UNDERSTANDING OF FINANCIAL STATEMENTS

OBJECTIVES OF FINANCIAL REPORTING

To provide information:
Useful for investor and creditor decisions.
That helps predict cash flows.
About economic resources, claims to resources, and changes in
resources and claims

Objectives

Qualitative
Characteristics
Understandability
Primary
Relevance
Reliability
Secondary
Comparability
Consistency

QUALITATIVE CHARACTERISTIC OF FINANCIAL STATEMENTS:

Attributes that MAKE THE INFORMATION provided in a set of financial statements useful to
users
Understandability
Means that users must understand the information within the context of the decision being made.
This is a user-specific quality because users will differ in their ability to comprehend any set of
information,
Several end users of financial statement could be a layman or could be a trained and
knowledgeable financial analyst, it would not be reasonable that financial statement
need to be understandable by everyone.
The information contained in a set of financial statement should be
understandable by a user who has reasonable knowledge of business and economics
activities
willingness to study information with reasonable diligence
PRIMARY QUALITATIVE CHARACTERISTICS
The primary decision-specific qualities that make accounting information useful are relevance one of the primary
decision-specific qualities that make accounting information useful; made up of predictive value and/or feedback
value, and timeliness. and reliability the extent to which information is verifiable, representationally faithful, and
neutral. . Both are critical. No matter how reliable, if information is not relevant to the decision at hand, it is
useless. Conversely, relevant information is of little value if it cannot be relied on

Relevance
Reliability
SECONDARY QUALITATIVE CHARACTERISTICS

Comparability
Consistency
RELEVANCE:
Information has the quality of relevance when it influences the economic decision of users and is
provided to users in a timely manner, by helping them evaluate past, present and future events or
conforming or correcting their past evaluations.
In order to be relevant information should at least have following three characteristics

 Predictive value
Confirmative value
Time lines
For example, if net income and its components confirm investor expectations about future cash-generating ability,
then net income has feedback value for investors. This confirmation can also be useful in predicting future cashgenerating ability as expectations are revised.
Information is timely if it is available to users before a decision is made, The need for timely information
requires that companies provide information to external users on a periodic basis. The SEC requires its registrants
to submit financial statement information not only on an annual basis, but also quarterly for the first three quarters
of each fiscal year.

THE CONCEPT OF RELEVANCE IS CLOSELY RELATED TO CONCEPT OF MATERIALITY

Information provided by financial statements may be relevant but if not reliable then is of little use
RELIABILTY: the extent to which information is verifiable, representationally faithful, and neutral
To be reliable information must be
Verifiable (Free from material error)
Representationally faithful
Neutral ,( free from bias)
Verifiable
Implies a consensus among different measurers. For example, the historical cost of a piece of land to be reported in
the balance sheet of a company is usually highly verifiable. The cost can be traced to an exchange transaction, the
purchase of the land. However, the market value of that land is much more difficult to verify. Appraisers could
differ in their assessment of market value. The term objectivity often is linked to verifiability. The historical cost
of the land is objective but the lands market value is subjective, influenced by the measurers past experience and
prejudices. A measurement that is subjective is difficult to verify, which makes it more difficult for users to
rely on.

Representationally faithful
Exists when there is agreement between a measure or description and the phenomenon it purports to represent. For
example, assume that the term inventory in a balance sheet of a retail company is understood by external users to
represent items that are intended for sale in the ordinary course of business. If inventory includes, say, machines
used to produce inventory, then it lacks representational faithfulness.
Several years ago, accountants used the term reserve for doubtful accounts to describe anticipated bad debts
related to accounts receivable. For many, the term reserve means that a sum of money has been set aside for

future bad debts. Because this was not the case, this term lacked representational faithfulness. The
description reserve now has been changed to allowance for uncollectible accounts or allowance for
doubtful accounts.

Neutral (free from bias)

Reliability assumes the information being relied on is neutral with respect to parties potentially affected. In that
regard, NEUTRALITY neutral with respect to parties potentially affected. is highly related to the
establishment of accounting standards. Changes in accounting standards can lead to adverse economic
consequences to certain companies, their investors and creditors, and other interest groups. Accounting standards
should be established with overall societal goals and specific objectives in mind and should try not to favor
particular groups or companies
SECONDARY QUALITATIVE CHARACTERISTICS

COMPARABILTY:
Comparability refers to information being comparable through times and across entities
Comparability over time means we can monitor the financial position of a company, its
performance from one period to another, thats why financial statement present figures not
only for the current year but also those of previous years.
Same accounting method over years
Comparison between companies of the same industry (same format)

The predictive and feedback value of information is enhanced if users can compare the performance of a
company over time

CONSISTENCY
Closely related to comparability is the notion that consistency permits valid comparisons between
different periods. of accounting practices over time permits valid comparisons between different
periods.

