Conceptual Framework for Preparation and Presentation

of Financial Statements Paper 5 : Advanced Accounting, Chapter : 1

CA. D. Suresh Kumar

AGENDA

1 • Introduction

2 • Purpose of the framework

3 • Status and Scope of the Framework

4 • Components of Financial Statements

5 • Objectives of Financial Statements

6 • Fundamental Accounting Assumptions

7 • Qualitative Characteristics

8 • Elements of Financial Statements

9 • Measurement of Elements of Financial Statements

10 • Capital Maintenance 2

Introduction

Accounting Standards Board (ASB) of the ICAI has issued a framework which provides the

fundamental basis for development of new standards as also for review of existing

standards

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Principal Areas Covered by the Framework

Components of Financial Statements

Objectivities of Financial Statements

Assumptions Underlying Financial Statements

Qualitative Characteristics of Financial Statements

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Elements of Financial Statements

Criteria for Recognition of Elements in Financial Statements

Principles of Measurement of Financial Elements

Concepts of Capital and Capital Maintenance

Principal Areas Covered by the Framework Contd..

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Purpose of the framework

To assist the enterprise in preparation of financial statements.

To assist ASB in its task of development and review of accounting standards

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Purpose of the framework

To assist ASB in promoting harmonization

To assist auditors in forming an opinion as to whether financial statements conform to the accounting standards

To assist the users in interpretation of financial statements

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Status and Scope of the Framework

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Status and Scope of the Framework

Financial Statements are prepared annually for external use.

Special purpose financial reports are outside the scope of the framework • Ex: Tax Purposes

Framework never overrides any specific Accounting Standard.

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Components of Financial Statements

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Components of Financial Statements

1 • Balance Sheet

2 • Profit & Loss A/c

3 • Cash Flow Statement

4 • Notes and Schedules

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1. Balance Sheet Common-size Balance Sheet of X-Company

As of Dec. 31, 1997 (Rs. 000's)Liabilities and Owner's Equity 1997 1996 Accounts Payable 175.20 145.60 Short-term Notes Payable 225.00 200.00 Other Current Liabilities 140.00 136.00Total Current Liabilities 540.20 481.60 Long-term Debt 424.61 323.43Total Liabilities 964.81 805.03 Common Stock 460.00 460.00 Retained Earnings 225.99 203.77Total Shareholder's Equity 685.99 663.77Total Liabilities and Owner's Equity 1650.80 1468.80Assets 1997 1996 Cash and Equivalents 50.00 57.60 Accounts Receivable 402.00 351.20 Inventory 838.00 715.20Total Current Assets 1290.00 1124.00 Plant & Equipment 527.00 491.00 Accumulated Depreciation 166.20 146.20Net Fixed Assets 360.80 344.80Total Assets 1650.80 1468.80

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2. Profit & Loss

Common-size Income Statement of X LtdFor the Year Ended Dec. 31, 1997 (Rs. 000's)Particulars 1997 1996Sales 3900.00 3500.00Cost of Goods Sold 3250.00 2864.00Gross Profit 650.00 636.00Selling and G&A Expenses 330.30 240.00Fixed Expenses 100.00 100.00Depreciation Expense 20.00 18.90EBIT 199.70 277.10Interest Expense 76.00 62.50Earnings Before Taxes 123.70 214.60Taxes @ 40% 49.48 85.84Net Income 74.22 128.76

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3. Cash Flow Statement X- Company

Statement of Cash FlowsFor the Year Ended Dec. 31, 1997 (000's)

Cash Flows from OperationsNet Income 74.22Depreciation Expense 20.00Change in Accounts Receivable -50.80Change in Inventories -122.80Change in Accounts Payable 29.60Change in Short-term Notes Payable 25.00Change in Other Current Liabilities 4.00Total Cash Flows from Operations -20.78Cash Flows from InvestingChange in Plant & Equipment -36.00Total Cash Flows from Investing -36.00Cash Flows from FinancingChange in Long-term Debt 101.18Cash Dividends Paid to Shareholders -52.00Total Cash Flows from Financing 49.18Net Change in Cash Balance -7.60

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Objectives of Financial Statements

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Users of Financial Statements

Users

Investors

Employees

Lenders

Suppliers &

Creditors Customers

Govt.

