Objective of Financial Reporting
…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.
Why Do We Need Accounting?
▪ Information asymmetry between stakeholders
• Adverse selection
➢ One party has more information than the other, i.e., information advantage
• Moral hazard
➢ One party’s actions cannot be fully observable by other, e.g., unobservability of manager’s effort
▪ To help control adverse selection: Valuation problem
• Converts insider information into useful information for outside investors
• Provides full and timely disclosure of useful information
➢ E.g., Balance Sheet, Income Statements, Cash Flow Statement,
Statement of Changes in Equity, notes to accounts, MD&A
▪ To help control moral hazard: Agency problem
• Provides information useful for controlling manager shirking and improving corporate governance
• Provides measures to encourage or restrict certain actions
➢ E.g., Bonus plans based on target ROA/ROE; Debt covenants restricting dividend payouts based on
net worth
Review: Qualitative Characteristics
1. Relevance: Predictive value; Confirmatory value; Materiality (nature and size; entity-specific)
2. Faithful representation: Complete (within bounds of materiality and costs); Neutral; Free from
error (≠ accurate in all respects)
3. Comparability: Over time; Across different entities; achieved via consistency;
≠ uniformity
4.Understandability: Clear and concise
5.Timeliness
6.Verifiability: Different knowledgeable and independent observers could reach consensus, not
necessarily complete agreement
Items (1) and (2): Fundamental QC
Items (3) to (6): Enhancing QC
Accounting Recognition, Measurement and Disclosure
Recognition
▪ Process of capturing for inclusion an item in an entity’s statement of financial position or statement
of financial performance
▪ General recognition criteria (conceptual framework):
• Meets the definition of a financial statement element
• Provides relevant information about the element
• Provides a faithful representation of the element
▪ Item-specific recognition criteria
• Found in the accounting standards governing the specific item
Accounting Recognition, Measurement and Disclosure
Measurement
▪ Process of determining the monetary amount of an item to be recognised and carried in the F/S
Disclosure – Accounting standards often require that certain information be disclosed either in the
main body of or in the notes to the financial statements.
▪ Is it the same as presentation?
,What Is Measurement?
▪ Measurement is the assignment of numerals to represent the magnitude of an attribute of a
phenomenon.
• Phenomenon
➢ Object or event to be measured
• Attribute
➢ Characteristic or quality of the phenomenon that is to be measured
How to Go about Measuring?
▪ Identify a relevant phenomenon.
▪ Identify a relevant attribute of the phenomenon.
▪ Find a reliable way to assess the magnitude of the relevant attribute of the
relevant phenomenon (i.e., measurement scale).
▪ Estimation may often be needed; substitute with a different phenomenon, a
different attribute, or both.
Mixed attributes
- Historical cost, present value, fair value etc.
- Used to measure different items
- Book value does not reflect market value well
P/B ratio increases -> balance sheet numbers represent only 10-15% of the value of the company
- Capital market sentiment and mixed attributes
- Intangible assets not recognised in books but are becoming more important
SFRS(I) 13 Fair Value Measurement
▪ Measurement and disclosure requirements of SFRS(I) 13 do not apply to the following:
• Share-based payment transactions under SFRS(I) 2
• Leasing transactions under SFRS(I) 16
• Measurements that have some similarities to fair value but are not fair value,
e.g., NRV in SFRS(I) 1-2 , Value in Use in SFRS(I) 1-36
▪ Framework for measuring fair value (SFRS(I) 13: B2)
• Determine the particular asset or liability being measured.
• For a non-financial asset, determine the highest and best use of the asset
(either in combination with other assets or on a stand-alone basis).
• Determine the market in which an orderly transaction would take place for the asset or liability.
• Determine the appropriate valuation technique to use.
➢ Maximise the use of relevant observable inputs and minimise unobservable inputs.
,▪ A fair value measurement of a non-financial asset takes into account a market participant’s ability
to generate economic benefits by using the asset in its highest and best use or by selling it to
another market participant that would use the asset in its highest and best use, taking into account
the use of the asset that is:
• Physically possible (SFRS(I) 13: 28(a))
• Legally permissible (SFRS(I) 13: 28(b))
• Financially feasible (SFRS(I) 13: 28(c))
▪ Highest and best use is determined from the perspective of market participants, even if the entity
intends a different use.
• However, an entity’s current use of a non-financial asset is presumed to be its highest and best
use;
• unless market or other factors suggest that a different use by market participants would maximise
the value of the asset.
Principal market versus most advantageous market
• Principal market has the greatest volume and activity level.
• Most advantageous market maximises amount received/paid net of transaction and transport
costs.
• Example adapted from SFRS(I) 13 Illustrative Example 6—assume firm owns an asset that can be
traded in the following markets:
Hint: Price is adjusted for transportation costs but not transaction costs. (SFRS(I) 13: 25–26)
Valuation techniques
• Price can be directly observable or estimated using valuation technique but valuation technique
should maximise (minimise) use of relevant observable (unobservable) inputs.
