Essentials of FA_Chapter 1

Essentials of Financial Accounting, Second Edition — ASISH K. BHATTACHARYYA

ESSENTIALS OF FINANCIAL ACCOUNTING BY ASISH K BHATTACHARYYASecond Edition

Chapter 1


Nature of Financial Accounting

Accounting is the science and art of measurement.

Financial accounting system records the economic effect of transactions and other events: on the economic resources that the company holds

and on the composition of claimants on those resources.

Companies prepare and present financial statements for use by investors and others who are external to the company using the data recorded by the financial accounting system.

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Use of Information in Financial Statements

Users of financial statements use the information to analyse the financial position and performance of the firm over a number of years (say, over the past six years) and to compare the financial position and performance of a firm relative to its peers for a particular year or over a number of years. Therefore, companies are required to use

accounting principles and methods consistently from year to year and also to apply generally accepted accounting principles (GAAP) in the preparation and presentation of financial statements to ensure comparability.

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Convergence of Accounting Practices

With the globalisation of capital markets, there are sincere and serious efforts to achieve convergence of accounting practices across the globe.

More than 100 countries (including the European Union) have adopted International Financial Reporting Standards (IFRS) which are issued by the International Accounting Standards Board (IASB).

India has decided to adopt IFRS from 1 April 2011. USA has prepared a road map to adopt IFRS from

the year 2014. IFRS have emerged as the global standard. Accounting principles and methods discussed in

this book are based on IFRS.

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Business Language

It is often said that financial accounting is the business language that is used by firms to communicate its economic performance and financial position to those who are external to the company, including investors.

Every manager should learn the basics of this business language and should develop the skill to read and analyse financial statements.

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Promoter

Implementation of a business idea developed by an entrepreneur requires capital.

An entrepreneur usually forms a limited liability company (also called joint stock company) to implement the business plan.

Individuals who float the company are called promoters of the company.

The term ‘promoter’ refers to individuals or other entities (e.g. an existing company) which devise a plan and take preliminary steps to form the company.

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Limited Liability Company

Limited liability companies in India are governed by the Companies Act, 1956.

The liability of the owners (promoters and other shareholders) is limited to their commitment to contribute to the capital of the company.

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Limited Liability Company: Juridical Person In the eye of law, a company is a juridical

person. It has an identity separate from investors in the

company. It can enter into contracts and can sue and be sued

in its own name using the common seal. A common seal is the official stamp or "signature"

of an association. A company acts through its Board of Directors.

Directors are elected by shareholders who provide equity capital.

The most important right of an equity holder is the voting right. Under the Indian Companies Act, one share has one

vote.

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Capital

Capital provided to a company belongs to the company. Use of the capital is decided by the company.

Investors provide capital to a company in exchange of claim on economic resources (assets) of the company.

Capital provided to a company is classified into equity and debt.

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Debt Capital

In the case of debt capital (also called loan fund) the company has an obligation to repay the capital and usually to pay a regular return (interest) on capital.

In the case the company defaults in its commitment, investors can take legal recourse to sell the assets and recover their investment, to the extent possible.

The debt holders have no other right on the company’s economic resources.

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Equity Capital In the case of equity capital, the company

has no obligation to repay the capital or to provide a return on capital. The Companies Act, 1956 does prohibit return of

contributed equity capital. Net profit belongs to the providers of equity

capital. However, the company has unconditional

discretion on the distribution of net profit to equity holders.

An investor in equity capital has the right to transfer her share in the company to another investor without obtaining consent of the company.

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Equity Capital (cont.)

In a situation of winding up of a company, first all liabilities (including debt capital) are settled from the sale proceeds of assets and the balance amount is distributed to investors in equity capital.

Therefore, it is said that investors in equity have residual claim on assets.

Law considers investors in equity as deemed owners. They exercise their ownership rights through the

Board of Directors.

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Preference Shares

Preference share-holders have a preferential claim on the assets of the company and on its profit. They are entitled for a pre-determined dividend if

the company earns profit. Their claim is superior to the claim of equity

shareholders but subordinate to the claim of creditors.

The Companies Act classifies preference shares as equity.

