AK0040

ACCOUNTING THEORY
Financial Statement

ACCOUNTING PROGRAM
Contents
• The Income Statement
The Economic Consequences of Financial Reporting
Income Statement Elements
Statement Format
Proposed Format of The Statement of
Comperhensive Income
The Value of Corporate Earnings
International Accounting Standards
Contents
• The Balance Sheet and The Statement of Cash Flows
The Balance Sheet
Fair Value Measurement under SFAS No. 157
Evaluating a Company’s Financial Position
The Statement of Cash Flows
Financial Analysis of Cash-Flow Information
Internasional Accounting Standards
The Economic Consequences of
Financial Reporting
Income measurement and financial reporting also involve
economic consequences, including the following:
• Financial information can affect the distribution of
wealth among investors. More informed investors, or
investors employing security analysts, may be able to
increase their wealth at the expense of less informed
investors.
• Financial information can affect the level of risk
accepted by a firm. Focusing on short-term, less risky
projects can have long-term detrimental effects.
(continued...)
The Economic Consequences of
Financial Reporting
Income measurement and financial reporting also
involve economic consequences, including the
following: (...continued)
• Financial information can affect the rate of capital
formation in the economy and result in a
reallocation of wealth between consumption and
investment within the economy.
• Financial information can affect how invesment is
allocated among firms.
Income Statement Elements
Financial statement elements are defined in SFAC No.6 ad follows:
Revenue – Inflows or other enhancements of assets of an entity or
settlement of its liabilities (or a combination both) during a period
from delivering or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major or central
operations.
Gains – Increases in net assets from peripheral or incidental
transactions of an entity and from all other transactions and other
events and circumstances affecting the entity during a period
except those that result from revenues or invesments by owners.
Expenses – Outflows or other using up of assets or incurrences of
liabilities (or a combinations of both) during a period from
delivering or producing goods, rendering services, or carrying out
other activities that constitute the entity;s ongoing major or
central operations.
Losses – Decreases in net assets from peripheral or incidental
transactions of an entity and from all other transactions and other
events and circumstances affecting the entity during except from
expenses or distributions to owners.
Statement Format
APB Opinion No.9
The APB Opinion No.9 prescribed statement format
included two income figures:
Net income from operations
Net income from operations plus extraordinary
items.
Statement Format
Income from Continuing Operations
• The amounts disclosed to arrive at income from
continuing operations are the company’s normal
and recurring revenues and expenses.
• The resulting income figure represents the amount
expected to recur in the in the future, often
referred to as the company’s sustainable income.
• Sustainable income is the amount investors should
use as a starting point to predict future earnings.
Statement Format
Nonrecurring Items of Income
Three nonrecurring items of income may also be
incurred by a company, such as:
1. Discontinued operations
2. Extraordinary items, and
3. Accounting changes.
Proposed Format of the Statement
of Comprehensive Income
• The FASB and th IASB are working on a proposal to
recast financial statements into a new format.
• The new proposed income statement has separate
categories for the disclosure of a company’s
operating business, financing activities, investing
activities, and tax payments.
• According to the proposal, all income and expense
items are to be classified into operating, investing,
and financing categories. Within those categories,
an entity disaggregates line items by function.
The Value of Corporate Earnings
• The financial analysis of a company’s income
statement focuses on a company’s operating
performance by posing question like these:
1. What are the company’s major source of revenue?
2. What is the persistence of a company’s revenues?
3. What is the company’s gross profit ratio?
4. What is the company’s operating profit margin?
5. What is the relationship between earnings and the
market price of the company’s stock?
International Accounting Standards
• Companies are required to select and apply
accounting policies on a consistent basis for similar
transactions.
• Addtionally, a company may change an adopted
accounting policy only if the change either:
Is required by a standard or interpretation
Results in the financial statements providing
reliable and more relevant information about the
effects of transaction, other events, or conditions
on the entity’s financial position, financial
performance, or cash flows.
The Balance Sheet
• The balance sheet should disclose a company’s
wealth at point time.
• Wealth is defined as the present value of all resources
less the present value of all obligations.
• Although the use of present-value measurements in
accounting is increasing, it is not used extensively for
all assets and liabilities.
• As result, a variety of methods are currently being
used to measure changes in the individual
components of the elements of the balance sheet.
• This measurements can be summarized as past
oriented – historical; current oriented – replacement
amounts; and future oriented – expected amounts.
Balance Sheet Elements
• FASB Statement of Concepts No.6 defined the
elements of the balance sheet as follows:
Assets
Liablities
Equity
Balance Sheet Elements
Assets
• Assets are probable future economic benefits obtained
or controlled by a perticular entity as a result of past
transactions or events.
• An assets has three essential characteristics:
1. It embodies a probable future benefit that involves
a capacity, singly or indirectly to future net cash
inflows
2. A particular enterprise can obtain the benefit and
control others’ access to it
3. The transaction or other event giving rise to the
enterprise’s right to or control of the benefit has
already occurred.
Balance Sheet Elements
Liabilities
• Liabilities are probable future sacrafices of economic
benefits arising from present obligations of a
particular entity to transfer assets or provides services
to other entities in the future as a result of past
transactions or events.
• A liability has three essential characteristics:
1. It embodies a present duty or responsibility to one
or more other entities that entails settlement by
