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Financial Reporting

and Analysis

CHAPTER

2-1

2-2

Financial Reporting
And Analysis

Accounting
Rules &
Guidelines

Parties involved
In
Financial Reporting

Nature & Purpose


of
Accounting

Accruals
Cornerstones of
Accounting

Fair
value
Accounting
Accounting
Analysis

2-3

Financial Reporting
And Analysis

Accounting
Rules &
Guidelines

2-4

GAAP
Types
Typesof
ofAccounting
Accountingrules
rulesand
andguidelines
guidelines

USA
USA
o Statements of Financial Accounting Standards
o Statements of Financial Accounting Standards
o APB Opinions.
o APB Opinions.
o Accounting Research Bulletins (ARB).
o Accounting Research Bulletins (ARB).
o AICPA pronouncements.
o AICPA pronouncements.
o EITF Bulletins.
o EITF Bulletins.
o Industry practices.
o Industry practices.
Malaysia
Malaysia
o Company Act 1967
o Company Act 1967
o MASBs ?
o MASBs ?
o IAS
o IAS
o FRS
o FRS

2-5

Financial Reporting
And Analysis

Accounting
Rules &
Guidelines

Parties involved
In
Financial Reporting

2-6

Environmental Factors

2-7

Environmental Factors
Parties Involved (Malaysia)
oo MIA (Malaysia Institute of Accountant)
MIA (Malaysia Institute of Accountant)
oo SC (Securities Commission)
SC (Securities Commission)
oo Professional Bodies (ACCA, CPA, ICAEW..)
Professional Bodies (ACCA, CPA, ICAEW..)
oo Government / Politician
Government / Politician
oo Investors
Investors
oo Association ?
Association ?

2-8

Environmental Factors
Managers of Companies
oo Primary responsibility for fair & accurate
Primary responsibility for fair & accurate

reports
reports
oo Accounting reporting to reflect business
Accounting reporting to reflect business
activities
activities
oo Managerial discretion is necessary in
Managerial discretion is necessary in
accounting
accounting

2-9

Auditing
1Investors
2Shareholders/owners
3

Appoint

Appoint

Shares

Auditors

Sell

Check

Financial
Statements

Directors

$$
Management

Prepare

2-10

Environmental Factors : Auditing


o SEC (USA)/ MROC, KLSE, SC requires Audit Report
o SEC (USA)/ MROC, KLSE, SC requires Audit Report
o Audit opinion can be:
o Audit opinion can be:

1)
1)clean
clean(fairly
(fairlypresented):
presented):

Standard
StandardUnqualified
UnqualifiedReport
ReportStandard
Standardwordings
wordings

2)
2)qualified
qualified(Overall
(Overallconsidered
consideredfairly
fairlypresented,
presented,except
except
for
forcertain
certainmatter)
matter)
Qualified
QualifiedReport
ReportExcept
Exceptfor
for

3)
3)disclaimer
disclaimer(no
(noopinion)
opinion)

Disclaimer
Disclaimerreport
reportno
noopinion
opinion

4)
4)adverse
adverse(no
(notruth
truthand
andfair)
fair)
Adverse
Adversereport
reportno
notruth
truthand
andfair
fair
o Check Auditor quality & independence
o Check Auditor quality & independence

2-11

Environmental Factors
Corporate Governance
oo Board of directors oversight
Board of directors oversight
oo Audit committee of the board
Audit committee of the board
oo oversee accounting process
oversee accounting process
oo oversee internal control
oversee internal control
oo oversee internal/external audit
oversee internal/external audit

oo Internal Auditor
Internal Auditor

2-12

BOD (Insider/outsider)

Inside/outside mix:
Insider/Executive Directors: Sit at the board & manage the company
Outsider/NEDS: Sit at the board only

BOD

Chairman
EDs

Management

Monitor

NEDs

Via
Audit committee, Risk committee, etc

2-13

Environmental Factors
Internal Users

External Users

2-14

Financial Reporting
And Analysis

Accounting
Rules &
Guidelines

Parties involved
In
Financial Reporting

Nature & Purpose


of
Accounting

2-15

Desirable Qualities of Accounting


Information

2-16

Financial Accounting
Relevance
Relevanceof
ofAccounting
AccountingInformation
Information
Relation
Relationbetween
betweenAccounting
AccountingNumbers
Numbersand
andStock
StockPrices
Prices

2-17

Financial Accounting
Important Accounting Principles
o Historical Cost - fair & objective values from arms-length
o Historical Cost - fair & objective values from arms-length

bargaining
bargaining
o Accrual Accounting - recognize revenues when earned,
o Accrual Accounting - recognize revenues when earned,
expenses
expenseswhen
whenincurred
incurred

o Materiality - threshold when information impacts decision


o Materiality - threshold when information impacts decision

making
making
o Conservatism - reporting or disclosing the least optimistic
o Conservatism - reporting or disclosing the least optimistic
information
informationabout
aboutuncertain
uncertainevents
eventsand
andtransactions
transactions

