Introduction to Financial Statement Analysis

Table of Contents
1. Meaning of Financial Statements................................................................................................2

3. Meaning of Financial Statement Analysis ..................................................................................3

4. Objectives of Financial Statement Analysis ...............................................................................3

5. Limitations of Financial Statement Analysis ..............................................................................4

Intensive Strategies .........................................................................................................................6

Vertical Integration Strategies ........................................................................................................7

Types of Defensive Strategies with examples ................................................................................8

Interrelated Sequential Steps in Financial Statement Analysis .......................................................9

IAS-1 ...............................................................................................................................................9

A complete set of financial statements .........................................................................................11

Retrospective and Prospective ......................................................................................................11

General features of FS ..................................................................................................................13

Offsetting ......................................................................................................................................15

Classification.............................................................................................................................15

Reclassification .............................................................................................................................16

Current assets ................................................................................................................................16

Current liabilities ..........................................................................................................................16

Income statement ..........................................................................................................................17

Conceptual framework ..................................................................................................................17

Purpose of the Conceptual Framework .....................................................................................18

Objective of general purpose financial reporting......................................................................18

Accrual basis vs Cash basis ......................................................................................................18

Fundamental qualitative characteristics ....................................................................................20

Enhancing qualitative characteristics ........................................................................................20

Going concern assumption ........................................................................................................21

1
 The reporting entity...................................................................................................................21

Definition of Assets ..................................................................................................................21

Definition of liabilities ..............................................................................................................22

Definition of equity ...................................................................................................................22

Definitions of income and expenses .........................................................................................22

Historical cost ...........................................................................................................................22

Current value .............................................................................................................................23

1. Meaning of Financial Statements

Every business concern wants to know the various financial aspects for effective decision making. The
preparation of financial statement is required in order to achieve the objectives of the firm as a whole.
The term financial statement refers to an organized collection of data on the basis of accounting
principles and conventions to disclose its financial information.

A complete set of financial statements includes: [IAS 1.10]

 a statement of financial position (balance sheet) at the end of the period

 a statement of profit or loss and other comprehensive income for the period (presented as
a single statement, or by presenting the profit or loss section in a separate statement of
profit or loss, immediately followed by a statement presenting comprehensive income
beginning with profit or loss)
 a statement of changes in equity for the period
 a statement of cash flows for the period
 notes, comprising a summary of significant accounting policies and other explanatory
notes
 comparative information prescribed by the standard.

2. Sources of Financial Information

i. Income Statement: The term 'Income Statements' is also known as Trading, Profit and
Loss Account. This is the first stage of preparation of final accounts in accounting cycle.
The purpose of preparing Trading, Profit and Loss Accounts to ascertain the Net Profit or
Net Loss of a business concern during the accounting period.
ii. Balance Sheet: Balance Sheet may be defined as "a statement of financial position of
any economic unit disclosing as at a given moment of time its assets, at cost, depreciated

2
 cost, or other indicated value, its liabilities and its ownership equities." In other words, it
is a statement which indicates the financial position or soundness of a business concern
at a specific period of time. Balance Sheet may also be described as a statement of source
and application of funds because it represents the source where the funds for the business
were obtained and how the funds were utilized in the business.
iii. Statement of Retained Earnings: This statement is considered to be as the connecting
link between the Profit and Loss Account and Balance Sheet. The accumulated excess of
earning over losses and dividend is treated as Retained Earnings. The balance of retained
earnings shown on the Profit and Loss Accounts and it is transferred to liability side of
the balance sheet.
iv. Statement of Changes in Financial Position: Income Statements and Balance sheet do
not disclose the operational efficiency of the concern. In order to measure the operational
efficiency of the concern it is essential to identify the movement of working capital or
cash inflow or cash outflow of the business concern during the particular period. To
highlight the changes of financial position of a particular firm, the statement is prepared
may emphasize of the following aspects:
o Fund Flow Statement is prepared to know the changes in the firm's working
capital.
o Cash Flow Statement is prepared to understand the changes in the firm's cash
position.
o Statement of Changes in Financial Position is used for the changes in the firm's
total financial position.

