Financial Accounting Flashcards
(27 cards)
When to recognize revenue
When customer starts to derive “economic benefits”
Except in long term contracts, where you use %completion
Other times to recognize revenue
Cash received (what if product doesn't arrive) Sale agreed (what if sale cancelled) Customer received product (what if it's returned)
This, “economic benefits” under IFRS is best
Recording revenues on IS or BS
IS: Accurate performance (relevant)
BS: Defer revenue (matching and reliable)
Realization
Realization is the TIMING of recognition
Recognition is continuous: sales flow in, but products may be returned.
Realization ends this process: it is the final accurate and exact totals
Recognition can be manipulated through deferrals. Realization cannot
Relevance vs reliability
Trade off: early information is VERY relevant, but will be uncertain and less reliable
IFRS is FVA, meaning that it favors relevance
HCA would favor reliability
Relevance is most important in dynamic changing environments
Reliability is most important when FRs not accurate, or irreversible or bad decisions can be made based on the FR
RELEVANCE is more important: timing is crucial, risk of bad information can be mitigated by clever stakeholders
Relevance
QUALITATIVE
Relevant: Timing is important. FR should give info that is needed at the moment. Can affect decisions
Reliability
QUALITATIVE
Accuracy is the most important factor. Information must all be correct
Percentage of completion method
Costs incurred to date / total costs of contract
If not, use discounted cash flow
IAS 16
Firms can still pick HCA or FVA
Against IFRS goal of promoting consistency and comparability
IAS 11
Long term contracts follow %of completion
Prudence
Conservative and cautious judgement in accounting
For example, accounting for depreciation but not for asset appreciation (HCA method). Other examples are BDP or impairment testing
IFRS (FVA) places less emphasis on this
Consistency
Reporting must maintain the same method of accounting across different time periods to maintain comparability
If consistency cannot be maintained, the reporting entity must disclose the change, the reason for the change, as well as impact of the change.
Materiality
Information that has the ability to affect the decisions of the users is “material”
Auditors decide whether information Is material and dictates where this information is shown (BS/IS or just footnotes)
Matching
Match revenue to expenses
Deferred tax assets
Are illiquid and unsafe assets
This is because they are only refunded out of future tax (requiring a profit) and also have an expiry date.
Problems with HCA
Continuous depreciation leads to assets with tiny residual value, despite its market price being far higher. Leads to massive selling profits
BS does not reflect true value of assets. Little relevance to investors
Problems with FVA
Annual revisions to market price is VERY costly
Illiquid markets lead to mark to model (unreliable and manipulative) or to HCA (inconsistent)
Pro-cyclical and leads to volatility. In a downturn, prices are depressed. Recent recession had billions of asset write-offs. Leads to lower profits and capital ratio issues
If the market value of a firms liabilities (such as bonds) falls, it can book this as a profit
Built on EMH, which has many problems
Enron had massive profits by following FVA and marking to market
FVA vs HCA
FVA is performance, HCA is health
FVA is relevance, HCA is reliability
HCA is better due to the shortcomings of FVA (especially in distressed times). With markets being imperfect in reality, the market value does not always reflect the FAIR value
Pros of Global Standardization
Increasing comparability and transparency leads to more efficient markets
Lower costs of preparing financial reports and easier cross-border business (no need to prepare one in each country)
Cons of global accounting standardization
Comparability on the surface, but there are many assumptions that feed into accounting.
Removes Darwinian competition, there may be no progress in standards. How do we know ours is the best?
Different countries have different emphasis on the key objective of FR. US focuses on shareholders, UK focuses on accountability
Cultural and national interpretations of transactions will differ
Mainly benefits large firms owned and traded in multiple countries. Not much effect on SMEs
International standard setter is less accountable: reports to no one
Political standardization will be difficult
Global accounting standards conclusion
A uniform classifications of transactions that occur in diverse environments is logically impossible
Standardization is too simplistic and thus is bad
Stock options
Under IFRS, stock options are expenses (traditionally just a double entry when exercised)
Stock option treatment
Traditionally there was no line entry when a SO was issued. When exercised: Debit Cash, Credit share equity.
Under IFRS, SO must be expensed when issued. Expense is difference between what firm could have received from selling shares in future and what it actually receives from the employee. Upon issue: Debit SO Expense, Credit SO
Cons of expensing stock options
Options are valued by Black-Scholes. Requires 6 inputs, and assumes stable markets and works on estimates. Problematic, subjective, and complex model.
An SO is a promise: there has been no transaction. Should there be a line entry if there is no transaction?
Effect of SOs can already be seen through diluted earnings per share. This is calculated based on outstanding SOs and should be incorporated into valuations
