The framework consists of the following chapters:

• Objectives of financial statements;
• Qualitative characteristics that determine the decision usefulness of information contained in the financial statements; and
• Definition, recognition and measurement of elements from which financial statements are constructed.

Objectives of financial statements

The objective of financial statements is to provide information on:

·        Financial position;

·        Changes in financial position; and

·        Financial performance of an organisation

Financial Position

Information on the financial position of an organisation include information about economic resources controlled by the entity, the financial structure, the liquidity and solvency position of the entity and also the ability of that entity to adapt to a changing and dynamic environment.

Economic resources controlled by an entity

Information about economic resources under the entity’s control will help assess the amount of future economic benefits that will probably be generated. Disclosing such information will assist the user in taking economic decisions. For instance, an investor will be in a better position to take more informed investing decisions; an employee may be more aware about any scope for salary increases and bonuses.

Financial structure

This refers to the mix of debt and equity of an entity. The more debt a company takes on, the greater the financial risk and hence the risk of bankruptcy. The financial structure enables users to assess:

·        The extent to which the company can obtain additional external sources of funds in the form of debts;
·        How profit is being distributed in the form of dividend and interest; and
·        The company’s ability to settle its existing debts

Liquidity and solvency

Information about liquidity helps to determine whether the company settle its short term debts as and when they fall due. Solvency is all about the entity’s ability to settle its long term debts as and when they fall due.

Changes in financial position

This provides information about the way cash is used or generated from operating, investing and financing activities. It allows the user to assess the cash adaptability of the organisation and the way in which cash is distributed.

Financial Performance

The net assets of an organisation indicate profit levels. Increases/decreases in net assets result in increases/decreases in profits. Information about financial performance of an organisation is essential since it helps the user:

·        To assess economic benefits generated from its existing resource base; and
·        To determine the efficiency with which the entity might employ additional resources

Qualitative Characteristics

The information contained in the financial statements should be relevant, reliable, understandable and comparable.

Relevance

Information is relevant so far it has the impact of influencing the decisions of users of financial statements. Information can be relevant by nature and by amount. Furthermore the timely nature of information is fundamental in determining its relevance. Materiality is a particular characteristic often associated to relevance. Materiality may be assessed by the impact information can have on the decisions of users. Past and current information may be of predictive value to the user while future information will be of confirmative value and hence all essential/relevant for the user.

Examples of relevance:

A key personnel staff is a close family member to the managing director of the company. Despite the fact that there might not be any transactions between the company and the staff, the nature of the related party relationship should be disclosed as this is purely relevant information by nature.

The resignation of Jose Mourino as manager of Chelsea has definitely been a relevant and important information in Premiership football. However, had the information been concealed and disclosed much later after his resignation, this information would not have had the same impact.

Disclosing information about the risks associated with financial instruments is also relevant. IFRS 7 Financial Instruments: Disclosure, highlights the importance of disclosing the risk level of financial instruments and also requires organisation to explain their policies towards managing such risks.

Disclosing and computing separate EPS for discontinued operations and for the whole operations (that is both continued and discontinued) is much relevant (IAS 33)

Reliability

Reliability is enhanced when information is free from errors/bias and any other form of misstatements. The elements contained in the financial statements faithfully represent the transactions that have occurred.

Users express greater confidence in the contents of financial statements when:

·        The financial statements are free from mistakes, errors, omissions and other misstatements;

·        Transactions are faithfully represented and are correctly recorded as assets, liabilities, incomes or expenses in the financial statements;

·        Information is free from bias;

·        Financial statements are prepared under conditions of uncertainty;

·        Information is complete and prudence is applied; and

·        Financial statements are prepared within the bounds of materiality.

Scenario 1- Faithful representation

Forest Ltd is a major producer and supplier of plywood. The company enters into a sale and repurchase agreement with Timber Ltd. Forest sells wood to Timber for $8m and purchases it for $10m in 4 years. Describe the nature of such a transaction.