3. Meaning of Financial Statement Analysis

Financial statement analysis is defined as the process of identifying financial strengths and
weaknesses of the firm by properly establishing relationship between the items of the balance
sheet and the profit and loss account.

There are various methods or techniques that are used in analyzing financial statements, such as
comparative statements, schedule of changes in working capital, common size percentages,
funds analysis, trend analysis, and ratios analysis.

4. Objectives of Financial Statement Analysis

Financial analysis is helpful in assessing the financial position and profitability of a concern. In
short the main objectives of analysis of financial statements are to assess:

i. The present and future earning capacity or profitability of the concern,

ii. The operational efficiency of the concern as a whole and of its various parts or
departments,
iii. The short-term and long-term solvency of the concern for the benefit of the debenture
holders and trade creditors,
3
 iv. The comparative study in regard to one firm with another firm or one department with
another department,
v. The possibility of developments in the future by making forecasts and preparing budgets,
vi. The financial stability of a concern,
vii. The real meaning and significance of financial data, and
viii. The long-term liquidity of its funds.

5. Limitations of Financial Statement Analysis

Analysis of financial statements is very important device but the person using this device must
keep in mind its limitations. The followings are the main limitations of the analysis:

i. Historical nature of financial statements

The basic nature of these statements is historical, i.e., relating to the past periods. Past
can never be precise and infallible index of the future and can never be hundred percent
helpful for the future forecast and planning.

ii. No substitute for judgment

Analysis of financial statements is a tool which can be used profitably by an expert

analyst but may lead to faulty conclusions if used by unskilled analyst.

iii. Reliability of figures

The reliability of analysis depends on reliability of figures of the financial statements

under scrutiny. The entire working of analysis will be vitiated by manipulations in the
income statement, window dressing in the balance sheet, questionable procedures
adopted by the accountant for the valuation of fixed assets and such other factors.

iv. Single year analysis

The analysis of these statements relating to a single year only will have limited use and
value. It will not be advisable to depend fully on such analysis.

v. Different interpretation

4
 The results or indications derived from the analysis of these statements may be difficulty
interpreted by different users. For example, a high current ratio may suit the banker, a
supplier of goods or the short term lender but it may be index of inefficiency of the
management due to non-utilization of funds.

vi. Pitfalls in inter firm comparison

When different firms are adopting different procedures, records, objectives, policies and
different items under similar headings, comparisons will become more difficult.

vii. Price level changes

The continuous and rapid changes in the value of money, in the present day economy,
also reduce the validity of the analysis. Acquisition of assets at different levels of prices
make comparison useless as no meaningful conclusions can be drawn from a
comparative analysis of such items relating to several accounting periods.

viii. Shortcoming of the tool analysis

There are different tools of analysis available to the analyst. Which tool is to be used in a
particular situation depends on the skill, training, intelligence and expertise of the
analyst. If a wrong tool is used, it may give misleading results and may lead to wrong
conclusions or inferences which may be harmful to the interest of the business.

Lecture-2

Strategies

Differences between Forward Integration and Backward Integration are explained in the below
table,

Vertical Integration Strategies

Forward Integration Backward Integration
Gaining ownership or increased control over Seeking ownership or increased control of a
distributors or retailers firm’s suppliers
The company gains control of the business The company gains control of the business
activities that are ahead in the value chain activities that were behind in their value chain

5
 Vertical Integration Strategies
Forward Integration
The company acquire or merge with a
distributor
Gain control over the distribution chain
The main purpose is to obtain a greater
market share
Example: FMCG goods production
company acquires or starts a distribution
company. Now the company can have
control over its distribution process.
Backward Integration
The company acquire/merge with a supplier or
manufacturer
Gain control over the supply chain
The main purpose is to realize economies of
scale
Example: Clothing manufacturing company
acquires or starts a fabric company. Now the
company can have adequate raw materials for
producing cloths.