Under IFRS, preference shares are classified as debt or equity depending on the terms of the issue.

Redeemable preference shares are classified as debt.

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Perpetual Succession

Perpetual succession is the continuation of a company’s existence despite the death, bankruptcy, insanity, change in membership or an exit from the business of any owner or member, or any transfer of shares. A company ceases to exist only when it is

liquidated through a legal process. Except in rare situations, a company cannot

refuse to register the transfer in its record. Return on investment in the equity capital of

a company is the total of dividend and capital appreciation.

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Private Limited Companies and Public Limited Companies The Companies Act, 1956 does not allow a

private limited company (also called a closely held company) to have more than 50 members (equity shareholders). A private limited company cannot invite public to

contribute to its equity capital. If promoters decide to invite the public to

contribute to the equity capital, they form a public limited company. The cost of complying with legal and regulatory

requirements in the case of a private limited company is much lower as compared to the same in case of a public limited company.

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Private Limited Companies And Public Limited Companies (cont.)

A private limited company is not required to make public disclosure of its strategies, and its management is not required to be concerned about quarterly results. Some feel that a private limited company

structure helps protect innovation and pursue long-term strategies.

For example, Kohler Company (domiciled in USA, website: http://www.kohler.com).

It is incorrect to assume that all private limited companies are small in size.

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Listed Company

Public limited companies usually list shares issued by them in recognised stock exchanges (e.g. BSE and NSE in India) to facilitate trading in the shares.

A company whose securities are listed in a recognised stock exchange is called a listed company or a publicly traded company.

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Listed Company (cont.)

Buying and selling of shares issued by a company require appropriate valuation of these shares.

Therefore, as per the standard agreement between a listed company and the stock exchange (called Listing Agreement), the company is required, among other things: to immediately inform the stock exchange

strategic and other important decisions; and to issue quarterly financial statements (abridged)

and annual financial statements, duly audited by an external auditor.

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Sole-Proprietorship and Partnership

If a venture requires small amount of capital, the entrepreneur floats either a sole-proprietorship firm or a partnership firm. In the case of sole-proprietorship, an individual

(the entrepreneur) provides the equity capital. In the case of partnership, a group of individuals

(partners) provide the equity capital. The liability of the sole proprietor or the partners

of a firm is unlimited.

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Limited Liability Partnership (LLP) LLP is specially designed for use by certain

professions (for example, accountants, lawyers and architects). Generally, partners in an LLP are not responsible for

the debts, obligations, or liabilities of the partnership resulting from negligence, malpractice or wrongful acts, or misconduct by another partner, employee or agent of the partnership.

An LLP is run like a general partnership and has a similar degree of management flexibility.

LLP facilitates partnership among individuals who operate in different geographic locations and who may not be closely known to each other.

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General Purpose Financial Statements

General purpose financial statements are intended to meet the needs of users who are not in a position to require a company to prepare reports tailored to their particular information needs. They are primarily targeted at investors.

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Balance Sheet

Balance sheet is the statement of financial position at the end of the accounting period.

It lists out the economic resources that the company holds as at the balance sheet date and claims on those assets. It is a stock statement in the sense that it presents

the position of capital, assets and liabilities at a particular point in time.

Measurement of assets and liabilities in the balance sheet is an important issue in financial accounting.

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Balance Sheet (cont.) Balance sheet with hypothetical

numbers

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Sources of Funds (Claimants)

Equity:

Contributed capital

Retained profit

Total equity

Debt:

Long-term debt

Short-term debt

Total debt

Invested capital (Equity + Debt)

Application of Funds (Economic Resources)

Fixed assets (Infrastructure)

Current assets (Operating assets)

Current liabilities (Operating liabilities)

Net current assets

Invested capital (Fixed assets + Net current

assets)

Rs. 10,00,000

50,00,000

Rs. 40,00,000

10,00,000

Rs. 60,00,000

( 30,00,000)

Rs. 60,00,000

50,00,000

Rs. 1,10,00,000

Rs. 80,00,000

30,00,000

Rs.1,10,00,000


Balance Sheet (cont.)

Fixed assets are assets that are used in production or administration. Examples are land, building, equipment, plant

and machinery, furniture and fixtures, computers and vehicles.

