Introduction

Company characteristics affecting financial

reporting behaviour
Content of financial statements
The basics of accounting measurement
Generally accepted accounting principles
Conventional measurement bases
Accounting for transactions
The IASB definition and recognition criteria of
elements of the balance sheet and the income
statement

Single public source of economic company

data
Prime external communication tool and of
interest to all main business partners
Subject to verification by external experts
Starting point for tax assessment
Important device to monitor contracts
Public through mandatory filing and
voluntary disclosure

Balance sheet and income statement are the key financial

statements

Balance sheet: shows, at a given date, the companys

financial position: the economic resources (assets) it controls
and where its finance comes from (liabilities and equity)
Income statement: sets out the performance (result) of a
companys operations for the accounting period

They provide specific, but partial, economic information

about a companys past activities, drawn up according to
a fairly flexible set of rules
Effective use necessitates knowledge of:
a) What are the rules?
b) To what extent are they flexible?
c) How this impacts upon interpretation of the information.

Financial reporting is deeply embedded

in a countrys culture and traditions
=>national accounting rules tend to
vary significantly
Additionally, company characteristics
will impact its reporting behaviour, e.g.

Nature of ownership
Managerial objectives
Nature of activity
Legal form
Company size

The core financial reporting process involves

preparing an annual income statement and
balance sheet

Income statement: brings together aggregated

information about a companys performance during a
fiscal year
Balance sheet: shows the state of the companys
financial position at the end of the fiscal year

The income statement presents flow-data

(covering a period), while the balance sheet is a
status report (a snapshot at a specific moment
in time)
They are usually published with comparative data
of the previous year.

Balance
sheet
31/12/20X1

Balance
sheet
31/12/20X2
Income
statement
20X2

Balance sheet
31/12/20X3
Income
statement
20X3

Income
statement
20X4

Balance
sheet
31/12/20X4

Accomplishments
=>
less
Efforts
=>
equals
Performance
=>

Revenues
-

Expenses

Profit (or Loss)

The income statement can be split into two

different sections:

Operating result (or profit before interest and tax): result

from the companys operating activities, irrespective of
the financial structure of the company
Returns to interested parties others than the owners:
Income taxes due to government
Interest on loan finance

Profit available for shareholders is the residual

return to equity providers
It is the wealth generated by the company during the
period
To pay dividend to shareholders or to finance future
growth (auto-financing)

Two formats to present operating

expenses:
Value-added approach
Shows inputs and outputs and enables one to calculate
the value added by the company
Operating expenses are presented by their nature
Most common in Europe

Functional approach
Presentation by type of activity to which the operating
expense was assigned
More common in UK and US

Cost of
sales

Distributio
n costs

Administrati
ve expenses

Salaries
and wages

Factory
employees

Sales
agents

Accountants

Depreciatio
n

Production
hall

Cars

Administration
buildings

Function:
Input costs:

A balance sheet presents a picture of the

companys finances at the end of the
financial year, and the assets which it has
acquired and which have not yet been
consumed within the business
A balance sheet can be presented
according to two basic formats:

Horizontal balance sheet

Vertical balance sheet

Resources

Assets

Sources of finance

Equities
Ownersequity
(interests of owners)
creditors)

Liabilities
(interests of

Left-hand side - the assets:

Fixed assets: used over a period of more than

one year

Tangible assets (e.g. physical plant and machinery)

Intangible assets (patents, brand names, licences)
Investments (shares of and loans to other companies)

Other (current) assets: constantly changing

during accounting period
Inventories
Receivables (amount due from customers)
Cash

Right-hand side - the financing:

Share capital: put into the company by the
owners
Provisions: a liability to pay in the future, but
amount or timing is uncertain
Financial Liabilities: loans made by banks and
financial markets
Trade liabilities: debts due to suppliers

Assets
Liabilities
Ownersequity => Residual claims of owners

Contributed funds (share capital)

Earned funds (accumulated profits)

Same content but different presentation

Liabilities are shown as a deduction from assets
Liabilities are split according to when they are
due for payment, with current liabilities deducted
from current assets
Capital (or equity) is shown as the residual: it is
more a proprietary approach (focusing on the
interests of the owners) while the horizontal
presentation follows an entity approach
(company presented as an economic whole)

Accounting measurement is based on a

set of assumptions and conventions which
automatically limit the information content
Generally accepted accounting principles
Conventional measurement bases

Accounting measurement necessitates

extensive use of estimates, which make it
a subjective process

A set of assumptions, conventions and rules

underlying financial accounting, necessary to
make financial statements comparable and
useful, but introducing significant constraints on
their content
Different Generally Accepted Accounting
Principles (GAAP)-sets exist, such as European
GAAP and related national GAAP, US GAAP, IFRS
GAAP,...
The true and fair view principle (or fair
presentation) of financial statements is
pragmatically linked to the proper application of
generally accepted accounting principles

