Corporate Financial Reporting

Session 2: PGP 2020-21

Introduction and Accounting Equation
 Session- 2: Learning Goals
• Quick Revision: Numericals - Basic Accounting Equation & Expansion
– Formal Definition of Elements of FS: Assets, Liabilities, Income,
Expenses, Stockholders’ Equity
• Basic Accounting Principles, Assumptions and Concepts :
– Assumptions: Money Measurement (Monetary Unit), Separate Entity
(Economic Entity), Going Concern, Cash Versus Accrual Accounting,
Accounting Period (Periodicity), Materiality
– Principles: Historical Cost & Fair value measurement, Full Disclosure,
Conservatism
• Conceptual Framework
– Qualitative characteristics of Accounting Information
• Fundamental and Enhancing Qualities
– Constraints : Materiality, Cost-Benefit
– Ethics : Sarbanes-Oxley (SOX), Preventing Fraudulent Reporting and
Corporate governance
• Assignments
• Case : Richie Advisors Private Ltd.

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 Elements of Financial Statements (BS)
ASSETS LIABILITIES
A (present) economic resource controlled Present obligation of the entity arising from past
by an entity as a result of past events and events, the settlement of which is expected to
from which future economic benefits are result in an outflow from the enterprise of
expected to flow to the entity resources embodying economic benefits
1. Future Economic Benefit is probable to 1. Economic benefit is expected to flow out of the
flow in (direct/indirect cash inflow) entity to settle the liability
2. Control : Right to use the item to the – Settlement can occur through payment of cash,
transfer of asset, replacement with other liability
exclusion of others
3. Result of a past event 2. Test: No realistic alternative but to settle the
obligation
• Is Investment in shares of a company 3. Result of past obligating event
which vanished after IPO an asset ?
• Is Salary paid to employees an asset ? Can be
• Is intention to purchase an equipment an – Contractual (Borrowings, creditors),
asset ? – Arising from operation of law (tax payable,
• Are patents owned by an entity an asset ? penalty imposed)
Ex: Borrowings, Bonds/ Debentures, Advances
Ex: Building, Plant and Machinery, from customers, Accounts Payable, Wages
Inventories, Accounts receivables, Cash outstanding, Taxes payable 3
 Elements of Financial Statements (BS): Shareholders’ Equity

SHAREHOLDERS’ EQUITY :
The owner’s funds invested and earned in the business.
– EQUITY is the residual interest (or claims of the owners) in the assets of the entity after
deducting all its liabilities

Contributed Capital (Original + New)

+ Retained Earnings (Profits less Distributions to equity holders)

– Retained Earnings:
• Measure of undistributed profits of a business
• Retained Earnings balance =
(Cumulative sum of profits earned since inception)
– (Cumulative sum of dividend distributed since inception)
• Dividends: Distribution to the owners out of the profits earned by the business
• Revenues increase RE, Expenses and Dividends decrease RE.

• Increase in assets without any change in liabilities -> increases equity

• Decrease in assets without any change in liabilities -> decreases equity

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 Revenues and Expenses
Revenues: Expenses:
Economic resources earned by an entity Resources consumed in the process of
during a given accounting period generating revenue during a given accounting
period
• These result from core operating (earning)
• These are incurred in the process of creating
activities or ordinary activities of an entity revenues & involve decrease in economic
• It involves gross inflow or increase in benefits in the form of :
economic benefits in the form of – Outflow or consumption of assets or
– Inflow or enhancement of assets – Incurrence of liabilities or
(A/R) or – A combination of both
– Settlement of liabilities or Example: Cost of goods sold, rent expense

– A combination of both • They result in decrease in RE, Equity

Can any decrease in equity called Expense ?
Example: For a manufacturer - Sale of • So, if an entity has Revenues > Expenses,
goods to customers, For insurance – It has made a profit and the same goes to
company – Premiums from policy • Increase owners’ equity
holders, Banks ? Lawyers ? • This profit can be called Net income or
• They result in increase in RE, Equity Net earnings
• But, if Revenues < Expenses, it has made a
Can any increase in equity called Revenue ? Net Loss 5
 New CF (IASB)
ASSETS LIABILITIES
A present economic resource controlled by the A present obligation of the entity to transfer an
entity as a result of past events economic resource as a result of past events
• An economic resource is a right that has the • An obligation is a duty or responsibility that
potential to produce economic benefits the entity has no practical ability to avoid
1. Right (to receive cash/ goods & services/ 1. the entity has an obligation
physical or intellectual property) • to transfer an economic resource
2. Potential to produce Economic Benefit (to • present obligation that exists as a result
receive contractual cashflows/ other of past events
economic resource/produce cash ins or avoid 2. No realistic alternative but to settle the
cash outs etc.) obligation