probable future transfer or use of assets at a
specified or determinable date, on occurrence of a
specified event, or on demand; (continued...)
Balance Sheet Elements
• A liability has three essential characteristics:
(...continued)
2. The duty or responsibility obligates a particular
enterprise, leaving it little or no discretion to
avoid the future sacrifice; and
3. The transaction or other event obligating the
enterprise has already happened.
Balance Sheet Elements
Equity
• Equity is the residual interest in the assets of an
entity that remains after deducting its liabilities
• In a business enterprise, stems from ownership
rights (or the equivalent)
• It involves a relation between an enterprise and its
owners as owners rather than as employees,
suppliers, customers, lenders, or in some other
nonowner role.
Balance Sheet Elements
Classification of Balance Sheets Elements
Assets
Current assets
Invesments
Property, plant, and equipment
Intangible assets
Other assets
Liabilities
Current liabilities
Long term liabilities
Other liabilities
Equity
Capital Stock
Additional paid-in capital
Retained earnings
Assets
Current Assets
Current assets are assets that may reasonably be expected to be
realized in cash, sold, or consumed during the normal operating
cycle of the business or one year, whichever is longer.
Invesment
Invesment may divided into three categories:
1. Securities acquired for spesific purposes, such as using idle
funds for long periods or exercising influence on the
operations of another company.
2. Assets not currently in use by the business organizations,
such as land held for a future building site.
3. Special funds to be used for special purpose in the future,
such as sinking funds.
Assets
Property, Plant, and Equipment and Intangibles
• Although property, plant, and equipment and
intangibles are physically dissimilar assets, the
valuation procedures associated with them are
similar.
• Except for land, the cost of these assets is allocated to
the variuos accounting periods benefiting from their
use.
• In the case of property, plant, and equipment, the
carring value is disclosed as the difference between
cost and acccumulated depreciation.
• However, intangible assets are generally disclosed at
the net amount of their cost less amortization.
Assets
Other Assets
• The preceding asset category captions will usually
allow the disclosure of all assets, but some
corporations include a final category: other assets.
• Items such as fixed assets held for resale or long-term
receivables may be included under this category.
• The valuation of these assets is generally their
carrying value on the balance sheet at the time they
were originally reported in the other assets category.
• Because the amounts associated with these items are
normally immaterial, it is unlikely that any alternative
valuation procedure would result in a significantly
different carrying value.
Asset Valuation
Consider the following measurement bases that are
included in a typical balance sheet presentation of
assets:
Asset Measurement Basis
Cash Current value
Account receivable Expected future value
Marketable securities Fair value or amortized cost
Inventory Current or past value
Invesments Fair value, amortized cost, or the result
of applying the equity method
Property, plant, and equipment Past value adjusted for depreciation
Liabilities
Current Liabilities
• Current liabilities have been defined as “obligations
whose liquidation is reasonably expected to require the
use of existing resources properly clasdified as current
assets or the creation of the current liabilities”.
• Notice that although the operating cycle is not explicity
discussed in this definition, it is implied because the
definition of current libilities depends on the definition
of current assets
• Examples of current liabilities are short-term payables,
the currently maturing portion of long-term debt,
income taxes payable, returnable deposits, and accrued
liabilities.
Liabilities
Long-term and Other Liabilities
• Long-term liabilities are obligations that will not
require the use of current assets within the current
year or operating cycle.
• This obligations include bonds, notes, mortgages,
and capital lease obligations and are originally
valued at the amount of consideration received by
the entity incurring the obligation.
• The long-term liability section may also include
long-term prepayments on contract, deffered
income taxes, and, insome cases, contingent
liabilities, each of which has an associated
measurement problem.
Liability Valutioan
• As with assets, liabilities are measured by a number of
different procedures.
• Most current liability measurements ignore the time
value of money.
• Their typical balance sheet measurement is equal to the
amount of resources that it will ultimately take to satisfy
the obligation.
• Conversely, the initial measurement of most long-term
liabilities is equivalent to the present value of future
payments discounted at the yield rate existing on the date
of issue.
• Failure to consider the current market interest rates can
cause the financial statements to be biased in favor of
current creditors, particularly when many obligations are
of a long-term nature.
Equity
• State laws and corporate articles of incorporation make
generalizations about the equity section of the balance
sheet somewhat difficult.
• However, certain practices have become widespread
enough to discuss several generally accepted standards
or reporting.
• Equity can be as:
Common Stock
Preffered Stock
Treasury Stock
Retained Earnings and Other Comprehensive
Income
Fair Value Measurements
(under SFAS No.157)
Definition of Fair Value
• Fair value defined as “the price that would be
received to sell as asset or paid to transfer a
liability in an orderly transaction between market
participants at the measurement date.”
• This definition is based on exit price.
Fair Value Measurements
(under SFAS No.157)
Fair Value Hierarchy
Level 1 : Quoted market prices for identical assets or
liabilities in active markets.
Level 2 : Observable market-based inputs.
Level 3 : Unobservable inputs
Fair Value Measurements
(under SFAS No.157)
Disclosure
The disclosure requirements are designed to indicate
the relative realibiliaty of fair value measurement.
Following are the major disclosure required at each
annual and interim balance sheet date:
1. For items that are measured on a nonrecurring
basis at fair value, a separate table is required for
assets and for liabilities.
2. For items measured on a recurring basis at fair
value, tables similar to those for nonrecurring
items are required.
Evaluating a Company’s Financial Position

