Why accounting analysis
 How well accounting captures business reality
 Appropriateness of accounting policies and estimates
 Degree of distortions in accounting numbers
 To improve the reliability and relevance of financial

statements

 Statement of Financial Position (Balance Sheet)
 Statement of Financial Performance (Income Statement)
 Cash Flow Statements

Foot Notes and Discussion and Analysis Section

A Hierarchy of Accounting Qualities

Accounting Equation
 Asset = Liability + Equity
 Profit = Revenue – Expenses

Elements of Financial Statements
 Assets
 Probable future economic benefits obtained or

controlled as a result of past business transactions

 Liabilities
 Obligations to transfer assets or provide services in the

future as a result of past business transactions

 Equity
 The residual interest in the assets after deducting

liabilities

Elements of Financial Statements—
Continued
 Investments by owners
 Increases in the equity due to transfers of value to obtain

or increase ownership interests (or equity) in it

 Distribution to owners
 Decrease in equity resulting from transferring assets,

rendering services, or incurrence of liabilities by the enterprise to owners

 Comprehensive income
 The change in equity during a period due to

transactions, events, and circumstances from nonowner sources Elements of Financial Statements—
Continued
 Revenues
 Inflows and other enhancements of assets or

settlements of liabilities from delivering or providing goods, rendering services, or carrying out other activities related to the central operations

 Expenses
 Outflows or consumption of assets or incurrence of

liabilities from delivering or providing goods, rendering services, or carrying out other activities related to the central operations

Elements of Financial Statements—
Continued
 Gains
 Increases in equity from peripheral or incidental

transactions of an entity

 Losses
 Decreases in equity from peripheral or incidental

transactions of an entity

Recognition and Measurement
 To be recognized, an item should meet the following criteria
 Fits in to a definition of elements
 Measurable with sufficient reliability
 Information should be relevant
 Information should be reliable

Recognition and Measurement—
Continued
 The five different measurement attributes used are
 Historical cost (historical proceeds)
 Current cost
 Current market value
 Net realizable (settlement) value
 Present (or discounted) value of future cash flows

Recognition and Measurement—
Continued
 A full set of financial statements for a period should show the following
 Financial position at the end of the period
 Earnings (net income)
 Comprehensive income (total nonowner change in

equity)
 Cash flows during the period
 Investments by and distributions to owners during the period Pitfalls in Reporting
 Example:
 How should revenue will be recognised when a firm

sells land to customer and also provide customer finance?  Research and Development Expenses – Assets or
Expenses?
 Managers have incentive to use distorted accounting numbers by making biased accounting numbers.

GAAP
 Historical Cost convention – Recording Assets and

Liabilities at Historical exchange prices or their fair value or value in use?
 Historical Cost reduces manager’s ability to overstate asset value but limits the information available to investors.
 Accounting standards increase the credibility of the financial statements but also reduces the flexibility for businesses to reflect genuine business differences
 Where significant business judgment is involved accounting standards are likely to be dysfunctional.

External Auditing and Liability
 Auditing ensures that managers use accounting rules

and conventions consistently over time.
 Auditing improves the quality and credibility of accounting data.
 Enron and Worldcom., HIH have shown that auditing is imperfect.
 Auditors cannot review all