Month: August 2021

The cost principle

The cost principle, also known as the historical cost principle, states that virtually everything the company owns or controls (assets) must be recorded at its value at the date of acquisition. For most assets, this value is easy to determine as it is the price agreed to when buying the asset from the vendor. There are some exceptions to this rule, but always apply the cost principle unless FASB has specifically stated that a different valuation method should be used in a given circumstance.

The primary exceptions to this historical cost treatment, at this time, are financial instruments, such as stocks and bonds, which might be recorded at their fair market value. This is called mark-to-market accounting or fair value accounting and is more advanced than the general basic concepts underlying the introduction to basic accounting concepts; therefore, it is addressed in more advanced accounting courses.

Expense Recognition (Matching) Principle

The expense recognition principle (also referred to as the matching principle) states that we must match expenses with associated revenues in the period in which the revenues were earned. A mismatch in expenses and revenues could be an understated net income in one period with an overstated net income in another period. There would be no reliability in statements if expenses were recorded separately from the revenues generated.

Revenue Recognition Principle

The revenue recognition principle directs a company to recognize revenue in the period in which it is earned; revenue is not considered earned until a product or service has been provided. This means the period of time in which you performed the service or gave the customer the product is the period in which revenue is recognized.

There also does not have to be a correlation between when cash is collected and when revenue is recognized. A customer may not pay for the service on the day it was provided. Even though the customer has not yet paid cash, there is a reasonable expectation that the customer will pay in the future. Since the company has provided the service, it would recognize the revenue as earned, even though cash has yet to be collected.

The objective of IAS 34 is to prescribe the minimum content of an interim financial report and to prescribe the principles for recognition and measurement in financial statements presented for an interim period.

The objective of this Standard is to prescribe the minimum content of an interim financial report and to prescribe the principles for recognition and measurement in a complete or condensed financial statements for an interim period. Timely and reliable interim financial reporting improves the ability of investors, creditors, and others to understand an enterprise’s capacity to generate earnings and cash flows, its financial condition and liquidity.

An interim financial report should include, at a minimum, the following components:

(a) Condensed balance sheet

(b) Condensed statement of profit and loss

(c) Condensed cash flow statement

(d) Selected explanatory notes.

Components:

A complete set of financial statements normally includes:

(a) Balance sheet

(b) Statement of profit and loss

(c) Cash flow statement

(d) Notes including those relating to accounting policies and other statements and explanatory material that are an integral part of the financial statements.

In the interest of timeliness and cost considerations and to avoid repetition of information previously reported, an enterprise may be required to or may elect to present less information at interim dates as compared with its annual financial statements.

The benefit of timeliness of presentation may be partially offset by a reduction in detail in the information provided. Therefore, this Standard requires preparation and presentation of an interim financial report containing, as a minimum, a set of condensed financial statements. The interim financial report containing condensed financial statements is intended to provide an update on the latest annual financial statements. Accordingly, it focuses on new activities, events, and circumstances and does not duplicate information previously reported.

This Standard does not prohibit or discourage an enterprise from presenting a complete set of financial statements in its interim financial report, rather than a set of condensed financial statements. This Standard also does not prohibit or discourage an enterprise from including, in condensed interim financial statements, more than the minimum line items or selected explanatory notes as set out in this Standard. The recognition and measurement principles set out in this Standard apply also to complete financial statements for an interim period, and such statements would include all disclosures required by this Standard (particularly the selected disclosures in paragraph as well as those required by other Accounting Standards.

The periods to be covered by the interim financial statements are as follows: [IAS 34.20]

balance sheet (statement of financial position) as of the end of the current interim period and a comparative balance sheet as of the end of the immediately preceding financial year statement of comprehensive income (and income statement, if presented) for the current interim period and cumulatively for the current financial year to date, with comparative statements for the comparable interim periods (current and year-to-date) of the immediately preceding financial year statement of changes in equity cumulatively for the current financial year to date, with a comparative statement for the comparable year-to-date period of the immediately preceding financial year statement of cash flows cumulatively for the current financial year to date, with a comparative statement for the comparable year-to-date period of the immediately preceding financial year.