• Investors and security analysts monitor company

performance by using financial ratios.
• Financial ratios evaluate the relationships between
financial statement elements and are most useful
when compared to previous years’ results,
competitor company results, industry averages, or
benchmarks.
The Statement of Cash Flows
APB Opinion No.19 prescribed the format of the statement as
follows:
1. The statement may be prepared in such a manner as to
express the financial position in terms of cash, cash and
temporary assets, quick assets, or working capital so long as
it utilizes the all-financial-resources concept and gives the
most useful portrayal of the financing and investing
activities of the entity.
2. In each case the statement should disclose the net change in
the cash, cash and temporary invesments, quick assets or
working capital, depending on the form of presentation.
3. The statement should disclose outlays for long-term assets,
net preceeds from the sale of long-term assets, conversion
of long-term debt or preferred stock to common stocks,
issuances and repayments of debts, issuances or
repurchases of capital stock and dividends.
The Statement of Cash Flows
Cash-Flow Information
• The cash inflows and outflows of a business are of
primary importance to investors and creditors.
• The presentation of cash-flow information by a
business enterprise shoul enable investors to:
1) Predict the amount of cash that is likely to be
distributed as dividends or interest in the
future, and
2) Evaluate the potential risk of a given invesment.
Financial Analysis of Cash-Flow Information

• A major objective of accounting is to present data that

allows investors and creditors to predict the amount of cash
that will be distributed in the form of dividends and interest
and to allow an evaluation of risk.
• Net income is the result of changes in assets and liabilites:
some current, and some noncurrent; consequently, net
income connot be equated with a change in cash.
• The statement of cashflows discloses the effects of earnigs
activities on cash resources, how assets were acquired, and
how they were financed.
• The ability of an enterprise to generate cash from
operations is an important indicator of its financial health
and the degree of risk associated with investing in the firm.
International Accounting Standards
The International Accounting Standards Board (IASB) has:
1. Discussed the Statement of Financial Position and the
various measurement bases used in financial
statements and has defined assets, liabilities, and
equity in its “Framework for Preparation and
Presentation of Financial Statements”
2. Discussed the information to be disclosed on the
balance sheet and statement of cash flows in its
revised IAS No. 1, “Presentation of Financial
Statements”.
3. Discussed the presentation of the statement of cash
flows in IAS No.7, “Statement of Cash Flows”
4. Discussed the presentation of fair value measurements
in IFRS No.13, “Fair Value Measurement”
Questions and Answers