3. Control : Present ability to direct the use of Can be

the economic resource and obtain the – Contractual (Borrowings, creditors),
economic benefits that flow from it
– Arising from operation of law (tax payable,
– Comes Not necessarily from ownership penalty imposed)
4. Result of a Past Event (say, a transaction) Ex: Borrowings, Bonds/ Debentures, Advances
Ex: Building, Plant and Machinery, Inventories, from customers, Accounts Payable, Wages
Investments, Accounts receivables, Cash outstanding, Taxes payable
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 New CF (IASB)
ASSETS LIABILITIES
A present economic resource controlled by the A present obligation of the entity to transfer
entity as a result of past events an economic resource as a result of past
• An economic resource is a right that has the events
potential to produce economic benefits • An obligation is a duty or responsibility
1. Right (to receive cash/ goods & services/ that the entity has no practical ability to
physical or intellectual property) avoid
2. Potential to produce Economic Benefit (to 1. the entity has an obligation
receive contractual cashflows/ other • to transfer an economic resource
economic resource/produce cash ins or • present obligation that exists as a
avoid cash outs etc.) result of past events
3. Control : Present ability to direct the use of 2. No realistic alternative but to settle the
the economic resource and obtain the obligation
economic benefits that flow from it
Can be
– Comes Not necessarily from ownership
– Contractual (Borrowings, creditors),
4. Result of a Past Event (say, a transaction) – Arising from operation of law (tax payable,
Ex: Building, Plant and Machinery, penalty imposed)
Inventories, Investments, Accounts Ex: Borrowings, Bonds/ Debentures, Advances
receivables, Cash from customers, Accounts Payable, Wages
outstanding, Taxes payable 7
 New CF (IASB)
Income Expenses:
• Increases in assets, or • Decreases in assets, or
• Increases in liabilities,
• Decreases in liabilities,
that result in decreases in equity,
that result in increases in equity, other than those relating to distributions to
other than those relating to contributions holders of equity claims.
from holders of equity claims.
Incomes include amounts generated by Expenses include amounts generated by
transactions and other events, including transactions and other events, including
changes in the carrying amount of assets changes in the carrying amount of assets and
and liabilities liabilities.
• Expenses include losses
• Income includes gains
Examples:
Examples:
• Revenue from sale of goods/services; • Cost of goods sold,
• Interest and dividend income from • Operating Expense like rent expense,
electricity expense etc
investments in financial assets; • Loss on sale of a PPE/ Investment
• Rent earned
• Gain from sale of a PPE/ Investment • Loss on Revaluation of a PPE
• Depreciation & Impairment of PPE
• Gain on revaluation of a PPE
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EXERCISE 1 : CLASSIFICATION OF FINANCIAL STATEMENT ITEMS

Classify the items :

1. Whether it belongs on the Income statement (IS), Balance Sheet (BS)
2. Whether it is a revenue (R ), expense (E ), asset(A), liability(L) or
stockholders’ equity (SE)
Item Appears on the Classified as
Cash BS A
1 Salaries Expense IS E
2 Equipment BS A
3 Accounts Payable BS L
4 Membership fees earned IS R
5 Capital Stock BS SE
6 Accounts Receivable BS A
7 Buildings BS A
8 Advertising expense IS E
9 Retained Earnings BS SE
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EXERCISE 1 : CLASSIFICATION OF FINANCIAL STATEMENT ITEMS

Classify the items :

1. Whether it belongs on the Income statement (IS), Balance Sheet (BS)
2. Whether it is a revenue (R ), expense (E ), asset(A), liability(L) or
stockholders’ equity (SE)
Item Appears on the Classified as
Cash BS A
1 Salaries Expense IS E
2 Equipment BS A
3 Accounts Payable BS L
4 Membership fees earned IS R
5 Capital Stock BS SE
6 Accounts Receivable BS A
7 Buildings BS A
8 Advertising expense IS E
9 Retained Earnings BS SE
Assignments: KWK - E1-15, E1-16 10
 Basic Accounting Equation - Extension
Assets = Liabilities + Common Stock + Retained Earnings (RE)