• Three widely-used valuation techniques are:
➢ Market approach
− Uses prices and other relevant information generated by market transactions involving identical or
comparable (i.e., similar) assets, liabilities or a group of assets and liabilities, such as a business
➢ Cost approach
− Reflects the amount that would be required currently to replace the service capacity of an asset
(often referred to as current replacement cost)
➢ Income approach
− Converts future amounts (e.g., cash flows or income and expenses) to a single current (i.e.,
discounted) amount
Inputs to valuation techniques
• Inputs to valuation techniques are categorised into three levels known as the fair value hierarchy:
➢ Level 1 inputs: Unadjusted quoted prices in accessible active markets for identical assets/liabilities
e.g. 3,000,000 ordinary shares, listed on Stock Exchange
➢ Level 2 inputs: Inputs other than Level 1 that are directly/indirectly observable
➢ Level 3 inputs: Unobservable inputs e.g. ordinary shares of privately owned entity
Valuation techniques
, • Disclose information to users for assessing
➢ The valuation techniques and inputs to valuation techniques used to develop FV measurements
➢ For recurring FV measurements using Level 3 inputs significantly, their effect on P/L or OCI
Is there also a gap in the income statement?
• Understand accounting income and economic income
• But before that… time value of money (i.e., computation of present value)
Time Value of Money
▪ The time value of money means that all things being equal, it is better to have money now rather
than later.
▪ Rationale: Like other commodities, money is a scarce resource. Receiving the same amount of
money later rather than now involves forgoing interest income that could have been earned during
the intervening period.
▪ Given the time value of money, a dollar is worth more today than it would be worth tomorrow
given its capacity to earn interest.
▪ Discounting is the method used to figure out how much future payments are worth today (i.e.,
their present value).
Present Value (PV) of a Single Sum
▪ PV of a single sum represents the value today of a single sum to be received or paid at a future
time.
▪ Formula:
▪ An annuity is a series of payments of equal amounts.
▪ PV of an annuity:
• Sometimes called PV of an ordinary annuity, to be differentiated from PV of an annuity due
Concept of (Net) Income in Economics
▪ Hick’s definition
• (Net) income: The maximum amount a man can consume in a period and still be as well off at the
end of the period as he was at the beginning
▪ Extending to a business entity…
• (Net) income: The amount by which an entity’s net worth has increased during a period, due
allowance being made for any new capital contributed by its owners, or for any distributions made
by the entity to its owners
Measurement of (Economic) Net Income under Ideal Conditions with Certainty
Assumptions:
▪ Future cash flows and interest rate are known publicly with certainty
• Known publicly: No information asymmetry
• With certainty: Ex ante prediction = Ex post realisation
• Relevant attribute: NPV of future cash flows
…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.
Why Do We Need Accounting?
▪ Information asymmetry between stakeholders
• Adverse selection
➢ One party has more information than the other, i.e., information advantage
• Moral hazard
➢ One party’s actions cannot be fully observable by other, e.g., unobservability of manager’s effort
▪ To help control adverse selection: Valuation problem
• Converts insider information into useful information for outside investors
• Provides full and timely disclosure of useful information
➢ E.g., Balance Sheet, Income Statements, Cash Flow Statement,
Statement of Changes in Equity, notes to accounts, MD&A
▪ To help control moral hazard: Agency problem
• Provides information useful for controlling manager shirking and improving corporate governance
• Provides measures to encourage or restrict certain actions
➢ E.g., Bonus plans based on target ROA/ROE; Debt covenants restricting dividend payouts based on
net worth
Review: Qualitative Characteristics
1. Relevance: Predictive value; Confirmatory value; Materiality (nature and size; entity-specific)
2. Faithful representation: Complete (within bounds of materiality and costs); Neutral; Free from
error (≠ accurate in all respects)
3. Comparability: Over time; Across different entities; achieved via consistency;
≠ uniformity
4.Understandability: Clear and concise
5.Timeliness
6.Verifiability: Different knowledgeable and independent observers could reach consensus, not
necessarily complete agreement
Items (1) and (2): Fundamental QC
Items (3) to (6): Enhancing QC
Accounting Recognition, Measurement and Disclosure
Recognition
▪ Process of capturing for inclusion an item in an entity’s statement of financial position or statement
of financial performance
▪ General recognition criteria (conceptual framework):
• Meets the definition of a financial statement element
• Provides relevant information about the element
• Provides a faithful representation of the element
▪ Item-specific recognition criteria
• Found in the accounting standards governing the specific item
Accounting Recognition, Measurement and Disclosure
Measurement
▪ Process of determining the monetary amount of an item to be recognised and carried in the F/S
Disclosure – Accounting standards often require that certain information be disclosed either in the
main body of or in the notes to the financial statements.
▪ Is it the same as presentation?
,What Is Measurement?
▪ Measurement is the assignment of numerals to represent the magnitude of an attribute of a
phenomenon.
• Phenomenon
➢ Object or event to be measured
• Attribute
➢ Characteristic or quality of the phenomenon that is to be measured
How to Go about Measuring?
▪ Identify a relevant phenomenon.
▪ Identify a relevant attribute of the phenomenon.
▪ Find a reliable way to assess the magnitude of the relevant attribute of the
relevant phenomenon (i.e., measurement scale).
