Chapter 1

The Adversarial Nature

of Financial Reporting

Topics:
 Purpose of Financial Reporting
 Flaws in the Reasoning
 Maximizing Growth Expectations
 Downplaying Contingencies and Importance of Being Skeptical
 Recognition of Profit, Revenue, and Expenses

Objectives:
After studying this chapter, you should:

 Know the objective of financial statement and financial reporting

 Understand the primary responsibility for the preparation of financial statements
 Prepare basic accounting in an organized and efficient manner
 Identify the general features in the preparation of financial statements
 Explain how the timing of expense and revenue recognition affects the financial
statements

Introduction
This chapter is intended to bridge the gap between your introductory studies in accounting and
the intermediate level that is the subject matter of this text. You might find that you know a lot
of this material already, although that does not mean that it would be advisable to skip
anything. At the very last, you will have had the summer vacation in which to forget s lot of the
basics. Furthermore, this chapter presents the basics in terms of the aspects that you really
need to know in order to proceed to the next level. Thus, there might be something new that
will make a huge different to your progress hidden away in the body of revision material.
One of the most important things that you need to understand in studying financial reporting is
that the whole discipline is entirely man made. There are very few concrete realities that arise
in the preparation of financial statements Admittedly, there are cash flows into and out of the
business’s bank accounts and there are resources that its managers can direct and control, but
the manner in which these are accounted for is open to great deal of discussion and debate.
We might have reached a stage where a lot of the arguments have been resolved, but there is
no reason why the financial statements that you have seen in your studies to date have to be as
they are. This is an important point, if only because understanding the interests and the ideas
that have shaped accountancy is one of the most interesting aspects of the subject.

TOPIC 1: Topic 1: Financial Statements

Financial statements are the means by which the information accumulated and processed in
financial accounting is periodically communicated to the users.
General purpose financial statements
General purpose financial statements are those statements intended to meet the needs of
users who are not in a position to require an entity to prepare reports tailored to their
particular information needs. Reports prepared at the request of an entity’s management or
bankers are not general-purpose financial statements because they are prepared specifically to
meet the needs of management or bankers.
Components of Financial Statements
A complete set of financial statements comprises the following components:
1. Statement of financial position
2. Income statement
3. Statement of comprehensive income
4. Statement of changes in equity
5. Statement of cash flows
6. Notes, comprising a summary of significant accounting policies and other explanatory
information
Many entities also present reports and statements such as environmental reports and value-
added statements, particularly in industries in which environmental factors are significant and
when employees are regarded as an important user group.
However, such statements and reports are not components of financial statements.
Objectives of financial statements
The objective of general-purpose financial statements is to provide information about the
financial position, financial performance and cash flows of an entity that is useful to a wide
range of users in making economic decisions.
Financial statements also show the results of the stewardship of management of the resources
entrusted to it.
To meet this objective, financial statements provide information about the following:
a. Assets
b. Liabilities
c. Equity
d. Income and expenses, including gains and losses
e. Contributions by distributions to owners in their capacity as owners
f. Cash flows

Such information, along with other information in the notes, would assist users of financial
statements do not provide all the information that users may need to make economic
decisions.
The reason is that the financial effects of past events and do not necessarily provide
nonfinancial information.
Financial Reporting
Financial reporting is the provision of financial information about an entity to external users
that is useful to them in making economic decisions and for assessing the effectiveness of the
entity’s management.
The principal way of providing financial information to external users is through the annual
financial statements.
However, financial reporting encompasses not only financial statements but also other means
of communicating information that relates directly or indirectly to the financial accounting
process.
Financial reports include not only financial statements but also other information such as
financial highlights, summary of important financial figures, analysis of financial statements and
significant ratios.
Financial reports also include nonfinancial information such as description of major products
and a listing of corporate officers and directors.
Objective of Financial Reporting
Under the conceptual framework for financial reporting, the objective of financial reporting is
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.
Simply stated, the overall objective of financial reporting is to provide information that is useful
for decision making.