Intensive Strategies
Intensive strategies are those strategies, which demand furthermore intensive efforts to improve
the performance of existing products in the market. We may also say that when an organization
struggles to improve its competitive position with the current products then different types of
intensive strategies should be considered.

Market Penetration: Seeking increased market share for present products or services in present
markets through greater marketing efforts. In other word, the organization tries to enhance its
market share through greater marketing efforts for its present products or services. This means
that the organization does not launch new products or does not modify its existing products.
Rather it increases the sales volume of its existing products by focusing more on the marketing
efforts in the existing markets.

 Enhancing the number of salespersons

 The advertising expenditure is enhanced
 Sales promotion items are extensively offered
 The publicity efforts are enhanced

Market Development: Introducing present products or services into new geographic areas.
Business Organization launches its existing products in the new markets or geographical areas.
This means that the organization does not introduce new or modified products rather the
products remain the same but the new markets are added by entering into new geographical
areas. In recent years market development is rapidly employed on an international basis where

6
multinational companies increase the market share by entering new regions & countries of the
world through their existing products. Furthermore, the airline industry must also consider
proper market development in the international market for its survival.

 New distribution channels should be approached that are inexpensive, reliable & have
good quality
 The organization become successful in its current operations
 When there are unsaturated or untapped markets available
 Human & capital resources are essential factors for managing the expanding operations
of the organization
 The condition when the production capacity is excessive enough
 The basic industry is quickly converted into a global one

3. Product Development: In this strategy, the organization tries to improve its competitive
position & sales through improvement & modification in its existing products. Usually, there are
large portions of expenditures that are associated with the New Product Development Strategy
as it requires detailed research & development activities to modify or improve the products.
There is a better example of a product development strategy that is employed by Apple electric
car.

1. When the product is passing through the maturity stage of its life cycle
2. The industry where there are much more technological advancements occurring is
effective for the employment of new product development strategy by the relating
organizations
3. Most of the competitors offer high-quality products at reasonable rates
4. The industry that shows high growth is favorable for the product development strategy
5. The organization with potential research & development capabilities is more suitable for
this strategy.

Vertical Integration Strategies

Related diversification Unrelated diversification
Adding new but related products or
Adding new, unrelated products or services
services
When firms expand from one industry or area
While unrelated diversification involves
into another unconnected industry or area. There
going into markets that are not connected
is no connections between the underlying
to the firm’s prior activities, related
resources and capabilities, customers served, or
diversification specifically tries to move to
other reasons to think that these areas would be
areas that the firm already has some
better performed by one company as opposed to
strengths. Related by resources: Related
two separate ones. if a show company was to
by products: Related by customers:
get into software production

7
 Vertical Integration Strategies
Related diversification Unrelated diversification
Diversifying into new industries, such as
Diversifying into business lines in the
Amazon entering the grocery store business
same industry; Volkswagen acquiring Audi
with its purchase of Whole Foods
Diversification into business with similar
Diversification into product markets with key
mar-keting and distribution characteristics,
success variables unrelated to the key success
similar production technologies or similar
variables of the acquirer’s principal business.
science based research activities.
Operating and functional skills, production
Efficient cash management and allocation of
& distribution capacities requires
investment capital and cost reduction.
excessively
Difficult to integrating problems with the Easy to achieve capital efficiency and benefits
parent and subsidiary company. from cross subsidization.

Types of Defensive Strategies with examples

Retrenchment: Retrenchment is also an aggressive strategy where a business can take a bold
decision of reducing businesses’ operations and expenses. The retrenchment strategy helps
businesses and companies in the defensive strategy in terms of cutting down the price and
offering discounts and incentives to the customers. For instance, a particular location of the
company is closed, and no possibility of its usage in the near future. The management finally
decides to sell its assets that don’t have any more of its use.

Divestiture: Divestiture is a type of retrenchment strategy where you re-examine the asset of
your business and company. If the assets aren’t serving anymore, then you sell them off. It helps
businesses to reduce their expenses.

For example, Thomson Reuters, a Canadian multinational company, decided to sell its science
and intellectual property division in 2016. The purpose of divestiture is because the company
wanted to decrease its leverage on the balance sheet.