Understandability

The IASB Framework emphasises on the need for information in financial statements to be clearly explicit since these are General Purpose Financial Statements (IAS 1, Presentation of Financial Statements). It is however expected that users have relatively sound business knowledge. Understandability is the quality of information that enables users to comprehend its meaning. It is essential that any relevant information; whatever be its complexity; be included in the financial statements. Understandability is enhanced through aggregation, categorisation, classification and presentation of financial information.

Comparability

A key characteristic of qualitative information is comparability.  Financial statements should be prepared on grounds that will enable their comparison over time and across boundaries (firms within the same industry). The adoption of similar accounting policies and application of IASs/IFRSs facilitates comparison.

Definition, Recognition and Measurement of elements

The financial statement is made up of five key elements: Asset, Liability, Income, Expense and Equity.

Definition – Asset

An asset is a resource controlled by an entity as a result of a past event from which it is probable that future economic benefits will flow.

In order to qualify as an asset, the item should not result in any form of cash outflow. Besides, ownership is not a necessary criterion for access to future economic benefits.

An item is recognised as an asset when

·        It can be reliably measured at cost;

·        It is probable that future economic benefits will flow to the entity

Definition – Liability

A liability is a present obligation arising from a past event, the settlement of which results in an outflow of resources embodying future economic benefits.

At no point in time will a liability give rise to an inflow of resources. The occurrence of liability may be viewed as a transfer of resources at the time of settlement.

An item is recognised as a liability when:

·        It can be reliably measured at cost;

·        It is probable that the settlement of the transaction will result in an                      outflow of resources embodying future economic benefits

Income, Expenses and Equity

The framework defines income as increases in economic benefits arising from the enhancement of assets or reduction in liability that results in increases in equity other than those arising from contributions from equity participants.

Increases in net assets lead to income so far those increases do not arise from any form of capital contribution (issue of shares).

Expenses are decreases in economic benefits in the form of depletion of assets or increase in liabilities that result in decreases in equity other than those arising from distribution to equity participants.

A reduction in net assets give rise to an expense so far that reduction is not attributed to any form of distribution to equity participants (dividends).

Equity/ Net Assets is the residual interest in the net assets of an entity after having deducted all liabilities. Equity consists of ordinary share capital and reserves. (Movements on reserve accounts are reflected in the statement of changes in equity)

Home Activity 1:  Outline the importance of the IASB Framework

Measurement Bases

The IASB Framework recognises the following measurement bases:

·        Fair value measurement;

·        Historical convention;

·        Current value approach;

·        Future value measurement; and

·        Present value method

One fundamental aspect of the IASB framework is that it lays much emphasis on the adoption of a balance sheet approach. This approach implies that decisions should be taken on the basis of the equity position of the organisation; hence the net assets.

With the government raising the gratuity limit, it makes sense to negotiate for a higher basic salary to ensure a better payout.

The Union cabinet’s decision to raise the tax-free gratuity limit from Rs 3.5 lakh to Rs 10 lakh is likely to become a tool for companies to retain employees.

In 2008, when the government implemented the Sixth Pay Commission for central government employees, it was with effect from 2006. This helped employeesreap rich benefits. The decision to increase the limit forprivate sector employees brings them at par with government employees in terms of gratuity benefits.

However, employees wanting to take advantage of this decision need to be aware of a few things. One, salary negotiations will become critical as it makes sense to ask for a higher basic salary, especially if he is planning to stay with the company for long. Also, job-hoppers stand to lose money which is deducted from their salary under the gratuity head.

“To have a cost-optimum structure, the basic salary should be 40-50 per cent of the pay,” says Vikas Vasal, executive director, KPMG. This ensures that a person strikes a balance between the taxes he has to pay, his take-home salary, and exemptions and deductions available under the Income-Tax Act.

While negotiating for a new job, it is best if you ask for a higher basic pay. This will help you accumulate a good gratuity, or “accrued benefit,” as it is called. “After this announcement, employees should be more concerned with the basic salary than the cost to company, especially the middle class, for whom Rs 10 lakh is a significant sum,” said K Pandia Rajan, managing director, Ma Foi Randstad, citing the example of the US, where the basic salary is 70 per cent of the total.