TOPIC 2: The Flaws in the Reasoning

The financial statements shall present fairly the financial position, financial performance and
cash flows of an entity.
Virtually, in all circumstances, fair presentation is achieved if the financial statements are
prepared in accordance with the Philippine Financial Reporting Standards which represent the
GAAP in the Philippines.
The application of Philippine Financial Reporting Standards, with additional disclosure, when
necessary, is presumed to result in financial statements that achieve a fair presentation.
An entity whose financial statements comply with PFRS shall make an explicit and unreserved
statement of such compliance in the notes.
Fair presentation is defined as faithful representation of the effects of transactions and other
events in accordance with the definitions and recognition criteria for assets, liabilities, income
and expenses laid down in the conceptual Framework.
Fair presentation requires an entity:
a. To select and apply accounting policies in accordance with PFRS.
b. To present information, including accounting policies, in a manner that provides
relevant and faithfully represented financial information.
 c. To provide additional disclosures necessary for the users to understand the entity’s
financial statements.

An entity cannot rectify inappropriate accounting policies either by disclosure of the accounting
policies used or by notes or explanatory information.

For example, corporations routinely and unabashedly smooth their earnings. That is, they
create the illusion that their profits rise at a consistent rate from year to year. Corporations
engage in this behavior, with the blessing of their auditors, because the appearance of smooth
growth receives a higher price-earnings multiple from stock market investors than the jagged
reality underlying the numbers.

Suppose that, in the last few weeks of a quarter, earnings threaten to fall short of the
programmed year-over-year increase. The corporation simply "borrows" sales (and associated
profits) from the next quarter by offering customers special discounts to place orders earlier
than they had planned. Higher-than-trendline growth, too, is a problem for the earnings-
smoother. A sudden jump in profits, followed by a return to a more ordinary rate of growth,
produces volatility, which is regarded as an evil to be avoided at all costs. Management's
solution is to run up expenses in the current period by scheduling training programs and plant
maintenance that, while necessary, would ordinarily be undertaken in a later quarter.

These are not tactics employed exclusively by fly-by-night companies. Blue chip corporations
openly acknowledge that they have little choice but to smooth their earnings, given Wall
Street's allergy to surprises. Officials of General Electric have indicated that when a division is in
danger of failing to meet its annual earnings goal, it is accepted procedure to make an
acquisition in the waning days of the reporting period. According to an executive in the
company's financial services business, he and his colleagues hunt for acquisitions at such times,
saying, "Gee, does somebody else have some income? Is there some other deal we can
make?"13 The freshly acquired unit's profits for the full quarter can be incorporated into GE's,
helping to ensure the steady growth so prized by investors.

TOPIC 3: Maximizing Growth Expectations

Imagine a corporation that is currently reporting annual net earnings of $20 million. Assume
that five years from now, when its growth has leveled off somewhat, the corporation will be
valued at 15 times earnings. Further assume that the company will pay no dividends over the
next five years and that investors in growth stocks currently seek returns of 25% (before
considering capital gains taxes).

Based on these assumptions, plus one additional number, the analyst can place an aggregate
value on the corporation's outstanding shares. The final required input is the expected growth
rate of earnings. Suppose the corporation's earnings have been growing at a 30% annual rate
and appear likely to continue increasing at the same rate over the next five years. At the end of
that period, earnings (rounded) will be $74 million annually. Applying a multiple of 15 times to
that figure produces a valuation at the end of the fifth year of $1.114 billion. Investors seeking a
25% rate of return will pay $365 million today for that future value.

These figures are likely to be pleasing to a founder/chief executive officer who owns, for sake of
illustration, 20% of the outstanding shares. The successful entrepreneur is worth $73 million on
paper, quite possibly up from zero just a few years ago. At the same time, the newly minted
multimillionaire is a captive of the market's expectations.

Suppose investors conclude for some reason that the corporation's potential for increasing its
earnings has declined from 30% to 25% per annum. That is still well above average for
Corporate America. Nevertheless, the value of corporation's shares will decline from $365
million to $300 million, keeping previous assumptions intact.

