1.1 Objectives of financial reporting

Financial reporting aims to provide useful information to investors, creditors, and other users for decision-making. It helps assess the economic resources, claims, and changes within an entity. The objectives focus on delivering relevant data to evaluate financial health and potential cash flows.

Users of financial statements include internal stakeholders like management and employees, as well as external parties such as investors and creditors. The information must possess qualitative characteristics like relevance and faithful representation to be valuable for these diverse users.

Objectives of financial reporting

• Provide useful information to investors, creditors, and other users in making investment, credit, and similar resource allocation decisions
• Help users assess the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans
• Provide information about the economic resources of an entity, claims to those resources, and changes in them

Users of financial statements

Internal users

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• Management uses financial statements to make strategic decisions, monitor performance, and allocate resources within the company
• Employees may use financial statements to assess the financial stability and growth prospects of their employer
• Board of directors relies on financial statements for oversight and governance purposes

External users

• Investors (equity and debt) use financial statements to evaluate the financial health, profitability, and growth potential of a company before making investment decisions
• Creditors, including banks and suppliers, use financial statements to assess the creditworthiness of a company and its ability to repay loans or meet payment obligations
• Regulatory authorities, such as the Securities and Exchange Commission (SEC), use financial statements to ensure compliance with reporting requirements and protect investors
• Competitors may analyze financial statements to benchmark their performance against industry peers and identify potential opportunities or threats

Qualitative characteristics

Fundamental characteristics

• Relevance refers to the ability of financial information to influence the decisions of users by helping them evaluate past, present, or future events or confirming or correcting their past evaluations
• Faithful representation means that financial information accurately depicts the economic phenomena it purports to represent, being complete, neutral, and free from error

Enhancing characteristics

• Comparability enables users to identify and understand similarities and differences between items, both within a single entity's financial statements and across different entities
• Verifiability means that different knowledgeable and independent observers could reach consensus that a particular depiction is a faithful representation
• Timeliness means having information available to decision-makers in time to be capable of influencing their decisions
• Understandability implies that financial information should be presented clearly and concisely, making it comprehensible to users who have a reasonable knowledge of business and economic activities

Assumptions in financial reporting

Going concern assumption

• The going concern assumption presumes that an entity will continue to operate for the foreseeable future (usually at least 12 months from the reporting date)
• This assumption justifies the use of historical cost accounting and the classification of assets and liabilities into current and non-current categories
• If management intends to liquidate the entity or cease operations, the financial statements may need to be prepared on a different basis (e.g., liquidation basis)

Accrual basis assumption

• Under the accrual basis of accounting, transactions and events are recognized when they occur, regardless of when cash is received or paid
• Revenues are recognized when earned, and expenses are recognized when incurred, matching them to the period in which they relate
• This assumption provides a more accurate picture of an entity's financial performance and position compared to the cash basis of accounting

Constraints on financial reporting

Cost vs benefit

• The cost constraint recognizes that providing financial information imposes costs on preparers and users, which should not exceed the benefits derived from that information
• Entities must balance the costs of providing additional disclosures or using more complex measurement techniques against the expected benefits to users

Materiality

• Information is considered material if its omission or misstatement could influence the decisions of users taken on the basis of the financial statements
• Materiality depends on the size and nature of the item judged in the particular circumstances of its omission or misstatement
• Entities may choose not to disclose or apply complex measurement to immaterial items, as the costs would likely outweigh the benefits

Elements of financial statements

Assets, liabilities, and equity

• Assets are resources controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity (cash, inventory, property, plant, and equipment)
• Liabilities are present obligations of an entity arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits (accounts payable, loans, bonds)
• Equity is the residual interest in the assets of an entity after deducting all its liabilities, representing the owners' claim on the entity's resources (common stock, retained earnings)

Income and expenses

• Income encompasses both revenues and gains, where revenues arise in the course of the ordinary activities of an entity (sales revenue, interest income), and gains represent other items that meet the definition of income (gain on disposal of an asset)
• Expenses encompass losses as well as those expenses that arise in the course of the ordinary activities of the entity (cost of goods sold, salaries, depreciation), while losses represent other items that meet the definition of expenses (loss from a natural disaster)

Recognition and measurement

Recognition criteria

• An item that meets the definition of an element should be recognized in the financial statements if it is probable that any future economic benefit associated with the item will flow to or from the entity, and the item has a cost or value that can be measured with reliability
• These recognition criteria ensure that only items that can be reliably measured and have a meaningful impact on the entity's financial position or performance are included in the financial statements

Measurement bases

• Historical cost measures assets at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition, and liabilities at the amount of proceeds received in exchange for the obligation
• Current cost (or replacement cost) measures assets at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently, and liabilities at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently
• Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
• Value in use (assets) and fulfillment value (liabilities) measure the present value of the future cash flows that an entity expects to derive from the continuing use of an asset or to incur in fulfilling a liability

Presentation and disclosure

Financial statement presentation

• A complete set of financial statements comprises a statement of financial position (balance sheet), statement of comprehensive income (income statement), statement of changes in equity, statement of cash flows, and notes to the financial statements
• Financial statements should be presented at least annually and should include comparative information for the preceding period
• An entity should present a classified statement of financial position, separating current and non-current assets and liabilities, unless a presentation based on liquidity provides more relevant and reliable information

Notes to financial statements

• Notes to the financial statements provide additional information that is relevant to an understanding of the financial statements and not presented elsewhere
• Notes typically include a summary of significant accounting policies, supporting information for items presented in the primary financial statements, and other disclosures required by accounting standards or regulations (contingencies, related party transactions, subsequent events)
• The order of the notes should follow a systematic structure, with more general information preceding detailed disclosures, and related information grouped together to enhance understandability