CH 3
CH 3
CH 3
FRAMEWORK FOR
PREPARATION AND
PRESENTATION OF
FINANCIAL STATEMENTS
LEARNING OUTCOMES
After studying this chapter, you will be able to:
♦ Understand the meaning and significance of Framework for the
Preparation and Presentation of Financial Statements;
♦ Learn objectives of Financial Statements
♦ Understand qualitative characteristics of Financial Statements;
♦ Comprehend recognition and measurement of elements of Financial
Statements;
♦ Know concepts of capital, capital maintenance and determination of
profit.
CHAPTER OVERVIEW
The framework sets out the concepts underlying the preparation and
presentation of general purpose financial statements prepared by enterprises
for wide range of users. The Accounting Standards Board (ASB) of the Institute
of Chartered Accountants of India (ICAI) issued a framework for the Preparation
and Presentation of Financial Statements in July 2000.
This Framework is relevant in context of Companies (Accounting Standards)
Rules, 2021, (which has replaced Companies (Accounting Standards) Rules,
2006, as amended from time to time) notified by the Central Government and
Accounting Standards issued by the ICAI.
This framework provides the fundamental basis for development of new
standards as also for review of existing standards. This framework also explains
components of financial statements, users of financial statements, qualitative
characteristics of financial statements and elements of financial statements.
The framework also explains concepts of capital, capital maintenance and
determination of profit.
1. INTRODUCTION
The development of accounting standards or any other accounting guidelines need
a foundation of underlying principles. (ASB) of ICAI issued a framework in July, 2000
which provides the fundamental basis for development of new standards as also
for review of existing standards. The principal areas covered by the framework are
as follows:
(a) Components of financial statements;
(b) Objectives of financial statements;
(c) Assumptions underlying financial statements;
All components of the financial statements are interrelated because they reflect
different aspects of same transactions or other events. Although each statement
provides information that is different from each other, none in isolation is likely to
serve any single purpose nor can anyone provide all information needed by a user.
Cash Flow Statement shows the way an enterprise has generated cash and the
way they have been used in an accounting period and helps in evaluating the
investing, financing and operating activities during the reporting period.
Users of Financial
Statements
d) Suppliers and other trade creditors - Suppliers and other creditors are
interested in information which enables them to determine whether amounts
owing to them will be paid when due. Trade creditors are likely to be
interested in an enterprise over a shorter period than lenders unless they are
dependent upon the continuance of the enterprise as a major customer.
Fundamental Accounting
Assumptions
These are assumptions, i.e., the users of financial statements believe that the same
has been considered while preparing the financial statements. That is why, as long
as financial statements are prepared in accordance with these assumptions, no
separate disclosure in financial statements would be necessary.
If nothing has been written about the fundamental accounting assumption in the
financial statements, then it is assumed that they have already been followed in
their preparation of financial statements.
However, if any of the above-mentioned fundamental accounting assumption is
not followed then this fact should be specifically disclosed.
Liabilities ` Assets `
Capital 60,000 Property, Plant and 65,000
Equipment
Profit and Loss Account 25,000 Stock 30,000
10% Loan 35,000 Trade receivables 20,000
Trade payables 10,000 Deferred expenditure 10,000
Bank 5,000
1,30,000 1,30,000
Additional information:
(a) The remaining life of Property, Plant and Equipment is 5 years. The pattern of
use of the asset is even. The net realisable value of Property, Plant and
Equipment on 31.03.X2 was ` 60,000.
(b) The trader’s purchases and sales in 20X1-X2 amounted to ` 4 lakh and ` 4.5
lakh respectively.
2.8 ADVANCED ACCOUNTING
(c) The cost and net realisable value of stock on 31.03.X2 were ` 32,000 and
` 40,000 respectively.
(d) Expenses (including interest on 10% Loan of ` 3,500 for the year) amounted to
` 14,900.
(e) Deferred expenditure is amortised equally over 4 years.
(f) Trade receivables on 31.03.X2 is ` 25,000, of which ` 2,000 is doubtful.
Collection of another ` 4,000 depends on successful re-installation of certain
product supplied to the customer.
