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 Concept Notes

Ch-2

FRAMEWORK FOR PREPARATION AND

PRESENTATION OF FINANCIAL STATEMENTS

INTRODUCTION

The ASB of ICAI established a foundational framework in July 2000, serving as the basis for
creating new accounting standards and reviewing existing ones. This framework outlines
essential principles, ensuring consistency and transparency in the development and evaluation
of accounting guidelines. The principal areas covered by the framework areas follows:

 Components of financial statements;

 Objectives of financial statements;
 Assumptions underlying financial statements;
 Qualitative characteristics of financial statements;
 Elements of financial statements;
 Criteria for recognition of elements in financial statements;
 Principles for measurement of financial elements;
 Concepts of Capital and Capital Maintenance.

PURPOSE OF THE FRAMEWORK

The primary purpose of the framework is to assist enterprises in preparing financial statements.
Its primary aims are to help enterprises comply with Accounting Standards, address uncovered
topics, aid ASB in standard development, promote regulatory harmonization, guide auditors in
assessing compliance, assist users in interpreting financial statements, and inform stakeholders
about ASB's approach to standard formulation.

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STATUS AND SCOPE OF THE FRAMEWORK

The framework applies to yearly financial statements created by businesses for external users.
It covers both public and private sector enterprises but excludes special purpose reports like tax
computations. While the framework can be used for such reports, it doesn't override specific
Accounting Standards. If there's a conflict, Accounting Standards take precedence over the
framework.

COMPONENTS OF FINANCIAL STATEMENTS

Financial statements comprise a Balance Sheet, a Statement of Profit and Loss, and a Cash Flow
Statement, complemented by notes and other explanatory materials. These components are
interconnected, reflecting various aspects of the same transactions or events. While each
statement offers distinct information, none in isolation serves a sole purpose, and collectively
they provide a comprehensive view of an enterprise's financial position, performance, and cash
flows.

The major information contents of different components of financial statements are

explained as below:

Balance Sheet: The Balance Sheet serves as a snapshot of an enterprise's economic resources,
detailing assets, liabilities, and equity. It crucially offers insights into the enterprise's liquidity
and solvency, aiding in predicting its ability to fulfill financial obligations as they come due.

Statement of Profit and Loss: The Statement of Profit and Loss, also known as the income
statement, shows how well a business performed during a specific time, revealing its
profitability. It summarizes revenues, costs, and expenses to provide a clear picture of the
enterprise's financial performance for the given accounting period.

Cash Flow Statement: The Cash Flow Statement outlines how a business gained and spent cash
in a specific period. It helps assess the sources and uses of cash, providing insights into the
enterprise's investing, financing, and operating activities during the reporting period.

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Notes and other statements: Notes and supplementary statements offer additional details
about items in the Balance Sheet and Statement of Profit and Loss. They provide relevant
information to meet users' needs, including disclosures about accounting policies, segment
reporting, related parties, earnings per share, and more. Essentially, these notes enhance the
understanding of the financial statements by offering important context and explanations.

OBJECTIVES AND USERS OF FINANCIAL STATEMENTS

Financial statements aim to furnish valuable information about an enterprise's financial

position, performance, and cash flows, serving as a crucial resource for diverse users in making
informed economic decisions.

The framework recognizes seven user groups of financial statements, emphasizing their
purpose to offer valuable information about an enterprise's position, performance, and cash
flows for economic decision-making. While financial statements address common user needs,
they don't aim to cover all information, specifically excluding non-financial data, acknowledging
their primary focus on essential financial insights.

The aforesaid users use financial statements in order to satisfy some of their information needs.
These needs may include the following:

Investors-Investors, as providers of risk capital, seek information on both the risk and return of
their investments. Additionally, they are interested in assessing an enterprise's ability to
distribute dividends.

Employees: Employees seek information on the stability and profitability of their employers, as
well as details that help assess the enterprise's capacity to provide remuneration, retirement
benefits, and employment opportunities.

Lenders: Lenders focus on information that aids them in determining the timely repayment of
loans and associated interest.

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Suppliers and other trade creditors: Suppliers and trade creditors seek information to assess if
amounts owed to them will be paid on time, with trade creditors focusing on a shorter
timeframe than lenders.

Customers: Customers are interested in the enterprise's continuity, particularly when they have
a long-term reliance on the enterprise for goods and services.

Public: Enterprises significantly impact the public through contributions to the local economy,
employment, and support for local suppliers. Financial statements serve the public by offering
insights into trends, recent developments, and the overall prosperity and scope of the
enterprise's activities, fostering transparency and understanding in the community.