Overnight, the long-struggling founder will see the value of his personal stake plummet by $13
million. Financial analysts may shed few tears for him. After all, he is still worth $60 million on
paper. If they were in his shoes, however, how many would accept a $13 million loss with
perfect equanimity? Most would be sorely tempted, at the least, to avoid incurring a financial
reverse of comparable magnitude via every means available to them under GAAP.

That all-too-human response is the one typically exhibited by owner-managers confronted with
falling growth expectations. Many, perhaps, most, have no intention to deceive. It is simply that
the entrepreneur is by nature a self-assured optimist. A successful entrepreneur, moreover, has
had this optimism vindicated. Having taken his company fro006D nothing to $20 million of
earnings against overwhelming odds, he believes he can lick whatever short-term problems
have arisen. He is confident that he can get the business back onto a 30% growth curve, and
perhaps he is right. One thing is certain—if he were not the sort who believed he could beat the
odds one more time, he would never have built a company worth $300 million.

Financial analysts need to assess the facts more objectively. They must recognize that the
corporation's predicament is not unique, but on the contrary, quite common. Almost invariably,
senior managers try to dispel the impression of
decelerating growth, since that perception can be
so costly to them. Simple mathematics, however,
tends to make false prophets of corporations that
extrapolate high growth rates indefinitely into
the future. Moreover, once growth begins to
level off (see Exhibit 1.1), restoring it to the
historical rate requires overcoming several
powerful limitations.

Shifting investors' perceptions upward through

the Corporate Credibility Gap between actual and
management-projected growth is a potentially
valuable but inherently difficult undertaking for a
company. Liberal financial reporting practices can
make the task somewhat easier. In this light,
analysts should read financial statements with a skeptical eye.

TOPIC 3: Downplaying Contingencies

A second way to mold disclosure to suit the issuer's interests is by downplaying extremely
significant contingent liabilities. Thanks to the advent of class action suits, the entire net worth
of even a multi-billion-dollar corporation may be at risk in litigation involving environmental
hazards or product liability. Understandably, an issuer of financial statements would prefer that
securities analysts focus their attention elsewhere.
At one time, analysts tended to shunt aside claims that ostensibly threatened major
corporations with bankruptcy. They observed that massive lawsuits were often settled for small
fractions of the original claims. Furthermore, the outcome of a lawsuit often hinged on facts
that emerged only when the case finally came to trial (which by definition never happened if
the suit was settled out of court). Considering also the susceptibility of juries to emotional
appeals, securities analysts of bygone days found it extremely difficult to incorporate legal risks
into earnings forecasts that relied primarily on micro- and macroeconomic variables. At most, a
contingency that had the potential of wiping out a corporation's equity became a qualitative
factor in determining the multiple assigned to a company's earnings.

Analysts must take particular care to rely on their independent judgment when a potentially
devastating contingent liability looms larger than their conscientiously calculated financial
ratios. It is not a matter of sitting in judgment on management's honor and forthrightness. If
corporate executives remain in denial about the magnitude of the problem, they are not
deliberately misleading analysts by presenting an overly optimistic picture. Moreover, the
managers may not provide a reliable assessment even if they soberly face the facts. In all
likelihood, they have never worked for a company with a comparable problem. They
consequently have little basis for estimating the likelihood that the worst-case scenario will be
fulfilled. Analysts who have seen other corporations in similar predicaments have more
perspective on the matter, as well as greater objectivity. Instead of relying entirely on the
company's periodic updates on a huge class action suit, analysts should also speak to
representatives of the plaintiffs' side. Their views, while by no means unbiased, will expose
logical weaknesses in management's assertions that the liability claims will never stand up in
court.

The Importance of Being Skeptical

By now, the reader presumably understands why this chapter is entitled "The Adversarial
Nature of Financial Reporting." The issuer of financial statements has been portrayed in an
unflattering light, invariably choosing the accounting option that will tend to prop up its stock
price, rather than generously assisting the analyst in deriving an accurate picture of its financial
condition. Analysts have been warned not to partake of the optimism that drives all great
business enterprises, but instead to maintain an attitude of skepticism bordering on distrust.
Some readers may feel they are not cut out to be financial analysts if the job consists of
constant naysaying, of posing embarrassing questions, and of being a perennial thorn in the
side of companies that want to win friends among investors, customers, and suppliers.