▪ Estimation may often be needed; substitute with a different phenomenon, a
different attribute, or both.
Mixed attributes
- Historical cost, present value, fair value etc.
- Used to measure different items
- Book value does not reflect market value well
P/B ratio increases -> balance sheet numbers represent only 10-15% of the value of the company
- Capital market sentiment and mixed attributes
- Intangible assets not recognised in books but are becoming more important
SFRS(I) 13 Fair Value Measurement
▪ Measurement and disclosure requirements of SFRS(I) 13 do not apply to the following:
• Share-based payment transactions under SFRS(I) 2
• Leasing transactions under SFRS(I) 16
• Measurements that have some similarities to fair value but are not fair value,
e.g., NRV in SFRS(I) 1-2 , Value in Use in SFRS(I) 1-36
▪ Framework for measuring fair value (SFRS(I) 13: B2)
• Determine the particular asset or liability being measured.
• For a non-financial asset, determine the highest and best use of the asset
(either in combination with other assets or on a stand-alone basis).
• Determine the market in which an orderly transaction would take place for the asset or liability.
• Determine the appropriate valuation technique to use.
➢ Maximise the use of relevant observable inputs and minimise unobservable inputs.
,▪ A fair value measurement of a non-financial asset takes into account a market participant’s ability
to generate economic benefits by using the asset in its highest and best use or by selling it to
another market participant that would use the asset in its highest and best use, taking into account
the use of the asset that is:
• Physically possible (SFRS(I) 13: 28(a))
• Legally permissible (SFRS(I) 13: 28(b))
• Financially feasible (SFRS(I) 13: 28(c))
▪ Highest and best use is determined from the perspective of market participants, even if the entity
intends a different use.
• However, an entity’s current use of a non-financial asset is presumed to be its highest and best
use;
• unless market or other factors suggest that a different use by market participants would maximise
the value of the asset.
Principal market versus most advantageous market
• Principal market has the greatest volume and activity level.
• Most advantageous market maximises amount received/paid net of transaction and transport
costs.
• Example adapted from SFRS(I) 13 Illustrative Example 6—assume firm owns an asset that can be
traded in the following markets:
Hint: Price is adjusted for transportation costs but not transaction costs. (SFRS(I) 13: 25–26)
Valuation techniques
• Price can be directly observable or estimated using valuation technique but valuation technique
should maximise (minimise) use of relevant observable (unobservable) inputs.
• Three widely-used valuation techniques are:
➢ Market approach
− Uses prices and other relevant information generated by market transactions involving identical or
comparable (i.e., similar) assets, liabilities or a group of assets and liabilities, such as a business
➢ Cost approach
− Reflects the amount that would be required currently to replace the service capacity of an asset
(often referred to as current replacement cost)
➢ Income approach
− Converts future amounts (e.g., cash flows or income and expenses) to a single current (i.e.,
discounted) amount
Inputs to valuation techniques
• Inputs to valuation techniques are categorised into three levels known as the fair value hierarchy:
➢ Level 1 inputs: Unadjusted quoted prices in accessible active markets for identical assets/liabilities
e.g. 3,000,000 ordinary shares, listed on Stock Exchange
➢ Level 2 inputs: Inputs other than Level 1 that are directly/indirectly observable
➢ Level 3 inputs: Unobservable inputs e.g. ordinary shares of privately owned entity
Valuation techniques
, • Disclose information to users for assessing
➢ The valuation techniques and inputs to valuation techniques used to develop FV measurements
➢ For recurring FV measurements using Level 3 inputs significantly, their effect on P/L or OCI
Is there also a gap in the income statement?
• Understand accounting income and economic income
• But before that… time value of money (i.e., computation of present value)
Time Value of Money
▪ The time value of money means that all things being equal, it is better to have money now rather
than later.
▪ Rationale: Like other commodities, money is a scarce resource. Receiving the same amount of
money later rather than now involves forgoing interest income that could have been earned during
the intervening period.
▪ Given the time value of money, a dollar is worth more today than it would be worth tomorrow
given its capacity to earn interest.
▪ Discounting is the method used to figure out how much future payments are worth today (i.e.,
their present value).
Present Value (PV) of a Single Sum
▪ PV of a single sum represents the value today of a single sum to be received or paid at a future
time.
▪ Formula:
▪ An annuity is a series of payments of equal amounts.
▪ PV of an annuity:
• Sometimes called PV of an ordinary annuity, to be differentiated from PV of an annuity due
Concept of (Net) Income in Economics
▪ Hick’s definition
• (Net) income: The maximum amount a man can consume in a period and still be as well off at the
end of the period as he was at the beginning
▪ Extending to a business entity…
• (Net) income: The amount by which an entity’s net worth has increased during a period, due
allowance being made for any new capital contributed by its owners, or for any distributions made
by the entity to its owners
Measurement of (Economic) Net Income under Ideal Conditions with Certainty
Assumptions:
▪ Future cash flows and interest rate are known publicly with certainty
• Known publicly: No information asymmetry
• With certainty: Ex ante prediction = Ex post realisation
• Relevant attribute: NPV of future cash flows
