Objective of financial reporting:

Provide financial information about the reporting entity that is useful to existing & potential
investors, lenders and other creditors in making decisions about providing resources to the
entity.

Why do we need accounting?

Due to information asymmetry and agency problem,
1. Control adverse selection
Adverse selection is when one party has more information that the other.
Accounting helps to convert insider information into useful information for investors.
Other measures:
Quarterly reporting (SFP, SPL, etc.)
Rules against insider trading

2. Control moral hazard

Moral hazard is when shareholders cannot observe the managers effort. Both s/h and
manager can only observe the outcome, but good outcome does not mean the managers
had put in high effort.
Accounting helps to provide information to control manager shirking and improve corporate
governance
Examples:
Bonus plans based on ROE/ROA
Debt covenants restricting dividend payouts (protect creditors)
Share buyback restrictions to protect creditors

Qualitative characteristics
Fundamental QC Enhancing QC
Relevance Timeliness closely related to relevance
Predictive value Example: Historical cost, definitely not
Confirmatory value timely and hence may not be relevant
Materiality
Faithful representation Verifiability closely related to faithful
Complete representation
Neutral
Free from error
Understandability (to people who are
financially literate)
Comparability
Same entity over time
Across different entities

Recognition:
Means incorporating an item in SFP or SPL.
In total, 5 criteria have to be met
1. Meet definition of element (usually 3 criteria in this, e.g. assets control, future ec
benefit, past event)
 2. Probable inflow/outflow of future economic benefits
3. Cost can be measured reliably

Specific recognition principles are found in their specific FRSs, and only apply to certain
items as stated by that FRS. They may not be fully consistent with general recognition
principles.

Disclosure:
Presentation > Disclosure
Presentation requires you to present it in some format, e.g. a table for FV level 1,2,3.
Presentation helps to improve understandability.

Measurement: Miller and Mosso 1983

Given the question, identify:
1. Relevant phenomenon
2. Relevant attribute
Example: If question requires us to find the price of an asset now, fair value
would be much more relevant than historical cost.
Most common attributes adopted in accounting:
o Fair value
o Historical cost
o Net present value
3. Find a reliable way to assess the magnitude of relevant attribute of relevant
phenomenon
4. Estimation may be needed, e.g. very costly to find the relevant attribute. Hence, we
could use a substitute attribute/ phenomenon instead.

Example: To find fair value of building,

Relevant Phenomenon
Relevant Attribute DIRECT OBSERVATION (CASE 1)
Find the amount a buyer is
willing to pay for the building
just put the building on the
market, not necessary to
dispose the building.
Substitute Attribute ESTIMATION (CASE 2)
Use a valuation model, e.g.
discounted PV model. Historical
cost also possible substitute
attribute but PV is a much
better one.
Substitute Phenomenon
ESTIMATION (CASE 3)
Find the past transacted price
of the building or the amount a
buyer is willing to pay for a
similar building.
ESTIMATION (CASE 4)
Look at past transacted prices
of similar buildings, make
adjustments and use valuation
model.

Notes:
Case 1 provides the first-order quality of measurement.
Case 4 is not always the worst case scenario. In the example above, Case 4 is
better than Case 3 since adjustments are made.
Other examples:
o Using historical cost of car adjusted for A/D as measure of fair value of car:
Substitute attribute of a relevant phenomenon.

Units used in measurement in accounting

Nominal dollars, meaning not adjusted for inflation. Different from purchasing power which
is adjusted.

Would aggregation (e.g. total assets) be meaningful in accounting?

Problems:
o Mixed attributes problem: assets can be measured at fair value, historical costs etc.
and still be summed up. Is also one of the reasons causing a difference in the NBV
and market price of firm.
o Mixed unit of measure: earlier we said that the only unit of measure is normal
dollars. However, due to inflation, a unit of nominal dollars in the past would be
difference from one now.

GAP in SFP: P/B ratio is high

P: share price
B: A L = E (net assets)
Why?
o Intangible assets: usually not recognized in books since do not meet definition
criteria or other asset recognition criteria. However, the market recognizes these
assets.
o Valuation problem: market uses fair value, but accounting does not always use fair
value.