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Summary of the lectures of Financial Reporting and Auditing
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- Vrije Universiteit Brussel (VUB)
Summary of the lectures of Financial Reporting and Auditing.
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Financial Reporting and Auditing1. Basic accounting techniques 4
1.1. Accounting: the language of business 4
1.2. Users of financial information 4
1.3. Financial accounting vs. management accounting 4
1.4. International accounting standards (IAS) - International financial reporting
standards (IFRS) 5
Annual financial statements - IAS 1 5
1.5. Balance sheet 5
1.6. Current and non-current assets - IASB definitions and format 6
1.7. Assets - According to IAS/IFRS (conceptual framework) 7
1.8. Liabilities - According to IAS/IFRS (conceptual framework) 7
1.9. Annual financial statements 8
1.9.1.The income statement 8
1.9.1.1.Operating expenses 8
1.9.2.The statement of retained income 8
1.9.3.Inter-relationships between financial statements 9
1.10. Cash vs. accrual accounting 10
1.10.1.International accounting standards (IAS) - International financial reporting
standards (IFRS) 10
1.10.2.Accrual accounting 11
1.10.2.1.Revenue recognition principle 11
1.10.2.2.Depreciation 12
1.11.Case Study - Newco 13
2. Conceptual framework and GAAP 14
2.1.Conceptual framework for financial reporting 14
2.1.1.Users of financial information 14
2.2.Accounting traditions 14
2.2.1.Anglo-Saxon: driven by the market 14
2.2.2.Continental Europe: ruled by the government 14
2.2.3.The concept of accounting conservatism 14
2.3.International Financial Reporting Standards 15
2.4.Qualitative characteristics of financial information 16
2.5.Generally accepted accounting principles (GAAP) 17
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, 3. Financial Statement Analysis 18
3.1.Annual reports 18
3.2.Financial statement analysis 18
3.2.1.Purpose 18
3.2.2.Tools of analysis 18
3.3.Horizontal and vertical analysis 18
3.3.1.Horizontal analysis 19
3.3.2.Vertical analysis 19
3.4.Financial ratios 19
3.4.1.Short-term liquidity ratios 19
3.4.2.Long-term solvency ratios 21
3.4.3.Profitability ratios 23
3.5.Financial leverage 24
3.5.1.The Dupont model: integrated profitability analysis 24
3.6.Corporate distress and insolvency 25
4. Cash ow statement 27
4.1.Inter-relationships between financial statements 27
4.2.The statement of cash flows 27
4.2.1.Cash flows from operating activities 28
4.2.2.Cash flow from operations, investing and financing activities - Inter-relations
29
4.2.3.Free cash flow 30
5. Consolidation techniques 31
5.1.Control as trigger for consolidation 31
5.2.Inter-company relationship and accounting consequences 31
5.2.1.Acquisition method 31
5.2.1.1.Goodwill 32
5.2.1.2.Non-controlling interest 32
5.2.2.Equity method 32
5.2.3.Fair value method 33
6. Creative accounting 34
6.1.Techniques 35
6.1.1.Manage earnings: revenues 35
6.1.2.Manage earnings: expenses 35
6.1.3.Income smoothing 36
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, 6.1.4.Big Bath accounting 36
6.1.5.Wrong presentation 36
6.1.6.Manage gearing - off balance financing 37
7. Overall objectives of an independent audit 39
7.1.What is an independent (statutory) audit 39
7.2.Who needs to appoint an auditor in Europe 39
7.3.International standards on auditing 40
7.4.Audit quality, inherent limitations of an audit and expectation gap 40
7.4.1.Audit quality 40
7.4.2.Inherent limitations 40
7.4.3.Expectation gap 41
7.5.Audit risk 41
7.5.1.Audit risk model 42
7.6.Materiality 42
8. Audit risk model 43
8.1.Audit risk model and audit process 43
8.2.Risk assessment 44
8.2.1.The entity and its environment - Inherent risk 44
8.2.2.The entity’s internal control - Control risk 44
8.2.3.Communicating deficiencies in internal control 45
8.3.Risk response 45
8.3.1.Test of controls 45
8.3.2.Inherent limitations of internal control 45
8.3.3.Substantive procedures 46
8.4.Quiz 46
9. The auditor’s opinion 47
9.1.Basic elements of the auditor’s report (ISA 700) 47
9.2.Modified (qualified, disclaimer, adverse) opinion (ISA 705) 47
9.3.Matters that do not affect the opinion: emphasis of matter paragraph/other
matter paragraph 48
9.4.Going-concern (ISA 570) 48
9.5.Key audit matters (ISA 701) 49
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,1. Basic accounting techniques
1.1. Accounting: the language of business
Accounting is the process of identifying, recording, summarising, and reporting economic
information (transactions) to
decision makers in the form of
financial statements.