Note disclosures

The explanatory notes required are designed to provide an explanation of events and transactions that are significant to an understanding of the changes in financial position and performance of the entity since the last annual reporting date. IAS 34 states a presumption that anyone who reads an entity’s interim report will also have access to its most recent annual report. Consequently, IAS 34 avoids repeating annual disclosures in interim condensed reports. [IAS 34.15].

The main differences between interim and annual statements can be found in the following areas:

• Some accompanying disclosures are not required in interim financial statements, or can be presented in a more summarized format.
• The revenues generated by a business may be significantly impacted by seasonality. If so, interim statements may reveal periods of major losses and profits, which are not apparent in the annual financial statements.
• Accrual basis. The basis upon which accrued expenses are made can vary within interim reporting periods. For example, an expense could be recorded entirely within one reporting period, or its recognition may be spread across multiple periods. These issues can make the results and financial positions contained within interim periods appear to be somewhat inconsistent, when reviewed on a comparative basis.

Construction workers tend to work based on contractors they make with the owners of property. Traditionally these contractors could choose from a variety of accounting procedures to account for the revenue they received from such contracts.

Long-term contracts are contracts for the building, installation, construction, or manufacturing in which the contract is completed in a later tax year than when it was started. However, a manufacturing contract only qualifies if it is for the manufacture of a unique item for a particular customer or is an item that ordinarily takes more than 1 year to manufacture.

Long term contracts frequently provide that the seller (builder) may bill the purchaser at intervals, as it reaches various points in the project. Examples of long-term contracts are construction-type contracts, development of military and commercial aircraft, weapons-delivery systems, and space exploration hardware. When the project consists of separable units, such as a group of buildings or miles of roadway, contract provisions may provide for delivery in installments. In that case, the seller would bill the buyer and transfer title at stated stages of completion, such as the completion of each building unit or every 10 miles of road. The accounting records should record sales when installments are “delivered.”

A company satisfies a performance obligation and recognizes revenue over time if at least one of the following three criteria is met:

• The customer simultaneously receives and consumes the benefits of the seller’s performance as the seller performs.
• The company’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
• The company’s performance does not create an asset with an alternative use. For example, the asset cannot be used by another customer.

In addition to this alternative use element, at least one of the following criteria must be met:

(a) Another company would not need to substantially re-perform the work the company has completed to date if that other company were to fulfill the remaining obligation to the customer.

(b) The company has a right to payment for its performance completed to date, and it expects to fulfill the contract as promised.

Long-Term Methods of Accounting

There are 2 primary methods of accounting to determine when revenue is recognized for long-term contracts:

• Completed contract method (CCM)
• Percentage of completion method (PCM)

Completed Contract Method

Using the completed contract method, the taxpayer does not recognize revenue until the contract is completed and accepted by the customer. Except for home construction contracts, CCM can only be used by small contractors for contracts with an estimated life that does not exceed 2 years. There should be no terms in the contract with the only purpose of deferring tax.

The CCM is required for home construction contracts that are for the construction of residential buildings with 4 or fewer dwelling units, where at least 80% of the estimated cost is for the dwelling units and related land improvements, even if the contract is for longer than 2 years or the contractor is a large contractor. Other types of construction contracts qualify for the completed contract method if they satisfy the general CCM requirements.

Percentage of Completion Method

Except for home construction contracts, large contractors must use the percentage of completion method for long-term contracts. PCM must also be used to determine liability under the alternative minimum tax (AMT) system. Under the PCM, the amount of progress on the project is determined by the total costs actually incurred as compared to the total estimated cost. Hence, revenue in any given year is determined by the actual contract costs incurred for that year divided by the total estimated cost multiplied by the total contract price:

Reportable Income = Contract Price × Annual Contract Cost/Estimated Total Cost

Qualitative Characteristics of Financial statement

Comparability

Comparability is the degree to which accounting standards and policies are consistently applied from one period to another. Financial statements that are comparable, with consistent accounting standards and policies applied throughout each accounting period, enable users to draw insightful conclusions about the trends and performance of the company over time. In addition, comparability also refers to the ability to easily compare a company’s financial statements with those of other companies.

• Financial statement of an enterprise through time to identify trends in financial position and performance
• Financial statement of different enterprise to evaluate financial position, performance and change in financial position.
• Consistent measurement and display of financial effect of like transactions and other events
• Implementation users must be informed of accounting policies employed, any changes in those policies an defects of such changes
• Annual statements must show corresponding information for preceding periods.

