Unit 6:

In financial accounting, several key concepts and characteristics guide the preparation and
interpretation of financial statements. These include the underlying assumption of "going
concern," the fundamental qualitative characteristics of relevance and faithful
representation, and the enhancing qualitative characteristics of comparability, timeliness,
understandability, and verifiability. Each of these elements plays a crucial role in ensuring
that financial information is useful, reliable, and capable of supporting informed decision-
making by stakeholders.

Going Concern Assumption

The going concern assumption is foundational to financial reporting. It assumes that a
business will continue to operate for the foreseeable future, rather than being liquidated or
significantly downsized. This assumption affects the valuation of assets and liabilities on the
balance sheet, where items are typically recorded at their historical cost rather than
liquidation values. If a business were not assumed to continue, the values assigned to assets
and liabilities would change drastically, affecting the relevance and reliability of the financial
information. The going concern assumption allows for the stable application of accounting
methods, creating consistency over time.

Fundamental Qualitative Characteristics

The usefulness of financial statements is primarily driven by two fundamental qualitative
characteristics: relevance and faithful representation.

Relevance
Financial information is relevant if it is capable of influencing the decisions of users.
Information is considered relevant when it has predictive value, confirmatory value, or both:
- Predictive value means the information helps users make predictions about future
outcomes, such as earnings potential.
- Confirmatory value means the information helps users confirm or revise previous
expectations.

For example, revenue trends provide predictive value, while actual financial results help
confirm or revise previous projections. Materiality is closely tied to relevance, as only
information that could influence decision-making is included. Material information is that
which, if omitted or misstated, could affect the users' decisions based on the financial
statements.

Faithful Representation
Faithful representation means that the information accurately reflects the entity’s financial
position and operations. This characteristic has three key components:
- Completeness requires that all necessary information for understanding is provided.
- Neutrality means the information is unbiased and objective, without intended influence on
decision-making.
- Free from error implies that while some uncertainty may be inherent, the information
should be as accurate as possible within reason.
For example, if a company reports an asset at its fair market value, it should represent that
value completely, accurately, and without bias. Faithful representation ensures that users
can trust that the financial statements reflect the actual conditions and transactions of the
business.

Enhancing Qualitative Characteristics

In addition to relevance and faithful representation, several enhancing characteristics
further improve the quality of financial information: comparability, timeliness,
understandability, and verifiability.

Comparability
Comparability enables users to identify similarities and differences between financial
statements across time periods or between different entities. This characteristic is
supported by the consistency of accounting methods and policies over time. For instance, if
a company uses the same depreciation method each year, users can more easily compare
asset values and expenses year-over-year.

Timeliness
Timeliness ensures that information is available to users in time to influence their decisions.
Delayed financial reporting can diminish the relevance of information, especially for
investors or creditors making time-sensitive decisions. Timely reporting, such as quarterly
earnings releases, allows stakeholders to respond to current conditions.

Understandability
Understandability means that financial information should be clear and comprehensible to
users with a reasonable knowledge of business and accounting. This requires a balance
between detail and simplicity. Complex financial information may be difficult for some users
to interpret, so financial statements should be structured in a way that makes them as
accessible as possible while still conveying complete and accurate information.

Verifiability
Verifiability implies that independent observers, using the same information and methods,
would reach the same conclusions about a piece of information. Verification can occur
directly (e.g., reconciling a cash balance) or indirectly (e.g., verifying an inventory balance
through similar methods). Verifiable information increases users' confidence in the accuracy
and reliability of financial statements.

Materiality and Its Link to Relevance

The concept of materiality is integral to the characteristic of relevance. Materiality refers to
the threshold above which missing or misstated information in financial statements could
influence the economic decisions of users. Materiality is not a fixed value but is based on
the context of the information and the users’ needs. For instance, a $5,000 misstatement
might be immaterial for a large corporation but highly material for a small business.

Materiality is linked to relevance because it helps determine what information is essential to

users. Only information that could impact decision-making is considered material, and
therefore relevant. If an item or error is deemed immaterial, it may be excluded from the
financial statements without significantly affecting their usefulness.

In conclusion, the principles of going concern, relevance, faithful representation, and the
enhancing characteristics work together to create financial statements that are useful for
decision-making. Materiality serves as a filter for relevance, ensuring that only information
significant to users is included, thus enhancing the quality of the financial statements. By
adhering to these principles, financial information achieves a level of consistency, clarity,
and dependability that supports the needs of a diverse range of stakeholders.

