total assets $862.50
Screen depreciation 50.00(50/100*100)
Printing charges 37.50 (50@$.75) Equity
Total expenses (337.50) Beginning equity $700.00
Add net income 162.50
Net income $162.50 Total equity $862.50
 2-22

Accruals-The Cornerstone
 2-23

Accruals-The Cornerstone

Foundations of Accrual Accounting

Revenue Recognition – recognize revenues when
(1) Earned
(2) Realized or Realizable
Expense Matching – match with corresponding revenues
- Product costs
- Period costs
 2-24

Accruals-The Cornerstone
Accruals and Cash Flows - Myths
o Myth: Since company value depends on future cash
flows, only current cash flows are relevant for
valuation.
o Myth: All cash flows are value relevant.
o Myth: Cash flows cannot be manipulated.
o Myth: All income is manipulated.
 2-25

Accruals-The Cornerstone
Accruals and Cash Flows - Truths

o Truth: Accrual accounting (income) is more

relevant than cash flow.
o Truth: Cash flows are more reliable than

accruals.
o Truth: Accrual accounting numbers are subject

to accounting distortions.
 2-26

Financial Reporting
And Analysis

Nature & Purpose Accruals –

Accounting of Cornerstones of
Rules & Accounting Accounting
Guidelines

Fair
value
Accounting
Parties involved
In
Financial Reporting
 2-27

Fair value accounting

Asset and liability values are determined on the

basis of their fair values (typically market prices)
on the measurement date (i.e., approximately
the date of the financial statements).
 2-28

Historical cost Vs Fair value

 2-29

Advantages & Disadvantages

Advantages
o Reflects current information.
o Consistent measurement criteria.
o Comparability
o No conservative bias
o More useful for equity analysis
Disadvantages
o Lower objectivity
o Susceptibility to manipulation.
o Lack of conservatism.
o Excessive income volatility.
 2-30

Financial Reporting
And Analysis

Nature & Purpose Accruals –

Accounting of Cornerstones of
Rules & Accounting Accounting
Guidelines

Fair
value
Accounting
Parties involved
In
Financial Reporting Accounting
Analysis
 2-31

Accounting Analysis
Sources of Accounting Distortions/misstatement
o Accounting Standards – attributed to
1) accounting principles and assumptions, and
2) conservatism
o Estimation Errors – attributed to estimation errors inherent in accrual
accounting
o Reliability vs Relevance – attributed to over-emphasis on reliability
at the loss of relevance
o Earnings Management – attributed to window-dressing of financial
statements by managers to achieve personal benefits
 2-32

Accounting Analysis
Earnings Management – Frequent Source of Distortion

Earning Management strategies:

o Increasing Income – managers adjust accruals to increase
reported income
o Big Bath – managers record huge write-offs in one period to
relieve other periods of expenses
o Income Smoothing – managers decrease or increase reported
income to reduce its volatility
 2-33

Accounting Analysis
Earnings Management – Motivations
o Contracting Incentives - managers adjust numbers used in
contracts that affect their wealth (e.g., compensation contracts)
o Stock Prices – managers adjust numbers to influence stock
prices for personal benefits (e.g., mergers, option or stock
offering)
 2-34

Accounting Analysis
Process of Accounting Analysis
Accounting analysis involves several inter-related processes and
tasks that can be grouped into two broad areas:
o Evaluating Earning Quality: Steps
1) Identify and assess key accounting policies
2) Evaluate extent of accounting flexibility
3) Determine the reporting strategy
4) Identify and assess red flags
o Adjusting Financial Statements:
Identify, measure, and make necessary adjustments to financial
statements to better serve one’s analysis objectives;
Chapters 3-6 focus on adjusting (recasting) the statements
 2-35

Questions (10 th
pages 122-123) (11th pages 118-119)

• 2-7 What it mean by management discretion AND what attribute to management discretion in
financial/accounting reporting
• 2-8 What is the risk of managerial discretion in in financial/accounting reporting
• AND how to manage or mitigate them
• 2-11 Distinguish between fair value and historical costing accounting AND their limitation
• 2-12 Define conservatism and its advantages
• 2-17 How revenue is recognized ?
• 2-18 Discuss about accrual accounting matching concept
• 2-45 Define and discuss accounting analysis and accounting distortion

Calculation Question
• Establish company and invest $800 equity
• Purchase plain 100T-shirts for $8 each
• Fixed screen cost of $200
• Variable print cost of $0.90 per T-shirt
• Sold 20 T-shirts at $15 each for cash
• Sold 30 T-shirts at $15 each on credit
Request: Prepare Statement under Cash and Accrual Accounting

Each student – 1) Where to allocate auditor report

2) Prepare and discuss at least 4 type of auditor report from listed companies