Liquidation: If a part of a business is going to lose and declining and there’s no way to pull it
back, then you finally decided to sell them off. It’s also a type of retrenchment strategy.
Liquidation also helps a business in the defensive strategy, especially when they’re cutting down
the prices.

8
For instance, a retail shop is running into losses. The retailer to sell off his entire business, but he
couldn’t find any interested buyer. Finally, he decides to get as much value out of it as possible
by selling all the equipment, inventory, fixture, and everything. The purpose is to permanently
shut down the entire business.

Chapter-1: Overview of Financial Reporting, Financial Statement Analysis, and Valuation.

Interrelated Sequential Steps in Financial Statement Analysis

1. Identify Economic Characteristics and Competitive Dynamics in the Industry

2. Identify Company Strategies

3. Assess the quality of the financial statement

4. Analyze Profitability and Risk

5. Project Future Financial Statements

6. Value of the Firm

IAS-1
Objective of the financial statement: This Standard prescribes the basis for presentation of
general purpose financial statements to ensure comparability both with the entity’s financial
statements of previous periods and with the financial statements of other entities. It sets out
overall requirements for the presentation of financial statements, guidelines for their structure
and minimum requirements for their content

General purpose financial statements (referred to as ‘financial statements’) are those intended to
meet the needs of users who are not in a position to require an entity to prepare reports tailored
to their particular information needs.

Material Misstatement: Material misstatements of items are material if they could, individually
or collectively, influence the economic decisions that users make on the basis of the financial
statements. Materiality depends on the size and nature of the omission or misstatement judged in

9
the surrounding circumstances. The size or nature of the item, or a combination of both, could be
the determining factor.

The components of other comprehensive income include:

o Changes in revaluation surplus (PPE, IAS 16 Property

o Re-measurements of defined benefit plans (IAS 19 Employee Benefits)
o Gains and losses arising from translating the financial statements of a foreign
operation (IAS 21, The Effects of Changes in Foreign Exchange Rates);
o Gains and losses from equity instruments investments designated at fair value
[through other comprehensive income in accordance with paragraph 5.7.5 of
IFRS 9 Financial Instruments;]
 (da) Gains and losses on financial assets measured at fair value [through other
comprehensive income in accordance with paragraph 4.1.2A of IFRS 9.]
o The effective portion of gains and losses on hedging instruments in a cash flow
hedge [and the gains and losses on hedging instruments that hedge investments in
equity instruments measured at fair value through other comprehensive income in
accordance with paragraph 5.7.5 of IFRS 9 (see Chapter 6 of IFRS 9);]
o For particular liabilities designated as at fair value through profit or loss, [the
amount of the change in fair value that is attributable to changes in the liability’s
credit risk (see paragraph 5.7.7 of IFRS 9);]
o Changes in the value of the time value of options when separating the intrinsic
value [and time value of an option contract and designating as the hedging
instrument only the changes in the intrinsic value (see Chapter 6 of IFRS 9); and]
o Changes in the value of the forward elements of forward contracts [when
separating the forward element and spot element of a forward contract and
designating as the hedging instrument only the changes in the spot element, and
changes in the value of the foreign currency basis spread of a financial instrument
when excluding it from the designation of that financial instrument as the
hedging instrument (see Chapter 6 of IFRS 9)]

Purpose of financial statements: The objective of financial statements is to provide

information about the financial position, financial performance and cash flows of an entity that
is useful to a wide range of users in making economic decisions. Financial statements also show

10
the results of the management’s stewardship of the resources entrusted to it. To meet this
objective, financial statements provide information about an entity’s:

(a) assets;
(b) liabilities;
(c) equity;
(d) income and expenses, including gains and losses;
(e) contributions by and distributions to owners in their capacity as owners; and
(f) cash flow

A complete set of financial statements

(a) A statement of financial position as at the end of the period

(b) A statement of profit or loss and other comprehensive income for the period;

(c) A statement of changes in equity for the period;