FUNDAMENTAL ACCOUNTING ASSUMPTIONS

As per the framework, there are three fundamental accounting assumptions: Fundamental
Accounting Assumptions

Fundamental Accounting Assumptions

Going concern Accrual Consistency

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Going Concern: Financial statements are typically prepared with the assumption that the
enterprise will continue operating in the foreseeable future without significant scale reduction.
This approach acknowledges the necessity of retaining profits for asset replacement and
ensuring adequate provision for liabilities. If an alternative basis, such as stating assets at net
realizable values, is used, it should be disclosed for transparency

Accrual Basis: Under the accrual basis, revenues and costs are recognized when earned or
incurred, not when money is received or paid, aligning with AS 1 and the mandatory
requirement of Section 128(1) of the Companies Act, 2013. Expressly stating the use of the
accrual basis is not required in financial statements, but any instance of recognizing income or
expenses on a cash basis should be explicitly mentioned for transparency.

Example 1

(a) A trader purchased article A on credit in period 1 for Rs.50, 000.

(b) He also purchased article B in period 1 for Rs.2, 000 cash.

(c) The trader sold article A in period 1 for Rs.60, 000 in cash.

(d) He also sold article B in period 1 for Rs.2, 500 on credit

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

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 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

Accrual basis of accounting

Credit purchase of article A and cash purchase of article B and cash sale of article A and credit
sale of article B is recognised in period 1 only.

Profit and Loss Account

Rs. Rs.
Period 1 To Purchase 52,000 Period 1 By Sale 62,500
To Net Profit 10,500
62,500 62,500

Consistency: Consistency in accounting policies from one period to another enhances

comparability over time. Accounting Standards permit changes in policies if required by statute,
Accounting Standards, or for a more appropriate presentation of financial statements.

QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

Understandability: Financial statements should be presented in a way that is easily understood

by users with reasonable knowledge of business, economic activities, and accounting principles.

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Relevance: Relevance in financial statements means including only essential information that
influences users' economic decisions. Materiality acts as a threshold, defining the significance
of information based on its potential impact on decision-making, emphasizing quality over
quantity.

Further it is important to know the constraints also on Relevant and Reliable Information to
better understand the qualitative characteristics of financial statements. Following are some of
the constraints:

Timeliness: Timeliness in reporting is crucial as delayed information may lose relevance.

Balancing timeliness and reliability is a management challenge; reporting promptly may
sacrifice some reliability, but delaying until all details are known could render the information
less useful to users who need to make timely decisions. The key is finding a balance that best
satisfies the information needs of users, considering both relevance and reliability.

Balance between Benefit and Cost: The balance between benefit and cost serves as a crucial
constraint in financial reporting, emphasizing that the advantages of information should
outweigh the expenses of its provision. This evaluation involves judgment, and both preparers
and users of financial statements should be cognizant of this constraint, ensuring a practical
balance between the value of information and the associated costs.

Reliability: Reliability is essential for information to be useful, requiring freedom from material
error and bias.

a) Faithful representation of transactions and events is crucial for reliability.

b) The principle of 'substance over form' must be applied in reporting transactions and events.
c) Reporting should be neutral, devoid of bias.
d) Prudence is necessary in reporting uncertain outcomes.
e) Completeness of information in financial statements is vital for reliability.

Comparability: Comparability in financial statements is crucial for effective analysis, allowing

for both inter-firm and intra-firm comparisons. Disclosing the financial impact of changes in

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accounting policies is essential for comparability. However, comparability should not be
confused with mere uniformity, and it shouldn't hinder the adoption of improved accounting
standards. An enterprise should align its accounting policies with the qualitative characteristics
of relevance and reliability, adopting more relevant and reliable alternatives when available,
ensuring that comparability doesn't compromise the pursuit of higher accounting standards.

TRUE AND FAIR VIEW

Financial statements must present a genuine and honest picture of how well a business is
doing. Even though the framework doesn't specifically talk about a "true and fair view,"
following the key principles and standards usually ensures that the financial statements
accurately reflect the performance, financial health, and cash flows of a company. In simple
terms, it means the financial statements give a reliable and honest snapshot of the business.

ELEMENTS OF FINANCIAL STATEMENTS

The framework categorizes financial statement items into five groups based on their economic
characteristics. Gains and losses, unlike income and expenses, may or may not occur in the
normal business operations. Despite similar economic characteristics, gains are treated like
income, and losses are treated like expenses. Therefore, gains and losses are not recognized as
distinct elements but are integrated into income and expenses, respectively.

Let us discuss each element of financial statement in detail.

