1 Fair Presentation
Fair presentation means financial statements should represent actual financial performance and position of organization.
It should be complete, neutral and free from error.
Financial statements will be considered as fairly presented, if they are in accordance with Generally Accepted Accounting Principles (GAAP) and relevant accounting standards. Relevant National or International Accounting Standards should be considered as a basis for preparing financial statements.
Divergence from accounting standards will be considered as unfair presentation except in exceptional circumstances where compliance will result in misleading information to the users and organization should be able to disclose the financial impact and consequences, in case of compliance with accounting standard.
2 Going Concern
Presumption of financial statement preparing is that organization will continue to operate in foreseeable future. Therefore, financial statements are prepared on going concern basis.
Going concern basis involves preparation of financial statement of either cost or market/fair value basis net of impairment losses (see later).
In case, if organization is expected to discontinue its operations, then financial statements are prepared on Net Realisable Value (NRV) basis (see later).
Accruals principle is one of the most important and frequently examinable principle.
Accrual principle gives rise to other principle. Contrary to accrual principle is cash basis accounting principle.
Cash basis accounting principle involves recognition of revenue and expenditures, when cash inflow and outflow takes place respectively.
Accrual basis accounting principle involves recognition of
Revenue, later of when:
- Sale is made.
- Goods or services are delivered.
- Right to receive payment establishes.
Expenditures, earlier of when:
- Expenditure is incurred.
- Goods or services are purchased.
- Liability to settle payment establishes.
This difference in timing for recognition of revenue and expenditure is due to prudence principle (see later).
Consistency is self-explanatory word. Accounting standards provides consistency to financial statement. However, accounting standards provides discretion on choice of accounting treatment for assets & liabilities and requires recognition of liabilities such as provisions based on estimates. Therefore, accounting policies and formula for making estimates are needed.
Consistency principle insists that once particular policy & formula for making estimates is adopted, then it should be applied to financial statements in upcoming years as well.
Consistency principle is not applicable when accounting standard is revised itself and requires different treatment. In that case, new account treatment should be consistently applied.
Materiality means significance. An item of revenue & expenditure or asset and liabilities is significant, if it can influence economic investment decisions taken by the users of financial statements.
Materiality should be judged from both financial such as bank loan and qualitative perspective, such as pending lawsuit, which can result in termination of license required for operating in particular industry.
All material items should be presented in the financial statements as separate line of item such as cost of sales, selling & administration expenses, rather than grouped as single item such as sundry expenses.
All financial items are material unless cost of disclosing information does not exceed benefits.
Relevance means financial statements should be user-targeted taking account for information needs, understandable taking account level of sophistication of ordinary user of financial statement and timely. Out of date information cannot assist users in taking future investment decisions.
Different users (shareholders, institutional shareholders, bankers, creditors, tax authorities, suppliers, customers, management, employees) have different information needs. Limited liability companies are legally required to prepare and report financial statements to shareholders. Therefore, the primary user of financial statements in limited liability companies is shareholders.
Shareholders require information on profitability performance and long-term growth. Profitability performance can be determined through SOCI (Statement of Comprehensive Income) and long-term growth can be determined through cash flow forecasts or estimates.
2) Tax authorities
Tax authorities require fairer recognition of revenue and expenditures. Fair recognition means arms-length transaction between unrelated individuals.
3) Creditors & Suppliers
Creditors want long-term stability and suppliers want short-term liquidity (ability to pay debts when due) see later in detail.
4) Management & Employees
Management and employees wants long-term stability for continued employment and growth through internal development of the organization. Internal development should create promotional opportunities and attractive reward packages.
Competitors are interested in information related to product mix and sales revenue, selling and distribution expenditure, receivable collection period etc.
Financial statements should allow users to understand the financial performance and position of organization and underlying substance of transactions.
Financial statement should consider the knowledge, and skills of users in deciding the level of details (either total or breakup, level of precision/rounding), format (horizontal or vertical) and structure (cross-referenced) in preparing financial statements.
Financial statement is historical data and usually present within six months from the respective year-end. Delay in presenting financial statement can make financial statement less relevant of financial decision-making.
Reliability means financial statements should be authorized, complete, and accurate.
Authorized means identifying the person responsible for preparation of financial statements. It brings confidence in users about the reliability of financial statements.
Complete means financial statements should contain all material financial and non-financial information necessary for investment decision making by the users of financial statements.
Accurate means financial statements should be free from material misstatements, errors and omission.
11 Faithful Representation
Conceptual framework states, “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 phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximise those qualities to the extent possible.”
12 Fair Presentation
IAS 1 Presentation of financial statements states, “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 events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework.44 The application of IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation.”
13 Substance Over Form
Substance over form means representing the economic value and nature of transactions rather than legal form.
IAS 16 property, plant & equipment states financial lease should be recognized as an asset, rather than recognize as expenditure based on legal contract between lessor and lessee.
Substance of transactions should be prevailed unless non-compliance with legal form can result in legal action.
Neutrality means free from bias and discrimination. Bias and discrimination means taking account of information needs of certain user more than other users.
Taking account of information needs of shareholders while ignoring the information needs of customers, suppliers etc.
Prudence means precaution. In cases where more than one accounting treatment is possible or accounting policy can be adopted. Organization should choose one that accounting treatment or policy, which will show pessimistic view of organization financial performance and position.
It means not recognizing revenue until organization all the three conditions met:
1) Legal entitled to receive cash or economic benefits.
2) It is certain that cash or economic benefits will certainly (100% chances) be received by the entity.
3) Reliable estimate of cash or economic benefit can be made.
And recognizing expenditure immediately, when any one condition met:
1) Legal obligation establish to pay
2) It is probable (<50% chances) cash or economic resources will outflow to settle liability.
3) Reliable estimate of cash or economic resources can be made.
Financial statements must contain complete information. Information will be complete, if source documents (invoices, legal docs etc), accounts and financial statements are free from omission.
Shareholders and most other users are interested in long-term performance of the entity. Therefore, financial statements showing financial performance and position for 12 months are not useful. Financial statement for previous year needs to be presented to facilitate comparison and enable users to determine the long-term trend of entity’s financial performance and position.
Organization may be facing exceptionally good or bad year. However, comparison with previous years can reveal the exceptional items such as catastrophes. International Accounting Standards does not allow recognition of exceptional items in the financial statement.
Consistency and comparability works together. Accounting standards, policies, formula should be consistently applied to facilitate comparison.
Classifying, characterising 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 potentially misleading.
Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even well informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.
19 Business entity concept
Business entity concept means financial statements should not include any cash spent, goods or services used and personal capital invested by owner in income statement. Rather it should be recognized in equity part of the statement of financial position as drawings and owner’s capital respectively.
Business entity concept should not be confused with separate legal entity concept.
Offsetting is showing the net effect of revenue and related expenditure such as interest income and interest expense or assets and liabilities such as trade receivables and trade payables.
Matching is including the revenue and related expenditure incurred to generate revenue in the same account period.
Matching is different from offsetting as revenues and expenditures are shown separately on each line.