Although pursuing relentless antagonism can indeed be an unpleasant way to go through life,
the stance that this book recommends toward issuers of financial statements implies no such
acrimony. Rather, analysts should view the issuers as adversaries in the same manner that they
temporarily demonize their opponents in a friendly pickup basketball game. On the court, the
competition can be intense, which only adds to the fun. Afterward, everyone can have a fine
time going out together for pizza and beer. In short, financial analysts and investor-relations
officers can view their work with the detachment of litigators who engage in every legal form of
shin-kicking out of sheer desire to win the case, not because the litigants' claims necessarily
have intrinsic merit.

Too often, financial writers describe the give-and-take of financial reporting and analysis in a
highly moralistic tone. Typically, the author exposes a tricky presentation of the numbers and
reproaches the company for greed and chicanery. Viewing the production of financial
statements as an epic struggle between good and evil may suit a crusading journalist, but
financial analysts need not join the ethics police to do their job well.
An alternative is to learn to understand the gamesmanship of financial reporting, perhaps even
to appreciate on some level the cleverness of issuers who constantly devise new stratagems for
leading investors off the track. Outright fraud cannot be countenanced, but disclosure that
shades economic realities without violating the law requires truly impressive ingenuity. By
regarding the interaction between issuers and users of financial statements as a game, rather
than a morality play, analysts will find it easier to view the action from the opposite side. Just as
a chess master anticipates an opponent's future moves, analysts should consider which gambits
they themselves would use if they were in the issuer's seat.

In reality, this book's goal is to make the reader a better analyst. If that goal could be achieved
by providing shortcuts, the authors would not hesitate to do so. Financial reporting occurs in an
institutional context that obliges conscientious analysts to go many steps beyond conventional
calculation of financial ratios. Without the extra vigilance advocated in these pages, the user of
financial statements will become mired in a system that provides excessively simple answers to
complex questions, squelches individuals who insolently refuse to accept reported financial
data at face value, and inadvisably gives issuers the benefit of the doubt.

These systematic biases are inherent in selling stocks. Within the universe of investors are many
large, sophisticated financial institutions that utilize the best available techniques of analysis to
select securities for their portfolios. Also among the buyers of stocks are individuals who, not
being trained in financial statement analysis, are poorly equipped to evaluate annual and
quarterly earnings reports. Both types of investors are important sources of financing for
industry, and both benefit over the long term from the returns that accrue to capital in a
market economy. The two groups cannot be sold stocks in the same way, however.

What generally sells best to individual investors is a "story." Sometimes the story involves a
new product with seemingly unlimited sales potential. Another kind of story portrays the
recommended stock as a play on some current economic trend, such as declining interest rates
or a step-up in defense spending. Some stories lie in the realm of rumor, particularly those that
relate to possible corporate takeovers. The chief characteristics of most stories are the promise
of spectacular gains, superficially sound logic, and a paucity of quantitative verification.

No great harm is done when an analyst's stock purchase recommendation, backed up by a

thorough study of the issuer's financial statements, is translated into soft, qualitative terms for
laypersons' benefit. Not infrequently, though, a story originates among stockbrokers or even in
the executive offices of the issuer itself. In such an instance, the zeal with which the story is
disseminated may depend more on its narrative appeal than on the solidity of the supporting
analysis.

Individual investors' fondness for stories undercuts the impetus for serious financial analysis,
but the environment created by institutional investors is not ideal, either. Although the best
investment organizations conduct rigorous and imaginative research, many others operate in
the mechanical fashion derided earlier in this chapter. They reduce financial statement analysis
to the bare bones of forecasting earnings per share, from which they derive a price-earnings
multiple. In effect, the less conscientious investment managers assume that as long as a stock
stacks up well by this single measure, it represents an attractive investment. Much Wall Street
research, regrettably, caters to these institutions' tunnel vision, sacrificing analytical
comprehensiveness to the operational objective of maintaining up-to-the-minute earnings
estimates on vast numbers of companies.

