Accounting Institutions and Regulation
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1 Accounting Institutions and Regulation (EAC PD 303) Renê Coppe Pimentel Prof. Renê Coppe Pimentel Pg. 1
2 THE ACCOUNTING ENVIRONMENT Firms future cash flows and their probabilities are know The economy has perfect and complete markets: there is no information asymmetry there is no barriers to fair and efficient working of markets Hence, asset and liability valuation is based on present value of future cash flows (value in use) Arbitrage ensures that present value and market value are equal Investors and managers have no disagreements over the role of financial reporting and no incentive to call for regulation Prof. Renê Coppe Pimentel Pg. 2
3 #BUTNOT Prof. Renê Coppe Pimentel Pg. 3
4 THE ACCOUNTING ENVIRONMENT The challenge for financial accountants is to survive and prosper in a complex environment characterized by conflicting preferences of different groups with interest in financial reporting The prospects for survival and prosperity will be enhanced if accountants have critical awareness of the impact of financial reporting on investors, managers and the economy (p.20) Prof. Renê Coppe Pimentel Pg. 4
5 THE ACCOUNTING ENVIRONMENT Central problem in financial accounting theory is to conciliate financial reporting structure to demands from: (i) investors (business valuation) and (ii) designing and monitoring efficient contracts. Prof. Renê Coppe Pimentel Pg. 5
6 INTRODUCTION Why Accounting Institutions and Regulation? The role of accounting Identify the economic events relevant to firm s business (identification) Record the economic events in a systematic way (recording) Communicate: accounting reports and financial statements Prof. Renê Coppe Pimentel Pg. 6
7 THEORY OF REGULATION Is accounting regulation necessary? The central problem in Accounting Theory: To conciliate financial report to: (i) investors (business evaluation) (ii) to form effective contracts (specially managerial compensation) How much information is necessary? Prof. Renê Coppe Pimentel Pg. 7
8 THEORY OF REGULATION Two main regulation approaches: Public Interests Theory: regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices. Interest Group Theory: regulation is an coalition effort to protect certain groups by formation of lobby The standard setting process (regulation) usually deals with dilemmas about usefulness of accounting information to decision making among different groups. Prof. Renê Coppe Pimentel Pg. 8
9 SOURCES OF INFORMATION USED IN EXTERNAL DECISION MAKING Prof. Renê Coppe Pimentel Pg. 9
10 ACCOUNTING INFORMATION Accounting information should be relevant, reliable and comparative How can we achieve that? By creating a solid set of principles, concepts, standards, and rules Prof. Renê Coppe Pimentel Pg. 10
11 ACCOUNTING INFORMATION Rule vs Principles It seems that the world is moving towards principles-based standards.... However, such standards will face pressures from managers and even governments, to bend financial reporting to their desires. To resist such pressures, auditors and accountants will have to adopt the longer-term view of their responsibilities The Board [FASB] believes that an approach focusing more clearly on the principles in accounting standards is necessary to improve the quality and transparency of U.S. financial accounting and reporting. The Board believes that if all participants in the U.S. financial accounting and reporting process are willing to make the changes required under a principles-based approach, the benefits of adopting that approach would outweigh its costs. Prof. Renê Coppe Pimentel Pg. 11
12 CONCEPTUAL FRAMEWORK It defines the fundamental concepts used in the overall accounting regulation Orientation Interpretation Acconting Standards (authoritative guidance on how companies should account for and report specific transactions), Conceptual Framework Prof. Renê Coppe Pimentel Pg. 12
13 CONCEPTUAL FRAMEWORK Prof. Renê Coppe Pimentel Pg. 13
14 CONCEPTUAL FRAMEWORK Describes the objective of, and the concepts for, general purpose financial reporting Assists the Board to develop IFRS Standards that are based on consistent concepts assists preparers to develop consistent accounting policies when no IFRS Standard applies to a particular transaction or event, or when a Standard allows a choice of accounting policy; and assists others to understand and interpret the Standards. Prof. Renê Coppe Pimentel Pg. 14
15 OBJECTIVE OF FINANCIAL REPORTING Prof. Renê Coppe Pimentel Pg. 15
16 STRUCTURE OF FINANCIAL STATEMENTS Balance Sheet: Measuring Financial Position A snapshot of the resources of a firm (assets) The claims on the firm (liabilities and shareholders equity) As of a specific date (usually the last day of the fiscal quarter or the fiscal year) The balance sheet reports the following equation: Assets = Liabilities + Shareholders Equity Resources can be viewed from two perspectives: Specific resources the firm holds The claims on the firm by the persons or entities that provided the resources Prof. Renê Coppe Pimentel Pg. 16