Relevance:

The predictive and conformity role of information is interrelated. The information has the quality of relevance when it influences the economic decision making of the users by helping them:

• Evaluate past, present or future events.
• Confirming or correcting their past evaluations.

Reliability

Users must be able to depend on it being faithful representation.

The information has the quality of reliability when:

• Financial statement are free from material error and bias
• Can be depended by the users
• Reliability comprises
• Faithful representation
• Substance over form: Substance and economic reality, not merely the legal form
• Neutrality free from biasness
• Prudence: Including a degree of caution in making estimates under conditions of un-certainty such that assets or income are not overstated and liabilities or expenses are not understated.

Understandability

Users must be able to understand the financial statements

For this user are assumed to have reasonable knowledge of business and economic activities and accounting and a willingness to study information with reasonable diligence. Understandability is the degree to which information is easily understood. In today’s society, corporate annual reports are in excess of 100 pages, with significant qualitative information. Information that is understandable to the average user of financial statements is highly desirable. It is common for poorly performing companies to use a lot of jargon and difficult phrasing in its annual report in an attempt to disguise the underperformance.

Financial statement Fundamental

Financial Statement: Statement of Changes in Equity

If you are interested in how much of the income a shareholder retains in the company, this is the place to be. The Statement of changes in equity describes the change in owner’s equity over an accounting period. The main things included on this statement are net income or losses that will be added or subtracted from the equity, any dividend payments to owners, as well as the previous and new shareholder equity balance.

Financial Statement: Cash Flow Statement

Where did the organization’s cash and cash equivalents go? That’s what you are likely to see in the statement of cash flow (or cash flow statement). It’s derived from the balance sheet and income statement. It shows how each balance sheet account and income affects a company’s cash flow.

When prepared using the direct method, the cash flow statement is divided into operating, investing and financing activities. This way you’re able to determine which type of activity generates or consumes the most cash.

Financial Statement: Income Statement

The income statement is perhaps one of the most common financial statements that you will be encountering in fundamental analysis. An income statement encompasses the organization’s revenue and expenses together with its gains/profits and losses. Unlike the balance sheet that’s a snapshot of financial health in time, the income statement is more like a change in financial health over a specific time period. The standard is that there are monthly, quarterly, annual income statements. However, technically a company can create an income statement for any time period.

For non-accountants, revenue and income may seem the same but they are not.

Revenue is the gross amount that a company earns from its principal operations such as a bakery selling bread and pastries. It includes all the funds that are coming in from these operations without accounting for any expenses.

Expenses are the costs of conducting business. Some examples include cost of goods sold, administrative costs, legal fees, insurance costs, office supplies, rent, repair, maintenance costs, and many more. When you subtract all expenses from revenue you arrive at the net profit or net income.

Net Income is the net of everything or revenue minus all expenses, including taxes.

Financial Statement: Balance Sheet

The balance sheet, otherwise known as the statement of financial position, shows the financial standing of a company. It’s a snapshot in time of a company’s financial health. This financial statement is organized into three sections, including assets, liabilities, and equity.

Assets = liabilities + equity.

Assets Section on a Balance Sheet

The assets section on a balance sheet includes the totals of all types of assets. Assets are the property and items that a company owns. There are three main types of assets. They include current assets, fixed assets, and intangible assets. Current assets are cash and other assets that can easily be converted into cash within a year. Current assets include cash equivalents, marketable securities, inventory, account’s receivables, and other liquid assets. Fixed assets are property plant and equipment that cannot be easily liquidated or sold. Intangible assets are not physical items such as patents, goodwill, company recognition, trademarks, copyright, and other similar things.

Liabilities Section on a Balance Sheet

Liabilities are debts and obligations a company owes to its creditors and customers. Every company incurs liabilities at one point of its operations. They can be broken down into current liabilities and long-term liabilities. Current liabilities are those debts and obligations which are due within a year. Examples include accounts payable, customer deposits, interest payable, the current due portion of long term debt and other short term debt. Whereas, long-term liabilities are those that are due after one year. They include multi-year loans, bonds payable, deferred revenue, pension obligations, mortgages, and other long term debt.

