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Revenue Recognition

IS Expense Recognition

Profit Foundations of accrual accounting are revenue recognition & expense matching

likely to produce economic benefits


Assets
measurable with reasonable degree of certainty

BS to be paid with reasonable degree of certainty


Liabilities obligation that
timing is reasoably well defined

Equities the difference

Accrual Accounting, Not Cash BS

IS

Mandatory as mandated by standard IFRS/US GAAP (5 components) ; Statement of Changes in Equity

Statement of Cash Flows

Notes to Financial Statement

It is more relevant for measuring a company’s


Accruals is superior
present and future cash-generating capacity.
Accrual basis (income) Vs cash basis (cash flow)
Myth
Myth vs Truth
Institutional Framework FS Truth

Applying accounting principles is the responsibility of management, who has superior knowledge of a firm’s business.

Contracts
Incentives exist for management to distort accounting numbers in their favor.
Reputation

Management’s Responsibility for Reporting Financial Information audit Auditor

corporate governance BoC, Audit Committe


mitigate by legal liability, auditing, public enforcement. Monitoring mechanism
internal : workers union
litigation
external : lenders, shareholders

The EU and other countries worldwide have relied on the IASB to set accounting standards (IFRS); many countries have endorsement procedures, including Indonesia

IFRS allows for consistency in reporting between firms and over different time periods of the same firm.
Principle Standard
Uniform accounting standards minimize manager’s ability to manipulate financial statement information.

Rigid accounting rules may be disfunctional;calls for principles-based accountingstandards.

Audit Required for publicly traded companies

Public enforcement Most countries have public enforcement bodies to review compliance and take actions to correct noncompliance. OJK, KPPU

1st : Why? Objective : Provide Entity’s Reporting Information

5 Components

Predictive Value

Relevance Confirmatory Value

Materiality
Fundamental

Completeness
2nd : The Bridge between 1st and 3rd (The tools and characteristic)
Qualitative Characteristic Reliability/Faithful Representation Neutrality

Free from error

Comparability

Verifiability
Enhancing
Conceptual Framework Timeliness

Understandability

Economic entity

Going concern

Basic assumptions Monetary unit

Periodicity

Accrual Basis

3rd : How to implement? Recognition, Measurement, Disclosure Measurement

Revenue recognition
Basic principles
Expense recognition

Full disclosure

Cost (historical cost)


Constraints
Materiality

1. Noise from accounting rules The fit between accounting standards and the nature of the firm’s transactions may introduce some distortion in the reported financial statements. PSAK 16?

2. Forecast errors Management’s estimates may result in accounting forecasting errors reflected in the financial statements. allowance for bad debt

Debt covenants

Compensation contracts

It is necessary to allow managers some discretion in applying accounting standards. As a result, three potential sources of noise and bias in accounting data include Contests for corporate control

3. Manager’s accounting choices Managers have a number of incentives to choose accounting disclosures that are biased Tax considerations
Factors Influencing Accounting Quality
Regulatory considerations

Relevance capacity of information to affect a decision Capital market and stakeholder considerations

Desirable Qualities of Accounting Information Relevance vs reliability Reliability must be verifiable, representationally faithful, and neutral Competitive considerations

Accounting information often demands a trade-off between relevance and reliability. For example, reporting forecasts increase relevance but reduce reliability.

Key policies and estimates used to measure risks and critical factors for success must be identified.
Step 1: Identify Principal Accounting Policies
IFRS require firms to identify critical accounting estimates

Step 2: Assess Accounting Flexibility Accounting information is less likely to yield insights about a firm’s economics if managers have a high degree of flexibility in choosing policies and estimates.

Flexibility in accounting choices allows managers to strategically communicate economic information or hide true performance

Norms for accounting policies with industry peers

Step 3: Evaluate Accounting Strategy Incentives for managers to manage earnings


Issues to consider include
Changes in policies and estimates and the rationale for doing so

Whether transactions are structured to achieve certain accounting objectives

Managers have considerable discretion in disclosing certain accounting information

Whether disclosures seem adequate

Adequacy of notes to the financial statements


Step 4: Evaluate the Quality of Disclosure
Issues to consider include: Whether the Management Report section sufficiently explains and is consistent with current performance

Whether IFRS restricts the appropriate measurement of key measures of success

Adequacy of segment disclosure

Poor financial performance-desperate companies

Reported earnings consistently higher than operating cash flows

Accounting Analysis : Adjust for accounting distortions so financial reports better reflect economic reality Qualified audit report

Auditor resignation or a non-routine auditor change

Unexplained or frequent changes in accounting policies

Sudden increase in inventories in comparison to sales

Use of mechanisms to circumvent accounting rules, such as operating lease and receivables securitization

Frequent one time charges & big baths


Step 5: Identify Potential Red Flags RED FLAGS
Unexplained transactions that boost profits

Unusual increases in inventory or A/R in relation to sales

Increases in the gap between net profit and cash flows or tax profit

Use of R&D partnerships, the sale of receivables to finance operations

Unexpected large asset write-offs

Large year-end adjustments

Qualified audit opinions or auditor changes

Related-party transactions

Step 6: Undo Accounting Distortions (involves computations) Use information from the cash flow statement and notes to the financial statements to (possibly imperfectly) undo distortions

Concepts of Income (Economic)

Additional read of accounting concept Fair Value

Adjust for accounting distortions so financial reports better reflect economic reality

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