Financial Accounting and Reporting
2020-2021
WEEK 1 (chapter 1 & chapter 2)
By FAR we always focus on the situations in which we have a principal and an agent. The principle provides capital
(finances) and the agent have to act in the best interest of the principal to create shareholder value or to create money
to repay back the loans
FAR concentrates on the separations of Ownership & Control, because this is an agency problem it is always about
the delegation of decision making authority (the agent always have decision making authority on behave of the
principal)
Agency problem
Who is the principal (P) and the agent (A) in Financial Accounting (FA) and in Management Accounting (MA)?
FA;
- P; Capital providers
- A; Top management
MA;
- P; Top management
- A; Employees
Agency theory
On this course we focus on agency problems, and by agency problems you always have the delegation of decision-
making authority. Agency problem is based on agency theory, and in agency theory they always make assumptions.
Assumption made in agency theory;
Bounded rationality
- The agent (who is the manager) has limited information processing compacity
Opportunistic, self-interested behavior
Risk attitude/preferences
Goal conflicts among participants
- Principals (who are the capital providers) have different goals than the agent. The agent is self-driven (he wants
to increase his own wealth). So, the goal of the manager is not the same as the goal of the capital provider.
Therefore, you have to monitor the agent
Information asymmetry
- Top management has more information than the investors. To reduce this information asymmetry, the top
management has to disclose information which should be useful for investors to make their decisions
Behavioral risks;
- Adverse selection
- Moral hazard
How to reduce information asymmetry;
In this course we always have this delegation of decision-making authority and the separation of Ownership & Control.
The agent is the manager and the principal is the capital provider. The idea is that the manager has to provide
information for the capital providers so that the capital provider can make useful decisions. This information needs to
meet certain characteristics, the more likely this information meets this characteristics, the more likely it will be useful
information for economic decision making
The 2 characteristics that always need to meet are; relevance and reliability
- Another word for reliability is face for representation
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,There are 2 mechanisms that ensure that information is relevant and face for represent what it should represent;
1. Accounting standards
- If the information meets the accounting standards, the more likely it will be useful information for decision making
- You could consider it as a corporate governance mechanism
2. External auditor
- External auditor has to increase the likelihood that information is reliable and, to a certain extent, is more relevant
Regulation
We make a distinction in accounting standards between;
Global accounting standards
- (Little bit) Principle-based; IFRS
Local accounting standards;
- Principle-based; Dutch GAAP
- Rule-based; US GAAP
This course is focused on IFRS; international Financial Reporting Standards
In Europe we follow IFRS (call it IFRS endorsed). The European parliament sometimes make small changes in the IFRS
(which is the endorsed part). Thus, in Europe we follow the IFRS but it is not exactly the same IFRS because there are
small changes
Which European companies have to follow IFRS?
All the stock exchange listed companies (public companies)
- All public companies in Europe have to follow the IFRS for the consolidated financial statements
The objective of general-purpose financial reporting is to provide financial information about the reporting entity that
is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources
to the entity
You could say that the investors, lenders and other creditors in making decisions are the capital providers
- The information has to be useful for capital providers
You could say that making decisions about providing resources to the entity is economic decision making,
economics is always about resources allocation
Thus, the objective of financial statements is;
Providing financial information to capital providers that is useful for economic decision making
Examples of economic decisions;
- Buy/sell/hold shares (and other equity instruments)
- Provide or settle loans and other forms of credit
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,Goals of financial reporting
1. Communicate information that is useful in making decisions
- In making resources allocation decisions
2. Assessing management stewardship
- Providing information in which you describe/explain how you use the resources provided by the principals and
whether you could generate financial returns on them
- Monitor managers’ activities
- Accountability; describe how you use money of capital providers and explain whether you for instance make profit
yes or no
- Discharge management form responsibility
3. Capital protection
There is a relationship between economic decision making and stewardship;
If you provide better information on how you used the money last year, it positively effects economic decision making
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,Example Capital protection;
A man from Sweden had a factory that produces matches
At the end of year 1, he has the following balance sheet and income statement;
You can see from his income statement that his net income is €27.000. From his balance sheet you can see that equity
is €127.000 (including his income)
- His return on equity is 21.3%
At the end of year 2, he has the following balance sheet and income statement;
You can see from his income statement that his net income is €50.000. From his balance sheet you can see that equity
is €200.000 (including his income)
- His return on equity is 25%
At the end of year 3, he has the following balance sheet and income statement;
You can see from his income statement that his net income is €100.000. From his balance sheet you can see that
equity is €400.000 (including his income)
- His return on equity is 25%
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,At the end of year n, he has the following balance sheet and income statement;
You can see from his income statement that his net income is €11.700.000. From his balance sheet you can see that
equity is €45.000.000 (including his income)
- His return on equity is 26%
Out of noting the Swedish guy was gone and nobody receives dividends anymore. What happened here?
