Week 13Analysing and Integrating GAAP

PowerPoint presentation by Yeny Lukito

Adapted by Ron Day

©2009 John Wiley & Sons Australia, Ltd

Overview – Week 13Text: Ch. 15. LO 1- 8, pp. 884 - 922

Demo Questions: Q.18, BE15.10, E15.10; E15.11; E15.12; PSA15.3*Self-Study: Q.1, 4, 9, 23; BE 15.9, E15.1; 15.4; 15.13; PSA15.10* PSA15.13* *optional

Learning Objectives:

1. Explain and apply the concepts and principles underlying the recording of accounting information.

2. Describe the conceptual framework for the preparation and presentation of financial statements (The Framework)

3. Explain the nature of the reporting entity

4. Explain the objective of general purpose financial reporting

5. Identify the main users and uses of financial reports

6. Identify and apply the qualitative characteristics and constraints.

7. Define the elements (assets, liabilities, equity, income, expenses), and apply their recognition criteria

8. Integrate principles, concepts, standards and the Framework

3

CONCEPTS AND PRINCIPLEUnderlying Accounting

Recall from Chp.1, the accounting principles that developed over time from Generally accepted accounting practice (GAAP)

- Monetary Principle

- Accounting Entity Concept- Note: Misconception identified in the mid-semester quiz regarding the

treatment of transactions with owners as owners’ equity

- Accounting Period Concept

- Going Concern Principle

- Cost Principle

- Full Disclosure Principle

The Framework–Developments

Historical Developments

› No generally accepted theory of financial accounting prior to late 1970s,

just general principles that had developed from practice over time

some inconsistencies between a/c’ing st’ds and accounting practices

› Some countries (e.g. US, UK, NZ, Australia) began to develop a normative theory of financial accounting & reporting – a Conceptual Framework (CF)

Recent Developments

› Prior to 2005, the conceptual framework in Australia was developed by the AASB and PSASB (from AARF) then by a merged new AASB from 2000

› In 2005, Australia adopted Australian equivalent International Financial Reporting Standards (A-IFRS) issued by the IASB.

› The AASB then issued a conceptual framework (the Framework) equivalent to the framework issued by the IASB

4

The Framework– Future Developments

› The IASB and US FASB are jointly developing an improved Conceptual Framework for development of future a/c’ing standards

› Aim: to develop internally consistent, principle-based standards that result in financial reporting practices that provide users with [useful] information they need to make decisions

› The project has been divided into 8 phases:

- Objectives and qualitative characteristics of financial information

- Definitions of elements (A, L, E, R, Exp), including recognition criteria

- Measurement

- Reporting Entity concept

- Boundaries of financial reporting, presentation, and disclosure

- Purpose and status of the framework

- Application for the framework for not-for-profits

- Remaining issues if any5

OVERVIEW – The Framework

6

The Reporting Entity

(SAC 1)

Objective of General-Purpose Financial

Reporting(SAC 2)

Qualitative Characteristics

Definition of Elementsof Financial Statements

1. The Reporting Entity (SAC 1)

Indicators:

- if the entity is managed by individuals who are not owners

- if the entity is politically or economically important;

- if the entity is considered large in sales, assets, borrowings, customers, and employees;

then the entity is more likely to be a reporting entity

7

an entity in which it is reasonable to expect the existence of users who depend on general-purpose financial reports to enable

them to make economic decisions

1. The Reporting Entity (Sac 1) Cont’d

Proposed improvements to the CF on ‘reporting entity’

• At present, there is no definition of reporting entity in the FASB’s conceptual framework and only a limited definition in IASB’s

• IASB and FASB set out to develop the concept of reporting entity

Preliminary views of the IASB - FASB joint CF Project

- the definition should be broadly defined

- it is Important to link the definition to the objective of financial reporting

- a new descriptor of ‘Circumscribed Area of Business Activity’ proposed (of interest to present/potential investors, lenders, and capital providers)

- no need to be legal entities

- can comprise of more than one company (i.e. parent entity and its subsidiaries)

- consolidated financial statements should be presented from the perspective of the group reporting entity rather than parent company’s shareholders

8

2. The Objective (SAC 2)of General-Purpose Financial Reporting

› Decision-useful objective (as outlined in SAC2 of the Australian CF)

• to provide information to users that is useful for making and evaluating

decisions about allocation of scarce resources

• where ownership is separated from control, GPFR’s could also fulfil a stewardship and accountability function by showing owners that their resources are being managed effectively making them accountable