1-7
Hierarchy of Desirable Characteristics of Accounting Information
APHIC

ELEMENTS:

RECOGNITION AND MEASUREMENT CONCEPTS

Assumptions
Economic entity
Going concern
Periodicity
Monetary unit
Economic entity:

An essential assumption is that all economic events can be identified with a particular economic entity.
Investors desire information about an economic entity that corresponds to their ownership interest. For
example, if you we are considering buying some ownership stock in FedEx, we want information on the
various operating units that constitute FedEx. we would need information not only about their United
States operations but also about their European and other international operations

Another key aspect of this assumption is the distinction between the economic activities of owners and
those of the company. For example, the economic activities of a sole proprietorship, Uncle Jims
Restaurant, should be separated from the activities of its owner, Uncle Jim. Uncle Jims personal residence,
for instance, is not an asset of the business.

Going concern
Another necessary assumption is that, in the absence of information to the contrary, it is anticipated that a business
entity will continue to operate indefinitely. Accountants realize that the GOING CONCERN ASSUMPTION does
not always hold since there certainly are many business failures. However, companies are begun with the hope of a
long life, and many achieve that goal.
This assumption is critical to many broad and specific accounting principles. For example, the assumption
provides justification for measuring many assets based on their historical costs. If it were known that an enterprise
was going to cease operations in the near future, assets and liabilities would not be measured at their historical
costs but at their current liquidation values. Similarly, depreciation of a building over an estimated life of 40 years
presumes the business will operate that long

Periodicity

The periodicity assumption relates to the qualitative characteristic of timeliness. External users need
periodic information to make decisions. This need for periodic information requires that the economic life
of an enterprise (presumed to be indefinite) be divided into artificial time periods for financial reporting.
Corporations whose securities are publicly traded are required to provide financial information to the SEC
on a quarterly and annual basis.39 Financial statements often are prepared on a monthly basis for banks and
others that might need more timely information.

For many companies, the annual time period (the fiscal year) used to report to external users is the calendar
year. However, other companies have chosen a fiscal year that does not correspond to the calendar year. The
accounting profession and the Securities and Exchange Commission advocate that companies adopt a fiscal
year that corresponds to their natural business year. A natural business year is the 12-month period that ends
when the business activities of a company reach their lowest point in the annual cycle. For example, many
retailers, Wal-Mart for example, have adopted a fiscal year ending on January 31. Business activity in
January generally is quite slow following the very busy Christmas period. We can see from the FedEx
financial statements that the companys fiscal year ends on May 31. The Campbell Soup Companys fiscal
year ends in July; Cloroxs in June; and Monsantos in August.

Monetary Unit Assumption.

To measure financial statement elements, a unit or scale of measurement must be chosen. Information would be
difficult to use if, for example, assets were listed as three machines, two trucks, and a building. A common
denominator is needed to measure all elements. The dollar in the United States is the most appropriate common
denominator to express information about financial statement elements and changes in those elements.

Principles
Historical cost
Realization
Matching

 Full Disclosure

Historical cost

The FASB recognized in SFAC 5 that elements in financial statements currently are measured by different
attributes. In general, however, GAAP measure assets and liabilities based on their original transaction
value, that is, their historical costs. For an asset, this is the fair value of what is given in exchange (usually
cash) for the asset at its initial acquisition. For liabilities, it is the current cash equivalent received in
exchange for assuming the liability. For example, if a company borrowed $1 million cash and signed an
interest-bearing note promising to repay the cash in the future, the liability would be valued at $1 million,
the cash received in exchange

Why base measurement on historical costs? After all, the current value of a companys manufacturing plant
might seem more relevant than its original cost. First, historical cost provides important cash flow
information as it represents the cash or cash equivalent paid for an asset or received in exchange for the
assumption of a liability. Second, because historical cost valuation is the result of an exchange transaction
between two independent parties, the agreed on exchange value is objective and highly verifiable.
Alternatives such as measuring an asset at its current market value involve estimating a selling price. An
example given earlier in the chapter concerned the valuation of a parcel of land. Appraisers could easily
differ in their assessment of current market value.

