Revenue Recognition

Expense Recognition

Operating CF
IS
FCF = OCF + cash investment & divestment in operating assets
Profit Foundations of accrual accounting are revenue recognition & expense matching
NCF =FCF + Financing CF

NI = OCF + Accruals

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

BS

IS

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

Statement of Cash Flows

Accrual Accounting, Not Cash
Notes to Financial Statement

Revenue recognition & expense matching yields an income number superior to C/F for evaluating “financial performance”

Accrual accounting produces a balance sheet that more accurately reflects the “financial condition” or level of resources available to the company to generate future C/F
It is more relevant for measuring a company’s
Accruals is superior
present and future cash-generating capacity.
through revenue recognition, accrual income reflects future C/F consequences

better aligns inflows & outflows over time through the matching process

Since company value depends on future cash flows, “only current cash flows are relevant for valuation” It is also “current income” relevant to valuation

All cash flows are “value relevant” Some relevant, some others not i.e cash (AR) collection

All accrual accounting adjustments are “value irrelevant” Some irrelevant (cosmetics), some others are relevant i.e sales on credit
Institutional Framework FS Accrual basis (income) Vs cash basis (cash flow) Myth
Cash flows “cannot be manipulated” It is easier to be manipulated i.e accelerating cash collections from customers

All “income is manipulated” forced by regulators

Myth vs Truth
It is “impossible to consistently manage income upward” in the long run It is possible by managing reversal of smaller adjustments from prior years

Accrual accounting (income) is “more relevant” than cash flow accrual income is more relevant than cash flow in measuring financial condition and performance and in valuation.

Cash flows “complement” accruals

Truth
Accrual accounting numbers are “subject to accounting distortions” caused by alternative accounting methods along with earnings management

“Company value” can be determined by using accrual accounting numbers discounted future residual income.

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 accounting standards.

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

BS

5 Components PL

Investment and Distribution to Owners

Predictive Value

Relevance Confirmatory Value

Materiality
Fundamental
2nd : The Bridge between 1st and 3rd (The tools and characteristic)
Completeness

Qualitative Characteristic Reliability/Faithful Representation Neutrality

Free from error

Comparability

Conceptual Framework Verifiability

Enhancing
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

Step 5: Identify Potential Red Flags RED FLAGS Frequent one time charges & big baths

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

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

Useful when the objective of analysis is determining the exact return to the shareholder for the period
Measures changes in shareholders wealth
Less useful for forecasting future earnings potential

“cash flow during the period (realized cash flow) plus change in present value of expected cash flow”, typically represented by the change in the market value of the
business’s net assets (unrealized holding gain / loss)

PERMANENT / SUSTAINABLE / RECURRING INCOME stable average income that a business is expected to earn over its life, given the current state of its business conditions
Type of economic income
OPERATING INCOME income that arises from a company’s operating activities

Accounting income based on the concept of accrual accounting main purpose is income measurement (revenue & expense recognition)

Some standards, for example, on pensions, adopt the permanent income concept,
Concepts of Income (Economic) Many alternative income concept Accounting standard setters are faced with a dilemma involving which concept to emphasize
while other standards, for example on marketable securities, adopt the economic income concept.

(1) the current cost of sales is not reflected in the income statement, such as under the FIFO inventory method, and
Historical cost The use of historical cost affects income in two ways:
(2) unrealized gains and losses on are not recognized.
Vs ACCOUNTING / REPORTED INCOME Reasons for difference with economic income:
Transaction basis Economic effects unaccompanied by an arm’s-length transaction often are not considered. For example, purchase contracts are not recognized in the financial statements until the transactions occur.

Conservatism in accounting income results in recognizing income-decreasing events immediately, even if there is no transaction to back it up
Conservatism
However, the effect of an income-increasing event is delayed until realized.

Earnings management Earnings management causes distortions in accounting income that has little to do with economic reality.

The implications are adjustment for permanent income, economic income, and operating income

Asset & liabilities value are determined on the basis of the fair values
(typically market prices) on the measurement date (i.e.,
approximately the date of F/S)

Transaction (actual/past/historical) valuation >< current valuation

Differences with historical cost Historical cost valuation (costs incurred) >< market based valuation (assumptions)

Income is determined by matching cost against revenues (historical cost model) >< income is determined merely by the net change in fair value of assets & liabilities (fair value model)

On the measurement date the date of the balance sheet—rather than the date when the asset was originally purchased

Hypothetical transaction fair values are determined “as if ” the asset were sold on the measurement date.

5 aspect to define Fair Value Orderly transaction “orderly” transaction eliminates exchanges occurring under unusual circumstances, such as under duress

Market-based measurement This means that fair value of an asset should reflect the price that market participants would pay for the asset (or de- mand for the liability)

Exit prices The fair value of an asset is the hypothetical price at which a business can sell the asset (exit price).

Level 1 : quoted prices in active markets that the reporting entity has the ability to access at the reporting date, for identical assets & liabilities.

Additional read of accounting concept (1) quoted prices from active markets for similar, but not identical, assets or liabilities,
Hierarchy of inputs Level 2 inputs. These inputs are either
or (2) quoted prices for identical assets or liabilities from markets that are not active (i.e., not frequently traded)
Fair Value
Level 3 inputs reflect manager’s own assumptions regarding valuation, including internal data from within the company.

Market approach (fair value is measured by directly or indirectly using prices from prices from actual market transactions)

Valuation techniques Income approach (fair value is measured by discounting future C/F (or earnings) expectations to the current period

Cost approach (fair value is determined as the current cost to a market participant (buyer) to acquire or construct a substitute asset that generate comparable utility

Reflects current information

Consistent measurement criteria

Adv Comparability

No conservative bias

Adv and Diadv More useful for equity analysis

Lower objectivity

Susceptibility to manipulation (use of level 3 inputs)

Diadv
Lack of conservatism

Excessive income volatility

(1) political process of standard-setting,

Accounting standards, attributed to (2) accounting principles and assumptions,

(3) conservatism

Estimation errors, attributed to estimation errors inherent in accrual accounting

Reliability >< relevance, attributed to over-emphasis on reliability at the loss of relevance

increasing reported income with adjust accruals

Adjust for accounting distortions so financial reports better reflect economic reality Strategies big bath (record huge write-offs in one period to relieve other periods of expenses)

income smoothing (decrease or increase reported income to reduce its volatility)

contracting incentives
Earnings management, attributed to window-dressing of F/S by managers to achieve personal benefits
Motivations stock price effects

other reasons adjust numbers to impact labor demands

income shifting (accelerate or delay recognition of revenues or expenses to shift income from one period to another)
Mechanism
classificatory earnings management (selectively classify revenues and expenses in certain parts of the income statement to affect analysis inference