• Change in Retained earnings during the year (∆ RE )

= (Revenues t – Expenses t – Dividends t )
• Retained Earnings at the end of the year (REt)
= Prior Retained Earnings (RE t-1) + ∆ RE
= Prior Retained Earnings (RE t-1) + (Revenues t – Expenses t – Dividends t )
= (Revenues – Expenses – Dividends) accumulated over the life of the entity
Thus,
Assets = Liabilities + Common stock + ⅀ (Revenues - Expenses – Dividends)

Net Income
Or re-arranging we can write:
Assets t + ⅀ Expenses + ⅀ Dividends = Liabilitiest + Common Stock t + ⅀Revenues

Assets = Liabilities + Common Stock + ( Beg. RE + Net Income – Dividend)

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 Basic Accounting Equation

Assets = Liabilities + Common Stock + ( Beg. RE + Net Income – Dividend)

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 Exercises: THE ACCOUNTING EQUATION
Exercise 2

BC starts the year with $100,000 in assets and $80,000 in liabilities. Net
Income for the year is $25,000 and dividends paid is $5000.
How much is owners’ equity at the end of the year ?
A = L + SE
Beginning of year $100,000 = $80,000 +$20,000
+ Net income +$25,000
– Dividends –5,000
Exercise 3
Stockholders’ equity at end of year $40,000
Revenue increases by $1000 and all other categories remain unchanged except
Assets. What is the change in Assets ?
Assets = Liabilities+ Common Stock + ( Beg. RE + Revenue – Expenses – Dividend)
Exercise 4
Expense increases by $500 and all other categories remain unchanged except
Cash. What is the change in Cash?
Assets = Liabilities + Common Stock + ( Beg. RE + Revenue – Expenses – Dividend)
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 Exercise 5
Assets = Liabilities + Stockholders' Equity
End: $550,000 = $301,000 + Stockholders' Equity
Beginning: $360,000 = $137,500 + Stockholders' Equity
Net income ?

Ex 5a . The stockholders made no investment in the business, no dividends

were paid during the year
Ans Assets = Liabilities + Stockholders' Equity
End: $550,000 = $301,000 + $249,000
Beginning: $360,000 = $137,500 + 222,500
Net income $ 26,500

Ex 5b. The stockholders made no investment in the business, but dividends

of $55,000 were paid during the year
Ans
Change in Stockholders' Equity $26,500
+ Dividends 55,000
Net income $81,500
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 Continued from previous slide
Assets = Liabilities + Stockholders' Equity
End: $550,000 = $301,000 + $249,000
Beginning: $360,000 = $137,500 + 222,500
26,500
Ex 5c. The stockholders invested $32,500 in the business, and no dividends
were paid during the year

Ans
Change in Stockholders' Equity $26,500
– Stockholders' investments 32,500
Net loss ($ 6,000)

Ex 5d. The stockholders invested $25,000 in the business, and dividends of

$58,000 were paid during the year

Ans
Change in Stockholders' Equity $26,500
+ Dividends 58,000
$84,500
– Stockholders' investments 25,000
Net income $59,500
Net Income = Change in SE - New Investments by SH +Dividends
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 EXERCISE CASE 1 CASE 2 CASE 3 CASE 4
Total assets, end of period $ 40,000 34,000 ? $ 75,000 $ 50,000
Total liabilities, end of period 9,000 ? 15,000 25,000 10,000
Capital stock, end of period 10,000 5,000 20,000 15,000
Retained earnings, beginning of period 15,000 8,000 10,000 20,000
Net income for the period 8,000 7,000 23,000 ? 9,000
Dividends for the period 2,000 1,000 3,000 4,000 ?

A = L + CS + (Beg. RE + Net Income – Div.)