Understanding the elements of financial statements—such as assets, liabilities, income, and

expenses—and the criteria for recognizing or derecognizing items are essential for creating
clear, accurate, and useful financial reports. Below, I outline these elements, discuss
recognition and derecognition criteria, and describe common measurement bases used in
financial reporting.

Elements of Financial Statements

1. Assets
- Assets are resources controlled by an entity that provide future economic benefits.
Examples include cash, inventory, property, and equipment.
- An asset is recognized in the financial statements when it is probable that future
economic benefits will flow to the entity, and the asset has a measurable cost or value.

2. Liabilities
- Liabilities are present obligations of an entity that result in future economic outflows,
such as loans, accounts payable, or bonds payable.
- A liability is recognized when it is probable that an outflow of resources embodying
economic benefits will be required to settle the obligation, and the amount can be reliably
measured.

3. Income
- Income (or revenue) is the increase in economic benefits during a period, typically
through inflows or increases in assets or decreases in liabilities. Examples include sales
revenue, interest income, and gains on asset disposals.
- Income is recognized when it is earned, the inflow of economic benefits is probable, and
the income can be reliably measured.

4. Expenses
- Expenses are decreases in economic benefits over a period due to outflows or depletions
of assets or increases in liabilities. Examples include cost of goods sold, wages, and utility
expenses.
- Expenses are recognized when they are incurred and matched with income if possible, in
the period in which they generate revenue.
These elements form the foundation of the primary financial statements: the balance sheet
(assets, liabilities, and equity), the income statement (income and expenses), and the cash
flow statement.

Reporting Transactions That Fail to Satisfy Recognition Criteria

If a transaction does not meet the recognition criteria, it should not be included on the face
of the financial statements. However, it may be disclosed in the notes to the financial
statements to provide users with a fuller understanding of the company’s operations and
risks. For example, a potential lawsuit that has not reached a stage where its outcome can
be estimated with reasonable certainty might not be recognized as a liability but disclosed
as a contingent liability in the notes.

Criteria for Recognition and Derecognition

Recognition Criteria
To recognize an item on the financial statements, it must meet the following criteria:
1. Definition: The item must meet the definition of one of the elements (asset, liability,
equity, income, or expense).
2. Probability: It must be probable that future economic benefits associated with the item
will flow to or from the entity.
3. Measurement: The item’s cost or value must be measurable with reliability.

If these criteria are not met, the item is generally not recognized, though it may be disclosed
if it is relevant to users’ decision-making.

Derecognition Criteria
Derecognition occurs when an asset or liability no longer meets the definition or recognition
criteria. This typically happens when:
1. Control over the asset is lost (e.g., it is sold or transferred), or
2. The obligation of the liability is discharged, cancelled, or has expired.

For example, if a company sells an asset, it will derecognize that asset and remove it from
the balance sheet. Similarly, if a loan is paid off, the liability for that loan is derecognized.

Measurement Bases in Financial Statements

Financial elements are measured using various bases, with two primary categories being
historical cost and current value.

1. Historical Cost
- Historical cost represents the original cost of an asset or liability at the time of acquisition
or incurrence. It is commonly used because it is objective, verifiable, and easy to
understand.
- Example: Inventory is often recorded at its purchase cost, providing a stable measure of
value. Another example is property, plant, and equipment initially recorded at acquisition
cost and depreciated over time.
2. Current Value
- Current value reflects the amount for which an asset or liability could be exchanged in a
transaction at the reporting date. This measurement basis can take several forms, including
fair value, value in use, and current replacement cost:
- Fair Value: The price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants.
- Example: Investments in marketable securities are often measured at fair value since it
reflects their current market price.
- Value in Use: The present value of future cash flows expected to be derived from an
asset, used in impairment testing.
- Example: A machine used in production may be recorded at its value in use if its
recoverable amount (through use or sale) is lower than its carrying amount.
- Current Replacement Cost: The cost to replace an asset at current prices, often used for
inventory in specific industries.
- Example: Inventory held in industries with rapid price changes may be valued at
replacement cost to reflect its market value better.

Summary and Discussion Points for Workshop

In a financial reporting context:

- Recognition and Derecognition: To recognize or derecognize an item, it must meet certain
criteria related to its nature, probability of economic benefit, and measurability. If a
transaction fails to satisfy these criteria, it may be disclosed in the notes rather than
recognized on the balance sheet or income statement.
- Measurement Bases: Different measurement bases, such as historical cost and current
value, serve different purposes. Historical cost provides reliability, while current value offers
relevance, particularly in dynamic markets. Balancing these can depend on the type of asset
or liability and the needs of financial statement users.