The important thing to remember for company health analysis is that the company should be able to meet its short-term and long-term obligations in a timely manner. If a company is unable to meet these obligations, it has a risk of becoming insolvent and could go bankrupt.

Equity Section on a Balance Sheet

Equity is the owner’s interest or residual claim in the business after deducting the company’s liabilities from its total assets. The amount of equity in the balance sheet will give you an idea of the net worth of a company or its value to its owners. Though, often it’s merely just book value in the balance sheet, especially for publicly traded companies (i.e. stocks).

Financial statement Assumptions

The period assumption

This assumption describes the time interval between financial statement reports.

Going concern

The financial statements are prepared under the going concern basis, which assumes that the business will continue its operations as normal into the foreseeable future.

Accrual basis

The financial statements are prepared under the accrual basis, which is a method of financial reporting that measures all cash relating to the business as it comes in and as it goes out, called ‘cash accounting’.

Fair presentation

Fair presentation is an assumption to ensure that the financial statements are prepared and presented fairly the financial position, performance and cash flows in accordance with all relevant International Accounting Standard (IASs)/International Financial Reporting Standard (IFRSs). This means that an entity need to disclose about the compliance with the IASs/IFRSs and all relevant IASs/IFRSs must be followed if the entity is in compliance with IASs/IFRSs.

The economic entity

The financial statements are prepared under the economic entity assumption, meaning that the business itself is separate from the owners of the business and any other businesses.

Consistency

Consistency of presentation refers to the presentation and classification of items in the financial statements should be in the same way from one period to another. There are two exceptions where an entity can depart from this consistency principle. First, when there is a significant changes in the nature of operations or a review of financial statements indicate to be more appropriate presentation. Last but not least, when the changes in presentation is required by IFRS.

The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which revenues and expenses are recognized. According to the principle, revenues are recognized when they are realized or realizable, and are earned (usually when goods are transferred or services rendered), no matter when cash is received. In cash accounting in contrast revenues are recognized when cash is received no matter when goods or services are sold.

The revenue recognition principle states that one should only record revenue when it has been earned, not when the related cash is collected.

Cash can be received in an earlier or later period than obligations are met (when goods or services are delivered) and related revenues are recognized that results in the following two types of accounts:

• Accrued revenue: Revenue is recognized before cash is received.
• Deferred revenue: Revenue is recognized when cash is received.

Revenue realized during an accounting period is included in the income.

Accounting for Revenue Recognition

If there is doubt in regard to whether payment will be received from a customer, then the seller should recognize an allowance for doubtful accounts in the amount by which it is expected that the customer will renege on its payment. If there is substantial doubt that any payment will be received, then the company should not recognize any revenue until a payment is received.

Also, under the accrual basis of accounting, if an entity receives payment in advance from a customer, then the entity records this payment as a liability, not as revenue. Only after it has completed all work under the arrangement with the customer can it recognize the payment as revenue.

Under the cash basis of accounting, you should record revenue when a cash payment has been received.

Conditions for Revenue Recognition

According to the IFRS criteria, for revenue to be recognized, the following conditions must be satisfied:

• Risks and rewards of ownership have been transferred from the seller to the buyer.
• The seller loses control over the goods sold.
• The collection of payment from goods or services is reasonably assured.
• The amount of revenue can be reasonably measured.
• Costs of revenue can be reasonably measured.

Steps in Revenue Recognition from Contracts

The five steps for revenue recognition in contracts are as follows:

1. Identifying the Contract

All conditions must be satisfied for a contract to form:

• Both parties must have approved the contract (whether it be written, verbal, or implied).
• The point of transfer of goods and services can be identified.
• Payment terms are identified.
• The contract has commercial substance.
• Collection of payment is probable.

2. Identifying the Performance Obligations

Some contracts may involve more than one performance obligation. For example, the sale of a car with a complementary driving lesson would be considered as two performance obligations the first being the car itself and the second being the driving lesson.

Performance obligations must be distinct from each other. The following conditions must be satisfied for a good or service to be distinct:

• The buyer (customer) can benefit from the goods or services on its own.
• The good or service is separately identified in the contract.