We use accounting to be able
to summarise financial
information into financial statements for the benefit of users such as stakeholders.
1.2. Users of nancial information
Accounting information is useful to anyone who makes decisions that influence business activities
and have economic results. Some of the main stakeholders who would be interested in the
economic information about how a company is doing, are:
- Investors/shareholders: they would want to know if a company is a good investment with
adequate returns
- Creditors (banks, suppliers = short-term creditors) want to know if they should extend credit
and how much to extend, for how long.
- Clients would want to know if they can rely on proper after sales service.
- (Future) Employees who want to know if the company is able to provide job security and a
good salary.
- Government agencies for tax collection purposes, grants or statistics
- The public
- …
1.3. Financial accounting vs. management accounting
The major distinction between financial and management accounting is the users of the
information.
Financial accounting focuses on the specific needs of decision makers that are external1 to the
organisation, such as shareholders, suppliers, banks, and government agencies.
Management accounting serves internal users, such as top executives, management, and
administrators within the organisation for a.o. budgets, forecasts, projections, …
1 Externally disseminated financial statements have to be drawn up by reference to a set of
accounting rules. These might be different depending on the jurisdiction.
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, 1.4. International accounting standards (IAS) -
International nancial reporting standards (IFRS)
Annual financial statements - IAS 1
The primary questions about an organisation’s success that decision makers want to know are:
Question Financial statement Answer
How well did the company Statement of comprehensive Revenue
perform during the year? income (which consists of the - Expenses
Income Statement and Other = Net income (or net loss)
Comprehensive Income) ± OCI
= Total comprehensive income
Why did the company’s Statement of changes in equity Beginning equity
equity change during the + Total comprehensive income
year? - Dividends
± Capital transactions (sale of an asset/
revaluation of an asset) with owners
= Ending equity
What is the company’s Statement of Financial Position Assets = Liabilities + Equity
nancial position at the (Balance Sheet)
end of the nancial year?
How much cash did the Statement of Cash Flows Operating Cash ows
company generate and ± Investing cash ows
spend during the year? ± Financing cash ows
= Net cash ows
1.5. Balance sheet
The balance sheet is a snapshot at one point in time in the life of a business.
Assets are the resources of the firm that are expected to produce a benefit in the future. They
increase or cause future cash flows (everything the firm owns).
The balance sheet equation:
Entity approach: A ssets = Li a bilit ies + O w n ers′ equit y
Proprietary approach: A ssets − Li a bilit ies = O w n ers′ equit y
The balance sheet equation is the basis for double-entry accounting which is a recording method
whereby at least two accounts are always affected by each transaction.
An account is a summary record of the changes in a particular asset, liability or owners’ equity
during a period.
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,Not every set of financial statements is the same because every business is a little different – this
slide shows you the types of line items you might see for each of these Balance Sheet categories.
There are also often Off Balance Sheet transactions that occur, take an airlines for example. What
would you expect to see on the balance sheet of Lufthansa airlines? Would you see airplanes?
Answer: No, although the planes are assets, they are not on their balance sheet because they
lease their airplanes they do not own them. Companies aren’t required to put them on their
balance sheet because they do not own them. It is important to note that we have to look at these
off-balance sheet transactions and make adjustments to incorporate them – in order to get a
realistic picture of value.