Realization (principle of recognition)

1. The earnings process is judged to. Determining accounting income by the accrual accounting model is a
challenging task. When to recognize revenue is critical to this determination. Revenues are inflows of assets
resulting from providing a product or service to a customer. At what point is this event recognized by an
increase in assets? The realization principle requires that two criteria be satisfied before revenue can be
recognized: be complete or virtually complete.
2. There is reasonable certainty as to the collectability of the asset to be received (usually cash).

Revenue should be recognized when the earnings process is virtually completed and
collection is reasonably assured.

Matching

When are expenses recognized? The MATCHING PRINCIPLE states that expenses are recognized in the
same period as the related revenues. There is a cause-and-effect relationship between revenue and expense
recognition implicit in this definition. In a given period, revenue is recognized according to the realization
principle. The matching principle then requires that all expenses incurred in generating that same revenue
also be recognized. The net result is a measurenet incomethat matches current period accomplishments
and sacrifices. This accrual-based measure provides a good indicator of future cash-generating ability

Although the concept is straightforward, its implementation can be difficult. The difficulty arises in trying to
identify cause-and-effect relationships. Many expenses are not incurred directly because of a revenue event.
Instead, the expense is incurred to generate the revenue, but the association is indirect.

Expenses are recognized in the same reporting period as the related revenues.

Full Disclosure

Remember, the purpose of accounting is to provide information that is useful to decision makers. So,
naturally, if there is accounting information not included in the primary financial statements that would
benefit users, that information should be provided too. The full-disclosure principle means that the
financial reports should include any information that could affect the decisions made by external users. Of
course, the benefits of that information, as noted earlier, should exceed the costs of providing the
information. Supplemental information is disclosed in a variety of ways, including:

1. Parenthetical comments or modifying comments placed on the face of the financial statements.
2. Disclosure notes conveying additional insights about company operations, accounting principles, contractual
agreements, and pending litigation.
3. Supplemental financial statements that report more detailed information than is shown

Any information useful to decision makers should be provided in the financial statements,
subject to the cost effectiveness constraint

INCOME STATEMENT

INTRODUCTION
DEFINITION
COMPONNENTS OF INCOME STATEMENT
BASIC PRINCIPLES AND SELECTED APPLICATION TO REVENUE RECOGNITION
BASIC PRINCIPLES AND SELECTED APPLICATION TO EXPENSE RECOGNITION
NON RECURRING AND NON OPERATING ITEMS
CALCULATION OF EPS
ANALYSIS
INTRDUCTION:
one of the objective of financial statement IS TO MEASURE the economic performance of the company
mainly through the income of the year, this indicate the extent to which business activities has increased the
wealth of the capital providers by comparing revenue and expenses for a period.
DEFINITION
The income statement presents information on the financial results of a company s business activities over a
period of time; it communicates how much revenue the company generated during a period and what costs it
incurred in connection with generating that revenue.
COMPONENTS:

The components of the income statement include: revenue; cost of sales; sales, general, and administrative
expenses; other operating expenses; non operating income and expenses; gains and losses; nonrecurring items; net
income; and EPS.
Revenue:
Refers to the amount charged for the delivery of goods and services in the ordinary activities (any activity
undertaken by a company within its business) of the business
Or
Gross inflow of economic benefits during the period arising in the ordinary activities of an entity when those
inflows result in increase in equity, other than increase relating to contributions from equity participants

Revenue is often used synonymously with sales

RECOGNITION refers to the process of admitting information into the basic financial statements.
MEASUREMENT is the process of associating numerical amounts to the elements.

For example, revenue was previously defined as an inflow of assets from selling a good or providing a service.
But, when should the revenue event be recorded, and at what amount?

