UNIT TWO

2. FINANCIAL REPORTING
MSPM 624
FINANCIAL REPORTING

1. Importance of Financial Reporting

2. Principles and Objectives of Financial

Accounting
3. Types of Accounts

4. Financial Statements; Income Statement,

Balance Sheet, Cash Flow Statement

Financial Statements
Financial statements (or financial reports) are formal
records of the financial activities and position of a
business, person, or other entity.
 Relevant financial information is presented in a

structured manner and in a form which is easy to

understand.
 They typically include four basic financial statements

accompanied by a management discussion and analysis.

Financial Statements
1. A balance sheet or statement of financial position,
reports on a company's assets , liabilities and owners
equity at a given point in time.
2. An income statement —or profit and loss
report (P&L report), or statement of
comprehensive income, or statement of revenue &
expense—reports is a summary of revenue and
expense of the company.
 A profit and loss statement provides information on the
operation/financial performance of the enterprise. These
include sales and the various expenses incurred during
the stated period.
3. A statement of changes in equity or statement of
equity, or statement of retained earnings, reports on the
changes in equity of the company over a stated period.
4. A cash flow statement reports on a company's cash
flow activities, particularly its operating, investing
and financing activities over a stated period.
Accounting from Users
Perspective
 Accounting from Users
Perspective
 Owners (Investors): In larger companies
there is separation of ownership from
management.
To decide when to buy, hold and sell shares.
To understand the adequacy of return from
the investment, at present and in the future.
 BOD:

 To assess the stewardship or accountability

of management.
 Cont…
 Management: Concerned with running the
business and using assets to generate
profit.
To manage the entity on day-to-day basis.
To add value to shareholders.
 Employees:

to assess the ability of the entity to pay

salary (wage) and provide other benefits to
its employees.
To assess the continuity of employment and
issues associated with the working
environment.
 Cont…
 Lenders:
To assess the security for amounts lent to
the entity.
To measure the vulnerability of the entity to
different risks.
 Suppliers or trade creditors:

To assess the continuity of supply.

To assess the ability of the firm to pay for
supplies delivered on credit terms.
 Cont…
 Governments and their Agencies:
To determine taxation policies.
To conduct governmental planning.
To prepare and use national income
statistics.
To regulate the activities of entities.
 Public interest:

Impact on local economy

Environmental concerns.
 The importance of financial reporting cannot be over
emphasized. It is required by each and every
stakeholder for multiple reasons & purposes.
1. In help and organization to comply with various
statues and regulatory requirements. The
organizations are required to file financial
statements, Government Agencies. In case of listed
companies, quarterly as well as annual results are
required to be filed to stock exchanges and
published.
2. It facilitates statutory audit. The Statutory auditors
are required to audit the financial statements of an
organization to express their opinion.
3. Financial Reports forms the backbone for financial
planning, analysis, benchmarking and decision
making. These are used for above purposes by
various stakeholders.
4. Financial reporting helps organizations to raise
capital both domestic as well as overseas.
5. On the basis of financials, the public in large can
analyze the performance of the organization as well
as of its management.
6. For the purpose of bidding, labor contract,
government supplies etc., organizations are
required to furnish their financial reports &
statements.
Objectives of Financial
statement
 The objectives of financial statements are to
provide information about the financial position,
performance and changes in financial position
that will assist wide spectrum of users in making
useful economic decisions.
 It identifies the following users of financial
information: investors, employees, lenders,
suppliers, customers, government and the
public.
 Information relating to financial position is
normally found in the balance sheet of an entity,
and is affected by the following:
Objectives of Financial
statment
(a) Economic resources controlled by the entity. This
information will enable users to predict the ability of the entity
to generate cash.
(b) Financial Structure of the entity. Users can predict
borrowing needs, distribution of future profits and the ability of
the entity to raise new finance.
(c) Liquidity and solvency of the entity. Users need this
information to predict the ability of the entity to meet its
financial commitments as they fall due.
 Information on the financial of an entity is basically provided

by the income statement. Such information is useful in

evaluating the returns obtained by an entity from the
resources available to it.
 Information about changes in financial position is contained

in the cash and how the cash generated is utilized.