- He used the money that the new investors paid to buy new shares, to pay the dividends. All these financial
statements were all false financial statements, to give the investors the impression that everything went very well.
Thus you need some type of mechanism that guaranteed that the financial statements are not fake, because otherwise
you could constantly be misled.
The capital protection mechanism has to assure that the information provided is reliable and truthfully represent
what it should represent
The main goal of accounting standards is providing information that is useful for economic decision making. It is also
about stewardship, accountability.
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,Example capital protection;
The management decides to pay dividends for 2018
You see in this income statement that it has a loss of €1.000.000
If you have a loss can you pay dividends to the shareholders? Is it economically and legally acceptable to pay dividends?
- Yes! Even if you make a loss you can still pay dividends to shareholders
What is the maximum amount of dividends that may be paid?
a) Not allowed d) € 0 g) € 300.000
b) € 1.100.000 e) € 1.200.000 h) € 1.400.000
c) € 1.500.000 f) € 2.200.000 i) Correct answer is missing
The maximum amount of dividend that you can pay is the amount that you have as retained earnings (€1.100.000)
- You never pay more dividends than you have created as retained earnings (we will later on explain why)
Medium-size and large companies always have to hire an external auditor. Small companies don’t have to, because
the principal-agent problem is not large enough to justify this
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,WEEK 2 (chapter 3 & chapter 4 & chapter 5)
You have accounting and finance
Accounting is mostly about;
- Revenues
- Expenses (costs)
Finance is mostly about;
- Receipts (cash inflow)
- Expenditures (disbursements; cash outflow)
If you would relate accounting and finance to each other;
There is a close relationship between the revenues and receipts and a relationship between expenses and
expenditures (but they are not the same!)
- Revenue and receipts = cash inflow
- Expenses and expenditures = cash outflow
Revenues – expenses = net income
Receipts – expenditures = net cash flow
Revenues ¹ Receipts
Non cash revenues; revenues but not related cash receipt (yet)
- Example; if you sent an invoice to a client and you have delivered your goods, and the client does not pay in the
same period, then you have a revenue and not a receipt
Cash inflows not recorded as revenues; money received when taking out a loan
- Example; if you close a contract and have a loan, you receive money (so you have cash inflow) then you have a
receipt and not a revenue (debtor paying the bill)
Example
You sent goods to a client and you have sent your invoice; (Non cash revenues)
Account receivable
Revenue
Later, the client pays its invoice, thus you receive the money; (Cash inflows not recorded as revenues)
Bank (cash and cash equivalents)
Accounts receivable
Expenses ¹ Expenditures
Non cash expenses; depreciation and amortization
Cash outflows not recorded as expenses; loan repayment / payment of investment / prepaid rent
Net income ¹ Net cash flow (from operations)
Thus, it is really important in accounting that you make a distinction between cash inflows and cash outflows and
between revenues and expenses.