1. Asset: An asset is a controlled resource stemming from past events, poised to provide
future economic benefits.
(a) Assets don't require physical form; they can be intangible (e.g., patents, copyrights) or
monetary (e.g., trade receivables). Intangible assets lack physical substance, like patents
and copyrights, while monetary assets involve money held or assets expected in fixed or
determinable amounts. In essence, assets can represent rights or expected future economic
benefits without the need for a tangible presence.

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(b) An asset is something a company controls, not just owns. In a financial lease, the lessee
considers the leased asset as theirs, even if the legal owner is the lessor. Control matters
more than ownership. Conversely, the lessor, owning the asset, doesn't see it as theirs in a
financial lease because they lack control. Control, not ownership, determines asset
recognition in such situations.
(c) Recognition as an asset requires sufficient control, which is why specific talents of an
employee, lacking control, aren't considered assets. However, if control is protected by legal
rights, like copyright, the resource, such as intellectual property, can be recognized as an
asset.
(d) For something to be recognized as an asset, it must likely generate future economic
benefits. If those benefits are expected to expire within the current accounting period, it's not
considered an asset but treated as an expense. For example, profit on the sale of machinery is
treated as an expense if it's expected to expire within the current period. However, unsold
items (closing stock) are recognized as assets, indicating the expectation of future economic
benefits (profit) in the next accounting period.

(e) For a resource to be considered an asset, it must have a measurable and reliable cost or
value.
(f) If the economic benefit from a resource is not expected to extend beyond the current
accounting period, the related expenditure is recognized as an expense rather than an asset.
This ensures that costs are matched with the period in which they contribute to generating
revenue.

2. Liability: A liability is a present obligation of the enterprise resulting from past events, with
the settlement expected to lead to an outflow of resources.

(a) A liability is a current obligation based on probable events, like potential compensation for a
pending damage suit. If it's likely the enterprise will lose the suit and the amount can be
reasonably estimated, a liability for damages is recognized by charging it against profit. If
there's more probability than not of losing the suit and the amount can be reasonably

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 estimated, a provision for damages is created. In other cases, where the probability or
amount is uncertain, damages payable are reported as a 'contingent liability,' not meeting
the definition of a liability per accounting standards. A provision, a type of liability, requires
a substantial degree of estimation.
(b) Certain provisions, like those for doubtful debts, depreciation, and impairment losses,
signify a decrease in the value of assets rather than obligations. Therefore, these provisions
should not be classified as liabilities.
(c) A liability is acknowledged only when the outflow of economic resources to fulfill a current
obligation is foreseeable and its value can be reliably measured. Future commitments, such
as a management decision to acquire assets, don't automatically create a present
obligation. The obligation typically arises when the asset is received or when the enterprise
commits to an irrevocable agreement to acquire the asset.

Example
A Ltd. has entered into a binding agreement with P Ltd. to buy a custom-made machine for `
40,000. At the end of 20X1-X2, before delivery of the machine, A Ltd. had to change its method
of production. The new method will not require the machine ordered and it will be scrapped
after delivery. The expected scrap value is nil. A liability is recognised when outflow of
economic resources in settlement of a present obligation can be anticipated and the value of
outflow can be reliably measured. In the given case, A Ltd. should recognise a liability of `
40,000 to P Ltd. 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. In the present case, flow of future economic benefit from the
machine to the enterprise is improbable. The entire amount of purchase price of the machine
should be recognised as an expense. The accounting entry is suggested below:

Dr. 40,000
Loss on change in production Method

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 40,000
To P Ltd.

(Loss due to change in production method)

Dr. 40,000
Profit and loss A/c

To Loss on change in production method 40,000

(loss transferred to profit and loss account)

3. Equity: Equity is the remaining interest in an enterprise's assets after subtracting all
liabilities. It is the owners' claim, including capital and reserves, distinct from liabilities. Changes
in equity result from contributions or distributions to equity participants and income earned or
expenses incurred.

4. Income: Income is the increase in economic benefits during the accounting period, involving
inflows or enhancement of assets or decreases in liabilities, resulting in increased equity. It
includes revenue (arising in the ordinary course of activities) and gains (may or may not be
ordinary). Income is associated with an increase in assets or a decrease in liabilities, and it's
recognized when the corresponding asset increase or liability decrease is identifiable. For
instance, a bank won't recognize interest on non-performing assets due to uncertainty about
future economic benefits.

Example

Suppose at the beginning of an accounting period, aggregate values of assets, liabilities and
equity of a trader are Rs.5 lakh, Rs.2 lakh and Rs.3 lakh respectively.