You are required to prepare Profit and Loss Accounts and Balance Sheets of the trader
in both cases (i) assuming going concern (ii) not assuming going concern.
Solution
Profit and Loss Account for the year ended 31st March, 20X2
Liabilities Case (i) Case (ii) Assets Case (i) Case (ii)
` ` ` `
Capital 60,000 60,000 Property, Plant 52,000 60,000
and Equipment
Profit & Loss A/c 44,600 47,200 Stock 32,000 40,000
10% Loan 35,000 37,500 Trade
receivables (less 23,000 19,000
provision)
Trade payables 12,000 11,400 Deferred 7,500 Nil
expenditure
Bank 37,100 37,100
1,51,600 1,56,100 1,51,600 1,56,100
(b) Accrual Basis: According to AS 1, revenues and costs are accrued, that is,
recognised as they are earned or incurred (and not as money is received or paid)
and recorded in the financial statements of the periods to which they relate.
Further Section 128(1) of the Companies Act, 2013 makes it mandatory for
companies to maintain accounts on accrual basis only. It is not necessary to
expressly state that accrual basis of accounting has been followed in preparation
of a financial statement. In case, any income/ expense is recognised on cash basis,
the fact should be stated.
Profit and Loss Account of the trader by two basis of accounting are shown below. A
look at the cash basis Profit and Loss Account will convince any reader of the
irrationality of cash basis of accounting.
Cash basis of accounting
Cash purchase of article B and cash sale of article A is recognised in period 1 while
purchase of article A on payment and sale of article B on receipt is recognised in
period 2.
Profit and Loss Account
` `
Period 1 To Purchase 2,000 Period 1 By Sale 60,000
To Net Profit 58,000 _______
60,000 60,000
Period 2 To Purchase 50,000 Period 2 By Sale 2,500
_______ By Net Loss 47,500
50,000 50,000
` `
Period 1 To Purchase 52,000 Period 1 By Sale 62,500
To Net Profit 10,500
62,500 62,500
(c) Consistency: It is assumed that accounting policies are consistent from one
period to another. The consistency improves comparability of financial statements
through time. According to Accounting Standards, an accounting policy can be
changed if the change is required
FRAMEWORK 2.11
(i) by a statute or
(ii) by an Accounting Standard or
(iii) for more appropriate presentation of financial statements.
7. QUALITATIVE CHARACTERISTICS OF
FINANCIAL STATEMENTS
The qualitative characteristics are attributes that improve the usefulness of
information provided in financial statements. The framework suggests that the
financial statements should observe and maintain the following four qualitative
characteristics as far as possible within limits of reasonable cost/ benefit.
Gains and losses differ from income and expenses in the sense that they may or
may not arise in the ordinary course of business. Except for the way they arise,
economic characteristics of gains are same as income and those of losses are same
as expenses. For these reasons, gains and losses are not recognised as separate
elements of financial statements.
(a) The resource regarded as an asset, need not have a physical substance.
The resource may represent a right generating future economic benefit,
e.g. patents, copyrights, trade receivables. An asset without physical
substance can be either intangible asset, e.g. patents and copyrights or
monetary assets, e.g. trade receivables. The monetary assets are money
held and assets to be received in fixed or determinable amounts of
money.
(b) An asset is a resource controlled by the enterprise. This means it is
possible to recognise a resource not owned but controlled by the
enterprise as an asset, i.e., legal ownership may or may not vest with
the enterprise. Such is the case of financial lease, where lessee
recognises the asset taken on lease, even if ownership lies with the
lessor. Likewise, the lessor does not recognise the asset given on
finance lease as asset in his books, because despite of ownership, he
does not control the asset.
(c) A resource cannot be recognised as an asset if the control is not
sufficient. For this reason specific management or technical talent of an
employee cannot be recognised because of insufficient control. When
the control over a resource is protected by a legal right, e.g. copyright,
the resource can be recognised as an asset.
(f) When flow of economic benefit to the enterprise beyond the current
accounting period is considered improbable, the expenditure incurred
is recognised as an expense rather than as an asset.