Preliminary views of the IASB - FASB joint CF Project- It should be based on decision-usefulness objective

- It should provide financial info useful to present/potential equity investors, lenders, and other creditors in making their decisions in their capacity as capital providers

- They also argue that this info may also be useful to non capital provider users

9

Users and Uses of Financial Reports

Current Framework (SAC 2): 3 types of usersInvestors Employees

LendersCreditors

ContributorsTax Payers (public sector)

Resource Resource ProvidersProviders

Recipients of Recipients of Goods and Goods and ServiceService

Parties performingParties performingreview/oversightreview/oversight

Beneficiaries

Customers

Special Interest GroupsMedia

Trade Unions

Governments

Regulatory Agencies

Parliament

Proposed Framework: 2 main user groups

Other UsersOther UsersCapital ProvidersCapital Providers

Equity Investors Lenders Other Creditors*

*when providing capital in credit

Shareholders

Other OwnersPartners

Lenders

Holders of debt instruments

Employees

SuppliersCustomers

Employees

Suppliers

CustomersOther Groups

3. Qualitative Characteristicsof Financial Reports

Summary of qualitative characteristics of financial information

outlined in the Framework: (see para 24-45)

11

• Readily able to be understood by users with reasonable knowledge and dilligence

Understandability(para 25)

• between different companies

• between different years of the same company

• information that influences the economic decisions of users

• provides a basis for predictions, or

• confirms or corrects previous expectations

Relevance(para 26-30)

• free from materialerror and bias

• faithful representation

• presents substanceover form

• neutral (unbiased) • prudent• complete

Reliability(para 31-38)

Comparability(para 39-42)

3. Qualitative Characteristics of Financial Reports - Constraints and limitations

These are subject to the following constraints: (see para 43-45)

- Timeliness- Balance between Benefit and Cost- Balance between Qualitative Characteristics

Some other limitations of financial reports include

› Financial reports are not the only source of decision-making information

- Other sources: economic trends, political climate, industry averages, specific company forecasts

› Much of the information is based on estimates and judgements

- Financial reports can be seen as models (representations) of transactions/events rather than exact depictions

12

3. Qualitative Characteristics (cont.d)The Framework v Proposed Conceptual Framework

The Framework Proposed Conceptual FrameworkQualitative Characteristics Qualitative Characteristics

13

• Relevance(including materiality)

• Reliability(including faithful representation, substance over form, free from material error, neutrality, prudence, completeness)

• Comparability (including consistency)

• Understandability

Constraints• Timeliness• Costs versus benefits• Balance

Fundamental• Relevance• Faithful representation

(including completeness, neutrality, free from material error)

Enhancing• Comparability

(including consistency)• Verifiability• Timeliness• Understandability

Constraints• Materiality• Cost

Demo Question Q.18, p. 935

4. Definition, Recognition and Measurementin Financial Statements

› Financial statements portray the effects of transactions and events in

relations to an entity by grouping them into elements.

› The elements of financial statements include:

- Assets

- Liabilities

- Equity

- Income

- Expenses

› The Framework provides a consistent definition for each element andsets out common criteria for their recognition

14

ASSETS - Definition

There are 3 essential characteristics:1. control over the asset by the entity (usually ownership, but not always

e.g. a finance lease)

2. as a result of a past event (after a transaction or event has taken place)

• Future purchases and /or intangibles not acquired , are not included

3. Future economic benefits are expected to flow to the entity

• in the form of cash or cash equivalents (e.g. Sale for cash, exchange for

another asset or to settlement of a liability, or use to produce goods & services

15

“a resource controlled by the entity as a result of past eventsand from which future economic benefits are expected to flow to the

entity” (para. 49(a))

Do BE15.10 (a), p. 938

ASSETS – Recognition(para 89-90)

Items that meet the definition should be recognised in statement of financial position when:

a) It is probable that the future eco benefits will flow to the entity

• Refers to the degree of uncertainty assessed on evidence available

• If it is improbable that economic benefits will flow to the entity beyond current period, the expenditure is recorded as an expense

AND

b) The asset has a cost or value that can be measured reliably• purchase price or cost

• It can be estimated (e.g. receivables (net realisable value) after allowance for doubtful debts)

• accounting standards may require it to be measured at fair value16

Do E15.10 (a - d), p. 942

LIABILITIES - Definition

There are 3 essential characteristics:

1. The entity must have a present obligation

• A duty to act or perform in the future, e.g. providing goods/services,

2. The obligation must be as a result of a past transaction or event

• e.g. after purchase of assets has taken place

3. A liability must result in an outflow of resources or economic benefits

• Outflow of economic benefits will reduce the entity’s future cash flows, e.g. paying cash, providing goods/services, or issuing another liability.