Financial statements are frequently described as

showing a true and fair view of, or as presenting
fairly, the financial position, performance and
changes in financial position of an entity.
Although this Framework does not deal directly
with such concepts, the application of the
principal
qualitative
characteristics
and
appropriate
accounting
standards
normally
results in financial statements that convey what
is generally understood as a true and fair view of,
or as presenting fairly such information.
Source: IASB-Framework for the Preparation and Presentation of
Financial Statements

Consistency of measurement and presentation

principles
Consistency in time and space
Same accounting principles should be applied from one
year to another
And, within the same year, in relation to similar
transactions.

If changes are necessary, they should be

explained in the notes to the accounts, together
with disclosure of extra information to enable
external observers to make a knowledgeable
evaluation of the effects of the change

Financial accounting aims to measure

business transactions at the time they
take place, rather than when cash
changes hands
This approach distinguishes financial accounting
from a simple record of cash transactions

Matching: all costs and revenues

associated with a particular sale should be
recognized together in the income
statement when the sale takes place

In order to meet their objectives, financial statements

are prepared on the accrual basis of accounting. Under
this basis, the effects of transactions and other events are
recognised when they occur (and not as cash or its
equivalent is received or paid) and they are recorded in
the accounting records and reported in the financial
statements of the periods to which they relate. Financial
statements prepared on the accrual basis inform users
not only of past transactions involving the payment and
receipt of cash but also of obligations to pay cash in the
future and of resources that represent cash to be
received in the future. Hence, they provide the type of
information about past transactions and other events that
is most useful to users in making economic decisions.
Source: IASB, Framework, par.22

Cash basis:

Revenue recognized when incoming cash flows occur

Expenses recognized when outgoing cash flows occur
No mutual link of expenses and revenues
No measure of profitability feasible

Accrual basis:

Expenses and revenue regarding a sale should be

recognized simultaneously (irrespective of time of
payment)
Matching principle
Measure of profitability of economic activities during
an accounting period

Income statement
Revenues and expenses with regard to a specific
accounting period
Revenue recognised in period when earned
Expenses related to the sale are recognised
in the same period as the revenue

Principle
Revenues should only be recognised when they
are certain
Expenses are recognised when they become
probable
Unrecoverable expenses should be recognized
even if not yet realized

Controversial
Conflict with principle of matching
Tax driven / Could lead to hidden reserves

IFRS: no priority for the prudence principle

Meaning of prudence is restrained to an
attitude of caution in the exercise of
judgements when these are needed to arrive
at estimates under conditions of uncertainty
such that assets/income are not overstated
and liabilities/expenses understated

In preparing financial statements it is assumed

that the company will continue in business for the
foreseeable future
Assumption is necessary to apply accrual principle

If no longer realistic: other set of measurement

rules needed (probably based on short-term
liquidation values)
IAS 1 Presentation of Financial Statements
requires management to make an assessment of
the companys ability to continue as a going
concern, when it prepares the financial
statements

Historical cost principle

Monetary measurement unit convention

Financial accounting is still largely based on

historical cost accounting
Historical cost = acquisition cost of the item

Historical consideration given

Past cost needed to acquire an asset on the date of
acquisition (the cash-equivalent acquisition cost)

Pros and cons

Advantage: historical cost is relatively easy to determine

and can be verified
Disadvantage: subsequent to the date of acquisition, the
continued reporting of historical cost based values does
not reflect any changes in market value

A/L/I/E are measured in monetary units

Money provides a common denominator by means of
which heterogeneous facts and relationships can be
expressed as numbers that can be added and
substracted.

Pros and cons

If nothing has been paid, no recognition of values in the
balance sheet, e.g.
Trade mark loyalty
Human capital

What if the value of monetary units changes ?