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,Cash basis accounting vs. accrual basis accounting
Example;
Suppose you rent a room, and the rent for that room is €320. You pay the rent for May in April (pre-paid expense)
In finance they only focus on the cash outflow;
What do I see on my bank account -----> a decrease of €320 in April
April May
Finance Payment; €320 -
Cash outflow; €320
In accounting you get a lot more information;
April May
Accounting Prepaid expenses; €320 Rent Expense; €320
To bank; €320 To prepaid expenses; €320
Cash outflow; €320 Expense; €320
In April you see a reduction of your bank account of €320
In May you see an expense of €320
Perspective of the landlord;
April May
Finance Receipts (cash inflow); €320 -
April May
Accounting Bank; €320 Prepaid rent; €320
Prepaid rent; €320 To rent revenues; €320
You can make a distinction between basis of accounting;
1. Cash basis of accounting
Recognizing revenues/expenses only in the period in which cash is received/paid by the firm
- The cash basis accounting is prohibited under IFRS because it violated both the revenue recognition principle
and the expense recognition principle
2. Accrual basis of accounting
Recognizing revenues as a firm sells goods/services (or delivers them) independent of the time when it receives
cash
- Companies recognize revenues when they satisfy a performance obligation (revenue recognition principle)
- Companies recognize expenses when incurred (expense recognition principle)
- Make a clear distinction between cash inflows and outflows and revenues and expenses
Transactions that change a company’s financial statements are recorded in the periods in which the event occur,
rather than in the periods in which the company receives or pays cash
- Accrual basis accounting make better predictions about future cash flows, so you can better predict the future
cash flows of the company, as well as the future performance
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,How to translate cash flows into accruals?
----> You need Accounting Principles & Principles for valuation and income measurement
See pyramid in the book (chapter 2)
Accounting principle;
- Revenue recognition (realization);
- Expense recognition (matching);
- Accounting practices; prudence / conservatism
Revenue recognition (realization); revenue is recognized when it is probable that future economic benefits will flow
to the entity and these benefits can be measured reliably
Companies recognize revenues in the accounting period in which performance obligation is satisfied
Example;
Klinke Cleaners cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of
July. Klinke should record revenue in June when it performed the service (satisfied the performance obligation) rather
than in July when it received the cash.
Revenue is recognized when; (theory)
1) It is probable that future economic benefits will flow to the entity; and
2) These benefits can be measured reliably
General rule
It is likely that the amount of revenue will be collected if the performance obligation has been met;
- Goods have been delivered / services have been provided
- Goods/services have a transaction price/cost/value that can be measured reliably
- Invoice has been sent
- It is probable that invoice will be paid
- It is likely that the amount of revenue will be collected
- It is probable that future economic benefits will flow to the entity
Revenues are recorded in the period when they are; (accounting practices)
1) Earned
2) Become ‘measurable’
Earned; the critical event in the process of earning a revenue has taken place;
- It is likely that the amount of revenue will be collected
- Goods have been delivered / services have been provided
- Invoice has been sent & it is probable that invoice will be paid
---> it is probable that future economic benefits will flow to the entity
Become ‘measurable’;
- Revenues can be measured with a reasonable degree of liability
- The asset has a cost or value that can be measured reliably
Thus;
Revenue is recognized when it is probable that future economic benefits will flow to the entity and these benefits can
be measured reliably.
- Revenues are recorded in the period when they are
1) Earned; and
2) Become ‘measurable’
- Revenue recognition independent of the time when it receives cash
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, Expense recognition (matching); recognize expenses in the period when it recognizes the related revenue
independent of the time when cash payment took place
Efforts (expenses) should be matched with accomplishments (revenues), if feasible
- Companies recognize expenses not when they pay wages or make a product but when the work (service) or the
product actually contributes to revenue
Expenses (costs)
Expenses are recorded in the same accounting period in which the revenues are recognized
- Product costs are allocated to recorded revenues (direct costs)
- Period costs are allocated to the period in which they occur (indirect costs)
Companies tie expense recognition to revenue recognition. That is, by matching efforts (expenses) with
accomplishment (revenues)
- Example; a company allocates the cost of equipment over all the accounting periods during which it uses the assets
because the asset contributes to the generation of revenue throughout its useful life
Costs are generally classified into two groups;
1) Product costs; material, labor, and overhead, attach to the product
- Companies carry these costs into future periods if they recognize the revenue from the product in subsequent
periods
2) Period costs; officers’ salaries and other administrative expenses, attach to the period
- Companies charge off such costs in the immediate period, even though benefits associated with these costs may
occur in the future
Prudence / conservatism principle; financial reports should reflect business risks and uncertainties adequately
- Record possible loses prudently as soon as they are probable and become measurable
- Example - inventory valuation; lower-of-cost-or-net realizable value
- Suppose you buy some inventory and a few weeks later the market prices are clearly lower than your initial
cost price. Then you apply the lower-of-cost-or-net realizable tool. The market value is lower than the initial
cost price and so you include depreciation
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