(d) A statement of cash flows for the period;

(e) Notes, comprising significant accounting policies and other explanatory information;

(ea) comparative information in respect of the preceding period as specified in paragraphs 38

and 38A; and

(f) A statement of financial position as at the beginning of the preceding period when an entity
applies an accounting policy retrospectively or makes a retrospective restatement of items in its
financial statements, or when it reclassifies items in its financial statements in accordance with
paragraphs 40A–40D

Retrospective and Prospective

Financial statements are prepared based on Company’s accounting policy and estimation. Every
company has a different accounting policies and different estimation as well, depend on the
nature of business, size of business, strategy, internal and external environment.

Accounting policies and estimation are made to make financial statements relevant and reliable
for the user and economic condition on the reporting date. In applying accounting policies and
estimation, Entity is required to apply consistently, so that the financial statements can be
compared with previous period. Consistency in applying accounting policies and estimates

11
doesn’t mean that we can’t change the policies and estimates. Accounting policies can be
changed if only:

 The changes are required by Mandatory Accounting Standards (Local Accounting

Standards).

 The changes can produce financial statements that give more reliable and relevant
information on impact of transaction, event, or other circumstances.

How it is Treated?

Retrospective means Implementation new accounting policies for transaction, event, or other
circumstances as if it had been implemented. In other words, retrospective will effect
presentation of financial statements for previous periods. While prospective means
implementation new accounting policies for transaction, event, or other circumstances after new
accounting policies or estimation has been implemented.

When prospective or retrospective implementation should be applied?

 Retrospective implementation should be applied if the new accounting standards or

policies are required by mandatory accounting standards and the changes can produce
financial statements that give more reliable and relevant information on impact of
transaction, event, or other circumstances. In the example above, if X company in 20X2
changes the inventory valuation method from FIFO to average, so that new accounting
policies should be applied retrospectively. Then, the financial statements of X company
for 20X1 should be restated. And Errors may arise from mistakes and oversights or
misinterpretation of information. Material prior- period errors are adjusted
retrospectively (that is, by restating comparative figures) unless this is impracticable.

 Prospective implementation should be applied if there is changes in accounting

estimation.

Retrospective Prospective
New accounting standards implementation and Changes in accounting estimates
required by mandatory
Implementation new accounting policies
Material Error
Change in accounting policy will impact all Prospective accounting is the accounting
12
prior financial statements. It happens when the concept that changes in accounting estimates
company has prepared the financial statement will impact the current and future period only.
for several accounting periods. Then We do not modify prior year financial
management decides to change accounting statements. Prospective accounting happens
policy, so they need to go back and change all when the company change in accounting
relevant information in the previous estimate.
statements.

Management needs to amend the financial

statements to ensure that the change will
reflect the prior period as well. We want to
ensure that all reports use the same policy
which enables the user to compare from one
period to another.

General features of FS

Fair
presentation

Consistency
Going
concern

General
Comparat
features
Materiality
ive of FS and
informati aggregatio
on n

Frequenc
y of Offsetting
reporting

 Fair presentation and compliance with IFRSs: Financial statements shall present
fairly the financial position, financial performance and cash flows of an entity. Fair
presentation requires the faithful representation of the effects of transactions, other