2-18

Financial Accounting
Limitations of Accounting Information
ooTimeliness - periodic disclosure, not real-time
Timeliness - periodic disclosure, not real-time

basis
basis

ooFrequency - quarterly and annually


Frequency - quarterly and annually
ooForward Looking - limited prospective
Forward Looking - limited prospective

information
information

2-19

Financial Reporting
And Analysis

Accounting
Rules &
Guidelines

Parties involved
In
Financial Reporting

Nature & Purpose


of
Accounting

Accruals
Cornerstones of
Accounting

2-20

Accruals-The Cornerstone
Illustration - Case Facts
ooEstablish company and invest $700 equity
Establish company and invest $700 equity
ooPurchase plain 100T-shirts for $5 each
Purchase plain 100T-shirts for $5 each
ooFixed screen cost of $100
Fixed screen cost of $100
ooVariable print cost of $0.75 per T-shirt
Variable print cost of $0.75 per T-shirt
ooSold 25 T-shirts at $10 each for cash
Sold 25 T-shirts at $10 each for cash
ooSold 25 T-shirts at $10 each on credit
Sold 25 T-shirts at $10 each on credit

2-21

Accruals- The Cornerstone


Case Illustration Cash Accounting
Statement of Cash Flows
Receipts
T-Shirt sales

Assets
$250

Payments
T-Shirt purchases $500
Screen purchase
100
Printing charges
75
Total payments
Net cash outflow

Cash

Balance Sheet (Cash basis)

$275

Equity
Beginning Equity
$700
Less net cash outflow (425)
$(675)
Total equity
$275
$(425)

2-22

Accruals-The Cornerstone
Case Illustration Accrual Accounting
Income Statement
Revenues
T-Shirt sales

Balance Sheet (Accrual basis)


$500.00

337.50
Expenses
T-Shirts costs
$250.00
Screen depreciation 50.00
Printing charges
37.50
Total expenses

(337.50)

Net income

$162.50

Assets
Cash
$275.00
T-Shirt inventory$337.50
Receivables
Total assets

250.00
$862.50

Equity
Beginning equity
Add net income
Total equity

$700.00
162.50
$862.50

2-23

Accruals-The Cornerstone

2-24

Accruals-The Cornerstone
Foundations of Accrual Accounting
Revenue
RevenueRecognition
Recognitionrecognize
recognizerevenues
revenueswhen
when
(1)
(1) Earned
Earned
(2)
(2) Realized
Realizedor
orRealizable
Realizable
Expense
ExpenseMatching
Matchingmatch
matchwith
withcorresponding
correspondingrevenues
revenues
- -Product
Productcosts
costs
- -Period
Periodcosts
costs

2-25

Accruals-The Cornerstone
Accruals and Cash Flows - Myths
ooMyth: Since company value depends on future cash
Myth: Since company value depends on future cash

flows,
flows,only
onlycurrent
currentcash
cashflows
flowsare
arerelevant
relevantfor
for
valuation.
valuation.
ooMyth: All cash flows are value relevant.
Myth: All cash flows are value relevant.
ooMyth: Cash flows cannot be manipulated.
Myth: Cash flows cannot be manipulated.
ooMyth: All income is manipulated.
Myth: All income is manipulated.

2-26

Accruals-The Cornerstone
Accruals and Cash Flows - Truths
ooTruth: Accrual accounting (income) is more
Truth: Accrual accounting (income) is more

relevant
relevantthan
thancash
cashflow.
flow.
ooTruth: Cash flows are more reliable than
Truth: Cash flows are more reliable than
accruals.
accruals.
ooTruth: Accrual accounting numbers are subject
Truth: Accrual accounting numbers are subject
to
toaccounting
accountingdistortions.
distortions.

2-27

Financial Reporting
And Analysis

Accounting
Rules &
Guidelines

Parties involved
In
Financial Reporting

Nature & Purpose


of
Accounting

Accruals
Cornerstones of
Accounting

Fair
value
Accounting

2-28

Fair value accounting


Asset
Assetand
andliability
liabilityvalues
valuesare
aredetermined
determinedon
onthe
the
basis
basisof
oftheir
theirfair
fairvalues
values(typically
(typicallymarket
marketprices)
prices)
on
onthe
themeasurement
measurementdate
date(i.e.,
(i.e.,approximately
approximately
the
thedate
dateof
ofthe
thefinancial
financialstatements).
statements).

2-29

Historical cost Vs Fair value

2-30

Advantages & Disadvantages


Advantages
Advantages
o
o
o
o
o
o
o
o
o
o

Reflects
Reflectscurrent
currentinformation.
information.
Consistent
Consistentmeasurement
measurementcriteria.
criteria.
Comparability
Comparability
No
Noconservative
conservativebias
bias
More
Moreuseful
usefulfor
forequity
equityanalysis
analysis

Disadvantages
Disadvantages
o
o
o
o
o
o
o
o

Lower
Lowerobjectivity
objectivity
Susceptibility
Susceptibilitytotomanipulation.
manipulation.
Lack
Lackofofconservatism.
conservatism.
Excessive
Excessiveincome
incomevolatility.
volatility.

