A Primer On Financial Accounting Concepts

Let us look at the basic accounting norms that companies follow for financial reporting as well as understand account concepts such as accruals. We will also look at what is IFRS and US GAAP.

What Is Accounting?

Companies deal with lakhs and crores of rupees. This includes the money borrowed from lenders and shareholders, the amount it takes to produce lakhs of goods and services, the payments to employees and suppliers as well as the money received from clients. This is a complex process, where money is exchanged every minute or second of the day.

This is why, it is important to maintain strict records of the inflows as well as the outflows. This process of keeping a detailed account of financial aspects of the company is called ‘accounting’.

Accounting Basics: Accruals, Adjustments And Assumptions

We start our study of accounting norms with an understanding of the accruals, adjustments and assumptions used in preparation of the financial statements.

• Accruals:

An accrual is a financial obligation that is created when one of the parties in a transaction fulfills its obligation but is yet to receive its compensation. It is a source of future income for a company when it has made the obligation, whereas, it is a source of future expense, when it is yet to pay for the obligation. Since accruals are expected to lead to future cash flows, they are recorded as assets or liabilities on the balance sheet. We will discuss this in detail in the next segment of this section.

Types Of Accruals:

• Accounts Receivable And Payable" These are created when a company sells/ buys goods but is yet to receive/pay for them. In case proceeds have to be received from the customers for the goods sold, they are referred to as accounts receivable. In case payments are to be made to suppliers for goods bought from them, it is called accounts payable. Receivables are recorded as an asset, whereas payables are recorded as a liability on the balance sheet.

• Unearned Income: Sometimes a company receives income for rendering a service, such as selling goods, before it has actually rendered it. Income thus received is called the unearned income. It is recorded as a liability on the balance sheet till the service has been performed. This generally happens with companies that sell large products, such as machinery, that are produced on demand.

• Accrued And Prepaid Expenses: Accrued expenses are similar to accounts payable. However, here, the company doesn’t owe money to its suppliers. Instead, it owes money to somebody from whom it has received a service, but has not paid yet. Accrued expenses may include rent, interest, wages etc. Similarly, when a company pays for these services in advance and receives them later, it is called prepaid expenses.

• Adjustments:

Accountancy is based on the double entry system. For every transaction, a company’s accounts get effected in two places. For example, when it buys something, the value of the purchase gets added to an asset account, and simultaneously, the same amount gets deducted from the cash account. Accruals drive a wedge between the two. In case of accruals, what the company receives is different from what it pays as of that moment. In the above example, if the company had purchased these goods on credit, the entire value of the goods would have come into the company.

However, only a proportion of this would have gone out as cash. At the end of the accounting period, such as a quarter or a financial year, the accounts would have to be adjusted for these differences. The entries passed for this are called adjusting entries or adjustments. Let’s look at a couple of examples:

Say a company makes sales worth Rs.1,000 crore in a financial year. Till the last day of the year, it only receives Rs.600 crore out of this. On the income statement, the company will record sales of Rs.1,000 crore because it has genuinely made these sales. However, on the balance sheet, under cash, it can only report Rs.600 crore because this is all it has received in cash. The remaining Rs.400 crore will be recorded as another asset called accounts receivable on the balance sheet. This is called the adjusting entry. As and when this amount is recovered, accounts receivable will reduce. We will explain the rationale behind recording accrued revenue as an asset later in this section.

Let’s look at another example. Assume a company operates from a rented office space. The monthly rent is Rs.2.5 lakh. However, for the previous month, the company has only been able to pay Rs.2 lakh. On the income statement, the company will show a rent expense of Rs.2.5 lakh because the company has already used the premises during the period. However, on the balance sheet, cash will only be reduced by Rs. 2 lakh. The remaining Rs.50,000 will be recorded on the liabilities side as an adjusting entry called accrued rent. As the company keeps paying this, the cash amount will keep reducing, along with the accrued rent amount.

• Assumptions:

Accounts prepared by companies are based on four basic assumptions. They are:

Accounting entity assumption: According to this assumption, the company is a separate entity from its ‘owners’. The personal possessions of the owner cannot be considered a part of the company. In case the business goes under and its assets have to be auctioned, the owners’ personal assets will remain separate.

Money measurement assumption: This assumption states that while preparing a company’s books of accounts, only those transactions that can be recorded in monetary terms will be recorded. For example, when a company obtains the services of an employee, it gets his valuable traits such as honesty, punctuality and commitment. However, only the compensation offered to him is recorded on the accounts of the company. These traits go unmentioned.

Going concern assumption: A company is assumed to last forever. The ‘owners’ may pass on, employees may leave, assets may be replaced, but the company is an accounting entity that never ceases to exist. It is always managed by new people who come in and new assets that are bought.

Accounting period assumption: The previous assumption states that a company is a going concern. If so, when do we evaluate its performance? There must be a fixed interval of time for reporting performance. In most cases this period is one year, at the end of which the books of the company are closed and an annual report that discusses its performance during the period is released. Thus, one year is the assumed accounting period.

Understanding Accrual Accounting

As mentioned above, accruals occur when an obligation has been fulfilled but the income in lieu of it has not been received yet. As such, accruals denote a future expense or income for the company.

• Accounting Treatment:

By definition, anything, tangible or intangible, that a company owns and expects to generate future income from is its asset. Similarly, anything that a company expects to incur a future outflow on account of, is its liability. As such, all accruals that are expected to generate future income are assets. Examples include, accounts receivable, prepaid expenses and deferred tax asset. Accruals that arise due to a counterparty fulfilling its obligations towards the company are recorded as liabilities. Examples include, accounts payable, unearned income, deferred tax liability.