3. Determining the Transaction Price

The transaction price is usually readily determined; most contracts involve a fixed amount. For example, a price of Rs.20,000 for the sale of a car with a complementary driving lesson. The transaction price, in this case, would be Rs.20,000.

4. Allocating the Transaction Price to Performance Obligations

The allocation of the transaction price to more than one performance obligation should be based on the standalone selling prices of the performance obligations.

5. Recognizing Revenue in Accordance with Performance

Recall the conditions for revenue recognition. Conditions (1) and (2) state that revenue would be recognized when the seller has done what is expected to be entitled to payment. Therefore, revenue is recognized either:

• At a point in time;
• Over time

GAAP Revenue Recognition Principles

The Financial Accounting Standards Board (FASB) which sets the standards for U.S. GAAP has the following 5 principles for recognizing revenue:

• Identify the customer contract
• Identify the obligations in the customer contract
• Determine the transaction price
• Allocate the transaction price according to the performance obligations in the contract
• Recognize revenue when the performance obligations are met

The Indian Accounting Standards (Ind AS) shall be applicable to the companies as follows:

1. On voluntary basis for financial statements for accounting periods beginning on or after April 1, 2015, with the comparatives for the periods ending 31st March, 2015 or thereafter.
2. On mandatory basis for the accounting periods beginning on or after April 1, 2016, with comparatives for the periods ending 31st March, 2016, or thereafter, for the companies specified below:

• Companies whose equity and/or debt securities are listed or are in the process of listing on any stock exchange in India or outside India and having net worth of Rs. 500 Crore or more.
• Companies other than those covered in (2.) (a) above, having net worth of Rs. 500 Crore or more.
• Holding, subsidiary, joint venture or associate companies of companies covered under (2.) (a) and (2.) (b) above.

3. On mandatory basis for the accounting periods beginning on or after April 1, 2017, with comparatives for the periods ending 31st March, 2017, or thereafter, for the companies specified below:

• Companies whose equity and/or debt securities are listed or are in the process of being listed on any stock exchange in India or outside India and having net worth of less than rupees 500 Crore.
• Companies other than those covered in paragraph (2.) and paragraph (3.)(a) above that is unlisted companies having net worth of rupees 250 crore or more but less than rupees 500 Crore.
• Holding, subsidiary, joint venture or associate companies of companies covered under paragraph (3.) (a) and (3.) (b) above.
• However, Companies whose securities are listed or in the process of listing on SME exchanges shall not be required to apply Ind AS. Such companies shall continue to comply with the existing Accounting Standards unless they choose otherwise.

4. Once a company opts to follow the Indian Accounting Standards (Ind AS), it shall be required to follow the Ind AS for all the subsequent financial statements.
5. Companies not covered by the above roadmap shall continue to apply existing Accounting Standards prescribed in Annexure to the Companies (Accounting Standards) Rules, 2006.
6. Banks:

• Scheduled commercial banks (excluding regional rural banks) will be required to prepare Ind AS based financial statements for accounting periods beginning from 1 April 2019 onwards. Ind AS will be applicable to both consolidated and individual financial statements.
• Holdings, subsidiaries, joint ventures or associate companies of scheduled commercial banks (excluding regional rural banks) will be required to prepare Ind AS based financial statements for accounting periods beginning from 1 April 2019 onwards.
• Urban cooperative banks and regional rural banks are not required to apply Ind AS and will continue to comply with the current accounting standards applicable to them.

7. Non-banking financial companies:

• Phase I companies required to prepare Ind AS based financial statements for accounting periods beginning from 1 April 2019 onwards (consolidated and individual financial statements) are:
• Non-banking financial companies having net worth of Rs. 500 crores or more; and holdings, subsidiaries, joint ventures or associate companies of the companies above other than those companies already covered under the general corporate roadmap.
• Phase II companies required to prepare Ind AS based financial statements for accounting periods beginning from 1 April 2019 onwards (consolidated and individual financial statements) are:
• Non-banking financial companies whose equity and/or debt securities are listed or are in the process of listing on any stock exchange in India or outside India and having net worth less than Rs .500 crores; non-banking financial companies that are unlisted companies, having net worth of Rs. 250 crores or more but less than Rs. 500 crores; and holdings, subsidiaries, joint ventures or associate companies of the companies above other than those companies already covered under the general corporate roadmap.
• Non-banking financial companies having net worth below Rs. 250 crores and not covered under the above provisions shall continue to apply the current accounting standards applicable to them.