17 STRUCTURE OF FINANCIAL STATEMENTS Income Statement: Measuring and Reporting Performance The income statement reports the financial results (profits or losses) of a firm s performance for a period of time (f.i. quarter or year). Revenues: inflows of assets and the settlements of obligations from selling goods and providing service to customers. Expenses: outflows of assets that a company consumes and the obligations it incurs in the process of operating the business to generate revenues. Net Income (or Net Loss): the bottom-line profit (or loss) of a company for the period. Net Income = Revenues Expenses + Gains Losses Prof. Renê Coppe Pimentel Pg. 17
18 STRUCTURE OF FINANCIAL STATEMENTS Statement of Cash Flows Reports for a period of time the net cash flows (inflows minus outflows) from operating, investing, and financing activities Provides useful information about how a firm is generating and using cash. Complements the income statement since it demonstrates how cash flows differ from accrual-based income Helps in evaluating the company s cash-generating ability To give information about the likelihood of future cash flows for future payments of obligations Prof. Renê Coppe Pimentel Pg. 18
19 STRUCTURE OF FINANCIAL STATEMENTS Statement of Shareholders Equity The statement of shareholders equity provides information about the common shareholders equity claims on the company and how those claims change during the period. Contributed capital: amounts initially contributed by shareholders for an interest in a company Earned capital: cumulative net income in excess of dividends declared Shareholders equity effects from the recognition or valuation of certain assets or liabilities Prof. Renê Coppe Pimentel Pg. 19
20 STRUCTURE OF FINANCIAL STATEMENTS Financial Statement Notes Companies must provide notes as additional information with the financial statements. Management Discussion and Analysis Extensive narrative discussion and quantitative analysis. Managers and Independent Auditors Attestations Management is responsible for financial statements and the underlying accounting and control system that generates the financial statements. Independent auditors are responsible for assessing a company s internal control system, designing audit tests, and forming an opinion about the fairness of the amounts reported in the financial statements. Prof. Renê Coppe Pimentel Pg. 20
21 ACCRUAL ACCOUNTING Accrual accounting measures and reports the economic effects of a company s transactions, events, and circumstances on a company s economic resources and claims in the period in which those effects occur, even if the related cash receipts and payments occur in a different period. Provides a better basis for assessing the company s past and future performance than information solely about cash receipts and payments. Prof. Renê Coppe Pimentel Pg. 21
22 PROVIDING USEFUL INFORMATION The following types of information are helpful in assessing the amounts, timing, and uncertainty of expected future cash flows to a company: Return on investment measure of overall company performance for equity shareholders Risk the uncertainty or unpredictability of future profitability of a company Financial flexibility the ability of a company to use its financial resources to adapt to change and to take advantage of opportunities Liquidity refers to how quickly a company can convert its assets into cash to meet short-term obligations and cover operating costs Operating capability refers to the ability of a company to produce goods and services for customers Prof. Renê Coppe Pimentel Pg. 22
23 PROVIDING USEFUL INFORMATION The following types of information are helpful in assessing the amounts, timing, and uncertainty of expected future cash flows to a company: Return on investment measure of overall company performance for equity shareholders Risk the uncertainty or unpredictability of future profitability of a company Financial flexibility the ability of a company to use its financial resources to adapt to change and to take advantage of opportunities Liquidity refers to how quickly a company can convert its assets into cash to meet short-term obligations and cover operating costs Operating capability refers to the ability of a company to produce goods and services for customers Prof. Renê Coppe Pimentel Pg. 23
24 PROVIDING USEFUL INFORMATION Prof. Renê Coppe Pimentel Pg. 24
25 MEASUREMENT BASIS Historical costs x Fair value accounting Reliability x Relevance Prof. Renê Coppe Pimentel Pg. 25
26 IFRS STANDARDS How to develop IFRS Standards: Prof. Renê Coppe Pimentel Pg. 26
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