Investment firms, moreover, are not the only workplaces in which serious analysts of financial
statements may find their style crimped. The credit departments of manufacturers and
wholesalers have their own set of institutional hazards.
Consider, to begin with, the very term "credit approval process." As the name implies, the
vendor's bias is toward extending rather than refusing credit. Up to a point, this is as it should
be. In Exhibit 1.3, "neutral" Cutoff Point A, where half of all applicants are approved and half
are refused, represents an unnecessarily high credit standard. Any company employing it would
turn away many potential customers who posed almost no threat of delinquency. Even Cutoff
Point B, which allows more business to be written but produces no credit losses, is less than
optimal. Credit managers who seek to maximize profits aim for Cutoff Point C. It represents a
level of credit extension at which losses on receivables occur but are slightly more than offset
by the profits derived from incremental customers.

To achieve this optimal result, a credit analyst must approve a certain number of accounts that
will eventually fail to pay. In effect, the analyst is required to make "mistakes" that could be
avoided by rigorously obeying.

EXHIBIT 1.3 The Bias toward Favorable Credit Evaluations

 Most Creditworthy

 Measures of Financial Strength

 Least Creditworthy

 Measures of Financial Strength

A. Approve 50%, Reject 50%

B. Zero Credit Loss

C. Profit Margin on Incremental Customers Narrowly Exceeds Credit Losses

D. Credit Losses Exceed Profit Margin the conclusions derived from the study of applicants'
financial statements. The company makes up the cost of such mistakes by avoiding mistakes of
the opposite type (rejecting potential customers who will not fail to pay).

Trading off one type of error for another is thoroughly rational and consistent with sound
analysis, so long as the objective is truly to maximize profits. There is always a danger, however,
that the company will instead maximize sales at the expense of profits. That is, the credit
manager may bias the system even further, to Cutoff Point D in Exhibit 1.3. Such a problem is
bound to arise if the company's salespeople are paid on commission and their compensation is
not tightly linked to the collection experience of their customers. The rational response to that
sort of incentive system is to pressure credit analysts to approve applicants whose financial
statements cry out for rejection.

A similar tension between the desire to book revenues and the need to make sound credit
decisions exists in commercial lending. At a bank or a finance company, an analyst of financial
statements may be confronted by special pleading on behalf of a loyal, long-established client
that is under allegedly temporary strain. Alternatively, the lending officer may argue that a loan
request ought to be approved, despite substandard financial ratios, on the grounds that the
applicant is a young, struggling company with the potential to grow into a major client.
Requests for exceptions to established credit policies are likely to increase in both number and
fervor during periods of slack demand for loans.

When considering pleas of mitigating circumstances, the credit analyst should certainly take
into account pertinent qualitative factors that the financial statements fail to capture. At the
same time, the analyst must bear in mind that qualitative credit considerations come in two
flavors, favorable and unfavorable. It is also imperative to remember that the cold, hard
statistics show that companies in the "temporarily" impaired and start-up categories have a
higher-than-average propensity to default on their debt.

Every high-risk company seeking a loan can make a plausible soft case for overriding the
financial ratios. In aggregate, though, a large percentage of such borrowers will fail, proving
that many of their seemingly valid qualitative arguments were specious. This unsentimental
truth was driven home by a massive 1989-1991 wave of defaults on high-yield bonds that had
been marketed on the strength of supposedly valuable assets not reflected on the issuers'
balance sheets. Bond investors had been told that the bold dreams and ambitions of
management would suffice to keep the companies solvent. Another large default wave in 2001
involved early-stage telecommunications ventures for which there was scarcely any financial
data from which to calculate ratios. The rationale advanced for lending to these nascent
companies was the supposedly limitless demand for services made possible by miraculous new
technology.

To be sure, defaults also occur among companies that satisfy established quantitative
standards. The difference is that analysts can test financial ratios against a historical record to
determine their reliability as predictors of bankruptcy. No comparable testing is feasible for the
highly idiosyncratic, qualitative factors that weakly capitalized companies cite when applying
for loans. Analysts are therefore on more solid ground when they rely primarily on the numbers
than when they try to discriminate among companies' soft arguments.