1.6. Current and non-current assets - IASB de nitions
and format
While most manufacturers have operating cycles of several months, a few industries require very
long processing times. This could result in an operating cycle that is longer than one year. To
accommodate those industries, the accountants' definitions of current assets and current liabilities
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, include the following phrase: ...within one year or within the operating cycle, whichever is longer.
(AccountingCoach.com)
The operating cycle is the time span required for a company to receive inventory, sell the
inventory and collect cash from the customers.
Operating cycle = average inventory period + average collection period
1.7. Assets - According to IAS/IFRS (conceptual
framework)
An asset is defined as an economic resource that the company controls at the reporting date as a
result of a past event.
• An economic resource is a ‘right’ that has the potential to produce economic benefits.
‣ It has to have the capacity to contribute directly/indirectly to the company’s future cash
flows.
- Capacity expenditure
- Investment to save costs
- Right to use a service
- Direct claim to cash inflow
- Cash on hand
‣ There has to be a degree of certainty that the future flow of economic benefits will arise.
There is no minimum probability level, but a reasonable level should be obtained.
• Controls:
- Obtain substantially all of the economic benefits
- Direct use of the resource; decision making right
- Mostly via legal ownership (eg. purchase), but not necessarily. Substance over form (eg.
leasing).
• Past event: Mostly via exchange with third parties (cash/credit)
These are necessary conditions but are not sufficient.
• Measurement is the ability to express the asset in monetary terms (cost/value).
- It should be readily available via eg. Purchase contract/invoice.
- But the measurement is not always readily available, then an estimation is needed
(based upon future cash flows). You should obtain a reasonable level of certainty.
Once an item has an existence certainty (at a reasonable level) and a measurement certainty (at a
reasonable level), it should be recognised as an asset.
1.8. Liabilities - According to IAS/IFRS (conceptual
framework)
A liability is defined as an obligation to transfer an economic resource as a result of a past event.
Existence is a reasonable certainty
Measurement is the ability to express the liability in monetary terms. Measurement is a reasonable
certainty.
Recognise the liability.
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➡︎
, 1.9. Annual nancial statements
Companies need a way to measure performance over discrete time periods. The most popular
period for measuring income is the calendar year, but many companies use a fiscal year, which is a
year that ends on a date other than December 31, usually at the low point in annual business
activity. Companies will also prepare statements for interim periods, generally on a quarterly or
monthly basis.
1.9.1.The income statement
The income statement provides a moving picture of events over a span of time and explains the
changes that have taken place between balance sheet dates.
The income statement is used to show the
(sales) revenues generated and the expenses
incurred over one financial year.
1.9.1.1.Operating expenses
Operating expenses can be categorised by
nature, the type of expense. It gives an
overview of added value created by the
company in transforming raw materials into
finished goods and selling it to outside
parties.
Operating expenses can be categorised by function, the activity to which the expense is assigned.
If you look at this portrayal of an
Income Statement, you see that there
are many claims on revenue.
- Cost of Goods Sold (COGs) –
material cost, labor cost associated
with generating the material, and
production cost
- Selling, General & Administrative
(SG&A) – all back office expenses – marketing, HR, IT, accounting/finance – when we talk about
outsourcing, we are talking about improving SG&A – our sweet spot with SG&A is outsourcing.
- Interest Expense – claim by debt investor on revenue
- Taxes – this is the government’s claim
- Net Income (NI) – the return to the equity holder – theoretically, equity investor has 2 choices –
take as a dividend, or reinvest in the business – where the NI goes back to the Balance Sheet in
Retained Earnings.
1.9.2.The statement of retained income
Retained income is the additional owners’ equity generated by income or profits. Revenues will
increase owners’ equity and expenses will decrease it.
Retained income can be described as the cumulative lifetime earnings of the company, less its
cumulative lifetime losses and dividends.
Although dividends decrease retained income, they are not treated as expenses: dividends are
not necessary for the generation of revenue, they are the result of the revenue generation
process.
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