Most accrual-based assets and liabilities are recorded as current assets/liabilities, because the cash for such transactions is expected to change hands soon. As and when they are settled, the combined value of that particular asset/ liability is reduced on the balance sheet and a similar amount is shown as an operating income/expense on the income statement.

• Benefits Of Accrual Accounting:

The beauty of accrual accounting is that it provides a holistic picture of a company’s affairs. It accounts for what the company ‘should’ have received or paid in cash rather than what it actually has.

Also, it is futuristic in nature because it tells investors what they can expect the company to receive or pay in future. In the earlier approach, only cash incomes and expenses were recorded in the financial statements.

Different Types Of Accounting Methods: IFRS, GAAP

Financial accounts are prepared by each company individually, in isolation with others. Allowing companies complete freedom with respect to accounting would lead to differently structured financial statements for each company. This will make it hard for the investors to compare them. To overcome this, a uniform set of accounting standards is developed and each company is required to follow it. In India, this set of standards is called Indian Accounting Standards (IAS). Internationally, two sets of accounting rules are popular – International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP). US GAAP is followed by companies domiciled or listed on exchanges within the US, whereas IFRS is used in most other countries to varying degrees.

• What Is IFRS:

IFRS was put together by the IASC between 1973 and 2001. The IASC has since been replaced by the IASB. IFRS requires the inclusion of the balance sheet, income statement, statement of changes in equity and cash flow statement in every annual report. In addition, it also requires a mention of the significant accounting policies of a company therein.

The principles it sets forth are:

• Fair presentation

• Going concern

• Accrual basis

• Consistency

• Materiality

The consistency principal requires that once a company adopts an accounting approach, it sticks to it, unless it finds another one that is an improvement over it. In that case, the change in principal must be mentioned in the notes to accounts. The materiality principle states that a company may ignore an accounting principal if doing so will only have an insignificant numerical impact on its financial statements.

IFRS also mention some presentation requirements:

• Items of similar nature must fall under a common head in the financial statements.

• Complete values of incomes and expenses, and assets and liabilities should be reported. They must not be netted-off against each other. Items on the balance sheet must be classified into current and non-current.

• The number of items to be mentioned on each financial statement is defined. Details must be given in notes to accounts

• The historical values of each item on a financial statement should be given to facilitate comparison.

• What Is Us GAAP:

US GAAP has been adopted by the US Securities Exchange Commission (SEC) and is currently in force in the US. The standards were presented as one consolidated document, called FASB Accounting Standards Codification, by the Federal Accounting Standards Board (FASB) in 2008. While the general ideology and purpose of GAAP and IFRS is the same, there are some technical differences between the two.

For example, US GAAP, unlike IFRS, allows the last-in first-out (LIFO) method of inventory recognition.

Hereby, companies are allowed to calculate the cost of goods sold (COGS) on the basis of the price of the most recent units of inventory, rather than the oldest ones. Some of the other key differences include differences regarding the recognition of intangible assets and the reversal of write downs.

The principals of GAAP were formulated with the objective of enabling financial statements to provide all the necessary information for stakeholders to take rational, informed decisions.

As world markets become more and more integrated, countries have realized the need for a common set of accounting rules to foster comparability across the paradigm. Today, most countries are at various stages of adopting IFRS. In India, IFRS was supposed to be implemented in 2012.

However, there has been little progress. Since 2002, FASB and IASB have been working towards the convergence of IFRS and US GAAP. However, there are some reservations regarding this convergence.

The SEC has expressed little faith in either accounting standard. It has called for a completely new approach to accounting to cope with the needs of the new, dynamic, technology-driven business environment.

Don't Fall For The Numbers: How To Find Loopholes, Red Flags

Even though financial reporting is based on a uniform set of accounting standards, there is sufficient freedom for companies with respect to reporting certain items. This, coupled with the malpractice of deliberately misreporting to give a better picture of the company, allows companies to produce financial statements that don’t depict a company’s performance accurately. Investors must look at numbers in the financial statements for signs of foul play. These signs are called red signs.

Some of them are:

• Out-Of-Line Sales Growth:

A company’s sales growth must be more or less in-line with that of the industry. In case the growth is far higher, it presents a suspicious case.

Acute growth in non-cash sales:

The accrued revenue of a company must increase in-line with increase in sales. If the increase in accrued earnings is greater than the increase in sales, it is a sign of foul play.

Low quality of cash flows:

A large proportion of a company’s cash flows should be contributed by operating inflows. A larger proportion of investing or financing cash inflows means the company is not generating enough revenue from its operations. It is trying to expand its balance sheet by raising cash from borrowing, issuing more shares and selling its assets.

• Non-Operating Incomes Classified As Operating Income:

Earnings are considered healthy when they are largely made up of sales and other recurring, operating sources. Companies sometimes classify non-operating incomes as operating to show high earnings quality. Thus, sources of operating income must be carefully inspected.

Peculiar categories of assets:

Recall that assets are reported on a company’s balance sheet and are depreciated each year. This depreciation is recorded on the income statement as an expense. As such, the entire value of the asset is expensed, but over a period of time and not in one go. Companies sometimes like to use the same strategy for large expenses. Instead of reporting them as an expense in one year and suffering a blow to the year’s profit (net income), companies report the expense as an asset on the balance sheet and report it on the income statement by and by, over many years. This is called amortization. It is an unfair practice.

To check for this, one should look at the assets mentioned on the balance sheet. Unusual assets and a high proportion of intangible assets (other than in industries such as IT, where intangible assets are a major component of the balance sheet) could be a consequence of spreading such large expenses over an extended period.