TOPIC 5: Recognition of Profit, Revenue, and Expenses

Presentation of Financial Statements

We will explore the whole process of setting accounting standards in the next chapter. This
section will lay some foundations for that by looking at the formatting requirements for the
main financial statements. This will give you an opportunity to revisit the basic accounting
statements, but will do so from the perspective of the formal presentation requirements laid
down by the accountancy profession.
The main rules relating to the format of a set of accounting statements can be found in
International Accounting Standard I Presentation of Accounting Statements (IAS 1). A revised
version was published in 2007, and so some companies may have financial statements in issue
that were published before the revisions came into effect.
The two statements that we shall focus on for the reminder of this chapter are:
  The statements of financial position (also known as the balance sheet)
 The statement of comprehensive income (which can be broken down into two
statements, the first of which is the income statement and the second of which shows
other components of ‘comprehensive income’, such as gains on revaluation).

IAS 1 requires that both of these statements be shown in very specific ways. For example, the
statement of financial position should be in the following format:

ABC plc
Statement of financial position as at 31 December 2018

Assets
Non-current assets
Property, plant and equipment 30
Goodwill 15
Other intangible assets 11
Financial assets 5
61

Current assets
Inventories 8
Trade receivables 9
Other current assets 2
Cash and Cash equivalents 4
23

Total assets 84

Equity and Liabilities

Equity
Share Capital 20
Retained Earnings 21
Other Components of equity 1
Total Equity 42

Non-Current Liabilities
Long-term borrowings 16
Long-term provisions 4
Total non-current liabilities 20
 Current liabilities
Trade and other payables 8
Short-term borrowings 5
Current portion of long-term borrowings 2
Current tax payable Short-term provisions 3
Short-term provisions 4
Total current liabilities 22

Total Liabilities 42
Total equity and liabilities 84

Thus, the statement of financial position shows the company’s assets, broken down between
non-current and current assets further subdivided within each category. The second part of the
statement shows how those assets were financed in terms of equity and liabilities, with
liabilities broken down between non-current and current.
The format shown above should be regarded as mandatory. Even if you have used an
alternative approach in your previous studies, IAS 1 lists a number of specific items that must
appear on the face of the statement of financial position and provides a very similar example to
the above as an illustration of good practice. From now on, you should get used to treating this
as a compulsory format. If you practice on as many questions as possible, then you will find that
using the prescribed format becomes second nature.
IAS 1 also lays down requirements for the layout of the statement of comprehensive income:

ABC plc
Statement of comprehensive income for the year ended 31 December 2018

Revenue 56
Cost of sales (24)
Gross profit 32
Other Income 2
Distribution costs (4)
Administrative expenses (7)
Other expenses (1)
Finance costs (3)
Profit before tax 19
Income tax expense (5)
Profit for the year 14
Other comprehensive income:
Gains on property revaluation 1

Total Comprehensive Income for the year 15

This statement indicates how the shareholders’ wealth has increased through both trading and
non-trading activities. This company earned a profit after tax of 14m. In addition, wealth
increased by a further 1m because a gain on the revaluation of non-current assets.
 The first variation is to split the statement into two. It would be perfectly acceptable to
have an ‘income statement’ that was used to calculate profit. That would be exactly as
the statement shown above, except that it would stop at the profit for the year. In that
case, the company would have to provide a second statement showing the total
comprehensive income. Such a statement would start would start with the profit for the
 year and would adjust for the other components of comprehensive income. This text
will use the simpler approach, which is to provide a single statement of comprehensive
income, rather than two separate statements.
 The second variation is to show the expenses by type of expense rather than function.
An example of this is shown below. Companies using this approach also have the
freedom to show two separate statements: an income statement and a statement of
total comprehensive income.
Note that the two presentations give exactly the same answer. The only difference is in the way
the costs are presented.