13
 events and conditions in accordance with the definitions and recognition criteria for
assets, liabilities, income and expenses.
 Going concern: When preparing financial statements, management shall make an
assessment of an entity’s ability to continue as a going concern. An entity shall prepare
financial statements on a going concern basis unless management either intends to
liquidate the entity or to cease trading, or has no realistic alternative but to do so.
 Materiality and aggregation: An entity shall present separately each material class of
similar items. An entity shall present separately items of a dissimilar nature or function
unless they are immaterial
 Offsetting: An entity shall not offset assets and liabilities or income and expenses,
unless required or permitted by an IFRS.
IAS 32: Financial Instrument- requires that a financial asset and a financial liability
should be offset as a net amount in the statement of financial position when, and only
when, both of the following conditions are satisfied:
 The entity currently has a legally enforceable right to set off the recognised
amounts of the asset and liability; and
 The entity intends to settle on a net basis, or to realise the asset and settle the
liability simultaneously.
If your company deals in derivatives and has a derivative asset and a derivative liability
with the same party, you may be able to report these as a single balance-sheet entry,
either as a net liability or a net asset. You can legally offset assets and liabilities when
you have a legal, enforceable right to treat them as one item.
 Comparative information:
 Minimum comparative information: An entity shall include comparative
information for narrative and descriptive information if it is relevant to
understanding the current period’s financial statements.
 Additional comparative information
 Change in accounting policy, retrospective restatement or reclassification: An
entity shall present a third statement of financial position as at the beginning of
the preceding period in addition to the minimum comparative financial
statements
 Frequency of reporting: An entity shall present a complete set of financial statements
(including comparative information) at least annually.

14
  Consistency of presentation: An entity shall retain the presentation and classification of
items in the financial statements from one period to the next unless (a) it is apparent,
following a significant change in the nature of the entity’s operations or a review of its
financial statements, that another presentation or classification would be more
appropriate having regard to the criteria for the selection and application of accounting
policies in IAS 8; or (b) an IFRS requires a change in presentation


Offsetting
Offsetting occurs when an entity recognises and measures both an asset and liability as separate
units of account, but groups them into a single net amount in the statement of financial position.
Offsetting classifies dissimilar items together and therefore is generally not appropriate.

As a rule, all assets and liabilities, and income and expenses are required to be reported
separately unless specifically permitted by any specific IFRS. Offsetting in the statements of
comprehensive income or financial position, except when this reflects the substance of the
transactions or other events, detracts from the ability of users both to understand the transactions
(or other events or conditions) that have occurred and to assess the entity’s future cash flows.
Measuring assets net of valuation allowances (e.g. inventories or receivables) is not regarded as
offsetting for the purposes of applying the above principle laid down in IAS 1:

Following are some examples where transactions are presented on net basis:

 Gains and losses on disposal of non-current assets, including investments and operating
assets
 Expenditure related to a provision that is recognised in accordance with IAS 37.
 Gains and losses arising from a group of similar transactions are reported on a net basis.

Classification
The sorting of assets, liabilities, equity, income or expenses on the basis of shared characteristics
for presentation and disclosure purposes.

Classification is applied to the unit of account selected for an asset or liability However, it may
sometimes be appropriate to separate an asset or liability into components that have different
characteristics and to classify those components separately. That would be appropriate when
classifying those components separately would enhance the usefulness of the resulting financial

15
information. For example, it could be appropriate to separate an asset or liability into current and
non-current components and to classify those components separately

Reclassification
If an entity changes the presentation or classification of items in its financial statements, it shall
reclassify comparative amounts unless reclassification is impracticable. When an entity
reclassifies comparative amounts, it shall disclose (including as at the beginning of the
preceding period): (a) the nature of the reclassification; (b) the amount of each item or class of
items that is reclassified; and (c) the reason for the reclassification. 42 When it is impracticable
to reclassify comparative amounts, an entity shall disclose: (a) the reason for not reclassifying
the amounts, and (b) the nature of the adjustments that would have been made if the amounts
had been reclassified

Current assets
An entity shall classify an asset as current when:

 it expects to realise the asset, or intends to sell or consume it, in its normal
operating cycle;
 it holds the asset primarily for the purpose of trading;
 it expects to realise the asset within twelve months after the reporting period;
 the asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is
restricted from being exchanged or used to settle a liability for at least twelve
months after the reporting period.

Current liabilities
An entity shall classify a liability as current when:

 it expects to settle the liability in its normal operating cycle;

 it holds the liability primarily for the purpose of trading;
 the liability is due to be settled within twelve months after the reporting period;
or
 it does not have an unconditional right to defer settlement of the liability for at
least twelve months after the reporting period.

