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.

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

4
 Revenues and Expenses
Revenues:
Economic resources earned by an entity
during a given accounting period
• These result from core operating (earning)
activities or ordinary activities of an entity
• It involves gross inflow or increase in
economic benefits in the form of
– Inflow or enhancement of assets
(A/R) or
– Settlement of liabilities or
– A combination of both
Example: For a manufacturer - Sale of
goods to customers, For insurance
company – Premiums from policy
holders, Banks ? Lawyers ?
• They result in increase in RE, Equity
Can any increase in equity called Revenue ?
Expenses:
Resources consumed in the process of
generating revenue during a given accounting
period
• These are incurred in the process of creating
revenues & involve decrease in economic
benefits in the form of :
– Outflow or consumption of assets or
– Incurrence of liabilities or
– A combination of both
Example: Cost of goods sold, rent expense
• They result in decrease in RE, Equity
Can any decrease in equity called Expense ?
• So, if an entity has Revenues > Expenses,
– It has made a profit and the same goes to
• Increase owners’ equity
• This profit can be called Net income or
Net earnings
• But, if Revenues < Expenses, it has made a
Net Loss 5
 New CF (IASB)
ASSETS
A present economic resource controlled by the
entity as a result of past events
• An economic resource is a right that has the
potential to produce economic benefits
1. Right (to receive cash/ goods & services/
physical or intellectual property)
2. Potential to produce Economic Benefit (to
receive contractual cashflows/ other
economic resource/produce cash ins or avoid
cash outs etc.)
3. Control : Present ability to direct the use of
the economic resource and obtain the
economic benefits that flow from it
– Comes Not necessarily from ownership
4. Result of a Past Event (say, a transaction)
Ex: Building, Plant and Machinery, Inventories,
Investments, Accounts receivables, Cash
LIABILITIES
A present obligation of the entity to transfer an
economic resource as a result of past events
• An obligation is a duty or responsibility that
the entity has no practical ability to avoid
1. the entity has an obligation
• to transfer an economic resource
• present obligation that exists as a result
of past events
2. No realistic alternative but to settle the
obligation
Can be
– Contractual (Borrowings, creditors),
– Arising from operation of law (tax payable,
penalty imposed)
Ex: Borrowings, Bonds/ Debentures, Advances
from customers, Accounts Payable, Wages
outstanding, Taxes payable
6
 New CF (IASB)
ASSETS
A present economic resource controlled by the
entity as a result of past events
• An economic resource is a right that has the
potential to produce economic benefits
1. Right (to receive cash/ goods & services/
physical or intellectual property)
2. Potential to produce Economic Benefit (to
receive contractual cashflows/ other
economic resource/produce cash ins or
avoid cash outs etc.)
3. Control : Present ability to direct the use of
the economic resource and obtain the
economic benefits that flow from it
– Comes Not necessarily from ownership
4. Result of a Past Event (say, a transaction)
Ex: Building, Plant and Machinery,
Inventories, Investments, Accounts
receivables, Cash
LIABILITIES
A present obligation of the entity to transfer
an economic resource as a result of past
events
• An obligation is a duty or responsibility
that the entity has no practical ability to
avoid
1. the entity has an obligation
• to transfer an economic resource
• present obligation that exists as a
result of past events
2. No realistic alternative but to settle the
obligation
Can be
– Contractual (Borrowings, creditors),
– Arising from operation of law (tax payable,
penalty imposed)
Ex: Borrowings, Bonds/ Debentures, Advances
from customers, Accounts Payable, Wages
outstanding, Taxes payable 7
 New CF (IASB)
Income
• Increases in assets, or
• Decreases in liabilities,
that result in increases in equity,
other than those relating to contributions
from holders of equity claims.
Incomes include amounts generated by
transactions and other events, including
changes in the carrying amount of assets
and liabilities
• Income includes gains
Examples:
• Revenue from sale of goods/services;
• Interest and dividend income from
investments in financial assets;
• Rent earned
• Gain from sale of a PPE/ Investment
• Gain on revaluation of a PPE
Expenses:
• Decreases in assets, or
• Increases in liabilities,
that result in decreases in equity,
other than those relating to distributions to
holders of equity claims.
Expenses include amounts generated by
transactions and other events, including
changes in the carrying amount of assets and
liabilities.
• Expenses include losses
Examples:
• Cost of goods sold,
• Operating Expense like rent expense,
electricity expense etc
• Loss on sale of a PPE/ Investment
• Loss on Revaluation of a PPE
• Depreciation & Impairment of PPE
8
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
9
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)

11 11
 Basic Accounting Equation

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

12
 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)
13
 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
14
 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
15
 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

16
 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
17
 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

20
 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
21