ABC plc
Statement of comprehensive income for the year ended 31 December 2018

Revenue 56
Other Income 2
Changes in inventories of finished goods 3
and work in progress
Raw material and consumables used (9)
Employee benefits expense (16)
Depreciation and amortization expense (12)
Other expenses (2)
Finance costs (3)
Profit before tax 19
Income tax expense (5)

Profit for the year 14

Other comprehensive income:

Gains on property revaluation 1

Total comprehensive income for the year 15

This text will use the format throughout. That is partly because most companies choose to
present their costs function rather that by type of expense, and partly because it is more
helpful to users to do so. Readers are often interested in, for example the gross profit. If a
company uses the alternative layout, then readers cannot see what the gross profit was.
A third statement provides an overview of changes in equity. This shows how the various
components of equity have changed during the year

ABC plc
Statement changes in equity for the year ended 31 December 2018

Share Capital Retained Profit Revaluation Reserve Total Equity

Balance at 31 December 2017 20 12 0 32

Profit for the year 14 14
Dividend (5) (5)
Gain on revaluation 1 1
Balance at 31 December 2018 20 21 1 42
Notes to the accounts

We will look at real set of financial statements in chapter 3. When we do, you will see that a
typical annual report comprises one page each for the main accounting system, followed by
dozens of pages of notes, most of which are cross-referenced to the financial statements
themselves.
The notes have three main functions:
1. They provide information about the manner in which the financial statements have
been prepared and the specific accounting policies used.
2. They disclose information required by accounting standards that is not presented
elsewhere in the financial statements.
3. They provide information that is not presented elsewhere in the financial statements
but is relevant to an understanding of any of them. This might include information that
is required by law rather than accounting standards, or it might be information that is
necessary for a reader of the financial statements to have an adequate understanding.
For a teaching point of view, there is no possibility of your every asked to produce an annual
report runs to more than 50 pages of statements and supplementary notes. We will deal with
some of the more commonplace notes in the course of later chapters of this text.

Profit Recognition

You perform profit recognition to estimate the profit for a job at any time during the job. The
system calculates job profit by creating journal entries to adjust the actual costs and revenue
for the job to what they should be, based on the percentage of completion of the job. The
profit estimates can reflect either a net profit or a net loss.

When you perform profit recognition, you can create journal entries to recognize your
estimated profit for financial reporting purposes. You do this to adjust actual profit to what it
should be, based on the percentage of completion of the job. You can also move costs from
work-in-progress (WIP) to your income statement.

Profit recognition is independent of the billing status of the job. For example, you can recognize
profit for a job even if you have not billed for all of the work that is complete.

You can use profit recognition to:

 Record job-to-date revenue and expenses on your income statement

 Relieve the WIP amounts from your balance sheet
 Record over billing and under billing amounts
 Enter adjustments for stored materials and accrued costs
 Record provision for projected loss
 The first step in profit recognition is to calculate the projected final cost, which is an
estimation of what the total job costs and billing amounts when the job is 100%
complete and 100% billed. While you can calculate costs at a header account level, it is
more accurate to perform a calculation for each cost account in the job.

Next, you determine how much progress has been made on the job. You can determine the
job's percent complete using one of two methods:

 Percent of Cost
 Percent of Revenue

Percent of cost divides actual cost by projected final cost to determine percentage complete.
Percent of revenue divides actual revenue by projected final revenue to produce the
percentage complete. These calculations indicate under- and over-billing situations and give
you an estimate of final profit or loss. Finally, you run the Build Recognition Data program to
create journal entries for financial reporting purposes.

Revenues and Matching Expenses

According to the principle of revenue recognition, revenues are recognized in the period when
it is earned (buyer and seller have entered into an agreement to transfer assets) and realized or
realizable (cash payment has been received or collection of payment is reasonably assured).

