Basic

Accounting
Concept 1
Textbook & Other references:

• Kieso, D., Weygandt, J., and Warfield, T. Intermediate

Accounting (IFRS Edition) (3rd or 4th Edition) Wiley

• Pincus, M., S. Rajgopal, and M. Venkatachalam. 2007. The accrual anomaly:

International evidence. The Accounting Review 82 (1):169-203.

• Bernard, V. L., and J. K. Thomas. 1989. Post-earnings-announcement drift - Delayed

price response or risk premium. Journal of Accounting Research 27:1-36.

• Ball, R., and P. Brown. 1968. Empirical Evaluation of Accounting Income Numbers.
Journal of Accounting Research 6 (2):159-178.

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Importance of this course
• Business Language
• Most prevalent structured big data for business
analysis
• Accurate
• Relevant
• Useful
• Standardized
• Legitimate
• Fewer biases and less uncertainty
• …

3
Importance of this course-Accounting Income

From Ball, R., and P. Brown. 1968 (JAR)

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Importance of this course-Better understand accounting
income

From Bernard, V. L., and J. K. Thomas. 1989.

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 Financial Reporting
and Accounting Standards

6
Financial Reporting
Economic Financial Additional
Entity Statements Information
Financial • Statement of • President’s letter
Information Financial Position
• Prospectuses
Accounting? • Income Statement
• Reports filed with
or Statement of
Identify Comprehensive
governmental
agencies
and Income
• News releases
Measure • Statement of Cash
Flows • Forecasts
and
• Statement of • Environmental
Communicate
Changes in Equity impact statements
• Note Disclosures • Etc.

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Objective of Financial Reporting

Objective: Provide financial information about the reporting

entity that is useful to
► present and potential equity investors,

► lenders, and

► other creditors

in making decisions about providing resources to the entity.

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Objective of Financial Reporting

General-Purpose Financial Statements

► Provide financial reporting information to a wide
variety of users.
► Provide the most useful information possible at the
least cost.

Equity Investors and Creditors

► Investors and creditors are the primary user group.

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Objective of Financial Reporting

Entity Perspective
► Companies viewed as separate and distinct from
their owners (shareholders).

Decision-Usefulness
► Investors are interested in assessing
1. the company’s ability to generate net cash
inflows and
2. management’s ability to protect and enhance
the capital providers’ investments.
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Standard-Setting Organizations

Main international standard-setting organization:

• International Accounting Standards Board (IASB)
• Issues International Financial Reporting Standards
(IFRS).
• Standards used on most foreign exchanges.
• IFRS used in over 149 countries.
• Two organizations that have a role in international standard-
setting are the International Organization of Securities
Commissions (IOSCO) and the IASB.
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 International Accounting Standards
Board

ILLUSTRATION 1.4
International Standard-Setting
Structure

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International Accounting Standards
Board
Types of Pronouncements
► International Financial Reporting Standards.

► Conceptual Framework for Financial Reporting.

► International Financial Reporting Standards

Interpretations.

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Conceptual Framework
Overview of the Conceptual Framework
Three levels:
u First Level = Objectives of Financial Reporting

u Second Level = Qualitative Characteristics and

Elements of Financial Statements

u Third Level = Recognition, Measurement, and

Disclosure Concepts.

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 ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic 1. Measurement 1. Cost
entity
2. Revenue
2. Going concern recognition Third level
The "how"—
3. Monetary unit 3. Expense
implementatio
recognition
4. Periodicity n
4. Full disclosure
5. Accrual
QUALITATIVE
CHARACTERISTIC ELEMENTS
S
1. Assets Second level
1. Fundamental 2. Liabilities
qualities Bridge between
3. Equity
levels 1 and 3
2. Enhancing 4. Income
qualities 5. Expenses

OBJECTIVE
Provide information
about the reporting
entity that is useful First level
ILLUSTRATION 2.7 to present and
Conceptual Framework The "why"—purpose
potential
for Financial Reporting of accounting
equity investors,
lenders, and other
creditors in their
capacity as capital 15
providers.
 Basic Objective

“To provide financial information about the reporting entity that

is useful to present and potential equity investors, lenders, and
other creditors in making decisions about providing resources to
the entity.
u Provided by issuing general-purpose financial statements.

u Assumption is that users need reasonable knowledge of business

and financial accounting matters to understand the information.

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Qualitative Characteristics

ILLUSTRATION 2.2
Hierarchy of
Accounting Qualities

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 Relevance

ILLUSTRATION 2.7
Conceptual Framework
for Financial Reporting

18LO 2
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Qualitative Characteristics

Fundamental Quality—Relevance

To be relevant, accounting information must be capable of

making a difference in a decision.

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32
 Faithful Representation

ILLUSTRATION 2.7
Conceptual Framework
for Financial Reporting

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21LO 2
Qualitative Characteristics
Fundamental Quality—Faithful Representation

Faithful representation means that the numbers and descriptions match

what really existed or happened.

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Qualitative Characteristics

Enhancing Qualities

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Exercise 2-1 (Identify which qualitative characteristic of accounting
information is best described in each of the following items)

a. The annual reports of Amazon.com are audited by external auditors

(certified public accountants)
Verifiability
b. Starbucks has used the same method to estimate depreciation expense
(straight-line depreciation) since it began operations
Consistency
(Comparability)
c. Heineken Holdings (NLD) issues its quarterly reports immediately after
each quarter ends
Timeliness
d. Nokia and Motorola both use the same inventory cost flow assumption
for their inventory accounting.
Comparability

uReply Testing: https://polyu.ureply.mobi

https://ed2.polyu.edu.hk/ 24
 Basic Elements

ILLUSTRATION 2.7
Conceptual Framework
for Financial Reporting

25LO 2
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 Basic Elements
Elements of Financial Statements

A resource controlled by the entity

as a result of past events and from
which future economic benefits are
expected to flow to the entity.