17

“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” (para. 49(b))

Do E15.11 (a -c), p. 942

LIABILITIES – Recognition(para 89-90)

Items that meet the definition should be recognised in the statement of financial position when

a) It is probable that an outflow of resources embodying will result from the

settlement of a present obligation

• Refers to the degree of uncertainty (more likely than less likely)

• Not dependent on occurrence of events outside the entity’s control

AND

b) The amount of settlement will take place can be measured reliably

Liabilities that do not satisfy recognition criteria are not recognised in the financial statements, but disclosed in the Notes as contingent liabilities

18

You try:

Explain for each item whether you would recognise them as a liability in the Statement of Financial Position for Bigger Home Builders Ltd:

Hint: Refer to the Framework definition an criteria to support your answer.

d) One of the Bigger Home Builders Ltd’s customers is suing the company as he is not happy with the colour scheme that Bigger Home Builders Ltd used to paint his house. The customer chose the colour scheme at the time of signing the contract and has now changed his mind. The law suit is for $15 000. Bigger Home Builders Ltd believe they might lose the case.No liability recorded as the amount of damages cannot be measured reliably.However, given that the company has been ordered by the court to pay damages even though the amount is uncertain, it must be disclosed in the notes of the financial statement as a contingent liability. Contingent liabilities are liabilities for which the amount of the future sacrifice is so uncertain that it cannot be measured reliably, that do not satisfy the probability criterion, or are dependent upon the occurrence of an uncertain future event outside the control of the entity. In this case there is an obligation but the amount is uncertain.

e) When constructing a home near a river, one of Bigger Home Builders Ltd’semployees dumped excess paint, cement and other waste products into that river.The company has been ordered by the court to pay damages; however, the exactamount is yet to be determined.

EQUITY - Definition

› It cannot be independently defined (residual)- From basic accounting equation: Equity = Assets – Liabilities

› Transactions/events that affect equity:

- Gains/losses

- Owner’s activities (capital investments, drawings, dividends)

- Asset revaluations

20

“the residual interest in the assets of the entity after deducting all its liabilities” (para 49(c))

You try

Equity is defined in the Framework as the residual interest in the equity of the entity after deducting all its liabilities.

Do BE15.10 (c), p. 938

Identify the errors in this definition and correct them.

Equity is defined in the Framework as the residual interest in the ‘assets’ (not ‘equity’) of the entity after deducting all its liabilities.

INCOME - Definition

The definition is linked to the definition of assets and liabilities

› Income includes:

1. Revenue - Increases in economic benefits arising in the course of ordinary activities (e.g. sales revenue, rent, dividends)

2. Gains - Other increases in economic benefits that do not arise from ordinary course of business e.g. gains from the sale of non-current assets

22

“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 of equity, other than those relating tocontributions from equity participants” (para 70 (a))

Do E15.11 (d & e), p. 942

INCOME - Recognition(para 92)

Items that meet the definition should be recognised in the

Income Statement when

- It is probable that ‘an increase in future economic

benefits, related to an increase in an asset or a decrease of

a liability, has arisen

AND- that it can be measured reliably’

› This means that income recognition occurs simultaneously with the recognition of increases in assets or decreases in liabilities

› Common practice: recognise revenue when it is earned

23

You try:

a) Received $24 000 in subscriptions from magazines to be delivered once per month for the next 12 months.

Do E15.12 (a, b, d), p. 942

Explain whether you would recognise the transaction as revenue in the Income Statement. Refer to definitions and criteria from the Framework.

Revenue is not recognised as the magazines have yet to be delivered, hence the transaction doesn’t meet the revenue recognition criteria as “the entity has NOT transferred to the buyer the significant risks and rewards of ownership of the goods”.

Currently Surfin’ Magazines has an obligation to either refund the money or to deliver the magazines, hence the $24,000 is recorded as a liability (Revenue Received in Advance) and not a revenue. Revenue will be recognised once the magazines have been delivered to subscribers.

b) Received dividends from IAG for shares owned by the business.

Dividend received is recognised as income because it is an increase in economic benefit during the accounting period in the form of inflow or enhancement of assets (i.e. cash) that results in increase in equity, other than those relating to contribution from equity participants. Since the dividend has already been received, the economic benefits associated with the transaction have flown to Surfin’Magazines and the amount of dividends can be measured reliably.

c) Paid interest on a loan to purchase a delivery vehicle.