By understanding and applying these elements, criteria, and measurement bases,

accountants create financial statements that are meaningful, comparable, and useful for
stakeholders. This framework also ensures transparency and consistency, helping users
make informed economic decisions based on reliable financial information.

In financial accounting, the concepts of capital and capital maintenance help determine
what constitutes profit and ensures that a business preserves its capital over time. These
concepts are crucial when preparing accrual basis financial statements, as they define how
profit is calculated and help maintain the value of the entity's capital.

Concepts of Capital and Capital Maintenance

1. Financial Capital Maintenance:

 - This concept is concerned with maintaining the monetary value of invested capital. Profit
is recognized only if the net assets (equity) at the end of a period exceed the net assets at
the beginning of the period, after excluding contributions from and distributions to owners.
- In other words, profit is the increase in financial capital, measured in monetary terms. If
the capital in terms of initial monetary investment is preserved, any increase over this
capital is considered profit.

2. Physical Capital Maintenance:

- Physical capital maintenance is focused on maintaining the operating capacity of the
business. Profit is recognized only if the physical productive capacity of the business (e.g.,
the ability to produce goods or services) is maintained.
- Here, capital is measured in terms of the productive assets needed to maintain the
company’s operations, adjusted for changes in the cost of replacing these assets. Under this
approach, the effect of price increases is taken into account to maintain the purchasing
power or operating capacity of the capital.

Illustration: Mandal Ltd.

Mandal Ltd. is established with an initial capital of 25,000 ordinary shares of £1 each, so its
initial capital is £25,000. During the year, the company buys stock worth £25,000, which it
sells for £30,000, generating £5,000 in nominal profit (sale price minus cost). At year-end,
the cost of purchasing the stock has increased to £27,500. We will calculate retained profit
under both capital maintenance concepts.

1. Financial Concept of Capital Maintenance

- Under financial capital maintenance, profit is calculated based on the initial capital of
£25,000. Since Mandal Ltd. started with £25,000 and ended with £30,000 after selling the
stock, the profit is simply the increase in monetary terms.

- Retained Profit Calculation:

{Retained Profit (Financial Concept)} = {Sales Revenue} - {Cost of Stock}

= £30,000 - £25,000 = £5,000

- Therefore, under the financial capital maintenance approach, Mandal Ltd.’s retained profit
is £5,000. This approach does not consider the increase in replacement cost of stock.

2. Physical Concept of Capital Maintenance

- In the physical capital maintenance approach, we account for the increased cost to
replace the stock at year-end prices (£27,500) to maintain the operating capacity of the
business.
- Since the stock’s replacement cost increased from £25,000 to £27,500, this additional
£2,500 is treated as an increase in the capital needed to maintain the business's productive
capacity. Thus, only the excess above this adjusted capital requirement is considered profit.
- Retained Profit Calculation:
{Adjusted Profit (Physical Concept)} = {Sales Revenue} - { Cost of Stock (Replacement Cost)}
 = £30,000 - £27,500 = £2,500

- Under the physical capital maintenance approach, Mandal Ltd.’s retained profit is £2,500.
This calculation reflects the impact of price increases on the cost of maintaining operational
capacity.

Summary

- Using the financial capital maintenance concept, retained profit is £5,000, as it measures
profit based solely on the difference between the monetary amounts of assets at the
beginning and end of the period.
- Using the physical capital maintenance concept, retained profit is £2,500, as it adjusts for
the increased cost of maintaining operating capacity due to the rise in stock prices.

In summary, the choice of capital maintenance concept has a significant impact on reported
profit. The financial concept considers profit in purely monetary terms, while the physical
concept accounts for inflation or cost increases, ensuring the business maintains its
productive capacity over time.

The primary objective of financial statements is to provide information about a company’s

financial position, financial performance, and cash flows that is useful to a wide range of
users, including investors, creditors, and regulators, for making economic decisions.
Financial statements help assess a company’s profitability, financial stability, and liquidity
and provide insights into its ability to generate future cash flows. This information enables
users to evaluate a company’s management, operational efficiency, and overall financial
health.

Statement of Profit or Loss and Other Comprehensive Income

The statement of profit or loss and other comprehensive income (often referred to as the
income statement) is designed to present a company’s performance over a specified period.
For public companies, this statement is essential for investors and analysts as it shows both
realized gains and regular earnings and tracks additional unrealized gains or losses.

This statement is usually divided into two sections:

1. Statement of Profit or Loss:

- This section focuses on revenue and expenses directly related to a company’s primary
operating activities.
- Revenue includes sales, services, interest, and other income directly from operations.
- Expenses encompass the cost of goods sold (COGS), operating expenses, administrative
costs, and finance costs.
- The difference between revenue and expenses provides the net income (or net profit) for
the period.
 - This part of the statement highlights the profitability of a company’s core business
activities and serves as a primary indicator of financial performance for investors.

