Chapter 3

Financial Reporting Standards

FIN410 - Spring 2020, Presented by Saima Tahsin

The course material and the lecture delivery of the material is for educational purposes only and do not constitute investment advice.

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Topics to be covered

Brief discussion about financial reporting standards, standard setting bodies & regulatory
authorities
The conceptual framework for financial reporting 2010
Evaluating quality of financial reports
Brief demonstration of how to measure Financial Reporting and Earning Quality (FREQ) of an
institution

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 Objective of Financial Reporting
IASB Conceptual Framework for Financial Reporting 2010

◦ To provide financial information about the reporting entity that is useful to existing and
potential investors, lenders, and other creditors in making decisions about providing
resources to the entity. Those decisions involve buying, selling, or holding equity and debt
instruments and providing or settling loans and other forms of credit.
Investors
◦ Buy, sell, or hold
Lenders and other creditors
◦ Lend or not
◦ Amount and terms

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 Financial Reporting Use in Security Analysis
and Valuation
Decisions by investors to buy, sell, or hold securities depends on expectations about returns (dividend
yield and price appreciation).
Expectations about returns depend on prospects for an entity’s future cash flows, and assessing those
prospects requires information about an entity’s
◦ resources,
◦ claims on resources, and
◦ use of the resources by management and board.
Financial reports are not designed to show the value of a reporting entity; they provide information to
help users estimate the value of the reporting entity.
Financial reports do not and cannot provide all the information needed by investors and creditors.
Other pertinent information must be obtained from other sources.

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 example
During an accounting period, In cook Inc., a hypothetical company that imports gourmet
cookware sets, had the following transactions:

Acquired office equipment for $9,000 in cash

Paid rent and other miscellaneous business expenses of $10,000
Purchased 100 sets of cookware at a cost of $700 each and paid 100% on delivery
Sold 60 sets to customers for $1,200 each ($72,000 total). In order to make the sales, In cook
had to offer credit terms to many customers. At year-end, customers owed In cook $15,000
for cookware that had been delivered (i.e., $57,000 cash was collected from customers and,
therefore, $15,000 remained outstanding from customers).
In cook’s two owners plan to split the profits 50/50. If no accounting standards existed, what
alternatives might be proposed as reasonable ways to compute the profits?

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 Example: cont’d.
Accounting standards limit the range of allowable approaches.

In cook would report sales revenues of $72,000; however, that amount would likely be reduced to reflect
an estimate for uncollectible accounts.

In cook would report cost of goods sold of $42,000.

◦ It sold 60 units, each of which cost $700.
◦ If the per-unit costs were different, cost of goods sold would require the choice of inventory cost
method.

In cook would report some amount of expense for at least part of the office equipment. The amount of
the expense would depend on
◦ Estimated useful life of the equipment,
◦ Estimated salvage value of the equipment at the end of its life, and Choice of depreciation method.

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Standard-Setting Bodies and Regulatory
Authorities
Generally,
◦ Standard-setting bodies set the standards and
◦ Regulatory authorities recognize and enforce the standards.
However, regulators often retain the legal authority to establish
financial reporting standards in their jurisdictions and can overrule
private sector standard-setting bodies.

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 Examples of standard-setting bodies
The International Accounting Standards Board (IASB) sets IFRS (International
Financial Reporting Standards).
The U.S. Financial Accounting Standards Board (FASB) sets U.S. GAAP (generally
accepted accounting principles).

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 Continuing Developments in Financial
Reporting Standards
As illustrated on the preceding slides, although many countries have adopted IFRS, not all
countries have done so.
Financial reporting standards (both IFRS and home-country GAAP) continue to evolve for
various reasons, including
◦ Changes in economic activity (new types of products and transactions),
◦ Improvements to existing standards, and
◦ Convergence between international and home-country standards.
An analyst needs to understand whether and how differences in financial reporting standards
affect comparability in cross-sectional analysis.

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 Global Convergence of Accounting
Standards: Differences Remain
Despite convergence efforts, differences remain between U.S. GAAP and IFRS.
Inventory
IFRS does not allow for the use of the LIFO (last in, first out) costing methodology for inventory,
which is permitted under U.S. GAAP.
In the United States, the Internal Revenue Service (IRS) has conformity provisions such that
certain methods of accounting are allowed for income tax purposes only if the entity also uses
that method for financial reporting purposes. LIFO is one such method subject to conformity
provisions.

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 Global Convergence of Accounting
Standards: Differences Remain.. cont’d
Measurement of Certain Asset Classes (optionality permitted under
IFRS)
Under IFRS, certain assets (e.g., capitalized acquired intangibles and property,
plant, and equipment) are initially recognized at cost. For subsequent
measurement, entities have a choice:
◦ To continue with a cost model or
◦ To revalue the assets within each class to fair market value.
U.S. GAAP does not permit use of a revaluation model.

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 Global Convergence of Accounting
Standards: Differences Remain.. cont’d
Impairment (property, plant, and equipment; inventory; and intangible assets)
The IFRS models allow for reversals of impairments up to a certain amount if
there is an indication that an impairment loss has decreased
U.S. GAAP does not allow reversals of impairments.
The SEC staff believes that the distinction could result in differences in the
timing and extent of recognized impairment losses.

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IFRS Conceptual Framework

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IFRS Conceptual Framework:
objective of financial reporting
At the core of the Conceptual Framework is
the objective to provide financial information
that is useful to current and potential
providers of resources in making decisions.
All other aspects of the framework flow from
that central objective.

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IFRS Conceptual Framework:
Fundamental qualitative Characteristics
Two fundamental qualitative characteristics
that make financial information useful:
◦ Relevance: Information that could
potentially make a difference in users’
decisions.
◦ Faithful Representation: Information that
faithfully represents an economic
phenomenon that it purports to
represent. It is ideally
◦ complete,
◦ neutral, and
◦ free from error.

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IFRS Conceptual Framework:
Enhancing Qualitative Characteristics
Four enhancing qualitative characteristics that make
financial information useful:
◦ Comparability: Companies record and report
information in a similar manner.
◦ Verifiability: Independent people using the same
methods arrive at similar conclusions.
◦ Timeliness: Information is available before it loses
its relevance.
◦ Understandability: Reasonably informed users
should be able to comprehend the information.

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IFRS Conceptual Framework: constraints
and assumptions
Constraint: The benefits of information
should exceed the costs of providing it.
Underlying Assumptions:
◦ Accrual Basis: Financial statements should
reflect transactions in the period when they
actually occur, not necessarily when cash
movements occur.
◦ Going Concern: Assumption that the
company will continue in business for the
foreseeable future.

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 Financial Statements
A complete set of financial statements includes
•Statement of financial position
•Statement of comprehensive income
•Statement of changes in equity
•Statement of cash flows
•Notes

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 General Features of Financial Statements

Fair presentation
Going concern
Accrual basis
Materiality and aggregation
No offsetting
Frequency of reporting
Comparative information
Consistency

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 Summary
Objective of financial reporting is to provide financial information about the reporting entity that is
useful to existing and potential investors, lenders, and other creditors in making decisions about
providing resources to the entity.
Fundamental qualitative characteristics that make financial information useful include
− Relevance and
− Faithful representation (complete, neutral, free from error)
Enhancing qualitative characteristics that make financial information useful include Comparability,
Verifiability, Timeliness, and Understandability
Constraint: benefits of info should exceed costs
Underlying Assumptions
− Accrual accounting
− Going concern

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