Week 13 Analysing and Integrating GAAP

Overview Week 13
Text: 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)
PowerPoint presentation by Yeny Lukito Adapted by Ron Day 2009 John Wiley & Sons Australia, Ltd

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

CONCEPTS AND PRINCIPLE Underlying 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

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/cing stds 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

- Accounting Period Concept - Going Concern Principle - Cost Principle - Full Disclosure Principle
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The Framework Future Developments

The IASB and US FASB are jointly developing an improved Conceptual Framework for development of future a/cing 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 any
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OVERVIEW The Framework

The Reporting Entity (SAC 1)

Objective of GeneralPurpose Financial Reporting (SAC 2)

Qualitative Characteristics

Definition of Elements of Financial Statements

1. The Reporting Entity (SAC 1) 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
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

1. The Reporting Entity (Sac 1) Contd Proposed improvements to the CF on reporting entity
At present, there is no definition of reporting entity in the FASBs conceptual framework and only a limited definition in IASBs 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 companys shareholders
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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, GPFRs could also fulfil a stewardship and accountability function by showing owners that their resources are being managed effectively making them accountable
Investors

Users and Uses of Financial Reports

Current Framework (SAC 2): 3 types of users

Employees Creditors Customers

Resource Providers Contributors

Lenders

Tax Payers (public sector)

Recipients of Goods and Service

Beneficiaries

Parties performing review/oversight

Governments Media Special Interest Groups

Parliament Regulatory Trade Unions Agencies

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
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Proposed Framework: 2 main user groups Capital Providers

Shareholders Lenders Employees Suppliers

Other Users

Employees Equity Investors Lenders Other Creditors* Customers Partners Other Holders Ownersof debt Customers Other Groups Suppliers instruments *when providing capital in credit

3. Qualitative Characteristics of Financial Reports

Summary of qualitative characteristics of financial information outlined in the Framework: (see para 24-45)
Understandability
(para 25) Readily able to be understood by users with reasonable knowledge and dilligence

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

Relevance
(para 26-30) information that influences the economic decisions of users provides a basis for predictions, or confirms or corrects previous expectations

Reliability
(para 31-38) free from material error and bias faithful representation presents substance over form neutral (unbiased) prudent complete

Comparability
(para 39-42) between different companies between different years of the same company

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

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

The Framework Qualitative Characteristics
Relevance (including materiality) Reliability (including faithful representation, substance over form, free from material error, neutrality, prudence, completeness) Comparability (including consistency) Understandability

4. Definition, Recognition and Measurement in 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 and sets out common criteria for their recognition

Proposed Conceptual Framework Qualitative Characteristics Fundamental

Relevance Faithful representation (including completeness, neutrality, free from material error)

Enhancing
Comparability (including consistency) Verifiability Timeliness Understandability

Constraints
Timeliness Costs versus benefits Balance Demo Question Q.18, p. 935

Constraints
Materiality Cost
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ASSETS - Definition 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 (para. 49(a))
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

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

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
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Do BE15.10 (a), p. 938

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

LIABILITIES - Definition 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))
There are 3 essential characteristics:
1. 2. 3. The entity must have a present obligation A duty to act or perform in the future, e.g. providing goods/services, The obligation must be as a result of a past transaction or event e.g. after purchase of assets has taken place A liability must result in an outflow of resources or economic benefits Outflow of economic benefits will reduce the entitys future cash flows, e.g. paying cash, providing goods/services, or issuing another liability.

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 entitys 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

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

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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 Builders Ltds customers suing Builders the company e) When constructing a Home home near a river, one of BiggerisHome Ltds as he is not happy with the colour scheme that cement Bigger Home Builders Ltd used tointo paint hisriver. house. employees dumped excess paint, and other waste products that The the ordered colour scheme at theto time signing the contract and has now The customer company chose has been by the court payof damages; however, the exact changed his mind. law suit is for $15 000. Bigger Home Builders Ltd believe they amount is yet to beThe determined. might lose the case. No liability recorded as the amount of damages cannot be

EQUITY - Definition the residual interest in the assets of the entity after deducting all its liabilities (para 49(c)) It cannot be independently defined (residual)
- From basic accounting equation: Equity = Assets Liabilities

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.

Transactions/events that affect equity:

- Gains/losses - Owners activities (capital investments, drawings, dividends) - Asset revaluations

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You try Equity is defined in the Framework as the residual interest in the equity of the entity after deducting all its liabilities.
Identify the errors in this definition and correct them.

INCOME - Definition 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 to contributions from equity participants (para 70 (a)) The definition is linked to the definition of assets and liabilities
Income includes:
1. Revenue - Increases in economic benefits arising in the course of

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

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
Do BE15.10 (c), p. 938 Do E15.11 (d & e), p. 942
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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
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You try: a) Received $24 000 in subscriptions from magazines to be delivered once per month for the next 12 months. b)c) Received dividends from to IAG for shares owned vehicle. by the business. Paid interest on a loan purchase a delivery
Explain whether you would recognise the transaction as revenue in the Income Statement. Refer to definitions and criteria from the Framework.

Payment of interest a as loan notincome recognised asto revenue. Dividend received is on recognised as because it is an Revenue is not recognised theis magazines have yet be Rather, it iseconomic recognised as an expense as it involves a increase in benefit during the accounting period in delivered, hence the transaction doesnt meet the revenue decrease future economic in the form of the outflows the form ofof inflow or enhancement of assets (i.e. cash) that recognition criteria as the entity benefits has NOT transferred to buyer of assets (cash). results in increase in equity, other than those relating to the significant risks and rewards of ownership of the goods. contribution from equity participants. Currently Surfin Magazines has an obligation to either refund the money or to Since the dividend has already been received, the economic deliver the magazines, hence the $24,000 is recorded as a liability (Revenue benefitsinassociated the transaction have flown to Surfin Received Advance) and with not a revenue. Revenue will be recognised once the magazines have been delivered to subscribers. Magazines and the amount of dividends can be measured reliably. Do E15.12 (a, b, d), p. 942

Income - Recognition (cont.)

Revenue recognition - sale of goods (AASB 118 Revenue para.14):
a) b) c) d) e) a) b) c) d) The entity has transferred to the buyer the significant risks and rewards of ownership of the goods; The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; The amount of revenue can be measured reliably; It is probable that the economic benefits of the revenue will flow to the entity; and The associated costs can be measured reliably The amount of revenue can be measured reliably; It is probable that the economic benefits associated with the transaction will flow to the entity; The stage of completion of the transaction at the reporting date can be measured reliably; and The costs incurred for the transaction and the costs to complete the transaction can be measured reliably 25

EXPENSES - Definition 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 to equity participants (para 78-80)
Like the definition of income, definition of expenses is also linked to the definition of assets and liabilities.

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

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)

Do BE15.10 (b), p. 938
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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
Matching principle: when resulting directly or jointly from the same transaction as revenues, expenses 27 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

Accounting period concept Economic life of business can be divided into artificial time periods

Revenue recognition criteria

Revenue recognised in the period in which the increase in assets or decrease in liabilities become probable and can be measured reliably

Expense recognition criteria

Expenses recognised in the period when the reduction in assets or increase in liabilities become probable and can be measured reliably

Revenue & expense criteria Form part of generally accepted accounting principles (GAAP)
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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 be required to settle the obligation currently
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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

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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 framework

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 EXAMS
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