2-31

Financial Reporting
And Analysis

Accounting
Rules &
Guidelines

Parties involved
In
Financial Reporting

Nature & Purpose


of
Accounting

Accruals
Cornerstones of
Accounting

Fair
value
Accounting
Accounting
Analysis

2-32

Accounting Analysis
Demand for Accounting Analysis
oo Adjust for accounting distortions/misstatement
Adjust for accounting distortions/misstatement

so
sofinancial
financialreports
reportsbetter
betterreflect
reflecteconomic
economic
reality
reality

oo Adjust general-purpose financial statements to


Adjust general-purpose financial statements to

meet
meetspecific
specificanalysis
analysisobjectives
objectivesof
ofaaparticular
particular
user
user

2-33

Accounting Analysis
Sources of Accounting Distortions/misstatement
Accounting
AccountingStandards
Standardsattributed
attributedtoto
1)
accounting
1)
accountingprinciples
principlesand
andassumptions,
assumptions,and
and
2)
conservatism
2)
conservatism
o Estimation Errors attributed to estimation errors inherent in accrual
o Estimation Errors attributed to estimation errors inherent in accrual
accounting
accounting
o Reliability vs Relevance attributed to over-emphasis on reliability at
o Reliability vs Relevance attributed to over-emphasis on reliability at
the
theloss
lossofofrelevance
relevance
o Earnings Management attributed to window-dressing of financial
o Earnings Management attributed to window-dressing of financial
statements
statementsby
bymanagers
managerstotoachieve
achievepersonal
personalbenefits
benefits
o

2-34

Accounting Analysis
Earnings Management Frequent Source of Distortion
Earning
EarningManagement
Managementstrategies:
strategies:

Increasing
IncreasingIncome
Incomemanagers
managersadjust
adjustaccruals
accrualstotoincrease
increase
reported
reportedincome
income
o Big Bath managers record huge write-offs in one period to
o Big Bath managers record huge write-offs in one period to
relieve
relieveother
otherperiods
periodsofofexpenses
expenses
o Income Smoothing managers decrease or increase reported
o Income Smoothing managers decrease or increase reported
income
incometotoreduce
reduceits
itsvolatility
volatility
o
o

2-35

Accounting Analysis
Earnings Management Motivations
Contracting
ContractingIncentives
Incentives- - managers
managersadjust
adjustnumbers
numbersused
usedinin
contracts
contractsthat
thataffect
affecttheir
theirwealth
wealth(e.g.,
(e.g.,compensation
compensationcontracts)
contracts)
o Stock Prices managers adjust numbers to influence stock
o Stock Prices managers adjust numbers to influence stock
prices
pricesfor
forpersonal
personalbenefits
benefits(e.g.,
(e.g.,mergers,
mergers,option
optionororstock
stock
offering)
offering)
o
o

2-36

Accounting Analysis
Process of Accounting Analysis
Accounting
Accountinganalysis
analysisinvolves
involvesseveral
severalinter-related
inter-relatedprocesses
processesand
and
tasks
tasksthat
thatcan
canbe
begrouped
groupedinto
intotwo
twobroad
broadareas:
areas:
ooEvaluating Earning Quality: Steps
Evaluating Earning Quality: Steps
1)
1)
2)
2)
3)
3)
4)
4)

Identify
Identifyand
andassess
assesskey
keyaccounting
accountingpolicies
policies
Evaluate
Evaluateextent
extentofofaccounting
accountingflexibility
flexibility
Determine
Determinethe
thereporting
reportingstrategy
strategy
Identify
Identifyand
andassess
assessred
redflags
flags

oAdjusting
AdjustingFinancial
FinancialStatements:
Statements:

Identify,
Identify,measure,
measure,and
andmake
makenecessary
necessaryadjustments
adjustmentstotofinancial
financial
statements
to
better
serve
ones
analysis
objectives;
statements to better serve ones analysis objectives;

Chapters
Chapters3-6
3-6focus
focuson
onadjusting
adjusting(recasting)
(recasting)the
thestatements
statements

2-37

Questions (10

th

pages 122-123) (11th pages 118-119)

2-7
2-8
2-11
2-12
2-17
2-18
2-45
2-47

Calculation Question
Establish company and invest $800 equity
Purchase plain 100T-shirts for $8 each
Fixed screen cost of $200
Variable print cost of $0.90 per T-shirt
Sold 20 T-shirts at $15 each for cash
Sold 30 T-shirts at $15 each on credit
Request: Prepare Statement under Cash and Accrual Accounting
Prepare and discuss at least 4 type of auditor report from listed companies