Changes in purchasing power are not taken into account

Balance sheet equation

Constructing a balance sheet

Finance

Production facility

Operations

Retained for growth

Profit / Cash

Corporate taxation

Paid to shareholders as dividend

The balance sheet equation is usually

stated as:
Assets = Debt (liabilities) + Equity
(uses of finance = sources of finance)

Any business transaction that will be recognized

in the accounting system (accounting
transaction), will have a dual impact on the
numbers in the companys accounting records
The balance sheet equation is in fact the formal
expression of the duality of accounting
transactions
Double-entry accounting: any accounting
transaction must be reflected in (at least) two
accounts

Any accounting transaction must preserve the

equilibrium between sources and uses of funds,
and will involve either a change in both, or a
reallocation within one side of the balance sheet
equation
Accounting transactions with impact on revenues
and expenses fit into this fundamental equation
approach
If profit is generated, it adds to the equity part of the
equation
Revenues have a positive impact on profit and, thus, on
equity
Expenses have a negative impact on profit and, thus, on
equity

Owners equity

1 jan. 20X1

= Assets Liabilities

Share capital 1/1 + Retained profits 1/1

=
Net assets 1/1
(NA)

Income statement
for year 20X1
During 20X1

Revenues
- Expenses

=
=

Increase NA
Decrease NA

Decrease NA

+ Profit
(- Loss)
- Dividend
31 dec.
20X1

Share capital 31/12 + Retained profits

31/12

Net assets 31/12

Every accounting transaction can be analysed according to

its dual impact on the balance sheet
We will follow a spreadsheet approach for analysing
accounting transactions

Rows represent accounts (upper part = asset rows; lower part =

equity and liability rows) and can be extended if needed
Columns represent the impact of accounting transactions on
the balances (net amounts) of the accounts this impact should
be such that the balance sheet equation is preserved at all
times

The spreadsheet represents the accounting database

Each row (or account) = a data file

Balance sheet = a highly aggregated summary of these data
files

Assets

Debit

Asset

Debit

Eq./Liab.

Credit

Increase (+) => debit

Decrease (-) => credit

Equity/Liabilities
Increase (+) => credit
Decrease (-) => debit

P&L accounts
Revenue => credit
Cost => debit

Debit

P&L

Cost Revenue

Credit

Credit

We will follow a sequence of accounting

transactions up to the construction of a balance
sheet
Initially, equity represents the finance put into the
company by the shareholders; equity changes
regularly as a result of operating activities
The net change in equity over a period is the
profit which has been made by the company
during that period - it is analysed in the income
statement
A balance sheet can, potentially, be drawn up
after each transaction

Assets

Cash

+20000
+15000
+15000

Receivables
Inventory
Property
Total

+50000

Liab./Equity
Long-term debt
Shares

+20000
+15000
+15000

Profit
Total

+50000

Situatio
n

Assets
Cash

+20000
+15000
+15000

+30000

+50000

+30000

Receivables
Inventory
Property
Total
Liab./Equity
Long-term debt
Shares

+30000
+20000
+15000
+15000

Profit
Total

+50000

+30000

Situatio
n

Assets
Cash

+20000
+15000
+15000

+30000

-55000

Receivables
Inventory
Property

+55000
Total

+50000

+30000

Liab./Equity
Long-term debt
Shares

+30000
+20000
+15000
+15000

Profit
Total

+50000

+30000

Situatio
n

Assets
Cash

+20000
+15000
+15000

+30000

-55000

-18000

Receivables
Inventory

+18000

Property

+55000
Total

+50000

+30000

Liab./Equity
Long-term debt
Shares

+30000
+20000
+15000
+15000

Profit
Total

+50000

+30000

Situatio
n

Assets
Cash

Situatio
n

+20000
+15000
+15000

+30000

-55000

-18000

7000

+18000

18000

Receivables
Inventory
Property

+55000
Total

+50000

+30000

55000
0

80000

Liab./Equity
Long-term debt
Shares

+30000

30000

+20000
+15000
+15000

50000

Profit
Total

+50000

+30000

80000

Assets

Equity and
Liabilities

Tangible assets
(Property)
Fixed assets
Inventory (Cars)
Cash at bank
Current assets
Total

55.000
55.000
18000

Share capital
Shareholdersequity
Financial liabilities
(LT debt)

50000
50000
30000

7000
25000
80000

Liabilities
Total

30000
80000

Assets

Situation
A

7000

(a) +5000
(c) -250

Inventory

18000

(b) -4000

Property

55000

Cash
Receivables

Total

80000

+750

Liab./Equity
Long-term debt

30000

Trade creditor
Shares

50000

Profit

(a) +5000
(b) -4000
(c) -250
Total

80000

+750

Situation
B

Assets
Cash

Situation
A

7000

+5000
-250

Receivables

(a)+7000

Inventory

18000

Property

55000
Total

80000

-4000

(b) -5500

+750

+1500

+5000
-4000
-250

(a)+7000
(b) -5500

+750

+1500

Liab./Equity
Long-term debt

30000

Trade creditor
Shares

50000

Profit

Total

80000

Situation B

Assets
Cash

Situation
A

7000

+5000
-250

Receivables

18000

Property

55000
80000

-4000

Situation B
11750

+7000

Inventory
Total

-5500

7000
+12000

20500
55000

+750

+1500

+12000

94250

Liab./Equity
Long-term debt

30000

30000

Trade creditor
Shares

+12000
50000

Profit

Total

80000

12000
50000

+5000
-4000
-250

+7000
-5500

+750

+1500

2250

+12000

94250

Sales

12000

Cost of sales
- Cars
- Repairs

9500
250
9750

Net Profit

2250

Assets

Equity and
Liabilities

Tangible assets
(Property)
Fixed assets

55.000
55.000

Share capital
Profit
Shareholdersequity

50000
2250
52250

Inventory (Cars)
Receivables

20500
7000

Financial liabilities
(LT debt)