` `
Loss on change in production Method Dr. 40,000
To P Ltd. 40,000
(Loss due to change in production method)
Profit and loss A/c Dr. 40,000
To Loss on change in production method 40,000
(loss transferred to profit and loss account)
FRAMEWORK 2.17
Example 3
Suppose at the beginning of an accounting period, aggregate values of assets,
liabilities and equity of a trader are ` 5 lakh, ` 2 lakh and ` 3 lakh respectively.
Also suppose that the trader had the following transactions during the accounting
period.
(a) Introduced capital ` 20,000.
(b) Earned income from investment ` 8,000.
(c) A liability of ` 31,000 was finally settled on payment of ` 30,000.
Balance sheets of the trader after each transaction are shown below:
The example given above explains the definition of income. The equity increased
by ` 29,000 during the accounting period, due to (i) Capital introduction ` 20,000
and (ii) Income earned ` 9,000 (Income from investment + Discount earned).
Incomes therefore result in increase in equity without introduction of capital.
Also note that income earned is accompanied by either increase of asset (Cash
received as investment income) or by decrease of liability (Discount earned).
the enterprise, e.g. loss on disposal of Property, Plant and Equipment. Losses
are separately shown in the statement of profit and loss because this
knowledge is useful in assessing performance of the enterprise.
Example 4
Continuing with the example 3 given earlier, suppose the trader had the following
further transactions during the period:
Balance sheets of the trader after each transaction are shown below:
The example given above explains the definition of expense. The equity decreased by
` 7,000 from ` 3.29 lakh to ` 3.22 lakh due to (i) Drawings ` 4,000 and (ii) Expenses
incurred ` 3,000 (Wages paid + Rent).
Expenses therefore result in decrease of equity without drawings. Also note that
expenses incurred is accompanied by either decrease of asset (Cash paid for wages)
or by increase in liability (Rent outstanding).
Note: The points discussed above leads us to the following relationships:
Closing equity (CE) = Closing Assets (CA) – Closing Liabilities (CL)
Opening Equity (OE) = Opening Assets (OA) – Opening Liabilities (OL)
Capital Introduced = C
Drawings = D
Income = I
Expenses = E
CE = OE + C + (I – E) – D
Or CE = OE + C + Profit – D
Or Profit = CE – OE – C + D
From above, one can clearly see that profit depends on values of assets and liabilities.
Since historical costs are mostly used for valuation, the reported profits are mostly
based on historical cost conventions. The framework recognises other methods of
valuation of assets and liabilities. The point to note is that reported figures of profit
change with the changes in the valuation basis. Conceptually, this is the foundation
of idea of Capital Maintenance.
Historical
Cost
Realisable
Value
1. Historical Cost: Historical cost means acquisition price. For example, the
businessman paid ` 7,00,000 to purchase the machine, its acquisition price
including installation charges is ` 8,00,000. The historical cost of machine
would be ` 8,00,000.
When Mr. X, a businessman, takes ` 5,00,000 loan from a bank @ 10% interest
p.a., it is to be recorded at the amount of proceeds received in exchange for
the obligation. Here the obligation is the repayment of loan as well as
payment of interest at an agreed rate i.e. 10%. Proceeds received are `
5,00,000 - it is the historical cost of the transaction. Take another case
regarding payment of income tax liability. You know that every individual has
to pay income tax on his income if it exceeds certain minimum limit. But the
income tax liability is not settled immediately when one earns his income. The
income tax authority settles it sometime later, which is technically called
assessment year. Then how does he record this liability? As per historical cost
basis, it is to be recorded at an amount expected to be paid to discharge the
liability.
Example 5
Mr. X purchased a machine on 1st January, 20X1 at ` 7,00,000. As per historical cost
basis, he has to record it at ` 7,00,000 i.e. the acquisition price. As on 1.1.20X6,
Mr. X found that it would cost ` 25,00,000 to purchase that machine. Mr. X also took
loan from a bank as on 20X1 for ` 5,00,000 @ 18% p.a. repayable at the end of 15th
year together with interest.
