Framework for preparation of Financial Statements

Framework introduces us to the most basic and important elements needed to understand any financial statements. If we see any annual report published by a Company, we can see multiple sections available and multiple information relating to Company Such as Directors report, Industry outlook, management discussion and analysis , standalone and Consolidated Financial statements etc..

Lets understand the framework with few simple Q&A's

Does Framework apply to all these reports?

No, Framework will be applicable only to general purpose financial statements, these will not apply to special purpose reports such as prospectus issued by a Company, Directors report etc.

What do we mean by general purpose financial statement?

These are financial statements prepared and presented to all with a general purpose and governed by GAAP giving common information required by the users of financial statements which have consistency and uniformity across the industry.

Whereas, special purpose financial statements, cater to specific need of the preparer or requestor.

What does Financial statements include?

Financial statements include Balance Sheet, Statement of Profit and Loss, Cash Flow Statement , Statement to Changes in Equity and Notes to Accounts.

All the other categories, provided in annual reports are not part of Financial statements and out of the purview of framework.

Let us now, go through the Financial statements…

Most common words we come across in financial Statements are Assets, Liabilities, Income , Expense ,Equity etc.. Lets understand those one by one:

Asset:

Whether asset should be tangible or intangible or can it be both?

Asset is a resource which can give future economic benefits inflow to the entity, so it can be both tangible and intangible.

Whether entity should be a legal owner of such resource?

Asset is a resource which can give future economic benefits inflow to the entity. Legal ownership is not mandatory.

E.g. In case of Hire purchase transaction, asset is recorded at the beginning even though the ownership is transferred at the repayment of last installment.

Liability:

Present means-Which exist on the last date of the Balance sheet.

An Obligation is a duty or responsibility to act or perform in a certain way. It can be both legal obligation or contractual obligation i.e. to say it can arise from normal business practice.

E.g. An entity decides to pay bonus to some of its employees even if they are not covered by the Bonus Act as a matter of normal matter of policy.

Equity:

This is the balance left out for the owners. In case of the companies it’s the Equity shareholders, partners incase of partnership /LLP and individual incase of proprietorship.

Equity is the residual interest in the net assets after deducting the liabilities i.e. who is ready to accept the remaining funds after clearing the liabilities.

Is redeemable preferential share capital a part of equity or liability?

Preference shareholders don't have any interest in the net assets of the Company and the entity has an obligation to repay the amount received after specified time.

Based on above example, it is clear that preference shares should be presented as Liability.

Income:

Income includes:

(a) Revenue i.e. which arises in ordinary course of business e.g. sales, fees, interest dividends etc..

(b) Gains represent other items which may or may not arise from ordinary activities. e.g. Profit on sale of non-current assets.

Expense:

Expense includes:

General expense i.e. which arises in the ordinary course of business. e.g. cost of gods sold, salaries, professional fees, etc.

Losses i.e. other items which may or may not arise from ordinary activities. e.g. loss on sale of non-current assets, decrease in value of investments value.

Based on above discussion, we have understood the main categories of financial statements. The financial statements are prepared based in below mentioned assumptions ( Detailed explanation will be provided in IND AS 1 Presentation of financial statements)

(a) Going Concern-It is assumed that business continues for infinite future.

(b) Consistency-All methods and disclosures used in preparation of financial statements should be used consistently

(c) Accrual basis-All expected loss much be accounted and all expected profits / gains should not be recognized.

Finally, the financial information is to be useful, it must be relevant and faithfully represent what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable.

Financial statement should have the following qualitative characteristics:

(a) Relevance -Given information in financials should be relevant to the decision making needs of the users.

(b) Materiality-Information is material if the misstatement could influence the economic decisions of users. It is an entity specific and depends on nature, relative size or both.

(c) Faithful presentation-To be useful, financial information must not only represent relevant, but it must also faithfully represent that it intends to represent.

(d) Comparability- It refers to the use of same methods for same items either from period to period within a reporting entity or in a single period across entities.

(e)Verifiability-Different knowledgeable and independent observers could reach consensus .

(f) Timeliness-It is one of the common objective to provide useful and reliable financial reports to the user but it should never be at the cost of time.

(g) Understandability-Classifying, characterizing and presenting information clearly and concisely make it understandable.

The above summarizes the basic details one needs to know before understanding the Accounting Standards. Hope that this article helps you in simplifying the Accounting Standards.