AC4304
Financial Reporting
Theory
Presentation
Casey Lau
Gloria Ho
Hayley Cheng
Virtues
of
Income Statement
Agenda
•
•
•
•
•
Background
Definition
Usefulness to users
Limitation
Recommendation
Background
Objectives
• Financial Statements
“to provide information that is useful to
users of assessing the financial position …
… and the performance and cash flows of
an enterprise ……”
(HKSA Stm. 2.01)
Objectives
• Income Statement
“…… while information about performance
is primarily provided in a profit and loss
account ……”
(HKSA Stm. 2.01)
“The financial statement of a firm that
summarizes revenues and expenses over a
specified time period.”
(The 'Lectric Law Library's Lexicon)
Functions
• Profitability
• Past year’s operating results
• Underlying accounting concept
Accrual / Matching
Main Items in I/S
•
•
•
•
•
Turnover
Cost of sales
Gross profit
Other revenue
Distribution /
Administrative / Other
operating expenses
• P/L from operation
• Finance cost
• Share of P/L of
associates / joint
ventures
• Tax expenses
• P/L from ordinary
activities
• Extraordinary items
• Minority interest
• Net P/L for the period
Usefulness
to
Investors
Investors are ...
• Equity security holders
• providers of risk capital
• concerned with the risk & return on
investments
Investors need ……
• to know if they should buy, hold or sell.
• to assess the enterprise’s ability to
pay dividends
i.e. Reward of ownership
Profitability
• Profits as measure of performance
• Ratios analysis :
- Profit margin
- Return on assets
- Dividend payout ratio
- Earnings per share (EPS)
Comparability
• Corresponding prior year’s information
• Development trend
• Comparison :
- Year-to-year
- Enterprise-to-enterprise
- Industry-to-industry
Control of Cost
• GP margin VS NP margin
• Comparative figures of expenses
- e.g. Financial cost
• Future prospect like capital gains ?
Usefulness
to
Creditors
Creditors are ……
• Trade creditors :
- Supplier of goods & service
• Non-trade creditors :
- Customers & employees with claims
- Lending institutions & individuals;
- Debt security holders.
Creditors need …...
• information that enables them to
determine whether amounts owing to
them will be paid when due
i.e. Solvency
• interested in an enterprise continuation
of the enterprise as a major customer.
Solvency
• If enterprise can meet short-term &
long-term obligation
- Finance costs e.g. interest expense
- operating profits
Going-concern
• The continuousness of the company by
comparative figures
• Profit / Loss ?
Separate Items
• Impairment Items
• Finance costs
• Operating profits
• Balance Sheet as a supplementary tool
Usefulness
to
Managers
Mangers are ……
• Managers are basically those who run
the firm on behalf of the shareholders.
They are expected to act in the best
interest of the shareholders.
• For the managers, income statements
are published as a compliance of the
Accounting Standards and the law.
Profitability
• They are concerned about the profitability
and the company’s performance.
Income Statement
Predict Future Growth, Profits Share Price
Channel of
Communication
• Income statements also serve as their
channel of communication with the
investors and to attract more investors.
Channel of
Communication
• According to George Staubus, Professor
of University of California, Berkeley in
the ‘Investor Theory’ –
“accounting/financial statements is to
provide information to the firm’s
suppliers of capital…..help them
ascertain the firm’s willingness to pay
Attract
investors.”
investors
Ability Assessment
• Income statements very often also serve as a
means to assess managerial ability and their
remunerations are tied to the current year
earnings.
“Famous scholars Paton & Littleton says in
their definition of income: ‘…. It reflects
managerial effectiveness and is of particular
significance to those who furnish the capital
and take the ultimate responsibility.”
Planning and Control
• Income statements (published accounts)
can be used for internal control but
normally managers mainly rely on the
management accounts.
• Act as a monitoring tool with the support of
budgeted I/S and comparison between
actual and planned performance.
Limitation
of the use of
Income
Statements
Limitations
• Information asymmetry
– Due to adverse selection, not all information
are available to the investors in the income
statements.
– Hence, income statements may not be able to
reflect the full picture.
Limitations
• Earnings management & Income smoothing
– manipulation of accounts
– intentional dampening of fluctuations
about some level of earnings that it
currently
considered
to be PICTURE
normal for!a
MAY NOT
BE THE TRUE
firm e.g. by classification, recognition,
allocation of time, etc. (Ronald D Picur;
JBFA)
Limitations
•
Stockholders/investors
a principal hire
e.g. consume perquisites
Agency relationship Exist whenever
somebody
else to act on its
Creditors
(Michael C. Jensen)
behalf as
anincrease
agent level of debt
e.g.
or take high risk projects
which are unanticipated
Results in agency costs
by creditors
Income statements may not be able to
reflect the firm’s real stability or
potential to make profit.
Recommendation
Comprehensive
Income Theory
• all-inclusive income
According to Financial Accounting Standards Board
(FASB) SFAS 130:
‘Comprehensive income is the change in equity of a
business enterprise during a period from
transactions and other events and circumstances
from non-owner sources. It includes net income and
other comprehensive income such as foreign
currency translation adjustments, unrealized gains
and losses, etc.
Comprehensive
Income Theory
• Advantages: (Stan Clark, University of Southern
Mississippi)
– Net income of the firm for the life of the firm
should be equal to the sum of the annual report
net incomes
– Income smoothing may be checked by the
inclusion of all income changes and credits
– A better picture of the total performance of the
firm is conveyed, especially when both
recurring and unusual, infrequently occurring
items are displayed separately in the income
statement.
Value-added income
statement
– Evaluate the firm in terms of its
contribution to the society and the
cooperative effort between the
employees, suppliers of fund, & the
government.
– Basis of theory: The above mentioned
parties should cooperate together in
order for a firm to survive and to
make profit.
Value-added income
statement
• (Waino Suojanen, Accounting Review)
– Performance measure of wealth
creation by the firm, reflect more
information e.g. social change
(Michael Morley, The Value Added
Statement, London)
Conclusion
~ The End ~