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 on a company's income, expenses and profits over a
stated period. A profit and loss statement provides information on the
operation 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.
 A comprehensive income statement involves those other comprehensive
income items which are not included while determining net income.
 (Notably, a balance sheet represents a single point in time, where the income
statement, the statement of changes in equity, and the cash flow statement each
represent activities over a stated period.)
Financial Statements
 IAS 1 Presentation of Financial Statements sets
out the overall requirements for financial
statements, including how they should be:
1) Structured,
2) The minimum requirements for their content
and overriding concepts such as going concern,
3) The accrual basis of accounting and the
current/non-current distinction.
 The standard requires a complete set of

financial statements to comprise a statement of

financial position, a statement of profit or loss
and other comprehensive income, a statement of
changes in equity and a statement of cash flows.
 Users of Financial Statements
 The objective of financial statements is to provide information
about the financial position, performance and changes in financial
position of an enterprise that is useful to a wide range of users in
making economic decisions.
 Financial Statements provide useful information to a wide range of
users:
 Managers require Financial Statements to manage the affairs of
the company by assessing its financial performance and position
and taking important business decisions.
 Shareholders use Financial Statements to assess the risk and
return of their investment in the company and take investment
decisions based on their analysis.
 Prospective Investors need Financial Statements to assess the
viability of investing in a company. Investors may predict future
dividends based on the profits disclosed in the Financial
Statements. Furthermore, risks associated with the investment may
be gauged from the Financial Statements. For instance, fluctuating
profits indicate higher risk. Therefore, Financial Statements provide
a basis for the investment decisions of potential investors.
 Users of Financial Statements
 Financial Institutions (e.g. banks) use Financial
Statements to decide whether to grant a loan or
credit to a business. Financial institutions assess the
financial health of a business to determine the
probability of a bad loan. Any decision to lend must
be supported by a sufficient asset base and liquidity.
 Suppliers need Financial Statements to assess the
credit worthiness of a business and ascertain
whether to supply goods on credit. Suppliers need
to know if they will be repaid. Terms of credit are set
according to the assessment of their customers'
financial health.
 Customers use Financial Statements to assess
whether a supplier has the resources to ensure the
steady supply of goods in the future
 Users of Financial Statements
 Employees use Financial Statements for assessing
the company's profitability and its consequence on
their future remuneration and job security.
 Competitors compare their performance with rival
companies to learn and develop strategies to
improve their competitiveness.
 General Public may be interested in the effects of
a company on the economy, environment and the
local community.
 Governments require Financial Statements to
determine the correctness of tax declared in the
tax returns. Government also keeps track of
economic progress through analysis of Financial
Statements of businesses from different sectors of
the economy
Importance of Financial
Statements
 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.
Importance of Financial
Statements
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
Accounting
 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
Accounting
(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.

UNDERLYING ASSUMPTIONS
 These assumptions are the accrual basis of accounting
and the going concern principle.
 Accrual Basis: When financial statements are prepared
under the accrual basis of accounting, the effects of
transactions and other events are recognized when they
occur and not as cash or its equivalent are received or
paid. They are recorded in the accounting records and
reported in the financial statements, of the periods to
which they relate.
 Going Concern Basis: Under the going concern basis,
the enterprise is regarded as a going concern, that is, as
continuing in operation for the foreseeable future. It is
assumed that the enterprise has neither the intention nor
the necessity to liquidate or reduce materially the scale of
its operations.
QUALITATIVE CHARACTERISTICS OF
FINANCIAL STATEMENTS
 Qualitative characteristics are the attributes that make the information
provided in financial statements useful to users
 Understandability
 Information in financial statements should be readily understandable by users
who have business, economics and accounting knowledge and willingness to
study the information carefully. Although financial reports should be
understandable, complex matters that are relevant to economic decision-
making should not be excluded merely because they are too difficult for users
to understand.
 Relevance
 To be useful, financial information should be relevant to the decision-making
needs of users. According to the Framework, information has the quality of
relevance when it influences the economic decision of users by helping them
evaluate past, present or future events or confirming, or correcting, their past
evaluations. Information may be considered relevant either because of its
nature (e.g. employee benefit expense) or because it is material. Financial
information is material if its omission or misstatement could affect the
economic decisions of users. Although materiality is not classified as a
threshold or cut-off point any information that fails the test of materiality need
not be disclosed separately in the financial statements.
QUALITATIVE CHARACTERISTICS
OF FINANCIAL STATEMENTS
 Reliability
 According to the framework, information is said to be “reliable” when
it is free from material bias and can be depended upon by users to
represent faithfully that which it either purports to represent or could
reasonably be accepted to represent. In view of the inherent
difficulties in identifying certain transactions or in finding appropriate
methods of measurement or presentation, financial statements
cannot be perfectly “accurate”, hence faithful representation might be
regarded as describing the closet that accountants can come towards
the absolute of total accuracy
 Comparability
 (a) Users should be able to compare the financial statements of an
entity through time (that is, over a period of time), to identify trends
in its financial position and performance.
 (b) Users should also be able to compare the financial statements of
different entities to determine their relative financial positions,
performance and changes in financial positions.
QUALITATIVE CHARACTERISTICS
OF FINANCIAL STATEMENTS
 Substance Over Form
 If information is to represent faithfully the transactions and other events that
it purports to represent, it is necessary that they are accounted for and
presented in accordance with their substance and economic reality and not
merely their legal form. The substance of transactions or other events is not
always consistent with that which is apparent from their legal or contrived
form. For example, an enterprise may dispose of an asset to another party in
such a way that the documentation purports to pass legal ownership to that
party; nevertheless, agreements may exist that ensure that the enterprise
continues to enjoy the future economic benefits embodied in the asset. In
such circumstances, the reporting of a sale would not represent faithfully the
transaction entered into (if indeed there was a transaction).
 Uncertainty/Prudence/Conservatism
 Recognition becomes difficult (or impossible) when there is uncertainty