Current assets are assets that support current operations. Examples are stock of finished goods, stock of

raw materials, amount owed to the entity by customers, and cash and bank balances.

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Balance Sheet (cont.)

Current liabilities are obligations to be settled within 12 months after the balance sheet date. Examples are amount that the entity owes to

suppliers of goods and services and advance received from customers.

Short-term debt is also classified as current liabilities.

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Profit and Loss Account

Profit and loss account (also called statement of comprehensive income) details how the equity has changed during the accounting period. Equity increases if the company earns net profit

during the period and retains the same. It decreases if the company incurs a loss during

the period. Profit and loss account lists incomes and

expenses for the period and, thus, presents the operating result for the period. Profit and loss account may be viewed as a flow

statement.

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Profit and Loss Account (cont.)

Profit and loss account with hypothetical numbers

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Income

Sales

Excise duty

Net sales

Other income (e.g. interest and dividend income)

Total income

Expenses

Cost of goods sold

Operating expenses

Interest

Income tax expense

Total expenses

Net profit (Total income minus total expenses)

Rs. 1,00,00,000

(20,00,000)

Rs. 80,00,000

10,00,000

Rs. 90,00,000

Rs. 60,00,000

10,00,000

5,00,000

6,00,000

81,00,000

9,00,000

Rs, 90,00,000


Profit And Loss Account (cont.)

Cost of goods sold represents the cost of the units sold during the period.

Operating expenses are not included in the cost of goods sold.

Examples of operating expenses are: Employee compensation, sales promotion

expenses, freight outward (that is, expenses incurred to deliver goods to customers), electricity expenses, telephone expenses, travelling expenses and conveyance charges.

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Statement of Changes in Equity

Statement of changes in equity reconciles the equity as at the beginning of the period and the same as at the end of the period. Indian GAAP does not require presentation of this

statement.

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Statement of Changes in Equity (cont.)

Statement of changes in equity with hypothetical numbers

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Balance at 1 January 2009

Equity shares issued and paid up during the year

Net profit for the period

Dividend for the year

Equity at 31 December , 2009

Rs. 50,00,000

30,00,000

10,00,000

(2,00,000)

Rs.88,00,000


Cash Flow Statement

Cash flow statement presents cash inflows and outflows from operating activities, investing activities and financing activities. Operating activities are principal revenue

generating activities of the firm. Investing activities are the acquisition and

disposal of long-term assets including acquisition and disposal of business.

Financing activities are activities that result in changes in the size and composition of contributed equity and borrowings of the firm.

Cash flow statement establishes a link between balance sheet and profit and loss account.

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Notes to Accounts

Notes to accounts summarise accounting policies and provide explanatory information.

Accounting policies refer to the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. Accounting policies are controlled by Accounting

Standards.

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Primary Objective of Financial Statements

The primary objective is to provide financial information that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers. Decision usefulness is the overriding principle for

the preparation and presentation of financial statements and transparency is the corner stone of financial statements.

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Secondary Objective of Financial Statements

The secondary objective is to provide information to evaluate management in its stewardship responsibilities.

Equity investors, as owners, use the information contained in financial statements to decide on: the replacement or reappointment of managers

(e.g. CEO); the compensation to managers; and how to vote on shareholder proposals about

management’s policies and other matters.

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Users of Financial Statements

Investors and analysts Investors and analysts use financial statements

and other components of the annual report as the primary source of information required to value the equity of the company.

Creditors, including providers of the debt capital, use information provided in financial statements to assess credit risk.

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Users of Financial Statements (cont.)

Managers and Board of Directors Managers and the Board of Directors use the

information to evaluate the effectiveness of their decisions in organising and allocating resources and the effectiveness of risk management.

Employees Employees use the information to assess the

stability and growth of the company and to estimate their future bonus and variable pay.

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Users of Financial Statements (cont.)

Citizens and government Citizens and government use the information to

assess the stability and growth of companies, discontinuance of which will have significant social impact.

Governments use the information to assess the impact of their policy decisions on the performance of companies.

Revenue departments of government use financial statements to assess whether a company has avoided paying duties and taxes to government.