For example, if a company enters into a new trading relationship with a buyer, and it enters
into an agreement to sell the buyer some of its goods. The company delivers the products but
does not receive payment until 30 days after the delivery. While the company had an
agreement with the buyer and followed through on its end of the contract, since there was no
pre-existing relationship with the buyer prior to the sale, a conservative accountant might not
recognize the revenue from that sale until the company receives payment 30 days later.
Understanding Revenue Recognition
Revenue is at the heart of all business performance. Everything hinges on the sale. As such,
regulators know how tempting it is for companies to push the limits on what qualifies as
revenue, especially when not all revenue is collected when the work is complete. For example,
attorneys charge their clients in billable hours and present the invoice after work is completed.
Construction managers often bill clients on a percentage-of-completion method.
Revenue accounting is fairly straightforward when a product is sold, and the revenue is
recognized when the customer pays for the product. However, accounting for revenue can get
complicated when a company takes a long time to produce a product. As a result, there are
several situations in which there can be exceptions to the revenue recognition principle.
Analysts, therefore, prefer that the revenue recognition policies for one company are also
standard for the entire industry. Having a standard revenue recognition guideline helps to
ensure that an apples-to-apples comparison can be made between companies when reviewing
line items on the income statement. Revenue recognition principles within a company should
remain constant over time as well, so historical financials can be analyzed and reviewed for
seasonal trends or inconsistencies.

Expense Recognition

The assets produced and sold or services

rendered to generate revenue also generate
related expenses. Accounting standards
require that companies using the accrual
basis of accounting and match all expenses
with their related revenues for the period, so
that the income statement shows the
revenues earned and expenses incurred in
the correct accounting period.

The matching principle, part of the accrual

accounting method, requires that expenses
be recognized when obligations are (1)
incurred (usually when goods are transferred,
such as when they are sold or services
rendered) and (2) the revenues that were
generated from those expenses (based on
cause and effect) are recognized.

For example, a company makes toy soldiers

and acquires wood to make its goods. It
acquires the wood on January 1st and pays for
it on January 15th. The wood is used to make
100 toy soldiers, all of which are sold on
February 15. While the costs associated with
the wood were incurred and paid for during
January, the expense would not be
recognized until February 15th when the
soldiers that the wood was used for were
sold.

If no cause-and-effect relationship exists (e.g.,

a sale is impossible), costs are recognized as
expenses in the accounting period they
expired (e.g., when they have been used up
or consumed, spoiled, dated, related to the production of substandard goods, or the services
are not in demand). Examples of costs that are expensed immediately or when used up include
administrative costs, R&D, and prepaid service contracts over multiple accounting periods.

ACTIVITY/ TASK
 Answers on the activity/task shall be written on whole sheet/s of yellow paper and
must be submitted not later than the agreed deadline. Late submissions will not be accepted
and will result to a failing grade.

A. Discuss/explain the following:

 Objective of financial statements and financial reports.

 Target users of financial reporting

 Specifically, what are the requirements of fair presentation?

B. Problem Solving (Revenue Recognition):

The Martino Corporation, in attempt to raise revenues, begins selling goods with
an automatic right to return within six months if not completely satisfied. On
November 1, 35,000 worth of goods with a cost of 22,000 are sold. Company
officials expect that 15% of the goods sold will be returned before the expiration
date in the following year. How much gross profit should be recognized on this
sale in the current year?

C. Assume that the name of company is “The Legendary”. Prepare/present the

following account into financial position statement as of December 31, 2019
and 2020. (Note: Just put xxx as the amount)

Accrued expenses Accumulated depreciation of fixed assets Annual liability

Prepaid Income Fixed asset Cash and cash equivalent
Short-term Investment Account receivables Expenses are paid in
advance
Investment Property Other’s debt Long-term debt
Account receivable Accounts payable Long-term investment

RUBRICS FOR WRITTEN OUTPUT

This criterion shall include the reliability and
ingenuity of the output. Its reliability shall be
Content evaluated based on the truthfulness, while ingenuity 50%
indicates the originality and creativity of the
incorporated ideas and concepts.
This criterion encompasses the ways how the ideas
and concepts are presented. Coherence and
Organization of Ideas 30%
structure of the content are the focus of the
criterion.
Grammar & This criterion shall include the grammatical
20%
Mechanics correctness, format and use of punctuations.
TOTAL 100%