Unit 2:
Presentation of Financial Statements
Topics covered as per syllabus
1.Users of financial statements 2.objective of financial statements, 3.Underlying assumptions, 4.Qualitative characteristics of financial statements, 5.The elements of financial statements, 6.Recognition of the elements of financial statements, 7.Measurement of the elements of financial statements, 8..Concepts of capital and capital maintenance
1.Users of financial statements
The users of financial statements include present and potential investors,
employees, lenders, suppliers and other trade creditors, customers,
governments and their agencies and the public.
(a) Investors. The providers of risk capital need information to help them determine whether they should
buy, hold or sell. They are also interested in information to assess the ability of the enterprise to pay
dividends.
(b) Employees-Employees and their representative groups are
interested in information about the stability and profitability of their employers. They also want to assess the ability of the enterprise to provide
remuneration, retirement benefits and employment opportunities.
(c) Lenders. Lenders are interested in information which enables
them to determine whether their loans, and the interest attaching
to them, will be paid when due.
(d) Suppliers and other trade creditors. Suppliers and other
creditors are interested in information which enables them to
determine whether amounts owing to them will be paid when
due.
(e) Customers. Customers have an interest in information about the
continuance of an enterprise, especially when they have a long term involvement with, or are dependent on, the enterprise.
(f) Governments and their agencies. Governments and their
agencies require information in
order to regulate the activities of enterprises and determine
taxation policies, and to serve as the basis for determination of
national income and similar statistics.
(g) Public-Financial statements may assist the public by providing
information about the trends and recent developments in the
prosperity of the enterprise and the range of its activities.
2.Objective of financial statements
The objective of financial statements is to provide information about
the financial position, performance and cash flows of an enterprise that is
useful to a wide range of users in making economic decisions.
Financial statements prepared for this purpose meet the common needs
of most users.
Financial statements also show the results of the stewardship of
management, or the accountability of management for the resources entrusted
to it. Those users who wish to assess the stewardship or accountability of
management do so in order that they may make economic decisions; these
decisions may include whether to hold or sell their investment
in the enterprise or whether to reappoint or replace the management.
3.Underlying assumptions
According to the Framework of IAS/IFRS, the underlying assumptions for the preparation of financial statements are:
Accrual basis -According to accrual basis of accounting, the transactions are recorded in the books of accounts when they occur and not when the cash is received or paid.
Going concern basis - Under going concern basis, it is assumed that the enterprise will continue in operation for the foreseeable future, and the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations.
Conservatism assumption. Revenues and expenses should be recognized when earned, but there is a bias toward earlier recognition of expenses.
Consistency assumption. The same method of accounting will be used from period to period, unless it can be replaced by a more relevant method.
Economic entity assumption. The transactions of a business and those of its owners are not intermingled.
Reliability assumption. Only those transactions that can be adequately proven should be recorded.
Time period assumption. The financial results reported by a business should cover a uniform and consistent period of time.
4.Qualitative characteristics of financial statements
Qualitative characteristics are the attributes that make the information
provided in financial statements useful to users.
The four principal qualitative
characteristics are understandability, relevance, reliability and comparability.
i)Understandability An essential quality of the information provided in financial statements
is that it must be readily understandable by users. For this purpose, it is
assumed that users have a reasonable knowledge of business and economic
activities and accounting .
Information about complex matters should be included in the financial
statements though it may be too
difficult for certain users to understand.
ii)Relevance To be useful, information must be relevant to the decision-making needs
of users. Information has the quality of relevance when it influences the
economic decisions of users by helping them evaluate past, present or future
events or confirming, or correcting, their past evaluations.
The relevance of information is affected by its materiality. Materiality depends on the size and nature of the item or error,
judged in the particular circumstances of its misstatement.
iii)Reliability To be useful, information must also be reliable. Information has the
quality of reliability when it is free from material error and bias and can be
depended upon by users to represent faithfully that which it either purports
to represent or could reasonably be expected to represent.
To be reliable, information must represent faithfully the transactions
and other events it either purports to represent or could reasonably be expected
to represent. Thus, for example, a balance sheet should represent faithfully
the transactions and other events that result in assets, liabilities and equity of
the enterprise at the reporting date which meet the recognition criteria.
To be reliable, the information contained in financial statements must
be neutral, that is, free from bias.
Prudence - The preparers of financial statements have to contend with the
uncertainties that inevitably surround many events and circumstances, such
as the collectability of receivables, the probable useful life of plant and
machinery, and the warranty claims that may occur.
Prudence is the
inclusion of a degree of caution in the exercise of the judgements needed in
making the estimates required under conditions of uncertainty
To be reliable, the information in financial statements must be complete
within the bounds of materiality and cost. An omission can cause information
to be false or misleading and thus unreliable
iv) Comparability -Users must be able to compare the financial statements of an enterprise
through time in order to identify trends in its financial position, performance
and cash flows. Users must also be able to compare the financial statements
of different enterprises in order to evaluate their relative financial position,
performance and cash flows.
Users need to be able to identify differences between the
accounting policies for like transactions and other events used by the same
enterprise from period to period and by different enterprises. Compliance
with Accounting Standards, including the disclosure of the accounting policies
used by the enterprise, helps to achieve comparability.