Public

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Fundamental Accounting Assumptions

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Fundamental Accounting Assumptions

1 • Going Concern

2 • Accrual Basis of Accounting

3 • Consistency

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Note: Audio for remaining slides will be updated shortly

Going Concern

An enterprise will continue in operation in the foreseeable future and neither there is

intention, nor there is need to materially curtail the scale of

operations

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Going Concern Example

Liabilities Rs. Assets Rs. Capital 60,000 Fixed Assets 65,000 Profit & Loss A/c 25,000 Stock 30,000 10% Loan 35,000 Trade receivables 20,000 Trade Payables 10,000 Deferred costs 10,000

Bank 5,000 1,30,000 1,30,000

Balance sheet of a trader on 31/03/10 is given below:

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Additional Information

The remaining life of fixed assets is 5 years. The use pattern of the asset is even. The net realizable value of fixed assets as on 31/03/11 was Rs.60,000.

The trader’s purchases & sales in 2010-11 amounted Rs.4 Lakhs and Rs.4.5 Lakhs.

The cost and net realizable value of stock at the end of 31/03/11 were Rs. 32,000 and Rs. 40,000.

Expenses for the year amounted to Rs. 14,900.

Deferred cost is amortized equally over 4 years.

Closing debtors is Rs.25,000, of which Rs.2,000 is doubtful. Collection of another Rs.4,000 depends on successful re-installation of certain product supplied to the customer.

Closing trade payable is Rs.12,000, which is likely to be settled at 5% discount.

Balance of closing cash is Rs.37,100.

There is an early repayment penalty for the loan Rs.2,500.

Prepare P&L and Balance sheet assuming (i) Going Concern (ii) Not Going Concern 21

Profit and Loss A/c for the Year Ended 31.03.2011

Particulars Case (i) Rs.

Case (ii) Rs.

Particulars

Case (i) Rs.

Case (ii) Rs.

To Opening Stock 30,000 30,000

By Sales 4,50,000 4,50,000

To Purchases 4,00,000 4,00,000 By Closing Stock 32,000 40,000

To Expenses 14,900 14,900 By Trade Payables - 600

To Depreciation 13,000 5,000

To Provision for doubtful debt

2,000 6,000

To Deferred Cost 2,500 10,000

To Loan - 25,000

To Net Profit 19,600 22,200

4,82,000 4,90,600 4,82,000 4,90,600

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Balance Sheet as on 31.03.11

Liabilities Case (i) Rs.

Case (i) Rs.

Assets Case (i) Rs.

Case (i) Rs.

Capital 60,000 60,000 Fixed Assets 52,000 60,000

Profit & Loss A/c 44,600 47,200 Stock 32,000 40,000

10% Loan 35,000 37,500 Trade Receivables (less provisions)

23,000 19,000

Trade Payables 12,000 11,400 Deferred Costs 7,500 Nil

Bank 37,100 37,100

1,56,100 1,56,100 1,51,600 1,51,600

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Consistency

Using same accounting policies for similar transactions in all accounting periods.

Reason for Changes in Accounting Policies

By a Statute

For more appropriate presentation

By an Accounting Standard

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Accrual Basis of Accounting

Transactions are recorded as soon as they occur irrelevant of

the amount received/paid.

Gives better matching between revenue and cost and

profit/loss.

More logical approach to profit determination.

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Accrual Basis of Accounting

A trader purchased article A on credit in period 1 for Rs.50,000.

He also purchased article B in period 1 for Rs.2,000 cash.

The trader sold article A in period 1 for Rs.60,000 in cash

He also sold article B in period 1 for Rs. 2,500 on credit

Prepare P&L on the basis of accrual and cash basis. 26

Profit & Loss A/c (Cash)

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PROFIT & LOSS A/C (ACCRUAL)

Rs. Rs.

Period 1 To Purchase 2,000 By Sale 60,000

To Net Profit 58,000

60,000 6000

Period 2 To Purchase 50,000 By sale 2,500

By Net Loss 47,500

50000 50000

Rs. Rs.

