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6 Characteristics That Accounting Information Should Possess
- 1. Understandable
- 2. Relevant
- 3. Reliable
- 4. Comparable and Consistent
- 5. Unbiased
- 6. Cost-Benefi t Eff ective
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4 Types of Accounting
- 1. GAAP
- a) Used by Investors and Creditors
- b) Emphasis on value as a going concern
- 2. SAP
- a) Used by Regulators
- b) Emphasis on Liquidation Market Value
- 3. Tax
- a) Used by Tax Authorities
- b) Emphasis on social and political issues
- 4. Internal
- a) Used by management
- b) Emphasis on the needs of management
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4 Principal Financial Reports
- 1. Balance Sheet: lists assets, liabilities, and surplus (equity) of the company
- 2. Income Statement: reports income, expenses, and earnings during reporting period
- 3. Cash Flow Statement: reports sources and uses of cash during reporting period
- 4. Notes and Disclosures: Allows for additional info not in above statements
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5 Types of Information in Notes and Disclosures
- 1. Description of accounting policies used to prepare statements
- 2. Discussion of values that may not be reliably estimable
- 3. Discussion of risks and uncertainty
- 4. Forward-looking info: estimates of future financial earnings or events to occur after publication
- 5. Subsequent events: events that occurred after statement date but before publication
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GAAP Hierarchy
- 1. Organization in charge of securities regulation (SEC)
- 2. Standards set by specifi ed accounting standard setter (FASB,IFRS)
- 3. Industry-speci fic guidance (SOPs from the AICPA)
- 4. Interpretations (IASB interpretations committee)
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Fair Value vs. Historical Cost
- 1. Fair Value
- a) IASB Defi nition - Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm's length transaction
- b) Very relevant, but less reliable
- 2. Historical Cost
- a) Original cost of asset or liability
- b) Very reliable, but less relevant
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Deferral Matching vs. Asset/Liability
- 1. Deferral/matching
- a) Coordinates timing of income and expense recognition to occur at same time
- b) Premiums recognized when earned
- c) Losses recognized when occurred
- d) Uses DAC to force matching of prepaid policy acquisition expenses on income statement
- e) Focus on timing of profi t emergence
- 2. Asset/liability approach
- a) Focus on the value of assets or liabilities that exist as of balance sheet date
- b) Assets booked if future stream of cash flows is certain
- c) Liabilities booked if entity committed to an obligation resulting in payment of future cash ows
- d) Does not recognize DAC as an asset if cannot be transferred to cash
- e) Revenue recognized up front once company gains control of asset resulting in revenue
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Advantages and Disadvantages of Principle-Based vs. Rule-Based
Accounting Standards
- 1. Principle-based standards
- a) Advantages - more exible with new and changing products, require less maintenance
- b) Disadvantages - danger that open interpretation could lead to manipulating fi nancial results
- 2. Rule-based standards
- a) Advantages - easier to audit, may produce more consistent reports across entities
- b) Disadvantages - lack of flexibility and requires more maintenance, potential for loop-holes
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Common Insurance Accounts: Balance Sheet - Assets
- 1. Premiums Receivable: due to policies either from the agent or policyholder
- 2. Reinsurance Recoverables: paid recoverables from reinsurers
- 3. Deferred acquisition costs (DAC): Expense payments deferred for income statement purposes under deferral/matching accounting paradigm
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Common Insurance Accounts: Balance Sheet - Liabilities
- 1. Policy Liabilities - liability for inforce insurance contracts for future events
- 2. Unearned Premium Liability - portion of policy premium for the unexpired portion of policy
- 3. Claim Liabilities - liability for events that have occurred
- 4. Claim Expense Liabilities - liability for cost of settling or defending claims for events that have occurred
- 5. Insurance Expense Liabilities - liability for expenses incurred but unpaid
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Common Insurace Accounts: Income Statement
- 1. Premiums - under deferral/matching earned, under asset/liability written
- 2. Losses - claims incurred during reporting period
- 3. Loss Expenses - claim expenses incurred on claims incurred during reporting period
- 4. Underwriting Expenses - expenses incurred that directly relate to the insurance operation
- 5. Underwriting Income - premium minus losses, loss expenses,and u/w expenses
- 6. Policyholder Dividends - generally included in u/w income, but may be subtracted from revenues
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3 Conditions for Biased Accounting Information to be Useful
- 1. Bias is consistent over time
- 2. User understands the bias
- 3. User can adjust the bias to reflect their own bias
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3 Characteristics of Relevant Information
- 1. Timely
- 2. Has predictive value
- 3. Provides useful feedback on past decisions
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4 Characteristics of Reliable Information
- 1. Representational faithfulness - info represents what it claims to represent
- 2. Veri fiability - another person should be able to recreate using same info
- 3. Completeness - should not be missing a material fact that would make info misleading
- 4. Neutrality - lack of bias
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Change in Accounting Principle vs. Change in Accounting Estimate
- 1. Change in accounting principle
- a) May require disclosure and recalculation of prior results
- 2. Change in Accounting estimate
- a) Would generally involve no prior period recalculation and only impact the latest reporting period
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3 Ways to Treat Discounting of Liabilities on Balance Sheet
- 1. Liability reported on undiscounted basis and amount of discount treated as an asset
- 2. Liability could be reported on a discounted basis directly
- 3. Include discount as a contra-liability in a separate liability account
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2 Ways to Treat Discounting of Liabilities on Income Statement
- 1. Report unwinding of discount over time as an interest expense
- 2. Report unwinding as a change in liability estimate with separate disclosure
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