Also suppose that the trader had the following transactions during the accounting period.

(a) Introduced capital Rs.20, 000.

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(b) Earned income from investment Rs. 8,000.

(c) A liability of Rs. 31,000 was finally settled on payment of Rs. 30,000.

Balance sheets of the trader after each transaction are shown below:

Transactions Assets Rs. Lakh (-) Liabilities Rs. Lakh (=)Equity Rs. lakh

Opening 5.00 2.00 3.00

(a) Capital introduced 5.20 2.00 3.20

(b) Income from 5.28 2.00 3.28

investments

(c) Settlement of liability 4.98 1.69 3.29

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).

Expense: Expenses are the decrease in economic benefits during the accounting period,
involving outflows or depletions of assets or the incurrence of liabilities, resulting in decreased
equity. This includes ordinary activities like wages paid and losses (which may not be ordinary
but are separately shown). Expenses are recognized when corresponding asset decreases or
liability increases are identified. Matching expenses with revenue is done in the Profit & Loss
statement. If economic benefits span multiple periods, systematic allocation methods (like
depreciation) are applied. Expenses are immediately recognized when they no longer meet the

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asset definition or when no future economic benefit is expected, as in the case of a product
warranty liability.

Example

Continuing with the example 3 given earlier, suppose the trader had the following further
transactions during the period:

(a) Wages paid Rs.2, 000.

(b) Rent outstanding Rs.1, 000.

(c) Drawings Rs. 4,000.

Balance sheets of the trader after each transaction are shown below:

Transactions Assets Rs. Lakh (-) Liabilities Rs. Lakh (=) Equity Rs. lakh

Opening 5.00 2.00 3.00

(a) Capital introduced 5.20 2.00 3.20

(b)Income from 5.28 2.00 3.28

investments

(c)Settlement of 4.98 1.69 3.29

liability

(d) Wages paid 4.96 1.69 3.27

(e) Rent Outstanding 4.96 1.70 3.26

(f) Drawings 4.92 1.70 3.22

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The example given above explains the definition of expense. The equity decreased by ` 7,000
from Rs.3.29 lakh to Rs.3.22 lakh due to (i) Drawings Rs. 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).

MEASUREMENT OF ELEMENTS OF FINANCIAL STATEMENTS

Measurement is the process of determining the monetary value at which an element is

recognized in the balance sheet or statement of profit and loss. The framework acknowledges
four measurement bases, mainly related to the valuation of assets and liabilities. Although
various bases can be used in combination, Accounting Standards often emphasize the use of
'historical cost' in financial statement preparation. For instance, while inventory is recorded at
historical cost upon acquisition, year-end valuation considers the lower of cost and net
realizable value.

Historical Cost: Historical cost accounting involves recording assets at the amount paid in cash
or the fair value at the time of acquisition. For example, if a businessman buys a machine for
Rs.7, 00,000 but the total cost with installation is 8, 00,000, the historical cost of the machine is
recorded as Rs. 8, 00,000. This principle extends to liabilities, which are recorded at the amount
received in exchange for the obligation. In some cases, liabilities are recorded based on the
expected cash or cash equivalent that will be paid to fulfill the obligation in the normal course
of business. Overall, historical cost accounting emphasizes the actual transaction values at the
time of acquisition or exchange.

Example

Mr. X purchased a machine on 1st January, 20X1 at Rs. 7, 00,000. As per historical cost basis, he
has to record it at Rs. 7, 00,000 i.e. the acquisition price. As on 1.1.20X6, Mr. X found that it

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would cost Rs.25, 00,000 to purchase that machine. Mr. X also took loan from a bank as on
20X1 for Rs.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 Rs.5, 00,000 at the amount of proceeds received in
exchange for obligation and asset is recorded at Rs. 7, 00,000.

Current Cost: Current cost accounting values assets based on the cash or cash equivalent
needed to acquire a similar asset at present. Liabilities are recorded at the current
undiscounted cash amount required to settle obligations immediately, offering a real-time
snapshot of financial positions.

Example

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 Rs.5
lakhs.

Current cost of the machine = Current market price = Rs.5, 00,000.

By historical cost convention, the machine would have been recorded at Rs.4, 90,000.

To settle the deferred payment on current date one must buy dollars at Rs.49/$. The liability is
therefore recognised at Rs.4, 90,000 ($ 10,000 × Rs. 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

Realisable (Settlement) Value: Realisable (Settlement) Value for assets is the immediate cash
achievable from selling an asset in an organized manner. For liabilities, it's the full,
undiscounted cash expected to be paid to settle the liability in the usual business process.