In India, many employers keep the basic pay low, say tax experts. In such cases, employees should take a re-look at their basic salaries. If the basic salary as a percentage of the overall salary is low, the person should ask the employer to bring it to the 40-50 per cent level. “In small organisations, there is a scope for such negotiations,” said a tax expert. Knowing the method of gratuity calculation will clarify this point. The calculation is based on the current basic salary multiplied by the number of years, and further multiplied by 15/26.

If an employee with a basic monthly salary of Rs 20,000 has resigned after completing five years of service, he will get Rs 57,692 as gratuity. For someone who is retiring after 30 years and has a basic salary of Rs 60,000, the gratuity will be Rs 10,38,461. Of this, the person does not need to pay tax on Rs 10 lakh. The remaining Rs 38,461 will attract tax. The taxpayer needs to add the excess amount to his income to calculate his tax liability. 

In future, an employee will be able to save tax on gratuity if he invests the amount in an annuity plan. “The draft of the Direct Tax Code has made a provision for such an investment,” said Vasal. In the Budget speech, the finance minister said the government was likely to implement the Direct Tax Code from April 1, 2011.

Any organisation with more than 10 employees needs to make provision for gratuity payouts according to the Payment of Gratuity Act, 1972. An employer makes this payment at the time of retirement, resignation, and death or disablement due to an accident or a disease.

In the private sector, only manufacturing companies have low employee churn. In other sectors, attrition rates are quite high.

Many feel that employees in the private sector do not give importance to gratuity as they rarely work in a company for long. “Young employees today look at cash-in-hand more than long-term benefits like gratuity,” said a human resource head of a large company.

To be eligible for gratuity, an employee needs to put in a substantial number of years in the job. While the Payment of Gratuity Act, 1972, pegs this at five years, many companies have set higher limits.

This article is for beginners of accounting profession who just started their long way and already struggling to understand the basics. The starting point of almost any accounting course is an explanation of the double-entry bookkeeping system which then stands as a core of any further studies. If you did not clearly understand how it works in the beginning the effect of further education will be zero.

I’ll try to illustrate the basics of accounting in the simplest possible way, avoiding in the beginning the use of such confusing terms like assets, liabilities, debits and credits, etc.

Let’s start:

Assume we have some Company X, which was established a year ago and now we are at the year-end, trying to draft accounts of Company.

All we can guess from the ‘accounting’ word itself, that it is a bunch of accounts. Great! That would be a starting point for us. Let’s put down some accounts on a paper (if you’re reading this article on your PC, it’s advised to do the below manipulations in Excel spreadsheet):

Account A

Account B

Account C

Account D

Account E

Account F

Account G

Account H

Account I

What you see above is just a list until we put some values opposite every account. The only point to bear in mind is that overall total of listed values should eventually be equal to 0:

Account A         12

Account B          9

Account C         -4

Account D         -8

Account E        -13

Account F         -5

Account G         -7

Account H          6

Account I           10

Total = 0

Coming back to accounting, each value above is called an Account balance. List itself is usually called a Trial balance. Let’s assume that these account balances were actual ones for our Company X at the year-end.

Now it’s time to understand how the double-entry system actually works. Basically the purpose of the double-entry system is to reflect transactions that Company was involved into. Not going deep into details let’s imagine that Company X made a credit sale on the first day of current year amounted to 5 dollars. The effect on our accounts will be the following:

Before                      Entry                 After

transaction                                        transaction

Account A                  12                                                     12

Account B                   9                            5                        14

Account C                  -4                                                      -4

Account D                  -8                                                       -8

Account E                 -13                                                      -1

Account F                  -5                            -5                        -10

Account G                  -7                                                       -7

Account H                   6                                                        6

Account I                   10                                                       10

Total 0 0

Above sample illustrates the main principle of accounting. So, every transaction, whatever the substance of it, simultaneously increase one account and decrease the another. In our case Account B that was increased by 5 and Account F – decreased by 5. That’s why the Total of accounts equal to 0 remains unchanged.

To make the example more practical let’s define what each account actually indicates and call these accounts respectively:

Account A Cash – The balance of this account shows how much cash our Company has in hand at the moment.

Account B Receivables – This account shows how much money our customers owe to us as at the moment.