Users wish to compare the financial position, performance and cash
flows of an enterprise over time. Hence, it is important that the financial
statements show corresponding information for the preceding period
5.The elements of financial statements
The main elements of financial statements are as follows:
Assets. These are items of economic benefit that are expected to yield benefits in future periods. Examples are accounts receivable, inventory, and fixed assets.
Liabilities. These are legally binding obligations payable to another entity or individual. Examples are accounts payable, taxes payable, and wages payable.
Equity. This is the amount invested in a business by its owners, plus any remaining retained earnings.
Revenue. This is an increase in assets or decrease in liabilities caused by the provision of services or products to customers. It is a quantification of the gross activity generated by a business. Examples are product sales and service sales.
Expenses. This is the reduction in value of an asset as it is used to generate revenue. Examples are interest expense, compensation expense, and utilities expense.
Of these elements, assets, liabilities, and equity are included in the balance sheet. Revenues and expenses are included in the income statement. Changes in these elements are noted in the statement of cash flows.
6.Recognition of the elements of financial statements
Recognition is the process of incorporating in the balance sheet or statement of profit and loss an item that meets the definition of an element and satisfies the criteria for recognition .
It involves the depiction of the item in words and by a monetary amount and the inclusion of that amount in the totals of balance sheet or statement of profit and loss.
Items that satisfy the recognition criteria should be recognised in the balance sheet or statement of profit and loss.
An item that meets the definition of an element should be recognised if:
(a) it is probable that any future economic benefit associated with
the item will flow to or from the enterprise; and
(b) the item has a cost or value that can be measured with reliability.
In assessing whether an item meets these criteria and therefore qualifies for recognition in the financial statements, regard needs to be given to the materiality considerations discussed in paragraph
The interrelationship between the elements means that an item that meets the definition and recognition criteria for a particular element
7.Measurement of the elements of financial statements
Measurement is the process of determining the monetary amounts at which the elements of financial statements are to be recognised and carried in the balance sheet and statement of profit and loss. This involves the selection of the particular basis of measurement.
A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. They include the following:
(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for
the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.
(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset were acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.
(c) Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values, that is, the undiscounted amounts of cash or cash equivalents expected to be required to settle the liabilities
in the normal course of business.
(d) Present value. Assets are carried at the present value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.The measurement basis most commonly adopted by enterprises in preparing their financial statements is historical cost. This is usually combined with other measurement bases.
8.Concepts of Capital and Capital Maintenance
capital is synonymous with the net assets or equity of the enterprise. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the enterprise based on, for example, units of output per day.
The selection of the appropriate concept of capital by an enterprise should be based on the needs of the users of its financial statements. Thus,a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital or the purchasing power of invested capital. I
Concepts of Capital Maintenance and the Determination of Profit
The concepts of capital described in paragraph give rise to the following concepts of capital maintenance:
(a) Financial capital maintenance. Under this concept, a profit is earned only if the financial amount of the net assets at the end of the period exceeds the financial amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
(b) Physical capital maintenance. Under this concept, a profit is earned only if the physical productive capacity (or operating capability) of the enterprise at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.
The concept of capital maintenance is concerned with how an
enterprise defines the capital that it seeks to maintain. It provides the linkage
between the concepts of capital and the concepts of profit because it provides
the point of reference by which profit is measured; it is a prerequisite for
distinguishing between an enterprise's return on capital and its return of
capital; only inflows of assets in excess of amounts needed to maintain capital
can be regarded as profit and therefore as a return on capital. Hence, profit
is the residual amount that remains after expenses (including capital
maintenance adjustments, where appropriate) have been deducted from
income. If expenses exceed income, the residual amount is a net loss.
105. The physical capital maintenance concept requires the adoption of
the current cost basis of measurement. The financial capital maintenance
concept, however, does not require the use of a particular basis of
measurement. Selection of the basis under this concept is dependent on the
type of financial capital that the enterprise is seeking to maintain.
The principal difference between the two concepts of capital
maintenance is the treatment of the effects of changes in the prices of assets
and liabilities of the enterprise. In general terms, an enterprise has maintained
its capital if it has as much capital at the end of the period as it had at the
beginning of the period. Any amount over and above that required to maintain
the capital at the beginning of the period is profit.
Under the concept of financial capital maintenance where capital is
defined in terms of nominal monetary units, profit represents the increase in
nominal money capital over the period. Thus, increases in the prices of
assets held over the period, conventionally referred to as holding gains, are,
conceptually, profits. They may not be recognised as such, however, until
the assets are disposed of in an exchange transaction. When the concept of
financial capital maintenance is defined in terms of constant purchasing power
units, profit represents the increase in invested purchasing power over the
period. Thus, only that part of the increase in the prices of assets that
exceeds the increase in the general level of prices is regarded as profit. The
rest of the increase is treated as a capital maintenance adjustment and, hence,
as part of equity.
Under the concept of physical capital maintenance when capital is
defined in terms of the physical productive capacity, profit represents the
increase in that capital over the period. All price changes affecting the
assets and liabilities of the enterprise are viewed as changes in the
measurement of the physical productive capacity of the enterprise; hence,
they are treated as capital maintenance adjustments that are part of equity
and not as profit.
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