This write-up is for people who have heard about the term IndAS but are yet to get into the scheme of things. This is the third in a series of articles that will walk you through the basics of the standards.
CAVEAT: The objective is to get the concepts and in the process the reader may not find the technical jargons and linguistic mumbo-jumbo.
This article is going to give you a peek into the "Framework for Preparation and Presentation of Financial Statements in accordance with Indian Accounting Standards"... or simply, "The Framework".
Though it is just a peek, it is very essential before we actually begin the IndAS because the framework is the core of the whole concept.
So, let's get started with "The Journey to the Centre of The Earth"!!
First things first. What is a framework?
Every set of Financial Reporting standards come with a framework. The framework is the basis of the entire concept. That means it contains the WHY, HOW and WHAT of things.
Every standard is written putting the framework in mind. The standard setters ensure that every recommendation made by a standard conforms to the framework.
If you're feeling like I am beating around the bush, you're right because the framework does essentially that!! (on a lighter note, of course!!).
What does the framework contain?
It contains the following four elements:
1. WHY financial statements are prepared? --- The Objective of fin. statements
2. HOW should they be prepared?--- The Qualitative Characteristics of fin. statements.
3. WHAT do they contain? -- The elements of fin. statements.
4. guys.. no hurry!! we will discuss the last one later ..
Let's get into each of these now.
1. WHY financial statements are prepared?
In other words, the objectives of the fin. statements. The framework says the FS are prepared to provide information about financial position, financial performance and cash flows.
Simple. Replace the underlined part above with Balance Sheet, Stmt. of Profit and Loss and Cash Flow statement.
Financial position -- liquidity, solvency etc. (BS gives you the info about these)
Financial performance - profitability, coverage's etc. (PL is the source)
Cash Flows -- how much is from operating, investing and financing (Cash Flow Statement)
2. HOW should they be prepared?
The fin. statements should be prepared in such a way that they have the following characteristics:
i. Understandability -- of course to those who are financially literate
ii. Relevance -- this is where materiality is born.
iii. Reliability-- you have to show the ground reality (substance over form).
iv. Comparability-- be consistent.
3. WHAT do they contain?
The whole issue is about four things. Income, Expense, Asset and Liability. For each of the four, the framework gives us the definition, recognition criteria and measurement criteria.
i. Income is an increase in economic benefits.........
ii. Expense is a decrease in economic benefits.........
iii Asset is a resource controlled by the enterprise.........
iv. Liability is a present obligation arising from past events........
The recognition criteria is a universal one. You find it in almost every standard. The benefits/costs must be certain and they must be able to measure reliably.
4. This segment unlike the other three, is a special one. It's called the "Concept of Capital and Capital Maintenance".
What is Capital? --- The common answers we get are:
"It's the amount brought by the owners".
"It's the amount of Net Assets".
"It's the amount of Assets-Liabilities".
"It's the amount sitting in equity".
All the above definitions speak about an "amount". They define Capital as MONEY. They look at it as a bag of RUPEES. This is nothing but the financial concept of capital,
Can't we say that capital is the production capacity of the entity?
We hear people saying "It's a 100 billion dollar company".
We also hear people saying "It's a 10000 MW plant".
This second point of view of capital is called the physical concept of capital.
So there are two concepts of capital, financial and physical. The framework says that an entity should choose one of the above concepts and prepare the financial statements accordingly.
The inevitable question is WHY? Will that cause any difference?
YES. It does.
Profit under both concepts would be different.
Yeah. It's high time we take up an example...
A company has an opening capital of Rs.1,00,000.
Each unit of product X costs Rs.10..
Company buys for Rs.50,000 and sells for Rs.60,000. Profit is Rs.10,000.
Closing Capital of the company would be Rs.1,10,000.
In the above example, capital increased. The FS show profit of 10000. This is under financial concept of capital. Sweet, Cute, Nice concept that we do daily.
The same example, let's look from physical concept of capital.
Opening Capital is Rs.100000.
Each unit of product X costs Rs.10.
That means the Opening Capital is 10,000 units of product X. (physical concept)
At the end of the year, amount in capital is Rs.1,10,000 as above.
But cost of product X went up to Rs.20
Closing Capital, according to physical concept is 5,500 units of product X (110000/20).
Here in physical concept, capital has eroded. Though numerically the capital rose by Rs.10,000, the purchasing power of capital has come down.
So for the same situation, one concept shows profit and the other shows loss!!
Based on the users, the entity has to choose one concept. We all draw our FS in accordance with Financial Concept commonly. As discussed, in the standard on Hyperinflationary economies, the second concept finds relevance.
Hope the "peek" was useful. Once equipped with the Framework, we can now get into the standards...
Having discussed on the importance of Financial Statements, let me conclude with a quote ..
"In the absence of uniform standards and accurate measurement of economic performance, resources cannot be allocated efficiently – measurement errors (whether inadvertent or deliberate) lead to the misallocation of resources"
OK! Was that supposed to be a "quote"?
It IS a quotable quote when it comes from 4th Century B.C and when it is said by Chanakya!!
The next article in the series will be on IndAS 1 "Presentation of Financial Statements".
Happy Reading and best wishes!!