Financial Reporting Framework

Accounting Assumptions:

Underlying assumptions for the preparation and presentation of financial statements are accrual and going concern.

Accrual assumption:

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The effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate.

Going concern assumption:

The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. It is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations. If such an intention or need exists, the financial statements shall be prepared on a different basis. Accordingly, the entity shall disclose the basis used for the preparation and presentation of financial statements.

Example 8.1:

X Ltd. purchased raw materials amounting to Rs.200,000 on 29 March, 2009. As per terms of purchase, the company takes possession of the goods purchased in the seller’s warehouse and makes transportation arrange­ment. The company paid the purchase bill on 16 April, 2009. When should the purchase be recognised – on 29 March or 16 April?

Solution:

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In accordance with accrual assumption, purchase shall be recognised on 29 March when the transaction occurred not on 16 April when the cash or cash equivalent was paid to settle the purchase bill.

Measurement Bases:

Elements of financial statements, i.e. assets, liabilities, equity, income and expense, are measured using different measurement bases like historical cost, current cost, realizable (settlement) value and present value.

Under the historical cost assets are recognized at cash or cash equivalent paid or at the fair value of consideration agreed upon at the time of acquisition. Similarly, liabilities are recognized at cash or cash equivalents received against the obligation. In some cases, liabilities are recognized at cash or cash equivalents expected to be paid in futures (for example, provision for warranty claim, income tax liability).

Current cost signifies current entry value of an asset if replaced currently. For a liability it represents undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.

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Under the 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. Settlement value of a liability means discounted/undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.

Under the present value an asset is carried at the discounted value of the future net cash inflows that the asset is expected to generate in the normal course of business. Liabilities are carried at the discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.

Various IFRSs explain the measurement bases of relevant transactions and other events. In absence of a specific guidance, an entity may follow a suitable measurement base out of historical cost, current cost, realizable value and present value.

Recognition of Financial Elements:

Recognition is a process of incorporating an item of asset, liability or equity in the statement of financial position (balance sheet) or an item of income or expense in the statement of income, or an item (like fair value gain of available for sale financial instruments) in the statement of other comprehensive income.

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General recognition Principles:

1. Fundamental recognition principles:

i. Economic benefits embodied in the element will flow to or from the entity,

ii. Cost or value can be measured reliably.

Recognition of any elements of financial statements shall be tested against these two fundamental principles. That apart specific IFRS would prescribe additional recognition criteria.

2. Disclosure is no remedy for recognition failure:

Elements of financial statements are recognized when the fundamental prin­ciples stated the Framework or any additional criteria stated in a specific IFRS applicable to that element are satisfied. Failure to recognize an element cannot be rectified by disclosure of accounting policy or by way of notes.

3. Materiality:

Recognition of an element of financial statements should satisfy the materiality test.

4. Use of probability:

In case there exists uncertainty as regards flow of resource embodying economic benefit to or from the entity, the concept of probability is used for the measure­ment of value of transactions or other events.

5. Reliability of measurement:

Reliability of Measurement

Qualitative Characteristics:

Qualitative characteristics are the attributes that make the information provided in financial statements useful to users. Four principal qualitative characteristics are presented in Figure 8.1. As an overall count, financial statements should reflect fair presentation.

Qualitative Characteristics

1. Understandability:

Information provided in financial statements is that it is readily understandable by the users having reasonable knowledge of business and economic activities and accounting and a willingness to study the informa­tion with reasonable diligence.

2. Relevance:

Information must be relevant to the decision-making needs of the users. If the information can influence the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations is considered as relevant. The information has predictive as well as confirmatory role. Information about financial position and past performance is frequently used as the basis for predicting future financial position and performance. Level of profit may be the basis of confirmation of debt service capacity, dividend payment, etc.

Classified information like classified balance sheet has better predictive ability. Similarly, an income statement which present operating profit and unusual items separately has better predictive ability.

Relevance is influenced by materiality and timeliness.