2. Other Comprehensive Income (OCI):

- OCI captures items that are not included in net profit because they are considered
unrealized gains or losses or items not directly related to core business operations.
- Examples of OCI items include:
- Unrealized gains or losses on available-for-sale financial assets
- Gains or losses from foreign currency translation adjustments
- Changes in the fair value of certain financial instruments or hedging activities
- Actuarial gains or losses on defined benefit pension plans
- These items are excluded from net profit but are included in total comprehensive
income, giving a fuller picture of the company’s overall gains and losses.

The statement of profit or loss plus other comprehensive income provides an overview of
both operational and non-operational financial performance, giving users a more complete
understanding of changes in a company’s equity during the period.

Constructing the Statement of Profit or Loss and Other Comprehensive Income

Public companies generally follow these steps to construct this statement:

1. Calculate Total Revenue:

- Total revenue includes all income generated by the company’s main operations, such as
sales revenue, service revenue, and other income.

2. Calculate Total Expenses:

- Direct costs like COGS and indirect costs like administrative and operating expenses are
recorded. Finance costs, such as interest expenses on loans, are also included here.

3. Compute Operating Profit (or Loss):

- Operating profit is the difference between total revenue and total operating expenses,
reflecting the company’s profit from core operations.

4. Include Non-operating Income and Expenses:

- Gains or losses from non-operating activities, such as investment income or losses, are
added.

5. Calculate Profit Before Tax and Net Profit:

- After considering non-operating items and taxes, the net profit for the period is derived.

6. Add Other Comprehensive Income (OCI) Items:

- OCI items are included after net profit. These items are often unrealized or relate to
valuation adjustments, such as changes in the fair value of investments.

7. Derive Total Comprehensive Income:

 - Total comprehensive income combines net profit and OCI, providing a full picture of both
realized and unrealized financial performance.

Key Difference Between the Statement of Profit or Loss and Other Comprehensive Income

The key difference between the statement of profit or loss and other comprehensive
income lies in the types of income and expenses they each report:

- The statement of profit or loss includes revenue and expenses that are directly related to
the primary business operations and that contribute to calculating net profit. This section
reflects the company’s core financial performance, measuring profitability in terms of its
primary activities.
- Other comprehensive income (OCI) includes items that are not directly tied to day-to-day
operations or are unrealized. These may be gains or losses from asset revaluations, foreign
currency translations, or adjustments related to financial instruments, which are volatile and
can impact the company’s financial position but are excluded from net profit calculations.

While net profit in the profit or loss statement reflects actual performance from operations,
OCI captures additional gains or losses that are yet to be realized or are beyond the
company’s operational control, providing a broader picture of potential gains or losses
affecting shareholders’ equity. This distinction helps users differentiate between realized
operational performance and potential or non-operational changes in value.
To assist Major Charles in evaluating Blue Bridge Limited’s (BBL) financial performance and
position, we can analyze the draft profit and loss account and balance sheet for the year
ended 31 December 2020. The analysis will highlight key areas such as revenue growth,
profitability, cost structure, liquidity, and debt levels to provide an overview of BBL’s
financial health and operational efficiency.

1. Financial Performance Analysis (Profit and Loss Account)

Revenue and Gross Profit

- Revenue Growth: BBL’s revenue increased significantly from £1,082,568 in 2019 to
£1,600,199 in 2020, an increase of approximately 47.8%. This growth suggests that the
company has been successful in increasing sales volumes or prices, or both.
- Gross Profit: Gross profit increased from £561,711 in 2019 to £724,037 in 2020, which is a
28.9% increase. However, Gross Profit Margin (Gross Profit / Revenue) has declined from
51.9% in 2019 to 45.3% in 2020. This indicates rising Cost of Sales relative to revenue,
potentially due to higher input costs or pricing pressures. The company might need to
control costs better to maintain profitability.

Operating Expenses and Profitability

- Distribution Costs: These costs increased slightly from £123,350 in 2019 to £130,926 in
2020, a rise of around 6.1%, which is manageable given the increase in revenue.
- Administrative Expenses: Administrative expenses rose sharply by 39.2% from £334,223 to
£465,329. This increase in operating costs is disproportionately high compared to the
revenue growth, which could be concerning as it reduces overall profitability.
- Profit Before Interest and Tax (PBIT): Despite the revenue growth, the increase in
operating costs has limited the growth in PBIT. PBIT rose by only 22.8% from £105,338 in
2019 to £129,314 in 2020, indicating that increased revenue did not fully translate into
higher operating profitability.