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Accounting Conventions

The entity convention All transactions are recorded from the point of

view of the entity itself and not from the perspective of other stake holders (e.g. owners).

Therefore, an entity records the amount due to owners as claims (equity capital) on assets it controls.

Money measurement convention All transactions and other events should be

measured in terms of money. Current accounting rules require companies to

measure transactions and other events at nominal amount, without any adjustment for inflation.

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Accounting Conventions (cont.)

Going concern convention Assets and liabilities at the balance sheet date

are measured with the assumption that the entity is a going concern, unless there is evidence to suggest otherwise.

An entity is a going concern if it is not expected to close down or curtail the scale of operation, intentionally or otherwise, in the foreseeable future.

Unless otherwise stated, users of financial statements assume that the entity is a going concern.

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Cost convention Traditionally, financial statements are prepared

and presented based on historical cost. With increase in complexity of transactions, and

gradual shift from transaction based accounting to event based accounting, accounting practice is deviating from the cost convention.

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Realisation convention An asset should be recorded at historical cost

and any change in value should be recognised at the time the firm realises or disposes of the asset.

An unrealised gain should not be recognised. For some assets and liabilities, the current

accounting principles contravene this convention. (Example, revaluation of fixed assets)

Accrual convention Income is recognised as it is earned and

expenditure is recognised, either as an asset or as an expense, when it is incurred.

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Matching convention In order to present true and fair view of the

operating result, accounting principles and methods should ensure matching of income and expenses, to the extent possible.

With shift of focus from the profit and loss account to balance sheet, matching principle is no more the overriding principle.

Periodicity convention The convention is to issue complete set of

financial statements at an interval of 12 months. Publicly traded companies are required to

publish abridged financial statements on quarterly basis.

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Conservatism convention In a situation of uncertainty, it is preferable to

understate profit and assets rather than overstating the same.

The operating rules are:(a) An entity should not anticipate income; it should

provide for all estimated losses.(b) Faced with a choice between two methods of valuing

an asset, the accountant should choose a method that leads to the lesser value.

The convention does not allow intentional overstatement of liabilities or understatement of assets.

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Fundamental Qualitative Characteristics

Relevance Information is relevant when it influences

economic decisions of users by helping them to evaluate past, present or future events or confirming or correcting their past evaluations.

The relevance of a financial statement gets enhanced if material items are shown separately.

Information is material if its misstatement or omission could influence the economic decisions of users taken on the basis of the financial statements.

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Fundamental Qualitative Characteristics (cont.)

Faithful representation Faithful representation is attained when the

depiction of an economic phenomenon is complete, neutral, and free from material error.

Economic substance (which is not always the same as the legal form) of the underlying transaction, event or circumstances should be considered for recording and presenting them in financial statements.

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Enhancing Qualitative Characteristics

Comparability Firms follow the same accounting policies

consistently from period to period to enable users to compare financial statements through time.

Financial statements show corresponding information for the preceding periods to facilitate trend analysis.

In order to enhance comparability of financial statements of different firms, accounting standards bring uniformity in accounting practices across entities by regulating their accounting policies.

Firms disclose accounting policies prominently in financial statements to enhance comparability.

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Enhancing Qualitative Characteristics (cont.)

Verifiability Verifiability is the test for reliability. If estimates by different experts, arrived at

independently, vary widely, the estimate by the management is not verifiable and hence not reliable.

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Enhancing Qualitative Characteristics (cont.)

Understandability Understandability is enhanced when information

is classified, characterised and presented clearly and concisely.

Comparability also enhances understandability. It is assumed that users have reasonable

knowledge of business and economic activities and have financial and accounting literacy.

In making decisions, users are expected to review and analyse the information with reasonable diligence.

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Constraints on Financial Reporting

Materiality Information is material if its omission or

misstatement could influence the decisions that users make on the basis of a company’s financial information.

The materiality of an item should be assessed in terms of its nature and amount.

Often, materiality is evaluated in terms of absolute or relative magnitude of the item.

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Constraints on Financial Reporting (cont.)

Cost Assessing whether the benefits of providing

information justify the related costs will usually be more qualitative than quantitative.