16
 Income statement
Revenue ……………………………………………………………………….X

Other income ………………………………………………………………….X

Changes in inventories of finished goods and work in progress …...X

Raw materials and consumables used ………………………………X

Employee benefits expense …………………………………………X

Depreciation and amortisation expense ……………………………..X

Other expenses ………………………………………………………X

Total expenses …………………………………………………………………(X)

Profit before tax ………………………………………………………………..X

classification using the function of expense method

Revenue ……………………………………………………………………….X

Cost of sales ………………………………………………………………….(X)

Gross profit ……………………………………………………………………X

Other income ………………………………………………………………….X

Distribution costs ……………………………………………………………..(X)

Administrative expenses ……………………………………………………..(X)

Other expenses ………………………………………………………………(X)

Profit before tax ……………………………………………………………….X

Conceptual framework
Chapters of Conceptual Framework

Chapter 1—the objective of general purpose financial reporting

Chapter 2—qualitative characteristics of useful financial information

17
Chapter 3—financial statements and the reporting entity

Chapter 4—the elements of financial statements

Chapter 5—recognition and derecognition

Chapter 6—measurement

Chapter 7—presentation and disclosure

Chapter 8—concepts of capital and capital maintenance

Purpose of the Conceptual Framework

The Conceptual Framework for Financial Reporting (Conceptual Framework) describes the
objective of, and the concepts for, general purpose financial reporting

(a) assist the International Accounting Standards Board (Board) to develop IFRS
Standards (Standards) that are based on consistent concepts;
(b) assist preparers to develop consistent accounting policies when no Standard
applies to a particular transaction or other event, or when a Standard allows a
choice of accounting policy; and
(c) assist all parties to understand and interpret the Standards.

Objective of general purpose financial reporting

The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential investors, lenders and other creditors in
making decisions relating to providing resources to the entity.

Those decisions involve decisions about:

 buying, selling or holding equity and debt instruments;

 providing or settling loans and other forms of credit; or
 exercising rights to vote on, or otherwise influence, management’s actions that affect the
use of the entity’s economic resources

Accrual basis vs Cash basis

Cash Basis of Accounting Accrual basis of Accounting

Definition

18
It is that basis of accounting where any income It is that basis of accounting where any income
or expense is recognised only when there is an or expense is recognised when it is earned/
inflow or outflow of cash incurred, irrespective of the time when it is
paid/ collected

Nature

Cash basis is simple in nature Accrual basis is complex in nature

Accounting system followed

Cash basis of accounting follows the single It follows a double entry system of accounting
entry system that records either inflow or where each transaction has two outcomes in
outflow of cash the form of debit and credit

Variations in Income Statement

Income statement will show a relatively lower Income statement will show higher income
income under cash basis of accounting levels under the accrual basis of accounting

Accuracy

Cash basis of accounting has low accuracy Accrual basis of accounting is more accurate
than the cash basis of accounting

Auditing of Financial Statements

Under cash basis of accounting financial Financial statements can be audited only when
statements cannot be audited they are prepared using accrual basis of
accounting

Suitable for

Cash basis of accounting is suitable for micro Accrual basis of accounting is suitable for
to small businesses large corporations

19
 Fundamental qualitative characteristics

Relevance
Fundamental
qualitative
characteristic
Faithful
presentation

Relevance: Relevant financial information is capable of making a difference in the decisions

made by users. Information may be capable of making a difference in a decision even if some
users choose not to take advantage of it or are already aware of it from other sources.
Information is capable of making a difference in decisions if it has predictive value,
confirmatory value or both. Financial information has confirmatory value if it provides feedback
about (confirms or changes) previous evaluations.

Faithful representation: Financial reports represent economic phenomena in words and

numbers. To be useful, financial information must not only represent relevant phenomena, but it
must also faithfully represent the substance of the phenomena that it purports to represent. In
many circumstances, the substance of an economic phenomenon and its legal form are the same.
If they are not the same, providing information only about the legal form would not faithfully
represent the economic phenomenon.

To be a perfectly faithful representation, a depiction would have three characteristics. It would

be complete, neutral and free from error.

A neutral depiction is without bias in the selection or presentation of financial information.

