LMT SCHOOL OF MANAGEMENT, THAPAR UNIVERSITYMasters of Business Administration

Course: Financial Reporting and AnalysisFaculty: Dr. Sonia Garg (Email: sonia.garg@thapar.edu)

Session 1: Overview and Scope of Financial Accounting

Duration: 60 minsSlides: 21

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Companies today are increasingly recognizing human capital as a form of wealth. “Our core corporate assets walk out every evening, mentally and physically tired.” So said one of the most sought-after CEOs of India Inc. to a graduating class of Wharton. Name the CEO.

NR Narayan Murthy

Overview and Scope of Financial Accounting

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Purpose of any business: PROFITHow does one ascertain what is the profit ?PROFIT & LOSS STATEMENT

Is the business earning a reasonable rate of return? This will depend on the amount of resources deployed, how do we know that?BALANCE SHEET STATEMENT

Does the firm have the ability to generate cash to run its operations?CASH FLOW STATEMENT

Together these statements are called FINANCIAL STATEMENTS

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Financial Statements

Growing complexities in the modern day business like– Separation of ownership and management– Large scale public participation– Dependence on lending institutions– Legal interventions of laws like Companies Act and Income Tax Act– Global fund raising– Increased general public awareness– Increased role of SEBI, IRDA, RBI, etc.

Have led to heavy demand on the enterprises in the preparation and presentation of Financial Statements which need to follow a FRAMEWORK

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Purpose of the FRAMEWORK The conceptual framework creates a base for financial statements which assist the:• Preparers in applying accounting standards and dealing with topics

that are yet not a subject of any accounting standard

• Auditors in forming an opinion as to whether financial statements conform to accounting standards or not

• Users in analysing and interpreting the information contained in financial statements

• The Accounting Standards Board of the ICAI in the development of future accounting standards and in the review of the existing ones

Overview and Scope of Financial Accounting

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Components of Financial Statements

Financial Statements are the most important part of Financial Reporting. A complete set of financial statements consist of:• Balance Sheet (stock reports)• Profit & Loss Statement (flow reports)• Cash flow Statement (flow reports)

Other items included in the Annual Reports like Director’s report, Chairman’s statement although an integral part of Annual Report are not financial statements

Overview and Scope of Financial Accounting

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Contents of the Annual Report 2005-06 of Tata Motors Ltd

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Why do we need other reports ?

Financial Statements do not provide all the information that the users may need as• They largely portray the financial effects of

past events• Throw little light on the future direction of

growth• Do not necessarily provide non-financial

information

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Objective of Financial Statements

• Financial Position– Economic Resources: that are controlled by the enterprise are

useful in predicting its ability to generate cash in future– Financial Structure: predicts present and future borrowing needs

and how profits will be distributed – Liquidity and Solvency: predicts the availability of cash to meet

short-term and long-term financial commitments respectively

• Performance: or profitability predicts capacity to generate internal cash flows and effectiveness of employing resources

• Cash flows: evaluate investing, financing and operating cash flows

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Users and Their Information Needs• Investors: return on investment, they should hold or sell, dividend paying ability

• Employees: ability to provide remuneration, retirement benefits and opportunities of unhindered employment and growth

• Lenders: ability to service loans and interest thereon, long-term solvency

• Suppliers: short-term liquidity

• Customers: product quality, credit policy and continuance of the enterprise

• Government and its agencies: information to regulate and formulate policies

• Public: ability to impart corporate social responsibility

• Management: evaluate their own performance Overview and Scope of Financial Accounting

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Example: Reliance Industries Ltd

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Assumptions underlying preparation of Financial Statements

• Accrual Basis: the effect of transactions is recognized when they occur not when cash is received or paid

• Going Concern: it is normally assumed that the enterprise will continue its operations for the foreseeable future

• Consistency: to achieve comparability, accounting policies are followed consistently from one period to another

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Qualitative Characteristics of Financial Statements

• Understandability: Information included in the financial statements should be understandable assuming the user has a reasonable knowledge of business, economic activity and accounting

• Relevance: Information must be relevant to the decision making needs of users

• Materiality: Information is material if its misstatement could influence the decision of users

• Reliability: Information is reliable if it is free from material error and bias

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Implications of Reliability

• Faithful representation: if valid amounts are unknown do not recognize

• Substance over form: economic reality over legal form• Neutrality: free from bias• Prudence: in making estimates required under uncertain

conditions• Completeness: within the bounds of materiality and cost• Comparability: explain if any changes in accounting

policy and effect of such change

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Constraints on Qualitative Characteristics

• Balance between timeliness and reliability• Balance between benefit and cost• Balance between qualitative characteristics

like completeness and materiality

Overriding consideration is how best to satisfy the information needs of users

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Generally Accepted Accounting Principles (GAAPs)

Financial Statements are prepared and presented on the basis of GAAPs, which includes• Conceptual framework• Accounting concepts• Requirements of Companies Act and rules made

thereunder• Accounting Standards formulated by the ICAI• Directives of regulatory bodies like SEBI, RBI, IRDA, etc.• Requirements of Income Tax Act and rules made

thereunder

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Requirement of the Companies Act

• Maintenance of proper books of accounts• Recommend Accounting Standards of ICAI to

be followed• Its Schedule VI sets out the form of balance

sheet, requirements as to the profit and loss account, some interpretations and balance sheet abstract

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Accounting Standards (ASs) of ICAI

• They apply to all enterprises engaged in commercial, industrial or business activity weather profit

• There are 31 ASs covering various aspects of financial accounting

• Company Law has attached greater authority to these Ass• Statutory Auditors are responsible for any non-compliance

or deviation from the ASs• ICAI has come up with IFRS converged Indian ASs for more

uniform financial reporting globally although their implementation is deferred for now

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Requirements of SEBI

• Clause 32 of the Listing Agreement: A copy of accounts to each shareholder, cash flow statement, consolidated financial statements, etc.

• Clause 41 of the Listing Agreement: quarterly unaudited financial results, segment results, accounting for taxes on income, etc.

• Clause 49 of the Listing Agreement: Corporate Governance

• Clause 50 of the Listing Agreement: Comply with the ASs of ICAI

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Requirement of Income Tax Act

Section 145 of Income Tax Act• Deals with the method of accounting to be followed

by the income tax payer in respect of his business income

• It allows both cash and accrual system (Company law allows only accrual system)

• Issues two accounting standards related to disclosure of accounting policies and disclosure of change in accounting policies. These correspond to AS-1 and AS-5 of ICAI

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Why did Steve Jobs sell all his Apple stocks except one after disagreement with John Sculley ?

To receive annual reports

Overview and Scope of Financial Accounting