Qualitative Characteristics
of financial information
 “The IASB identified the Qualitative
Characteristics of accounting information that
distinguish better (more useful) information
from inferior (less useful) information for
decision-making purposes.”
 In
addition, the IASB identified a cost constraint
as part of the Conceptual Framework.
 Thecharacteristics may be viewed as a
hierarchy.
 To be relevant, accounting information must be
capable of making a difference in a decision
when it has predictive value, confirmatory value,
or both.
 Financial information has:
1. Predictive value, exist if it has value as an
input to predictive processes used by
investors to form their own expectations
about the future.
 Accounting information should be helpful to external
decision makers by increasing their ability to make
predictions about the outcome of future events
 For example, information about the current level and
structure of asset holdings help users to assess the
entity’s ability to exploit opportunities and react to
adverse situations
 Confirmatory value, exist if it helps users
confirm or correct prior expectations.
3. Materiality - Information is material if omitting
it or misstating it could influence decisions that
users make on the basis of the reported financial
information
 Fundamental Quality – Faithful
Representation
 Faithful representation means that the
numbers and descriptions match what really
existed or happened.
 Faithful representation is a necessity

because most users have neither the time

nor the expertise to evaluate the factual
content of the information.
 To be a faithful representation, information

must be complete, neutral, and free of

material error.
 Attributes of Faithful Representation
1. Completeness - means that all the information
that is necessary for faithful representation is
provided.
 An omission can cause information to be false

or misleading and thus not be helpful to the

users of financial reports.
2. Neutrality - means that a company cannot
select information to favor one set of interested
parties over another.
 Preparers of financial reports must not attempt to induce a
predetermined outcome or a particular mode of behavior
 3. Free from Error - an information item
that is free from error will be a more
accurate (faithful) representation of a
financial item.
 Enhancing Quality – Consistency
 It is present when a company applies the
same accounting treatment to similar
events, from period to period.
 Through such application, the company

shows consistent use of accounting

standards.
 Enhancing Quality – Verifiability
 It occurs when independent measurers,
using the same methods, obtain similar
results.
 Enhancing Quality – Timeliness
 Having relevant information available
sooner can enhance its capacity to
influence decisions, and a lack of timeliness
can rob information of its usefulness
 Enhancing Quality – Understandability
 It is the quality of information that lets
reasonably informed users see its
significance.
 Understandability is enhanced when
information is classified, characterized, and
presented clearly and concisely.
UNDERLYING ASSUMPTIONS
 These assumptions are
 Economic Entity – company keeps its activity separate
from its owners and other businesses.
 Going Concern - company to last long enough to fulfill
objectives and commitments.
 Monetary Unit - money is the common denominator.
 Periodicity (time period) - company can divide its
economic activities into time periods.
 Accrual Basis of Accounting - transactions that
change a company’s financial statements are recorded in
the periods in which the events occur.
Principles
 Measurement – The most commonly used
measurements are based on historical cost and fair
value.
 Selection of which principle to follow generally
reflects a trade-off between relevance and faithful
representation.
Historical Cost – the price, established by the exchange
transaction, is the “cost”.
 Issues:
 IFRS requires that companies account for and report many assets and liabilities
on the basis of acquisition price (historical cost principle).
 The advantage of cost is that it is generally thought to be a faithful
representation of the amount paid for a given item.
2) Fair Value – is defined as “the price that
would be received to sell an asset or paid to
transfer a liability in an orderly transaction
between market participants at the
measurement date.”
 Issues:

Fair value is therefore a market-based measure.