Account C Payables – Shows the total amount that we owe to our suppliers at the moment.

Account D Borrowings – Shows how much we are due on Bank loan at the moment.

Account E Share capital – Shows how much money the Company owes to its Shareholder, i.e. money invested into business by owners.

Account F Revenue – This account shows how much Company earned from its main activity for the period of time (usually year to date).

Account G Other income – This account shows any other revenues earned out of main activities for the period of time.

Account H Operating expenses – Shows cumulatively how much Expenses Company incurred to run it’s main business for period of time.

Account I Interest expense – Shows the amount of interest paid to Bank for the period of time.

Let’s now get back to our transaction when Company sold the goods for 5 dollars on credit. It resulted in increasing of Account B and decreasing of Account F. Let’s see why. Account B showing us an amount receivable from customers and since we sold goods on credit this amount should increase from 9 to 14. On the other hand by selling goods we earned a revenue which must be reflected on Revenue account. Before the transaction Revenue balance was -5, showing us that we earned 5 dollars so far – negative sign should be ignored, as it’s used only for the purpose of getting equality. Surely by selling more at the amount of 5 dollars, we should increase our Revenue to make it 10. However because of the negative sign in place, mathematically we decrease the -5 and it becomes -10.

Let’s take another example. Company pays 3 USD rental for the office in cash. Consequently we should decrease Account A (Cash) by 5 and increase Account H (Operating expenses) by 5.

Now, when we understand how double entries work, let’s see how these accounts form financial statements which are usually the ultimate purpose of any accounting. For that purpose we’ll allocate our accounts to certain groups: Assets, Liabilities, Equity, Incomes and Expenditures. Accounts A (Cash) and B (Receivables) will form Assets of the Company. Assets are what Company actually possess(e.g. Cash) or suppose to possess (e.g. Receivables). Next group is Liabilities. That’s what Company owes to suppliers, banks, other partners. In our case Liability group will include: Accounts C (Payables) and D (Borrowings). Another group is Equity, which comprises of accounts showing how much Company owes to its shareholders. Also this group can be called share capital. All 3 above – Assets, Liabilities and Equity eventually constitute Balance Sheet of the Company. Balance sheet accounts are always showing information as of particular date. E.g. if Cash account balance equal to 3, it means that as of present moment Company has 3 USD of cash in hand.

Other groups are Incomes and Expenditures. Income or revenue accounts reflect all incoming money that Company earn from its activities. E.g. for supermarket it would be revenue from goods sold, for bank – interest income, etc. Expenditures reflect amounts expended to maintain business. Main point to remember about Income and Expenditure accounts is that they are always showing us amounts earned or expended FOR the period of time (usually year to date). E.g. if Revenue account balance equals to 500 USD as at March 31 it usually means that Company made sales totaling to 500 USD since the beginning of year up to date.

Let’s now draft financial statements out of Trial Balance we have above. They will look like this:

Balance Sheet

Assets

A Cash                                    12

B Receivables                          14

Total Assets                            26

Liabilities

C Payables                              -4

D Borrowings                            -8

Total Liabilities                      -12

Equity

E Share capital                         13

Current year’s profit                    -1

Total Equity                            -14

Total Liabilities and Equity     -26

Income Statement

F Revenue                                -10

G Other income                          -7

Total income                           -17

H Operating expenses                 6

I Interest expense                       10

Total expenses                         16

Net Profit                                  -1

Now we came to the last point – introduction of Debits and Credits. In above example we were calling accounting entries like Increase of Account B and Decrease of Account F. However to making life easier accountants use Debits and Credits to formulate accounting entries. There is following rule:

• Assets and Expenses accounts increase by debit and decrease by credit.
• Liabilities, Equity and Income accounts increase by credit and decrease by debit.

To apply this rule, let’s formulate above entry:

Dr Receivable     5

Cr Revenue       -5

Remember that taxation is on actual profit you make.  The government compares you to the average worker. Everyone has to get to work and home from work. That expense is not deductible. However, if you drive for your job during the day, most workers don’t have to do that and the mileage is deductible.