Case 1: 40 = L + 10 + (15 + 8 – 2)
Liabilities = 9

Case 2: A = 15 + 5 + (8 + 7 – 1)
Assets = 34
Case 3: 75 = 25 + 20 + (10 + N. Income – 3)
Income = 23
Case 4: 50 = 10 + 15 + (20 + 9 – Div.)
Dividends = 4

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 Basic Assumptions
Money Measurement (or Monetary Unit) Assumption
• Financial accounting records only those events which can be expressed in
monetary terms
• Money provides a common denominator to all transactions
• FS prepared in currency of the country where incorporated (& where listed if
needed)
• Limitations ? Qualitative information, Inflation

Separate Entity (or Economic Entity) Assumption

• Business: Separate entity, distinct from its owners, creditors, customers
• Accounts are kept for entities as distinguished from the persons associated with
the entities. Its financial records and reports should refer to the financial affairs
of the business only.
• So, capital brought in by the owner to his business is kind of an obligation of the
business entity to its owner
• Holds irrespective of the form of the business even if from legal point of view
separate entity doesn’t hold (Sole Proprietor, Partnership)
• Economic events of every entity can be separately identified and accounted for
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 Basic Assumptions
Going Concern Assumption
– An entity would continue to operate in foreseeable future, and is not going to be
liquidated
– Will continue operation long enough to carry out its existing objectives and
commitments
– Helps to spread the effect of long term transactions over time
– Measurement of Assets and Liabilities on closing date
– Going Concern Value > Liquidation Value
Accounting Period or Periodicity Assumption
• Measurement of income generated by an entity can not be postponed indefinitely
– since a number of users need to have the information at periodic intervals for
their economic decisions
• Interval of time, at the end of which financial statements of the entity are prepared
is called an Accounting period
– So, economic life of a business can be divided into artificial time periods/
intervals
– The intervals are generally of equal length,
• Usually 1 year which can be calendar year, Can be prepared for the interim
period (Quarterly) 18
 Basic Assumptions: Accrual versus Cash Basis
Limitation of Cash Basis Accounting :
Timing of cash flows can be different from the substance of the transaction
• Selling goods on credit, Receiving money in advance for services to be provided in
the future (magazine subscription)
– time of cash receipts might not be the same as the time of revenue being
earned (Revenues can be earned in a period other than the one in which
cash is received)
– the time of cash payments might not match the time of expense being
incurred
Suppose that FC paints a building in 2015. In 2015, it incurs total expenses
(salaries and paint costs) of $50,000 but pays $40,000 during 2015.
It bills the customer $80,000, but receives payment of $20,000 until 2015.

• This Complexity is addressed by Accrual Basis of Accounting (required by GAAP)

– Transactions (like revenues and expenses) are recorded when they occur (&
not when cash is exchanged) and are reported in FS of the period to which
they relate
– This is more appropriate than cash basis for calculation of profits because it
leads to matching of revenues with expenses
– It informs users of not only past cash transactions but also future venues of
cash receipts (A/R) and payments (A/P, Loan repayment) 19
 Accounting Principles

• Measurement Bases: Historical Cost Principle and Fair value

– Cost or historical cost principle, dictates that companies record assets
at their acquisition cost (price + costs to get the asset ready for use)
– Fair Value: Indicates that assets and liabilities should be reported at
fair value (the price received to sell an asset or settle a liability)

• Full disclosure Principle: Requires that financial statements and their

notes present all information relevant to users
– Explanatory Notes / Notes to FS: Clarify FS & provide additional details
• Explanations to keep FS from being misleading
– Mandatory Disclosure :
• Accounting Policies used in preparing FS like Revenue recognition
policy, Depreciation accounting, Inventory Valuation
– Voluntary Disclosure : Judgment
• Too much disclosure can create clutter and be misleading

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 Conservatism or Prudence
Conservatism : When dealing with measurement uncertainties, if two
estimates of some future amounts are equally likely,
– there should be preference for the smaller number when measuring
assets and revenues &
– for the larger number for liabilities and expenses
Ex: Valuing closing inventory at cost or market value whichever is lower
Anticipate no profits but provide for all losses
Currently, move towards Prudence :
Exercise of caution in making judgments (when arriving at estimates) under
conditions of uncertainty
• Seeks to prevent Overstatement of Assets & Income, and Understatement
of Liabilities & Expenses and, thus avoid Overstatement of profits
– possibility of such overstated profit being distributed by way of dividend
• However, deliberate overstatement of liabilities/expenses and deliberate
understatement of assets /income is not allowed
– can bias the financial statements with hidden reserves
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