Recently, IFRS has increasingly called for use of fair
value measurements in the financial statements.
 Revenue Recognition – companies
recognize revenue in the accounting period in
which the performance obligation is satisfied.
 Expense Recognition – recognition of
expenses is related to net changes in assets
and earning revenues.
 In practice, the approach for recognizing
expenses is, “Let the expense follow the
revenues.”
 Full Disclosure – providing information that
is of sufficient importance to influence the
judgment and decisions of an informed user.
 Users find information about financial position,
income, cash flows, and investments in one of
three places:
1) within the main body of financial statements,
2) in the notes to those statements, or
3) as supplementary information.
Constraints
 Cost- Benefit constraint
 The financial reporting must be cost
effective
 The cost of providing the information must

be weighed against the benefits that can be

derived from using it.
 The benefits must exceed the cost
Limitations of Financial Reporting

 Different accounting policies and

frameworks
 Accounting frameworks such as IFRS allow

the preparers of financial statements to use

accounting policies that most appropriately
reflect the circumstances of their entities.
 Whereas a degree of flexibility is important

in order to present reliable information of a

particular entity, the use of diverse set of
accounting policies amongst different
entities impairs the level of comparability
between financial statements.
Limitations of Financial Reporting
 Accounting estimates
 Accounting requires the use of estimates in the
preparation of financial statements where precise
amounts cannot be established. Estimates are inherently
subjective and therefore lack precision as they involve
the use of management's foresight in determining values
included in the financial statements.
 Professional judgment
 The use of professional judgment by the preparers of
financial statements is important in applying accounting
policies in a manner that is consistent with the economic
reality of an entity's transactions. However, differences in
the interpretation of the requirements of accounting
standards and their application to practical scenarios will
always be inevitable
Limitations of Financial Reporting
 Verifiability
 Audit is the main mechanism that enables users to
place trust on financial statements. However, audit
only provides 'reasonable' and not absolute assurance
on the truth and fairness of the financial statements
which means that despite carrying audit according to
acceptable standards, certain material misstatements
in financial statements may yet remain undetected
due to the inherent limitations of the audit.
 Use of historical cost
 Historical cost is the most widely used basis of
measurement of assets. Use of historical cost presents
various problems for the users of financial statements
as it fails to account for the change in price levels of
assets over a period of time.
Limitations of Financial Reporting
 The effect of the use of historical cost basis is best
explained by the use of an example.
 Company A purchased a plant for $100,000 on 1st
January 2006 which had a useful life of 10 years.
 Company B purchased a similar plant for $200,000 on
31st December 2010.
 Depreciation is charged on straight line basis.
 At the end of the reporting period at 31st December
2010, the balance sheet of Company B would show a
fixed asset of $200,000 while A's financial statement
would show an asset of $50,000 (net of depreciation).
 The scenario above presents an accounting anomaly.
Even though the plant presented in A's financial
statements is capable of producing economic benefits
worth 50% of Company B's asset, it is carried at a
historical cost equivalent of just 25% of its value.
TYPES OF ACCOUNTS
 Financial Statements represent a formal record
of the financial activities of an entity. These are
written reports that quantify the financial
strength, performance and liquidity of a company.
Financial Statements reflect the financial effects
of business transactions and events on the entity.
 Four Types of Financial Statements
 The four main types of financial statements are:
 1. Statement of Financial Position
 2. Income Statement
 3. Cash Flow Statement
 4. Statement of Changes in Equity
1. Statement of Financial
Position
 Statement of Financial Position, also known as the Balance
Sheet, presents the financial position of an entity at a given
date. It is comprised of the following three elements:
 Assets: A resource controlled by the entity as a results of the
past events and from which the future economic benefits are
expected to flow the entity (e.g. cash, inventory, plant and
machinery, etc)
 Liabilities: a present obligation of the entity arising from the
past event the settlements which is expected to the result in out
flow from the entity of the resource embodying economic
benefit (e.g. creditors, bank loans, etc)
 Equity: the residual interest of asset after deducting of liability.
This represents the amount of capital that remains in the
business after its assets are used to pay off its outstanding
liabilities. Equity therefore represents the difference between
the assets and liabilities.
1. Statement of Financial
Position
 Basic Elements of Balance Sheet
 The balance sheet consists of assets (i.e. the
enterprise resources), liabilities (i.e. the debts of
the enterprise) and the owners’ equity (i.e.
owner’s interest in the enterprise).
 The records of assets are obtained from two
major sources, namely: Owners and creditors. At
any given point in time, the assets must be equal
to the contribution of the creditors and owners.
 The financial/accounting equation is expressed
thus:
 ASSETS = LIABILITIES + OWNERS’ EQUITY
1. Statement of Financial
Position
 Balance sheet is a statement showing the assets
belonging to an organization offset by its liabilities
and shareholders’ funds.
 A balance sheet shows the financial condition of a
firm/an entity as at a particular time.
 Balance sheet indicates the state of affairs of a
business at that particular time.
 Its function is to show the financial status of a
business at a point in time. It provides a list of an
enterprise assets and liabilities at a particular
period.
 It shows that the capital structure of the
organization
Assets

