Lecture Notes: The BIG Picture

The BIG Picture

Why do we need financial reporting? What is its purpose?

Who are some of the key players in financial reporting?

PROVIDER EXTERNAL USERS

REGULATORS

The ultimate product of the financial reporting process is the companys annual report
(form 10-K filed with the SEC). This report typically includes the following:
1. Description of the companys business and risk factors

2. Managements Discussion and Analysis (MD&A)

3. Comparative Financial Statements (including notes to the financial statements)

4. Independent Auditors Report on Financial Statements and Internal Controls

5. Managements Certification of Financial Statements and Internal Controls

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 Who develops financial reporting standards (i.e., Generally Accepted Accounting
Principles) in the U.S.?
o Securities and Exchange Commission (SEC)

o Financial Accounting Standards Board (FASB)

GAAP
o Generally Accepted Accounting Principles have authoritative support.
o FASB Accounting Standards Codification (ASC or the "Codification") is the only
source of GAAP.
Only exception: Rules and interpretative releases of the SEC.

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 What guides the standard-setting process?
FASBs Conceptual Framework
o What is it?
A coherent system of interrelated objectives and fundamentals that is intended
to lead to consistent standards and that prescribes the nature, function, and
limits of financial accounting and reporting.
o Why do we need it?

Qualitative characteristics of decision-useful information

Overriding Objective Decision Usefulness

Fundamental Faithful Representation

Relevance
Characteristics

Components

Comparability/ Verifiability Timeliness Understandability

Enhancing
Consistency
Characteristics

Constraint Cost Effectiveness

Components:
A. Completeness includes all information necessary to understand what is going on
B. Confirmatory Value information helps to confirm or correct expectations
C. Free from Material Error no errors or omission in description of event or process
used to report
D. Materiality whether something impacts a users decision making
E. Neutrality free from bias in selection and presentation of information
F. Predictive Value ability to predict future earnings/cash flows

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 Enhancing characteristics
o Comparability

o Verifiability

o Timeliness

o Understandability

EXAMPLE: Qualitative characteristics

1. Donald Kirk, former chairman of the FASB, once noted that there must be public
confidence that the standard-setting system is credible, that selection of board
members is based on merit and not the influence of special interests Which
characteristic is implicit in Mr. Kirks statement?

2. In September 2015, Apple changed its revenue recognition policies by lowering the
value of hardware sales it attributes to recurring software upgrades in order to reflect
competition, the ubiquity of smartphones and the ease of software-update installation.
Consequently, the company lowered to amount of a given hardware sale that was set
aside as deferred revenue. Because Apple booked lower deferred revenue in fiscal
2016, its gross margin increased. Which characteristic is jeopardized by this change?

3. Nike, Inc., a publicly traded company, files quarterly and annual financial statements
with the SEC. Which characteristic is relevant to the time of these periodic filings?

4. Tootsie Roll Industries, Inc. leases a manufacturing and warehousing facility in

Chicago. The lease is renewable by the Company every five years through June,
2041. In other words, for the entire duration of the buildings useful life. Although,
the company is not the legal owner of the building, it recognizes the leased building
as an asset in its balance sheet sine I has control over the economic benefits derived
from the use of the asset. Consequently, this information possesses which
characteristic?

5. You are evaluating two company for future investment potential. Your task is made
easier because both companies use the same accounting methods when preparing
their financial statements. Which characteristic does this information possess?

6. Which characteristic would allow a company to record the purchase of a $120 printer
as an expense rather than capitalizing the printer as an asset?

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 The conceptual framework also defines the basic elements of financial statements.
o Below are the 10 interrelated elements of financial statements. In other words, the
numbers in one financial statement will correspond to balances in another. These are
the building blocks with which the financial statements are constructed.

Element Definition Example

Assets Probable future economic benefits obtained or
controlled by a particular entity as a result of past
transactions or events.
Liabilities Probable future sacrifices of economic benefits
arising from present obligations of a particular
entity to transfer assets or provide services to
other entities in the future as a result of past
transactions or events.
Equity (Net assets) Called shareholders equity or stockholders
equity for a corporation, it is the residual interest
in the assets of an entity that remains after
deducting its liabilities.
Investment by Increases in equity of a particular business
owners enterprise resulting from transfers to it from
other entities of something of value to obtain or
increase ownership interests in it.
Distributions to Decreases in equity of a particular enterprise
owners resulting from transfers to owners.
Comprehensive The change in equity of a business enterprise
income during a period from transactions and other
events and circumstances from nonowner
sources. It includes all changes in equity during a
period except those resulting from investments
by owners and distributions to owners.
Revenues Inflows or other enhancements of assets of an
entity or settlements of its liabilities during a
period from delivering or producing goods,
rendering services, or other activities that
constitute the entitys ongoing major or central
operations.
Expenses Outflows or other using up of assets or
incurrences of liabilities during a period from
delivering or producing goods, rendering
services, or other activities that constitute the
entitys ongoing major or central operations.
Gains Increases in equity from peripheral or incidental
transactions of an entity.
Losses Represent decreases in equity arising from
peripheral or incidental transactions of an entity.

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When should these elements be recognized?

General Recognition Criteria

o An item should be recognized in the basic financial statements when it meets the
following four criteria, subject to a cost effectiveness constraint and materiality threshold:
1. Definition
2. Measurability
3. Relevance
4. Reliability

Lets think about these criteria with respect to assets. What are your two or three
biggest assets?

Which assets on Apples balance sheet most resemble your assets?

What are some of Apples biggest resources that are missing from this balance sheet?

Some of a companys resources meet the definition of an asset, but are not reported.
o Why? To be recognized, a resource must (1) meet the definition of an asset and (2) it
must be possible to measure its value reliably.

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o The ability to measure an asset reliably varies with the type of asset
Assume that 1,000 honest and objective measurement experts have agreed to
measure the financial value your cash, car, and talent.

What information do they need to know to measure each?

How different would their answers be for each of the assets? Why?

o Further Guidance on Revenue and Expenses

o Revenue:
Inflows of assets or settlements of liabilities resulting from providing a product or
service to a customer

Revenue recognition used to be guided by the realization principle (two criteria)

In May of 2014, the FASB and the International Accounting Standards Board (IASB)
issued converged guidance on recognizing revenue in contracts with customers. The
new guidance provides a more robust framework for addressing revenue issues and
improves comparability by providing consistent principles for recognizing revenue
regardless of geography and/or industry. In general, the new standard requires that we
recognize revenue when goods or services are transferred to customers for the
amount the company expects to be entitled to receive in exchange for those goods
or services. More on this later in the semester

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 o Expenses:
Outflows or other using up of assets or incurrences of liabilities from providing goods
or services.

Expense recognition often matches revenues and expenses that arise from the same
transactions or other events
Four approaches:
Based on an exact cause-and-effect relationship

By associating an expense with the revenues recognized in a specific time

period

By a systematic and rational allocation to specific time periods

In the period incurred, without regard to related revenue

How should the elements be measured and disclosed?

Mixed attribute measurement model

1.

2.

3.

4.

5.

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 Full-disclosure principle
o What is it?

o How do companies achieve this?

Parenthetical comments or modifying comment

Disclosure notes

Supplemental schedules and tables

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NOW, think about these questions:
Analysts and professional investors are THE primary users of financial reports. What do
they want when they read financial reports? In other words, what do they consider decision
useful information?

What about management? How do the following factors affect the quality of information
conveyed in the financial reports?
o Regulators

o Firm reputation

o Investors

o Personal incentives (e.g., bonuses)

o Creditors/debt covenants

o Trade secrets

Assignment: Christys Lemonade Stand

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