Enhancing qualitative characteristics

Comparability: Users’ decisions involve choosing between alternatives, for example, selling or
holding an investment, or investing in one reporting entity or another. Consequently,
20
information about a reporting entity is more useful if it can be compared with similar
information about other entities and with similar information about the same entity for another
period or another date.

Verifiability: Verifiability helps assure users that information faithfully represents the economic
phenomena it purports to represent. Verifiability means that different knowledgeable and
independent observers could reach consensus, although not necessarily complete agreement, that
a particular depiction is a faithful representation.

Timeliness: Timeliness means having information available to decision-makers in time to be

capable of influencing their decisions

Understandability: Classifying, characterizing and presenting information clearly and

concisely makes it understandable. Some phenomena are inherently complex and cannot be
made easy to understand. Excluding information about those phenomena from financial reports
might make the information in those financial reports easier to understand. However, those
reports would be incomplete and therefore possibly misleading.

Going concern assumption

Financial statements are normally prepared on the assumption that the reporting entity is a going
concern and will continue in operation for the foreseeable future. Hence, it is assumed that the
entity has neither the intention nor the need to enter liquidation or to cease trading. If such an
intention or need exists, the financial statements may have to be prepared on a different basis. If
so, the financial statements describe the basis used.

The reporting entity

A reporting entity is an entity that is required, or chooses, to prepare financial statements. A
reporting entity can be a single entity or a portion of an entity or can comprise more than one
entity. A reporting entity is not necessarily a legal entity.

Definition of Assets
An asset is 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. This section
discusses three aspects of those definitions:

 right
 potential to produce economic benefits and
21
  control

Definition of liabilities
A liability is a present obligation of the entity to transfer an economic resource as a result of past
events. For a liability to exist, three criteria must all be satisfied:

(a) the entity has an obligation

(b) the obligation is to transfer an economic resource and
(c) the obligation is a present obligation that exists as a result of past events

Definition of equity
Equity is the residual interest in the assets of the entity after deducting all its liabilities. Equity
claims are claims on the residual interest in the assets of the entity after deducting all its
liabilities. In other words, they are claims against the entity that do not meet the definition of a
liability. Such claims may be established by contract, legislation or similar means, and include,
to the extent that they do not meet the definition of a liability:

 shares of various types, issued by the entity; and

 some obligations of the entity to issue another equity claim

Definitions of income and expenses

Income is increases in assets, or decreases in liabilities, that result in increases in equity, other
than those relating to contributions from holders of equity claims.

Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity,
other than those relating to distributions to holders of equity claims.

Historical cost
Historical cost measures provide monetary information about assets, liabilities and related
income and expenses, using information derived, at least in part, from the price of the
transaction or other event that gave rise to them. Unlike current value, historical cost does not
reflect changes in values, except to the extent that those changes relate to impairment of an asset
or a liability becoming onerous. The historical cost of an asset when it is acquired or created is
the value of the costs incurred in acquiring or creating the asset, comprising the consideration
paid to acquire or create the asset plus transaction costs. The historical cost of a liability when it
is incurred or taken on is the value of the consideration received to incur or take on the liability
minus transaction costs. When an asset is acquired or created, or a liability is incurred or taken

22
on, as a result of an event that is not a transaction on market terms, it may not be possible to
identify a cost, or the cost may not provide relevant information about the asset or liability. In
some such cases, a current value of the asset or liability is used as a deemed cost on initial
recognition and that deemed cost is then used as a starting point for subsequent measurement at
historical cost.

Current value
Current value measures provide monetary information about assets, liabilities and related
income and expenses, using information updated to reflect conditions at the measurement date.
Because of the updating, current values of assets and liabilities reflect changes, since the
previous measurement date, in estimates of cash flows and other factors reflected in those
current values. Unlike historical cost, the current value of an asset or liability is not derived,
even in part, from the price of the transaction or other event that gave rise to the asset or
liability.

Fair Value: Fair value is the price that would be received to sell an asset, or paid to transfer a
liability, in an orderly transaction between market participants at the measurement date.

23