8. Insurers: Insurance companies will be required to prepare Ind AS based financial statements for accounting periods beginning from 1 April 2020 onwards. Ind AS will be applicable to both consolidated and individual financial statements.

A statement of changes in equity and similarly the statement of changes in owner’s equity for a sole trader, statement of changes in partners’ equity for a partnership, statement of changes in shareholders’ equity for a company or statement of changes in taxpayers’ equity for government financial statements is one of the four basic financial statements.

The statement explains the changes in a company’s share capital, accumulated reserves and retained earnings over the reporting period. It breaks down changes in the owners’ interest in the organization, and in the application of retained profit or surplus from one accounting period to the next. Line items typically include profits or losses from operations, dividends paid, issue or redemption of shares, revaluation reserve and any other items charged or credited to accumulated other comprehensive income. It also includes the non-controlling interest attributable to other individuals and organisations.

This primary purpose of Statement of Changes in Equity is to provide details about all the movements in the equity account during an accounting period, which is otherwise not available anywhere else in the financial statements. As such, it helps the shareholders

 and investors in making more informed decisions about their investments. Further, it also allows the analysts and other readers of the financial statements to understand what factors resulted in the change in the equity capital.

The statement is expected under the generally accepted accounting principles and explains the owners’ equity shown on the balance sheet, where:

Owners’ equity = Assets – Liabilities

Requirements of IFRS

IAS 1 requires a business entity to present a separate statement of changes in equity (SOCE) as one of the components of financial statements.

The statement shall show:

• Total comprehensive income for the period, showing separately amounts attributable to owners of the parent and to non-controlling interests
• The effects of retrospective application, when applicable, for each component
• Reconciliations between the carrying amounts at the beginning and the end of the period for each component of equity, separately disclosing:
• Profit or loss
• Each item of other comprehensive income
• Transactions with owners, showing separately contributions by and distributions to owners and changes in ownership interests in subsidiaries that do not result in a loss of control

Requirements of the GAAP

In the United States this is called a statement of retained earnings and it is required under the Generally Accepted Accounting Principles  whenever comparative balance sheets and income statements are presented. It may appear in the balance sheet, in a combined income statement and changes in retained earnings statement, or as a separate schedule.

Therefore, the statement of retained earnings uses information from the income statement and provides information to the balance sheet.

Retained earnings are part of the balance sheet (another basic financial statement) under “stockholders equity (shareholders’ equity)” and is mostly affected by net income earned during a period of time by the company less any dividends paid to the company’s owners / stockholders. The retained earnings account on the balance sheet is said to represent an “accumulation of earnings” since net profits and losses are added/subtracted from the account from period to period.

Retained Earnings are part of the “Statement of Changes in Equity”. The general equation can be expressed as following:

Ending Retained Earnings = Beginning Retained Earnings − Dividends Paid + Net Income

This equation is necessary to use to find the Profit Before Tax to use in the Cash Flow Statement under Operating Activities when using the indirect method. This is used whenever a comprehensive income statement is not given but only the balance sheet is given.

Closing Balance of Equity = Opening Balance of Equity + Net Income – Dividends +/- Other Changes

• Opening Balance: It represents the value of equity capital at the beginning of the reporting period, which is the same as the prior period’s closing balance of equity.
• Net Income: It represents the net profit or loss reported in the income statement during the period.
• Dividends: Dividends declared during the reporting period should be subtracted from the equity balance as it represents the distribution of wealth among shareholders.

Steps

Step 1. Firstly, determine the value of the equity at the beginning of the reporting period, which is the same as the value at the end of the last reporting period. It is the opening balance of equity.

Step 2. Next, determine the net income or loss booked by the firm.

Step 3. Next, determine the value of the dividend declared by the management for the reporting period.

Step 4. Next, determine all the adjustments for the reporting period, which may include effects of changes in accounting policies, correction of prior period errors, changes in reserve capital as well as share capital.

Step 5. Finally, the closing balance of equity can be derived by adding net income (step 2) to the opening balance of equity (step 1), deducting dividends (step 3), and other adjustments (step 4), as shown below.