 Information reported is less likely to be uncertain if:

 Events reported are likely or probable, and

 They are measurable
 When in doubt, choose the solution that will be least likely to overstate assets

and income.
 Qualitative characteristics

Main objective of FS: Provide reliable information on financial position,

performance and changes in financial position

Main characteristic: Decision usefulness

Major qualitative Understand ability Comparability

characteristics:
Relevance Reliability
(Materiality)

Substance over form Prudence

True and fair view

 Constraints
Main objective of FS: Provide reliable information on financial position,
performance and changes in financial position

Main characteristic: Decision usefulness

Major qualitative Understand ability Comparability

characteristics:
Relevance Reliability
(Materiality)

Substance over form Prudence

Constraints: Timeliness Cost-benefit

balance
True and fair view
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
 Timeliness
 Timeliness is how quickly information is available to users of
accounting information. The less timely (thus resulting in
older information), the less useful information is for decision-
making.
 Timeliness matters for accounting information because it
competes with other information.
 For example, if a company issues its financial statements a
year after its accounting period, users of financial statements
would find it difficult to determine how well the company is
doing in the present.
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.
 Moreover, the depreciation charged in A's financial statements
(i.e. $10,000 p.a.) does not reflect the opportunity cost of the
plant's use (i.e. $20,000 p.a.).
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: Something a business owns or controls (e.g.
cash, inventory, plant and machinery, etc)
 Liabilities: Something a business owes to someone
(e.g. creditors, bank loans, etc)
 Equity: What the business owes to its owners. 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.
Assets

 Definition
 Asset is a resource controlled by the entity as a result of past events and
from which future economic benefits are expected to flow to the
entity (IASB Framework).
 Explanation
 In simple words, asset is something which a business owns or controls to
benefit from its use in some way. It may be something which directly
generates revenue for the entity (e.g. a machine, inventory) or it may be
something which supports the primary operations of the organization (e.g.
office building).
 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.

Asset Classification Economic Benefit

Machine Non-current Used for the production of goods for sale to customer.

Provides space to employees for administering company

Office Building Non-current
affairs.

Used in the transportation of company products and also for

Vehicle Non-current
commuting.

Inventory Current Cash is generated from the sale of inventory.

Cash Current Cash!

Receivables Current Will eventually result in inflow of cash.

Liabilities
 A liability is an obligation that a business owes to someone and its
settlement involves the transfer of cash or other resources. 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 nature:
 Trade and other payables primarily include liabilities due to suppliers and
contractors for credit purchases. Sundry payables which are too
insignificant to be presented separately on the face of the balance sheet
are also classified in this category.
 Short term borrowings typically include bank overdrafts and short term
bank loans with a repayment schedule of less than 12 months.
 Long-term borrowings comprise of loans which are to be repaid over a
period that exceeds one year. Current portion of long-term borrowings
include the installments of long term borrowings that are due within one
year of the reporting date.
Equity
 Equity is what the business owes to its owners. 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:
 Share capital represents the amount invested by the
owners in the entity
 Retained Earnings comprises the total net profit or
loss retained in the business after distribution to the
owners in the form of dividends.
 Revaluation Reserve contains the net surplus of any
upward revaluation of property, plant and equipment
recognized directly in equity.
Balance

Sheet
Balance Sheet or Statement of Financial Position, is directly related to
the income statement, cash flow statement and statement of changes
in equity.
 Assets, liabilities and equity balances reported in the Balance Sheet at
the period end consist of:
 Balances at the start of the period;
 The increase (or decrease) in net assets as a result of the net profit (or
loss) reported in the income statement;
 The increase (or decrease) in net assets as a result of the net gains (or
losses) recognized outside the income statement and directly in the
statement of changes in equity (e.g. revaluation surplus);
 The increase in net assets and equity arising from the issue of share
capital as reported in the statement of changes in equity;
 The decrease in net assets and equity arising from the payment of
dividends as presented in the statement of changes in equity;
 The change in composition of balances arising from inter balance sheet
transactions not included above (e.g. purchase of fixed assets, receipt
of bank loan, etc).
 Accruals and Prepayments
 Receivables and Payables
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.
The elements of income statement
are:
 Revenue
 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.
 Cost of Sales
 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.
 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.
The elements of income statement
are:
 Administrative Expenses
 Administrative expenses generally comprise of costs relating to the
management and support functions within an organization that are
not directly involved in the production and supply of goods and
services offered by the entity.
 Other Expenses
 This is essentially a residual category in which any expenses that
are not suitably classifiable elsewhere are included.
 Finance Charges
 Finance charges usually comprise of interest expense on loans and
debentures.
 The effect of present value adjustments of discounted provisions
are also included in finance charges (e.g. unwinding of discount on
provision for decommissioning cost).
 Income tax
 Income tax expense recognized during a period is generally
comprised of the following three elements:
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
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.
 END
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