As per historical cost, the liability is recorded at` 5,00,000 at the amount of proceeds
received in exchange for obligation and asset is recorded at ` 7,00,000.
FRAMEWORK 2.23
Example 6
A machine was acquired for $ 10,000 on deferred payment basis. The rate of
exchange on the date of acquisition was ` 49 per $. The payments are to be made in
5 equal annual instalments together with 10% interest per year. The current market
value of similar machine in India is ` 5 lakhs.
To settle the deferred payment on current date one must buy dollars at ` 49/$. The
liability is therefore recognised at ` 4,90,000 ($ 10,000 × ` 49). Note that the amount
of liability recognised is not the present value of future payments. This is because, in
current cost convention, liabilities are recognised at undiscounted amount.
3. Realisable (Settlement) Value: For assets, this is the amount of cash or cash
equivalents currently realisable on sale of the asset in an orderly disposal. For
liabilities, this is the undiscounted amount of cash or cash equivalents
expected to be paid on settlement of liability in the normal course of business.
4. Present Value: Assets are carried at the present value of the future net cash
inflows that the item is expected to generate in the normal course of business.
Liabilities are carried at the present value of the future net cash outflows that
are expected to be required to settle the liabilities in the normal course of
business.
Present value (P) is an amount, one has to invest on current date to have an
amount (A) after n years. If the rate of interest is R then,
2.24 ADVANCED ACCOUNTING
A = P(1 + R)n
A 1
Or P (Present value of A after n years) = n
= A× n
1+R 1+R
If an asset generates ` 11,000 after 1 year, and ` 12,100 after two years, it is
actually contributing ` 20,000 (approx.) at the current date if the rate of earning
required is 10% (` 11,000 × 0.909 + ` 12,100 × 0.826). In other words the value
of the asset is ` 20,000(approx.), i.e. the present value of net future cash inflow
it generates.
Under present value convention, assets are carried at present value of future net
cash flows generated by the concerned assets in the normal course of business.
Liabilities under this convention are carried at present value of future net cash
flows that are expected to be required to settle the liability in the normal course
of business.
FRAMEWORK 2.25
Example 7
Carrying amount of a machine is ` 40,000 (Historical cost less depreciation). The
machine is expected to generate ` 10,000 net cash inflow. The net realisable value
(or net selling price) of the machine on current date is ` 35,000. The enterprise’s
required earning rate is 10% per year.
The enterprise can either use the machine to earn ` 10,000 for 5 years. This is
equivalent of receiving present value of ` 10,000 for 5 years at discounting rate 10%
on current date. The value realised by use of the asset is called value in use. The value
in use is the value of asset by present value convention.
Value in use = ` 10,000 (0.909 + 0.826 + 0.751 + 0.683 + 0.621) = ` 37,900
Net selling price = ` 35,000
The present value of the asset is ` 37,900, which is called its recoverable
value. It is obviously not appropriate to carry any asset at a value higher
than its recoverable value. Thus the asset is currently overstated by ` 2,100
(` 40,000 – ` 37,900).
Where: Profit = P
Opening Assets = OA and Opening Liabilities = OL
Closing Assets = CA and Closing Liabilities = CL
A business should ensure that Retained Profit (RP) is not negative, i.e. closing equity
should not be less than capital to be maintained, which is sum of opening equity
and capital introduced.
It should be clear from above that the value of retained profit depends on the
valuation of assets and liabilities. In order to check maintenance of capital, i.e.
whether or not retained profit is negative, we can use any of following three bases:
Financial capital maintenance at historical cost: Under this convention, opening
and closing assets are stated at respective historical costs to ascertain opening and
closing equity. If retained profit is greater than or equals to zero, the capital is said
to be maintained at historical costs. This means the business will have enough funds
to replace its assets at historical costs. This is quite right as long as prices do not
rise.
Example 8
A trader commenced business on 01/01/20X1 with ` 12,000 represented by 6,000
units of a certain product at ` 2 per unit. During the year 20X1 he sold these units at
` 3 per unit and had withdrawn ` 6,000. Thus:
Opening Equity = ` 12,000 represented by 6,000 units at ` 2 per unit.