 Classification
 Assets may be classified into Current and
Non-Current. The distinction is made on the
basis of time period in which the economic
benefits from the asset will flow to the entity.
 Current Assets are ones that an entity expects
to use within one-year time from the reporting
date.
 Non Current Assets are those whose benefits
are expected to last more than one year from
the reporting date.
1. Statement of Financial Position
Types and Examples
Following are the most common types of Assets and their
Classification along with the economic benefits derived from those
assets.
Classificati
Asset Economic Benefit
on
Used for the production of goods for
Machine Non-current
sale to customer.
Office Provides space to employees for
Non-current
Building administering company affairs.
Used in the transportation of company
Vehicle Non-current
products and also for commuting.
Cash is generated from the sale of
Inventory Current
inventory.
Cash Current Cash!
Receivables Current Will eventually result in inflow of cash.
Liabilities( A-E=L)
 Liability is present obligation of the entity arising from the past
event the settlements which is expected to the result in out flow
from the entity of the resource embodying economic benefit
Liabilities must be classified in the statement of financial
position as current or non-current depending on the duration
over which the entity intends to settle the liability. A liability
which will be settled over the long term is classified as non-
current whereas those liabilities that are expected to be settled
within one year from the reporting date are classified as current
liabilities.
 Liabilities are also classified in the statement of financial position

on the basis of their time:

1. Short term liability : a liability expected to pay within a short
period of time usually less than or equal to one year. E.g account
payable ,notes payable, interest payable salary payable
2. Long term liability : a liability expected to pay within a short
period of time usually greater than one year. E.g bond
Equity(A-L=E)
 Equity is derived by deducting total liabilities from the
total assets. It therefore represents the residual interest
in the business that belongs to the owners.
 Equity is usually presented in the statement of financial

position under the following categories:

1.Share capital represents the amount invested by the
owners in the entity at the establishment of the business
2. Retained Earnings comprises the total net profit or loss
retained in the business after distribution to the owners in
the form of dividends.( Revenue –expense–dividend or NI-
dividend)
3. Revaluation Reserve contains the net surplus of any
upward revaluation of property, plant and equipment
recognized directly in equity.
Statement of Financial Position as at 31 st December 2019

2019 2018
Notes
Birr Birr

ASSETS

Non-current assets

Property, plant & equipment 9 130,000 120,000

Goodwill 10 30,000 30,000

Intangible assets 11 60,000 50,000

220,000 200,000

Current assets

Inventories 12 12,000 10,000

Trade receivables 13 25,000 30,000

Cash and cash equivalents 14 8,000 10,000

45,000 50,000

TOTAL ASSETS 265,000 250,000

EQUITY AND LIABILITIES

Equity

Share capital 4 100,000 100,000

Retained earnings 50,000 40,000

Revaluation reserve 5 15,000 10,000

Total equity 165,000 150,000

Non-current liabilities

Long term borrowings 6 35,000 50,000

Current liabilities

Trade and other payables 7 35,000 25,000

Short-term borrowings 8 10,000 8,000

Current portion of long-term

6 15,000 15,000
borrowings

Current tax payable 9 5,000 2,000

Total current liabilities 65,000 50,000

Total liabilities 100,000 100,000

TATAL EQUITY AND LIABILITIES 265,000 250,000

2. INCOME STATEMENT
 The Income statement is another aspect of
financial statement which is considered
important because it measures the financial
strength of an enterprise. It is used to state
the income (revenue), earnings and
operational expenses of an enterprise. This
unit will discuss income statement, its
usage, basic element, limitations and
preparation.
INCOME STATEMENT
 Income Statement provides the basis for measuring
performance of an entity over the course of an
accounting period.
 Performance can be assessed from the income

statement in terms of the following:

