Lecture 1.2 - Slides

Chapter 1: Accounting Basics and Financial Statements Overview
Lecture 1.2: Accounting Basics Part 2

 Generally Accepted Accounting Principles (GAAP): Set by the Financial Accounting Standards Board (FASB)
together with the Securities Exchange Commission (SEC) in the United States
 International Financial Reporting Standards (IFRS): Set by the International Accounting Standards Board
(IASB) and is currently being applied in more than 100 countries worldwide The European Union has
adopted the IFRS in 2005 for listed companies
Each country adapts its regulatory system to accommodate the IFRS general rules.
In Portugal, the SNC (Sistema de Normalização Contabilística) replaced the previous system (POC – Plano
Oficial de Contabilidade), adapting regulation to the IFRS
The US is the largest of the few remaining hold-outs and is expected to move completely from GAAP to
IFRS as intended by SEC (cross-listed firms in the US may apply the IFRS since 2007). The two systems are
not widely different but there are still some differences.
Recognize 1 000
as revenue
Company sells a good today for 1 000€ and is

paid 400€ today, with the remaining 600€ due in
6 months
Recognize 600 as
revenue
How is the income statement built?
 According to the revenue recognition principle, a revenue should be
(CASH FLOW IS NOT THE

ACCRUAL ACCOUNTING
CRITERION TO RECORD)
recognized when:
The entity has transferred to the buyer the significant risk and rewards
from the ownership of the goods (i.e. earnings process is accomplished);
The amount of revenue can be measured reliably;
It is probable that the economic benefits associated with the transaction
will flow to the entity (i.e. receipt of cash is reasonably certain);
 According to the matching principle, an expense should be recognized in
such a way that the company matches the expenses against the revenue
for which they are incurred
When Example
If I render a service or make a sale to a client and he is due I make a sale of 1,000 Euros but I only receive 400
Accounts
to pay me, that is an account receivable to the company, Euros today. The remaining 600 Euros are recorded
Receivable and
recorded as an asset on the balance sheet. on the balance sheet as an account receivable.
Accounts Payable
If I incur in an expense that has yet to be paid and that is Christmas subsidies paid to employees in December
Accrued Assets not due yet, that expense is recorded on the income must be recorded as an expense, and as an accrued
and Accrued statement when they occur (accrual accounting) and a liability every month, since they are an expense
Liabilities liability of the same amount is recorded on the balance related with the work carried out by the employees
sheet under the name of accrued liability. every month.
Prepaid/ Deferred If I pay for an expense now but which I actually only I pay at the end of September a yearly insurance of
Expenses and benefit from later, I do not recognize the expense right $4,000. At the end of the year, I record an expense
Unearned/ away (against accrual accounting) and I recognize a right of $1,000 which corresponds to the period from
Deferred on my balance sheet - the right to make use of whatever I October to November. For the remaining 9 months, I
Revenues paid for that I have yet to use. That right is a prepaid will record a Prepaid Expense of $3,000 in my
expense. balance sheet.
How is the balance sheet built?
Depending on the items, there are specific principles to record their value on the balance sheet:
 Historical cost accounting: reported at the amount paid when they were acquired or incurred and amortized
subsequently
 Fair value accounting: reported at their market values at all times (i.e. how much they would be worth it if sold
in the market)
Dealing with Fair Value Assets
 There has been a lot of debate about whether financial assets and liabilities should be reported at fair value or historical
cost and the trade off is effectively one of relevance vs reliability
 Fair value might be more relevant for investors but it can also be less reliable because it can be manipulated more easily and
makes earnings more sensitive to temporary fluctuations.
 How is fair value calculated? Using a fair value hierarchy system:
i. Level I: quoted prices in an active market for identical assets or liabilities
ii. Level II: no quoted prices, but available prices for comparables
iii. Level III: no comparables, so fair value must be estimated using a valuation model
 Depreciations and amortizations are accounting figures that allow us to allocate the “usage” of the asset
as an expense to the income statement of each year (instead of allocating it entirely the moment of the
acquisition)
 We talk about depreciations for fixed assets and amortizations for intangible assets.
 Note that although depreciations also decrease the value of the asset over time on the balance sheet
according to its estimated usage, they are not a way of showing the real value of the assets – it is purely
an accounting movement that moves some value from the balance sheet as assets (unused) to the
income statement (as used)
Example of Depreciation Method
Purchase Year 1 Year 2 Year 3 Year 4 Year 5

Net Asset Value (BS) 1,000 800 600 400 200 0
Cumulative Depreciations (BS) 0 200 400 600 800 1,000
Yearly Depreciation Expense (IS) 0 200 200 200 200 200
 Another way assets can loose value is through impairments.
 Whereas certain assets are expected to depreciate over time and the amount is calculated based on a
predetermined calculation that assumes a typical usage over time, impairment losses account for unusual and
drastic drops in the fair value of assets.
 When an asset is tested for impairment and it is deemed that its fair value is lower than its outstanding amount
on the balance sheet, companies must record an impairment loss to make up for that.
 Accounting has rules that stipulate that certain assets must be tested for impairment regularly to prevent
overstatement of their amounts on the balance sheet and it also has rules that dictate how much impairment
can be recorded at each moment.
 An impairment is recognized both as an expense in the income statement and as a asset reduction in the
balance sheet. Like depreciations and amortizations, there is no actual cash movement.
 A company’s activity implies risks associated with potential future events.
 Provisions are accounting’s response to these risks – they represent resources that are “set aside” in advance to
protect the company from future situations that may result in payments.
 Common provisions include legal processes against the company, warranties or provisions for doubtful
accounts.
 The moment a provision is made, it does not imply any cash flow movement at all.
 Because of this, in the past, creative accountants have used provisions to smooth out profits, adding more
provisions in a successful year and limiting them when earnings were down. Nowadays a company cannot simply
recognize a provision whenever they see fit – accounting has introduced a number of norms to limit this.

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Chapter 1: Accounting Basics and Financial Statements Overview

Lecture 1.2: Accounting Basics Part 2

Company sells a good today for 1 000€ and is

(CASH FLOW IS NOT THE

Purchase Year 1 Year 2 Year 3 Year 4 Year 5

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