You have to log your trips, however. Keep a small spiral bound pad in the visor of the car along with a pen. Don’t start your car until you write down the day, the mileage on odometer and note not only where you’re going but also whether the trip is commuting, business or personal. At the end of the week, simply tally up the business miles. Your trip to work or your first appointment and your trip home are commuting and not deductible.

At the first of the year, or as soon as you decide to get yourself organized.  Create folders for each type of expense you have, whether you’re in business or not.  Business owners need to have several folders. If they manufacture something, they need to track all the expenses for materials to make that product. If they provide a service, they need to track the materials used on a job. These offset the profits of the job and lower your taxable income.

If you own a small business, you’ll want to make a folder for all of the following items that apply to your situation: Advertising, Car and truck expense, Rents and leases of vehicles, Machinery or equipment   Rent on other business property, Repairs and maintenance, Supplies, Taxes and licenses, Commissions and fees
Contract labor, Employee benefits, Business insurance, Interest on loans for the business, Utilities, wages, Mortgage interest, Legal or other professional services, Meals, travel and Entertainment (make sure you write the clients name on the receipt),Other expenses not noted such as professional memberships or cost of additional training.

You don’t have to be a business owner to keep files for your expenses. Homeowners can benefit from saving receipts on their improvements. There are energy credits available to offset some of the tax you owe if you qualify. You also should note any mortgage interest. This is particularly important if you purchased a home on land contract, since financial institutions send you a form at the end of the year.

Keep a file for other potential deductions. If you have to take additional classes for your present job, list your mileage to the class and home, the cost of the course, supplies and even any tolls or parking you have to pay. If you wear a uniform, the cost of the uniform is also deductable.

At the end of each month, record your totals either on paper or in a computer program. Save the files and the receipts. If you use the services of an accountant or bookkeeper, take your totals and your files in when they do your taxes. If you don’t, you’ll be ready for that year’s tax preparation and it should only take a short time to complete

T-Account

Accounting records about events and transactions are recorded in accounts. An account is an individual record of increases and decreases in a specific asset, liability, or owner’s equity item. Look at accounts as a place for recording numbers related to a certain item or class of transactions. Examples of accounts may be Cash, Accounts Receivable, Fixed Assets, Accounts Payable, Accrued Payroll, Sales, Rent Expenses and so on.

An account consists of three parts:

- title of the account

- left side (known as debit)

- right side (known as credit)

Because the alignment of these parts of an account resembles the letter T, it is referred to as a T account. You could draw T accounts on a piece of paper and use it to maintain your accounting records. However, nowadays, instead of having to draw T accounts, accountants use accounting software (i.e., QuickBooks, Microsoft Accounting, Peachtree, JD Edwards, Oracle, and SAP, among others).

Debit, Credit and Account Balance

In account, the term debit means left side, and credit means right side. These are abbreviated as Dr for debit and Cr for credit. Debit and credit indicate on which side of a T account numbers will be recorded.

An account balance is the difference between the debit and credit amounts. For some types of accounts debit means an increase in the account balance, while for others debit means a decrease in the account balance. See below for a list of accounts and what a debit to such account means:

Asset – Increase
Contra Assets – Decrease
Liability – Decrease
Equity – Decrease
Contribution Capital – Decrease
Revenue – Decrease
Expenses – Increase
Distributions – Increase

Credits to the above account types will mean an opposite result.

Double-entry Accounting System

A double-entry accounting system requires that any amount entered into the accounting records is shown at least on two different accounts. For example, when a customer pays cash for your product, an account would show the cash received in the Cash account (as a debit) and in the Sales account (as a credit). All debit amounts equal all credit amounts provided the double-entry accounting was properly followed.

Having a double-entry accounting system has benefits over regular, one-sided systems. One of such benefits is that the double-entry system helps identify recording errors. As I mentioned, if one amount is entered only once in error, then debits and credits won’t balance and the accountant will know that one or more entries were not posted fully. Note, however, that this check will help spot errors, but will not identify all cases of errors. For example, equal debits and credits will not identify an error when an amount was posted twice, but was posted to wrong accounts. Keep this in mind when analyzing causes of errors in accounting records.