Closing Equity = ` 12,000 (` 18,000 – ` 6,000) represented entirely by cash.
Example 9
In the previous example 8, suppose that the average price indices at the beginning
and at the end of year are 100 and 120 respectively.
Current cost of opening stock = (` 12,000 / 100) x 125 = 6,000 x ` 2.50 = ` 15,000
Current cost of closing cash = ` 12,000 (` 18,000 – ` 6,000)
2.28 ADVANCED ACCOUNTING
The negative retained profit indicates that the trader has failed to maintain his
capital. The available fund of` 12,000 is not sufficient to buy 6,000 units again at
increased price of ` 2.50 per unit. The drawings should have been restricted to ` 3,000
(` 6,000 – ` 3,000). Had the trader withdrawn ` 3,000 instead of ` 6,000, he would
have left with `15,000, the fund required to buy 6,000 units at ` 2.50 per unit.
You are required to compute the Capital maintenance under all three bases ie. (i)
Historical costs, (ii) Current purchasing power and (iii) Physical capital maintenance.
Solution
Financial Capital Maintenance at historical costs
` `
` `
Closing capital (At closing price) 12,000
` `
Closing capital (At current cost) ( 4,800 units) 12,000
Less: Capital to be maintained
Opening capital (At current cost) (6,000 units) 15,000
Introduction (At current cost) Nil (15,000)
Loss resulting in non-maintenance of capital (3,000)
SUMMARY
Components of Financial Statements
benefits.
Equity Residual interest in the assets of an enterprise after
deducting all its liabilities
Income/gain Increase in economic benefits during the accounting
period in the form of inflows or enhancement of assets
or decreases in liabilities that result in increase in
equity other than those relating to contributions from
equity participants
Expense/loss Decrease in economic benefits during the accounting
period in the form of outflows or depletions of assets
or incurrence of liabilities that result in decrease in
equity other than those relating to distributions to
equity participants
(a) The business can continue in operational existence for the foreseeable
future.
(b) The business cannot continue in operational existence for the foreseeable
future.
Practical Questions
(1) Earned 10% dividend on 2,000 equity shares held of ` 100 each
You are required to show the effect of above transactions on Balance Sheet in
the form of Assets - Liabilities = Equity after each transaction.
10. Balance Sheet of Anurag Trading Co. on 31 st March, 20X1 is given below:
FRAMEWORK 2.35
Bank 3,000
1,33,000 1,33,000
Additional Information:
(i) Remaining life of Property, Plant and Equipment is 5 years with even use. The
net realisable value of Property, Plant and Equipment as on 31st March, 20X2
was ` 64,000.
(ii) Firm’s sales and purchases for the year 20X1-X2 amounted to ` 5 lacs and
` 4.50 lacs respectively.
(iii) The cost and net realisable value of the stock were ` 34,000 and ` 38,000
respectively.
(iv) General Expenses for the year 20X1-X2 were ` 16,500.
(v) Deferred Expenditure is normally amortised equally over 4 years starting from
F.Y. 20X0-X1 i.e. ` 5,000 per year.
(vi) Out of trade receivables worth `10,000, collection of `4,000 depends on
successful re-design of certain product already supplied to the customer.
(vii) Closing trade payable is `10,000, which is likely to be settled at 95%.
(viii) There is pre-payment penalty of `2,000 for Bank loan outstanding.
Prepare Profit & loss Account for the year ended 31 st March, 20X2 by assuming it is
not a Going Concern.
2.36 ADVANCED ACCOUNTING
ANSWERS/HINTS
MCQs
Theoretical Questions
Closing equity
18,00,000 represented by cash
(` 30 x 60,000 units)
` `
To Opening Stock 36,000 By Sales 5,00,000
To Purchases 4,50,000 By Trade payables 500
To General expenses 16,500 By Closing Stock 38,000
To Depreciation (69,000-64,000) 5,000
To Provision for doubtful debts 4,000
To Deferred expenditure 15,000
To Loan penalty 2,000
To Net Profit (b.f.) 10,000
5,38,500 5,38,500