Summary Financial Management 2 (for 1st test)

Chapter 5: Foundations of Financial Reporting and
the Classified Balance Sheet

Profitability and liquidity are important measures for investors and creditors; financial
statements support these decision makers and should enable these users to do the
following:
- Assess cash flow prospects
- Assess stewardship
Aside from financial statements, financial reporting also involves other information
such as management’s explanations, assumptions, uncertainties and estimates.

The objective of financial reporting is to provide financial information about the
reporting entity to present and potential equity investors, lenders, and other creditors
in their capacity as capital providers.

Qualitative characteristics
Relevance: information has a direct effect on a decision
1. Predictive value: helps capital providers make decisions about future actions.
2. Confirmative value: information confirms or changes previous evaluations.
3. Materiality: its omission or misstatement could influence the user’s economic
decisions taken on the basis of the specific entity’s financial statement.
Materiality is related to both the nature of an item and its size or
misstatement. The materiality of an item normally is determined by
relating its dollar value to an element of the financial statement, such as
net income or total assets (5% of net income).
Faithful representation
1. Completeness: provides all information necessary for a reliable decision.
2. Neutrality: information is free from bias intended to achieve a certain result to
bring about a particular behaviour.
3. Free from material error: information meets a minimum level of accuracy so
it does not distort what is being reported.
It does not mean that information is absolutely accurate because most
financial information is based on estimates and judgements




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, Enhancing qualitative characteristics
Comparability: the quality that enables users to identify similarities and differences
between two sets of financial data.
Verifiability: the quality that different knowledgeable and independent observers
could reach consensus, although not necessarily complete agreement, that a
particular depiction is a faithful representation.
Timeliness: the quality that enables users to receive information in time to influence
their decisions.
Understandability: the quality that enables users to comprehend the meaning of the
information.
These enhancing characteristics are subject to the cost constraint (or cost-
benefit).
Cost constraint: holds that the benefits to be gained from providing
accounting information should be greater that the costs of providing it.

Accounting conventions: helps with understanding accounting information
Consistency: requires that once a company has adopted an accounting procedure,
it must use it from one period to the next unless a note to the financial statement
informs users of a change.
Full disclosure: requires that financial statements present all the information
relevant to users’ understanding of the statements.
The statement must include any explanation needed to keep them from being
misleading.
Conservatism: this convention holds that, when faced with choosing between two
equally acceptable procedures or estimates, accountant should choose the one that
is least likely to overstate assets and income.
Lower-of-cost-or-market method: if an item’s market value is greater than its
original cost, the more conservative cost figure is used.

Chief Executive Officer, Chief Financial Officer, and auditors must certify that financial
statements are accurate, complete, and not misleading.




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