Interest and Profit After Tax

- Interest Payable: Interest costs decreased slightly from £23,676 in 2019 to £21,228 in
2020. While interest expense is lower, the financial statements show that BBL still has debt
obligations that may affect future cash flows.
- Profit Before Tax (PBT): PBT increased from £83,520 in 2019 to £109,792 in 2020, a 31.5%
increase. This improvement reflects the company’s revenue growth, though higher
operating costs and interest payments have moderated this growth.
- Profit After Tax: Profit after tax rose by 41.1% from £57,219 to £80,747. This growth is
positive and signals improved profitability, but the company could achieve higher profits if it
controlled operating expenses more effectively.

2. Financial Position Analysis (Balance Sheet)

Assets
- Fixed Assets: Tangible assets increased from £181,069 to £224,757, suggesting that BBL
has invested in long-term assets, possibly to support growth. This could be a positive sign if
these assets are expected to enhance productivity or capacity.
- Current Assets:
- Inventory: Inventory decreased from £19,856 in 2019 to £11,826 in 2020, a 40.4%
reduction. While lower inventory might suggest improved efficiency or faster turnover, it
could also mean that BBL has less stock available to meet demand, which may be a risk if
demand surges.
- Debtors: Debtors increased significantly from £73,029 to £150,835, which could indicate
increased credit sales or slower collections. This is a risk factor for cash flow management,
as higher receivables can strain liquidity if collections are not timely.
- Cash: Cash levels remain minimal (£27 at year-end), highlighting potential liquidity
constraints and limited cash reserves to cover unexpected expenses or opportunities.

Liabilities
- Current Liabilities: Current liabilities increased from £117,449 in 2019 to £134,645 in 2020,
a 14.6% increase. This is a modest increase relative to revenue growth, though it could
strain liquidity, especially given the low cash balance.
- Net Current Assets: BBL has shifted from net current liabilities of £24,504 in 2019 to net
current assets of £28,043 in 2020, a positive shift suggesting improved short-term financial
stability.
- Long-Term Liabilities: Long-term liabilities increased from £25,948 to £47,321, nearly
doubling. This increase in debt could imply reliance on external financing, which may pose
risks if BBL’s cash flows are insufficient to meet these obligations.

Shareholders’ Equity
- Retained Earnings: Retained earnings (Profit and Loss Account) increased from £108,852 to
£182,099, driven by retained profits from the current year. This growth in equity reflects
retained profits and is a positive indicator of BBL’s ability to generate earnings for
reinvestment.
- Share Capital and Share Premium: Share capital and share premium remain unchanged,
indicating that no additional equity has been issued. Any new investment from Major
Charles could strengthen the equity base and potentially reduce BBL’s reliance on debt
financing.

Key Considerations for Major Charles

1. Revenue Growth: BBL’s significant revenue increase is a positive indicator of demand for
its products. However, sustaining this growth will require effective cost management,
especially in terms of cost of sales and administrative expenses.
2. Declining Gross Margin: The decline in gross margin suggests rising costs in proportion to
revenue, which could impact profitability in the long run. Major Charles should consider
whether BBL can improve operational efficiency or increase prices without losing customers.
3. Rising Operating Expenses: The sharp rise in administrative expenses may be a red flag.
Major Charles should investigate the reasons behind these increased costs and evaluate
whether they are necessary or if cost-control measures could be implemented.
4. Liquidity Risk: With minimal cash and high receivables, BBL’s liquidity position may be
weak. The increase in debtors suggests slower collections, which could strain cash flow.
Major Charles should assess BBL’s credit policies and the effectiveness of its collection
processes.
5. Increased Leverage: The increase in long-term liabilities suggests higher reliance on debt
financing. Major Charles may want to evaluate the terms of this debt and BBL’s ability to
service it, especially if cash flow remains limited.
6. Investment in Fixed Assets: The increase in fixed assets could be promising if it supports
future growth and operational efficiency. Major Charles should review these assets to
determine whether they will provide sufficient returns on investment.

Summary

In summary, BBL has shown revenue growth and increased profit after tax in 2020.
However, rising costs, especially in cost of sales and administrative expenses, have limited
profitability improvements. Liquidity appears to be a concern, with low cash levels and high
receivables, and the company’s increased reliance on debt could pose financial risks if not
managed carefully.

For Major Charles, an equity investment in BBL could provide the business with needed
capital to improve operations and reduce its debt reliance. However, it would be prudent to
ensure that BBL has a robust plan to manage its costs, improve cash flow, and strengthen its
balance sheet.