3. Reliability:

An information is reliable if it is;

i. Free from material error and bias and

ii. Presented faithfully which it either purports to represent or could reason­ably be expected to represent.

Example:

There is a lawsuit against the entity which it believes as fructuous. However, the opponent party has made a widespread campaign that it would win the case and get a claim of Rs.10 million from the entity. Based on this market information, the entity should not recognize a liability as this information is not free from bias. It has relevance as it may affect the profit of the entity substantially but its reliability is equally relevant.

Reliability is influenced by faithful presentation, substance over form, neutrality, prudence and completeness.

4. Comparability:

It facilitates comparison of financial statements of an entity through time in order to identify trends in its financial position and performance. To ensure comparability, consistency of presentation is required. Normally, an entity shall retain the presentation and classification of items in the financial statements from one period to the next.

Comparability is ensured through disclosure of comparative information in respect of the previous period for all amounts reported in the current period’s financial statements. It has to include comparatives for narrative and descriptive information when it is relevant to the understanding of the current period’s financial statements.

Materiality:

Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. It depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Often separate line item or sub-item is decided based on materiality. National level law may specify materiality limit for separate disclosure of an item.

Faithful presentation:

Most of the financial information fraught with risk of faithful presentation not primarily because of bias but for inherent measurement difficulties. It is more so in the fair value measurement as compared to historical cost measure­ment. However, IFRSs explain unbiased measurement principles application which may lead to faithful presentation.

Substance over form:

Transaction and other events should be presented based on substance not in accordance with the legal form. Example recognition of assets by economic benefits not by ownership.

Neutrality:

Financial information should be free from bias. In case of ‘earning management’ or ‘creative accounting’ information is presented with an objective to achieve pre-determined result. The resultant financial statements are not reliable as lacks neutrality.

Prudence:

Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncer­tainty, such that assets or income are not overstated and liabilities or expenses are not understated. The exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions.

Completeness:

The information in the 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 and deficient in terms of its relevance.

Constraint on relevant and reliable information:

Important constraints are:

(i) Timeliness,

(ii) Balance between benefit and cost, and

(iii) Balance between qualitative characteristics.

Timeliness:

A piece of information loses relevance if there is delay in the reporting of information. Normal frequency of financial reporting is one year. This is because the concept of interim financial reporting has gained ground.

However, the management would require to balance between timeliness and reliability. A premature disclosure of information without judging all aspects may turn out to be unreliable whereas too much delay in disclosure would make the disclosure redundant.

Balance between benefit and cost:

The benefits derived from information should exceed the cost of providing it. But the costs do not necessarily fall on those users who enjoy the benefits. Of course, the evaluation of benefits and costs is substantially a judgmental process.

Balance between qualitative characteristics:

This is aimed at achieving a balance between two or more qualitative characteristics.

True and Fair View:

Financial statements are frequently described as showing a true and fair view of, or as presenting fairly, the financial position, performance and changes in financial position of an entity. The IASB Framework does not deal with this concept. However, the application of the principal qualitative characteristics and of appropriate accounting standards normally results in financial statements that convey what is generally understood as a true and fair view of, or as presenting fairly such information.

Capital Maintenance:

Capital maintenance concept is inherent in the profit measurement process comparing assets, liabilities and equity of two different accounting dates. However, under IFRS based accounting model, profit is measured comparing expenses and income. Of course, expenses are matched with related revenue if they are directly related. For indirect expenses like depreciation and amortiza­tion, the inherent method is systematic allocation over the useful life.

Various assets and liabilities are measured following a mixture of historical cost, current cost (entry value), realizable value (exit value) and present value (economic value). So income and expense are the outcome of such heterogeneous valuation system. No specific capital maintenance concept is adhered to.

Of course, in theory there are two concepts – financial capital maintenance and physical capital maintenance. Under financial capital maintenance concept, profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) 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. Under physical capital maintenance concept, profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) 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.

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