MEASUREMENT OF REVENUE:
AT WHAT AMOUNT REVENUE SHOULD BE RECORDED?
Two principles:

Cost principle
Fair value principle

COST PRINCIPLE:
IFRS requires that companies account for and report many assets and liabilities on the basis of ACQUISITION
PRICE.
BENEFIT
Faithful presentation
Verifiable
Objectivity
FAIR VALUE PRINCIPLE:
The amount for which an asset could be exchanged, a liability settled or an equity instrument granted can be
exchanged, fair value is therefore a market based measure, IFRS has increasingly called for use of fair value
measurements in the financial statements.
BENEFITS:
More useful than historical cost for certain type of assets ,liabilities and in certain industries
Brokerage house, mutual funds
Agricultural industry, biological assets (crops, live stock) are measured on the basis of net realizable
value (approximates fair value of these assets)
Initially historical cost and fair value are same , in subsequent period market and economic condition
changes historical cost and market value often diverge, thus fair value measures or estimates
provides more relevant information about the expected future cash flows related to asset and
liability. Impairment in case of long lived assets.
Fair value option (financial assets and liabilities)

 A financial asset is an intangible asset that derives value because of a contractual claim. Examples
include bank deposits, bonds, and stocks. Financial assets are usually more liquid than tangible
assets, such as land or real estate, and are traded on financial markets
LAST POINT:
PRESENTLY WE HAVE MIXED ATTRIBUTE SYSTEM, THAT PERMITS THE USE OF
HISTORICAL COST AND FAIR VALUE , ALTHOUGH HISTORICAL COST PRINCIPLE
CONTINUES TO BE IMPORTANT BASIS FOR VALUATION , RECORDING AND REPORTING
OF FAIR VALUE INFORMATION IS INCREASING

The question of measurement involves two choices: (1) the choice of a unit of measurement, and (2) the choice of
an attribute to be measured. SFAC 5 essentially confirmed existing practice in both of these areas. The monetary
unit or measurement scale used in financial statements is nominal units of money without any adjustment for
changes in purchasing power. In addition, the board acknowledged that different attributes such as historical cost,
net realizable value, and present value of future cash flows are presently used to measure different financial
statement elements, and that they expect that practice to continue. For example, property, plant, and equipment are
measured at historical cost; accounts receivable are measured at their net realizable value; and most long-term
liabilities, such as bonds, are measured at the present value of future cash payments.
RECOGNITION OF REVENUE
WHEN SHOULD COMPANY RECORD REVENUE?
Revenue is recognized in the period it is earned, which may or may not be in the same period as the related cash
collection. Recognition of revenue when earned is a fundamental principal of accrual accounting.
OR
Revenue is to be recognized when it is probable that future economic benefits will flow to the company and reliable
measurement of revenue is possible (generally at the point of sale)
IASB PROVIDES THAT REVENUE FOR THE SALE OF GOODS IS TO BE RECOGNIZED WHEN
FOLLOWING CONDITIONS ARE SATISFIED

Transfer of significant risk and rewards of the ownership to buyer (normally when goods are delivered or
legal title to goods transfers)
The entity neither continuing managerial involvement to the degree usually associated with the ownership,
nor effective control over the goods
The amount of revenue can be measured reliably
It is probable that economic benefits associated with transaction will flow to entity
The cost incurred or to be incurred in respect of transaction can be measured reliably

In limited circumstances (revenue may be recognized after or before goods or services delivered or rendered)
specific revenue recognition methods may be applicable, including percentage of completion, completed contract,
installment sales, and cost recovery.

At the point of sale

After or before sales

LONG TERM CONTRACTS:

(BEFORE OR AFTER?)

CONTRACTS span a number of accounting periods, with outcome reliably measured

Percentage of completion method
CONTRACTS span a number of accounting periods, with outcome cannot be measured
reliably, company does not report any revenue until the contract is finished

Completed contract method

Also appropriate when the contract is not a long term contract

INSTALLMENT SALES (BEFORE OR AFTER)

SALES in which proceeds are to be paid in installments over extended period

Installment method ,cost recovery method
Under installment method the portion of total profit of the sale that is recognized in each period is
determined by percentage of the total sales price for which seller has received cash.
Under cost recovery method seller doesnt repot any profit until cash amount paid by the buyer are greater
than the sellers cost

EXPENSES:

These criteria help ensure that a revenue event is not recorded until an enterprise has performed all or most of its
earnings activities for a financially capable buyer. The primary earnings activity that triggers the recognition of
revenue is known as the critical event. The critical event for many businesses occurs at the point-of-sale. This
usually takes place when the goods or services sold to the buyer are delivered (i.e., title is transferred).

Listed below are several terms and phrases associated with basic assumptions, underlying
principles, and constraints. Pair each item from List A (by letter) with the item from List B that is
most appropriately associated with it.