30000

Cash at bank

11750

Trade creditor

12000

Current assets
Total

39250
94250

Liabilities
Total

42000
94250

Net Profit (Income statement)

2250

Value of inventory sold (paid previously)

9500

Amount due by customer (still to be

received)
Change in cash during
period

-7000
+4750

Elements of financial statements are the

building blocks of a balance sheet and
income statement
Broad categories according to their economic
characteristics

The IASB Conceptual Framework identifies

and defines five elements of financial
statements
assets, liabilities, equity, income and expenses

c.f. IASB Conceptual Framework

Five basic elements:

Assets
Liabilities
Equity
Income
Expenses

Financial position
Financial performance

Financial position
Assets Liabilities = Equity

Financial performance
Income Expenses = Profit

A resource controlled by an entity as a

result of past events from which future
economic benefits are expected to flow
to the entity
Key elements:
a) Assets are resources, arising from past transactions
or past events
b) They embody future economic benefits: the
capacity to contribute directly or indirectly to future
net cash inflows
c) Control: one has the capacity to benefit exclusively
from these economic benefits

Economic benefits may result from:

the productive capacity of the asset
plant and equipment

the ability of the asset to reduce future cash outflows

renewal expenditure on equipment that results in future
production cost savings

the rights incorporated in the asset to receive services in

the future
prepayments

direct claims to cash inflows

receivables and short-term investments

cash in hand

can be exchanged for goods and services (economic benefits)

A present obligation of an entity

arising from past events, the
settlement of which is expected to
result in an outflow from the entity of
resources embodying economic
benefits
Key elements:

a) Present (at balance sheet date) responsibility

obligating the company to act or perform in a
certain way (towards third parties)
b) Arising from an obligating event in the past
c) Leading to a sacrifice of economic benefits
(transfer of cash or other assets, rendering of
services, replacement by another obligation, ...)

The residual interest in the assets of an

entity after deducting all liabilities
Key elements:

The residual interest is the ownership interest

Representing a claim to the companys net assets

Equity will be usually sub-divided:

Funds contributed by shareholders
Retained profits
Reserves representing appropriation of retained profits

Increases in economic benefits during

the accounting period in the form of
inflows or enhancements of assets or
decreases of liabilities that result in
increases in equity, other than those
relating to contributions from equity
participants
Key elements:

Defined in terms of changes in assets and liabilities

Results in increases of equity
Must not come from capital contributions of owners
Encompasses both revenue and gains

Decreases in economic benefits during

the period in the form of outflows or
depletions of assets or incurrences of
liabilities that result in decreases of
equity, other than those relating to
distributions to equity participants
Key elements:

Defined in terms of changes in assets and liabilities

Results in decreases of equity
May not relate to distributions to owners
Encompasses both expenses and losses

The IASB standards contain additional rules with

respect to specific occurrences of elements of
financial statements
In addition to more detailed definitions, the IASB
standards typically focus on three aspects of
financial statement elements:

Recognition: process of incorporating an item (meeting

one of the definitions) in the financial statements
Measurement: process of determining the monetary
units at which they are to be recognised and carried in
the financial statements
Disclosure: process of additional information
dissemination in the notes to the accounts

An item meeting one of the definitions will

only be recognised in the financial
statements, if:
1) It is probable that any future economic benefit
associated with the item will flow to or from the
entity, and
2) The item has a cost or value than can be measured
with reliability

Stage 1 - Definitions

Does the item meet the definition of a financial statement element ?

Stage 2 Recognition

Can the item be recognized according to the generic recognition criteria ?

Are there any specific recognition rules for the item?

Stage 3 Measurement

Select the appropriate measurement base to determine the monetary amount at

which the item will be recognized and carried in the balance sheet or income
statement

Stage 4 Disclosure

Is any (additional) mandatory or recommended information to be included in the

notes to the accounts?

Historical value versus economic value

Conservatism: assets are measured at
the minimum amount that can be
expected from sale or use
Characteristics of economic value
Related to future net cash flows
Taking into account time value of money
Corrected for risk