Financial REPORTING Insight

In my first piece in this column, I defined Financial Statements, their uses and the users, their advantages and possible limitations, the components that make up Financial...

In my first piece in this column, I defined Financial Statements, their uses and the users, their advantages and possible limitations, the components that make up Financial Reports and what you should expect from this column week on week.

As a follow up I wish to discuss the components that make up the Financial Statements which are the building blocks of information that enable users to make informed decision as to whether to commit economic resources to an entity either in form of capital or loan or otherwise.

The components that make up what are known as Financial Statements as I mentioned last week are: Statement of Financial Position or what was known then as Balance Sheet, Profit or loss or Statement of Comprehensive Income, Statement of changes in Equity, Statement of cash flows and Significant or important accounting policies and Explanatory Notes to the Financial Statements.

These five are collectively known as Financial Statements and that is the reason they are always expressed in plural form. I emphasise on this because the misleading assumption that it is a singular term had been made time and time again not only by non-accountants but by professional accountants, auditors, financial analysts, etc.

International Accounting Standard 1 (IAS1) known as Presentation of Financial Statements is the IAS that governs the components enumerated in the above paragraph. At this point it is pertinent to delineate IAS and IFRS (International Financial Reporting Standards) that readers may be aware of the distinction between the two. IASs were issued by the International Accounting Standards Committee (IASC). In July 2001, the name was changed to International Accounting Standards Board (IASB) after a major restructuring of the same institution. The old standards issued by IASC are known as IASs and those issued by the new body are known as IFRSs. The Board is gradually phasing out the old standards to new ones while at the same time issuing new IFRSs Standards when the need arises. Accounting therefore is a living subject changing along the changes in the society and in business world-wide. The history of the Board is a beautiful history to study when in later days I come to it. But now let me talk about the components.

Statement of Financial Position

The most important components of Financial Statements is the Statement of Financial Position or what is commonly known as Balance Sheet. It is a Statement that presents information about an entity’s assets, its liabilities and its equity, where the compiled result should match the common formula: Total assets =Total liabilities plus Equity.

The Statement of Financial Position reports the aggregate effect of transactions of a specific date for example, say 31st December 2019. It is mainly used to assess an entity’s liquidity and its ability to meet its obligations as they fall due. I intend to talk about the components one after the other in the coming weeks but suffice it to say that as shown in the last paragraph above; it is made up of assets, liabilities and equity. Assets are economic resources subject to three criteria: it is a right of the entity, it has the potential to produce economic benefits; and is under the control of the entity. Therefore, assets can simply be defined as economic resources controlled by an entity; and from which it expects to deliver future economic benefits. These benefits may involve operational activities or convertibility into cash.

The conceptual framework defines a liability simply as a present obligation of the entity to transfer an economic resource as a result of past events. For a liability to exist, three criteria must be satisfied namely: the entity has an obligation; the obligation is to transfer an economic resource; it is a present obligation that exists as a result of past events.

The equity of an entity is the residual interest in the assets of the entity after deducting all its liabilities. In another way, equity claims are claims against the entity that do not meet the definition of a liability. Such claims may be established by contract, legislation or similar means that do not meet the definition of a liability: shares of various types; issued by the entity, some obligations of the entity to issue another equity claim.

Different classes of equity claims, such as ordinary shares and preference shares, may confer on their holders different rights to receive some or all the following from the entity: dividends; if the entity decides to pay dividends to eligible shareholders; the proceeds from satisfying the equity claims either in full on liquidation or in part at other times of other equity claim. I am quoting directly from the conceptual framework.

Statement of Profit or Loss

IAS1 recognises various names in determining the financial performance of an entity whereby incomes and expenses are the major elements; Profit or Loss or total comprehensive income.

As in the Statement of financial position, it is necessary for the readers to be aware of the definition of the two elements mentioned above:

Incomes are increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.

Expenses are decreased in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

In other words; contributions from holders of equity claims are not income and distributions to holders of equity claims are not expenses.

IAS 1 requires that all items of income and expense be presented either: in a single statement of profit or loss and other comprehensive income (with a separate section in the order stated) or a statement of comprehensive income beginning with profit or loss and containing components of other comprehensive income (OCI)

Components of comprehensive income will be discussed in details when financial instruments are discussed under IFRS 9. But suffice it to say that other comprehensive income are items like: changes in revaluation surplus relating to property,plant and equipment and intangible assets (IAS 16 -Property, Plants and Equipment);re-measurements in defined benefits plan in accordance with (IAS 19 -Employee Benefits);gains and losses arising from translating the financial statements of a foreign operation (IAS 21- The effects of changes in Foreign Exchange Rates);gains and losses from investments in equity instruments designated at fair value through other comprehensive income. (IFRS 9- Financial Instruments) Some of these items may be reclassified to profit or loss and some may not. Don’t worry all these will be explained as we sail deeper into the high seas of financial reporting.

A profit or loss statement shows whether a profit or a loss has been made. It results in a profit when income exceeds expenses and results in a loss when expenses exceeds income. This is very important to all stakeholders as one of the reasons for committing capital to an entity is to make profit and partake in the distributions in cash or in kinds. In later weeks I will now deal in details this important component.

Statement of Changes in Equity

The statement of changes is equity reconciles changes in the equity classification in the statement of financial position within an accounting period. Most financial statements users hardly read this statement but it has a more specialised use than the statement of comprehensive income. The statement is made up of the following line items: total comprehensive income for the period attributable to the holding company; total comprehensive income in respect to non-controlling interest known formally as minority interest if any; the effects of retrospective application or restatement for each component of equity with separate line items for changes in accounting policies and the correction of errors; finally, changes due to profit or loss, other comprehensive income , and owner transactions for each component of equity, in a reconciliation format. Terms like holding company, controlling and non-controlling interest will be treated in future in this column. When I discuss this particular component in the coming weeks I will endeavour to show practical example also.

Statement of Cash Flows

The statement of cash flows contains information about the flows of cash into and out of entity coterminous with the period covered by the total comprehensive income statement. It shows the extent of those entity activities that generate and use cash and cash equivalents. It is useful in assessing the differences between net income and the related cash receipts and payments. IFRS requires that statement of cash flows be presented as an integral part of the financial statements. Unfortunately stakeholders do not use this report as the use the comprehensive income statement or the balance sheet. A practical example will be given in the coming weeks.

Significant Accounting Policies and Notes

Every entity has significant accounting policies which must be disclosed in the financial statements which tells the reader how certain events and transactions are treated in the presented statements. With the Introduction of IFRS accounting policies may only differ slightly depending on the nature of the business thus allowing for compatibility.

In the preparation of financial statements, IFRS requires events and transactions to be recognised, measured, presented and disclosed if specified criteria are met. The disclosure requirements are commonly known as notes to the financial statements. These notes form an integral part of the financial statements as they further clarify the contents of the information presented within the statements. These notes can include a broad range of information, depending on the type of business the entity is engaged in. In the coming week I will talk more on notes and accounting policies but next week I will start by discussing in details the format of a balance sheet of a listed manufacturing entity.