Present Value: Present Value for assets is the current worth of expected future cash inflows in
the normal business flow, while for liabilities; it's the current worth of expected future cash

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outflows needed to settle obligations in the regular course of business. It reflects the current
value of anticipated cash flows for both assets and liabilities.

Example

Carrying amount of a machine is Rs.40, 000 (Historical cost less depreciation). The machine is
expected to generate Rs.10, 000 net cash inflow. The net realisable value (or net selling price)
of the machine on current date is Rs. 35,000. The enterprise’s required earning rate is 10% per
year.

The enterprise can either use the machine to earn Rs. 10,000 for 5 years. This is equivalent of
receiving present value of Rs. 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 = Rs.10, 000 (0.909 + 0.826 + 0.751 + 0.683 + 0.621) = Rs.37, 900

Net selling price = Rs.35, 000

The present value of the asset is Rs.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 Rs.2, 100

(Rs.40, 000 – Rs. 37,900).

CAPITAL MAINTENANCE

Capital maintenance is crucial for a business, as it represents the net assets used for operations.
To sustain operational levels, it's essential to avoid a decrease in net assets. This is achieved by
ensuring that dividends do not exceed profits after making provisions for asset replacement, as
reflected in legal regulations like the Companies Act, which mandates provisions for
depreciation on Property, Plant, and Equipment before dividend distribution.

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Financial capital maintenance at historical cost: Financial capital maintenance at historical cost
involves valuing assets at their original historical costs for both opening and closing balances to
determine equity changes. If retained profits are at least zero, capital is considered maintained
at historical costs, indicating the business has sufficient funds to replace assets at their original
prices. This holds true as long as there is no significant inflation, ensuring the adequacy of funds
for asset replacement.

Example

A trader commenced business on 01/01/20X1 with Rs.12, 000 represented by 6,000 units of a
certain product at Rs. 2 per unit. During the year 20X1 he sold these units at Rs.3 per unit and
had withdrawn Rs. 6,000. Thus:

Opening Equity = Rs.12, 000 represented by 6,000 units at Rs.2 per unit.

Closing Equity = Rs. 12,000 (Rs.18, 000 – Rs.6, 000) represented entirely by cash.

Retained Profit = Rs.12, 000 – Rs.12, 000 = Nil

Nil The trader can start year 20X2 by purchasing 6,000 units at Rs.2 per unit once again for
selling them at Rs.3 per unit. The whole process can repeat endlessly if there is no change in
purchase price of the product.

Financial capital maintenance at current purchasing power: Financial capital maintenance at

current purchasing power involves restating opening and closing equity at historical costs using
average price indices. For example, suppose opening equity at historical cost is Rs. 3, 00,000
and opening price index is 100. The opening equity at closing prices is Rs.3,60,000 if closing
price index is 120).A positive retained profit implies having sufficient funds to replace assets at
the average closing price. However, this method may not accurately reflect real situations, as
the prices of individual assets can vary significantly from the average rate. For instance, a
machine's price might increase by 30%, while the average increase is only 20%, highlighting a
potential limitation in this approach.

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Example

In the previous example Suppose that the average price indices at the beginning and at the end
of year are 100 and 120 respectively.

Opening Equity = Rs. 12,000 represented by 6,000 units at Rs. 2 per unit.

Opening equity at closing price = (Rs.12, 000 / 100) x 120 = Rs. 14,400 (6,000 x Rs.2.40) Closing
Equity at closing price = Rs.12, 000 (Rs.18, 000 – Rs.6, 000) represented entirely by cash.
Retained Profit = Rs. 12,000 – Rs.14, 400 = (–) Rs. 2,400

The negative retained profit indicates that the trader has failed to maintain his capital. The
available fund of Rs.12, 000 is not sufficient to buy 6,000 units again at increased price Rs. 2.40
per unit. In fact, he should have restricted his drawings to Rs. 3,600 (Rs. 6,000 – Rs.2, 400).

Had the trader withdrawn Rs. 3,600 instead of Rs.6, 000, he would have left with Rs. 14,400,
the fund required to buy 6,000 units at Rs.2.40 per unit.

Physical capital: In physical capital maintenance at current costs, a company adjusts the
historical costs of its assets and liabilities to reflect today's prices using specific price indices for
each asset. Liabilities are restated at the economic value needed to settle them at the current
date. The opening and closing equity are then calculated by finding the excess of the total
current cost values of assets over the total current cost values of liabilities. If there's a positive
retained profit, it means the company has set aside funds to replace each asset at its current
market price, adapting to changing economic conditions.

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