I. Change in sales revenue over the period and in
comparison to industry growth
II. Change in gross profit margin, operating profit
margin and net profit margin over the period
III. Increase or decrease in net profit, operating profit
and gross profit over the period
IV. Comparison of the entity's profitability with other
organizations operating in similar industries or
sectors
The elements of income statement
are:
 Revenue(Income from operation )
 It increase the economic benefit during the
accounting period in the form of inflow or
enhancements of asset or decrease of liabilities
that increase equity other than those relating
to contributions from equity participant.
 Revenue includes income earned from the
principal activities of an entity. So for example,
in case of a manufacturer of electronic
appliances, revenue will comprise of the sales
from electronic appliance business.
 Satisfying performance obligations
 Other Income
 Other income consists of income earned from activities
that are not related to the entity's main business. For
example, other income of an entity that manufactures
electronic appliances may include:
 Gain on disposal of fixed assets
 Interest income on bank deposits
 Exchange gain on translation of a foreign currency
bank account
 Distribution Cost
 Distribution cost includes expenses incurred in
delivering goods from the business premises to
customers.
EXPENSE
 It decrease the economic benefit during the
accounting period in the form of outflow or
depletions of asset or incurrence of liabilities that
results in decrease in equities other than those
relating to distribution to equity paricipant.
 There are two categories of expense. Such as:

1. Cost of purchase or produce (cost of good sold

)
 Cost of sales represents the cost of goods sold or

services rendered during an accounting period.

 Hence, for a retailer, cost of sales will be the sum of

inventory at the start of the period and purchases

during the period minus any closing inventory.
2. Cost to Sell

a. Marketing and selling expense(operating

expense)
b. Administrative expense
3. Cash Flow Statement
 Cash Flow Statement, presents the movement in cash
and bank balances over a period.
 The movement in cash flows is classified into the
following segments:
 Operating Activities: Represents the cash flow from
primary activities of a business.
 Investing Activities: Represents cash flow from the
purchase and sale of assets other than inventories
(e.g. purchase of a factory plant)
 Financing Activities: Represents cash flow generated
or spent on raising and repaying share capital and
debt together with the payments of interest and
dividends.
3. Cash Flow Statement
 This is an aspect of financial statement which
provides useful information about a business
organization activities in generating cash through its
operations to settle debt, distribute dividends, or
reinvest such funds in order to maintain or expand
the operating capacity of the business financing
activities (be it debt or equity; and about its
investing or spending of cash).
 The statement is the base for the analysis of cash
flows which is useful for short-term planning. In
principle and practice, every enterprise needs
enough cash to settle its indebtedness that matured
in the near future, pay interest as they fall due, pay
dividends and other expenses.
Basic Elements of Cash Flow Statement

(a) Operating activities

 Operating activities consist of all transactions plus other events

that are not investing or financing activities.

 Cash flows from operating activities are generally the cash effects

of transactions and other events that is added to determine net

income such as: typical cash inflows and typical cash outflows.
(b) Investing activities
 Investing activities consist of lending money and collecting on

these loans and acquiring and selling investments and productive

long-term assets such as: typical cash inflows and typical cash
outflows.
(c) Financing activities
 Financing activities consist of cash flows relating to liability and

owners’ equity including typical cash inflows and typical cash

outflows.
4. Statement of Changes in
Equity
 Statement of Changes in Equity, also known as
the Statement of Retained Earnings, details the
movement in owners' equity over a period. The
movement in owners' equity is derived from the
following components:
 Net Profit or loss during the period as reported in
the income statement
 Share capital issued or repaid during the period
 Dividend payments
 Gains or losses recognized directly in equity (e.g.
revaluation surpluses)
 Effects of a change in accounting policy or
correction of accounting error.
 Sample exercise for financial statement
The Adjusted Trial Balance and preparations of Financial Statements
 END
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