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 Basic Elements
Elements of Financial Statements

A present obligation of the entity

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

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 Basic Elements
Elements of Financial Statements

The residual interest in the assets of

the entity after deducting all its
liabilities.

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 Basic Elements
Elements of Financial Statements

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
48 from equity participants.
 Basic Elements
Elements of Financial Statements

Decreases in economic benefits

during the accounting period in the
form of outflows or depletions of
assets or incurrences of liabilities that
result in decreases in equity, other
than those relating to distributions
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to equity participants.
 Exercise 2-2 (For each item below, indicate to which category
of elements of financial statements it belongs)

a. Land Assets

b. Inventory Assets
Expenses
c. R&D expenses
Assets
d. Prepaid insurance ((to an insurance company)
Income
e. Sales
Liabilities
f. Bank loan payable
Equity
g. Dividends
Assets
h. Brand
Assets
i. Patents

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 Recognition, Measurement, and
Disclosure Concepts

These concepts explain how companies should

recognize, measure, and report financial elements and
events.
Recognition, Measurement, and Disclosure
Concepts
ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic 1. Measurement 1. Cost
entity
2. Revenue
2. Going concern recognition
3. Monetary unit 3. Expense
recognition
4. Periodicity
4. Full disclosure
5. Accrual
ILLUSTRATION 2.7
Conceptual Framework for Financial Reporting
51
 Assumptions

Economic Entity – company keeps its activity

separate from its owners and other business unit.

Going Concern - company to last long enough to

fulfill objectives and commitments.

Monetary Unit - money is the common denominator.

Periodicity - company can divide its economic
activities into time periods.

Accrual Basis of Accounting – transactions are

recorded in the periods in which the events occur.

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 Assumptions

Exercise 2.3: Identify which basic assumption of

accounting is best described in each item below.
(a) The economic activities of FedEx
Corporation (USA) are divided into 12-
month periods for the purpose of issuing
annual reports.
(b) Total S.A. (FRA) does not adjust amounts
in its financial statements for the effects
of inflation.
(c) Barclays (GBR) reports current and non-
current classifications in its statement of
financial position.
(d) The economic activities of Tokai Rubber
Industries (JPN) and its subsidiaries are
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merged for accounting and reporting
 Basic Principles of Accounting

Measurement Principles
u Historical Cost is generally thought to be a faithful
representation of the amount paid for a given item.

u Fair value is defined as “the price that would be

received to sell an asset or paid to transfer a liability
in an orderly transaction between market
participants at the measurement date.”

IASB has given companies the option to use fair value as

the basis for measurement of financial assets and
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financial liabilities.
 Basic Principles of Accounting

Measurement Principles
IASB established a fair value hierarchy that provides
insight into the priority of valuation techniques to use to
determine fair value.

ILLUSTRATION 2.4

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 Basic Principles of Accounting

Revenue Recognition Principle

When a company agrees to perform a service or sell a
product to a customer, it has a performance obligation.

Requires that companies recognize revenue in the

accounting period in which the performance obligation is
satisfied.

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Basic Principles
of Accounting

Illustration: Assume
the Airbus (DEU)
signs a contract to
sell airplanes to
British Airways (GRB)
for €100 million. To
determine when to
recognize revenue,
Airbus uses the five
steps for revenue
recognition shown at
right.

ILLUSTRATION
57 2.5
The Five Steps of
Revenue
 Basic Principles of Accounting

Expense Recognition - Outflows or “using up” of

assets or incurring of liabilities during a period as a
result of delivering or producing goods and/or
rendering services.

ILLUSTRATION 2.6
Expense Recognition Procedures for Product and Period Costs

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 Basic Principles of Accounting

Full Disclosure Principle

Providing information that is of sufficient importance
to influence the judgment and decisions of an
informed user.

Provided through:
u Financial Statements

u Notes to the Financial Statements

u Supplementary information

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 Basic Principles of Accounting

Exercise 2-4: Identify which basic principle of

accounting is best described in each item below.
(a) Parmalat (ITA) reports revenue in its
income statement when it delivered goods
instead of when the cash is collected.
(b) Google (USA) recognizes depreciation
expense for a machine over the 2-year
period during which that machine helps the
company earn revenue.
(c) KC Corp. (USA) reports information about
pending lawsuits in the notes to its financial
statements.
(d) Fuji Film (JPN) reports land on its
statement of financial position at the
60
amount paid to acquire it, even though the
 Cost Constraint

Companies must weigh the costs of providing the

information against the benefits that can be derived
from using it.

u Rule-making bodies and governmental agencies

use cost-benefit analysis before making final their
informational requirements.

u In order to justify requiring a particular

measurement or disclosure, the benefits perceived
to be derived from it must exceed the costs
perceived to be associated with it.

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 Cost Constraint

Exercise 2-5: Determine whether you would classify

these transactions as material.
(a) Blair Co. has reported a positive trend in
earnings over the last 3 years. In the
current year, it reduces its bad debt
expense to ensure another positive
earnings year. The impact of this
adjustment is equal to 3% of net income.
b.
(b) Hindi SE has a gain of €3.1 million on
the sale of plant assets and a €3.3 million
loss on the sale of investments. It decides
62 to net the gain and loss because the net
effect is considered immaterial. Hindi SE’s
 Cost Constraint

2-5: Determine whether you would classify these

transactions as material.
(c) Damon SpA expenses all capital
equipment under €2,500 on the basis
that it is immaterial. The company has
followed this practice for a number of
years.

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Summary of
the
Structure
ILLUSTRATION 2.7
Conceptual Framework
for Financial Reporting

64 45LO 2