Payment of interest on a loan is not recognised as revenue. Rather, it is recognised as an expense as it involves a decrease of future economic benefits in the form of outflows of assets (cash).

Income - Recognition (cont.)

› Revenue recognition - sale of goods (AASB 118 Revenue para.14):

a) The entity has transferred to the buyer the significant risks and rewards of ownership of the goods;

b) The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;

c) The amount of revenue can be measured reliably;

d) It is probable that the economic benefits of the revenue will flow to the entity; and

e) The associated costs can be measured reliably

› Revenue recognition - services (AASB 118 Revenue para. 20):

a) The amount of revenue can be measured reliably;

b) It is probable that the economic benefits associated with the transaction will flow to the entity;

c) The stage of completion of the transaction at the reporting date can be measured reliably; and

d) The costs incurred for the transaction and the costs to complete the transaction can be measured reliably 25

EXPENSES - Definition

Like the definition of income, definition of expenses is also linked to the

definition of assets and liabilities.

› Expenses include:

1. Expenses - Decreases in economic benefits that arise in the ordinary activities of the entity (e.g. cost of sales, salaries)

2. Losses - Expenses that do not necessarily arise in the ordinary course of business (e.g. loss from natural disasters)

26

“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 todistributions to equity participants” (para 78-80)

Do BE15.10 (b), p. 938

EXPENSES – Recognition(para 94-98)

Items that meet the definition should be recognised in the Income Statement when

- It is probable that “a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen”

AND

- that can be measured reliably

27

Matching principle:

when resulting directly or jointly from the same transaction as revenues, expenses

should be recognised on the basis of a direct association with revenues Do E15.13, (a, d, e), p. 943

Revenue Recognition, Expense Recognition, and

Accounting Period Concept

28

Economic life of business can be divided into artificial time periods

Revenue recognised in the period in which the increase in assets or

decrease in liabilities become probable and can be measured reliably

Expenses recognised in the period when the reduction in assets or

increase in liabilities become probable and can be measured reliably

Form part of generally accepted accounting principles

(GAAP)

Accounting period concept

Revenue recognition criteria Expense recognition criteria

Revenue & expense criteria

Measurement Bases to measure the elements of Financial Statements

Measurement: ‘the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the statement of financial position and income statement’

The Framework outlines 4 measurement bases:

1. Historical cost

• Assets are recorded at the amount paid or consideration given at the time of acquisition

• Liabilities are recorded at the amounts of expected to be paid to satisfy the liability in the normal course of business

2. Current Cost

• Assets are carried at the amount that they would have to be paid if the same asset was acquired currently

• Liabilities are carried at the undiscounted amount that would berequired to settle the obligation currently 29

Measurement Bases to measure the elements of in Financial Statements (cont.)

3. Realisable (settlement) value

• Assets are carried at the amount that could currently be obtained by

selling the asset in an orderly disposal

• Liabilities are carried at settlement value

4. Present value

• Assets are carried at the present value of future net cash inflows that

is expected to be generated in the normal course of business

• Liabilities are carried at present value of the future net cash outflows

required to settle liabilities in the normal course of business

30

Integrating GAAP

› Generally accepted accounting principles (GAAP)

consist of accounting standards, underlying concepts and principles, and

the Framework that are inter-related and do not operate in isolation

› They provide a set of rules, concepts, principles and practices that provide

guidance for financial reporting purposes

› GAAP, therefore consists of (in order of applying):

− Accounting standards which have legislative backing by the Corporations Law

− The Framework provides guidance to standard setters in setting new

standards, and preparers, where there is no standards

−Concepts and principles developed over time provide guidance when it is not

provided by standards or the framework31

ANNOUNCEMENTS

› Complete Unit 13 Self Study Questions and check solutions

› Group Assignment: Check blackboard announcement and your Myuni account (for marks)› Exam format, Exam Rules and Procedures on Blackboard Assessment Final

Exam

› Sample Final Exam Questions on Blackboard (Assessment Final Exam). Solutions will be released during week 13.

› Consultations during study vacation and before exam – check Blackboard

› Exam Preparation:- Lecture notes and demonstration questions- Self study Questions – Review and perhaps redo if not done well- Consult text and/or review/ask questions on blackboard (use correct forum!), where needed- Do Sample Exam Questions before you look at solutions- Practice, practice, practice!!

› All questions to Discussion Forum or during consultation. No emails, please.

THANK YOU and GOOD LUCK IN YOUR EXAMS32