In applying the cost constraint, standard setters assess whether the benefits of reporting information are likely to justify the costs incurred to provide and use that information.

When making this assessment, they consider whether one or more qualitative characteristics might be sacrificed to some degree to reduce cost.

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True and Fair View Financial statements provide true and fair

view only if they meet the desired qualitative characteristics. A reporting enterprise must ensure that financial

statements meet the minimum threshold of all the desired qualities.

Generally, financial statements provide a true and fair view if it is free from any material error and bias; it is prepared using the appropriate accounting

policy and applicable accounting standards; and it is presented in the prescribed format.

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True and Fair View Override

‘True and fair view override’ allows an entity to deviate from the principles and methods stipulated in accounting standards.

However, it is very rarely that compliance with accounting standards impairs the true and fair view of economic consequences of transactions and other events.

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Events Occurring After the Balance Sheet Date

Management develops its perception about the economic consequences of transactions and other events based on information collected by it using reasonable efforts. Information gathered by it is likely to be

incomplete. Therefore, management takes into

consideration additional evidence (about the conditions at the balance sheet date) provided by events unfolded after the balance sheet date but before approval by the Board of Directors for issuance of financial statements. Events that provide the additional evidence are

called adjusting events.

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Events Occurring After the Balance Sheet Date (cont.)

Events that are indicative of conditions that arose after the balance sheet date are non-adjusting events. Assets and liabilities should not be adjusted for

non-adjusting events. If the non-adjusting event destroys the fulcrum

of the business and invalidates the ‘going concern’ assumption, the assets and liabilities are measured based on the assumption that the firm was not a going concern at the balance sheet date.

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Events Occurring After the Balance Sheet Date (cont.) Companies disclose non-adjusting events in

the Board of Director’s report. Examples of non-adjusting events:

Major business combination Announcing a plan to discontinue an operation Purchase or disposal of assets, or acquisition of

major assets by the government Commencement of a major restructuring Major change in exchange rates Major change in tax rates Issuance of significant guarantees on behalf of

third parties Commencement of major litigation.

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Internal Control

Internal control is a process designed to provide reasonable assurance regarding achievement of objectives in the following categories: Effectiveness and efficiency of operations Reliability of financial reporting Compliance with applicable rules and regulations

Internal control cannot ensure success or even survival.

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Internal Control Components

Control environment Discipline and structure Integrity, ethical values and competence of

people Management’s philosophy and operating style The way management invests authority and

gives responsibility, and organizes and develops people

The attention and direction provided by Board of Directors.

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Internal Control Components (cont.)

Risk assessment Risk assessment is the identification and analysis

of relevant risks for achieving an enterprise’s objectives.

Internal control provides mechanisms to identify and deal with special risks.

Control activities The policies and procedures that ensure that

management activities are carried out efficiently and effectively.

Approvals, authorisations, verifications, and reconciliations, reviewing of operating performance, security of assets and segregation of duties.

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Internal Control Components (cont.)

Information and communication Pertinent information should be identified,

captured and communicated in a form and timeframe that enable people to carry out their responsibilities.

Monitoring Regular monitoring is essential to ensure that the

internal control system is adequate and operating effectively.

In the absence of monitoring, an internal control system breaks down.

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Internal Auditing

The Institute of Internal Auditors of USA defines internal auditing as: “Independent, objective assurance and

consulting activity designed to add value and improve an organisation’s operations. It helps an organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance process”.

Internal auditing reviews other controls and, therefore, it is often called the control of controls.

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External Auditing

The term ‘external audit’ is often used to refer to audit of financial statements. The auditor of financial statements provides a

reasonable assurance that financial statements provide a true and fair view of the financial position and operating results of the enterprise.

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External Auditing (cont.)

An auditor may give any of the following four types of opinion:1. An unqualified assertion that the financial

statements give a true and fair view (unqualified audit report)

2. A qualified assertion that the financial statements give a true and fair view subject to certain discrepancies observed by the auditor

3. An assertion that the financial statements do not give a true and fair view (qualified audit report)

4. An assertion that he could not form an opinion on whether the financial statements give a true and fair view (disclaimer).

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END

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Essentials of FA_Chapter 1