Period 1 To Purchase 52,000 By Sale 62,500

To Net Profit 10,500

62,500 62,500

Qualitative Characteristics 28

Qualitative Characteristics

1 • Understandability

2 • Relevance

3 • Reliability

4 • Comparability

5 • True and Fair view

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Elements of financial statements

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Elements of financial statements

1 • Assets

2 • Liabilities

3 • Equity

4 • Income

5 • Expenses

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Measurement of Elements of Financial Statements

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Present Value

Historical Cost

Current Cost

Realizable Cost

Measurement of Elements of Financial Statements

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Historical Cost

Acquisition Price of Asset

Liabilities are recorded at the amount of proceeds received in exchange for the obligation.

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Historical Cost Example A machine was acquired in exchange of an old car

and Rs. 20,000 paid in cash. The carrying amount of the car was Rs. 1,75,000. The fair value of the car on the date of exchange was Rs. 1,50,000. Give accounting entries. Rs. Rs.

Machinery A/c 1,70,000 150000+20000 Loss on disposal of car A/c 25,000 175000-150000

To Car A/c 1,75,000 To Bank A/c 20,000

Historical Cost of the Machine = Fair value of car given on exchange +

Cash Paid

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Current Cost

The amount that would have been paid if the same or equivalent asset was acquired currently.

Liabilities are carried at undiscounted amount that would be required to settle the obligation currently

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Current Cost Example

A machine was acquired for $10,000 on deferred payment basis. The rate of exchange on the date of acquisition was Rs. 49 /$. The payments are to be made in 5 equal annual installments together with 10% interest per year. The current market value of similar machine in India is Rs. 5 Lakhs.

Current Cost of the machine=Current Market Price= Rs.5,00,000 By historical cost convention the machine would have been recorded

at Rs.4,90,000.

Rs. Rs. Machinery A/c Dr. 5,00,000 To Deferred Payment Obligation 4,90,000 To Revaluation Reserves 10,000

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Realizable (Settlement) Value

Currently realizable value on sale of the asset in an orderly

disposal.

Liabilities, the amount to be paid on

settlement of liability in the normal course of

business

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Present Value

Present value of an amount ‘A’, after ‘n’ years is the amount ‘P’, one has to

invest on current date to have ‘A’ after ‘n’ years. If the

rate of interest is ‘R’ then,

A = P (1+R)n

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Capital Maintenance 40

Capital Maintenance

P = ( CA – CL ) – ( OA – OL ) – C + D

P – Profit

OA – Opening Assets and OL – Opening Liabilities

CA – Closing Assets and CL – Closing Liabilities

Introduction of capital = C and Drawings/Dividends = D

Retained Profit = P – D = ( CA – CL ) – ( OA – OL ) – C

Retained Profit = Closing Equity – ( Opening + Capital Introduced) 41

Financial Capital Maintenance

Historical Cost

Current Purchasing Power

Physical Capital Maintenance at Current Cost

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Example for Capital Maintenance

A trader commenced business on 01.01.2010 with Rs.12,000 represented by 6,000 units of a certain product at Rs.2 per unit. During the year 2010 he sold these units at Rs.3 per unit and had withdrawn Rs.6000.

Compute the retained profit under

• Historical Cost • Current Purchasing Power • Physical Maintenace

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Financial Capital Maintenance at Historical Costs

Rs. Rs. Closing capital ( At historical cost) 12,000 Less: Capital to be maintained Opening capital ( At historical Cost) 12,000 Introduction ( At historical Cost) Nil 12,000 Retained Profit Nil

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Financial Capital Maintenance at Current Purchasing Power

Rs. Rs. Closing capital ( At closing Price) 12,000 Less: Capital to be maintained Opening capital ( At closing Price) 14,400 Introduction ( At closing Price) Nil 14,400 Retained Profit (2,400)

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Financial Capital Maintenance at Historical Costs

Rs. Rs. Closing capital ( At Current Cost) 12,000 Less: Capital to be maintained Opening capital ( At Current Cost) 15000 Introduction ( At Current Cost) Nil 15,000 Retained Profit (3000)

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Lesson Summary

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Thank You