TT233: Financial Statements

Introduction

Financial statements are important to enable users to make economic decisions about an entity but also serve a number of other purposes to include, reporting the performance of the entity under the directors’ stewardship, profits form the basis of tax computations reported to tax authorities, to determine realised profits available for distributions to shareholders, or for lenders to assess compliance with lending covenants.

FRS102 (“the standard”) provides the framework, replacing all current extant FRSs, SSAPs and other standards (“old UK GAAP”), to enable directors to comply with the objectives of financial reporting.

Principles

Before we look at some of the financial reporting requirements of the new standard it is perhaps worth looking at some of the fundamental concepts and principles.

The standard sets out qualitative characteristics to be adopted in preparing financial statements to include understandability of information presented, relevance to the decision making needs of users, reliability, completeness, comparability, substance over form, prudence and materiality.

With regard to the final principle the standard only applies to material items which depends on size (i.e. monetary value) nature (i.e. of an omission) with regard to the surrounding circumstance, that if omitted or misstated could influence the economic decision of a user.

The primary financial statements are very familiar albeit the terminology different, and include:

Statement of financial position

The financial position is the relationship of assets, liabilities and resultant equity. The requirements are not that different from old UK GAAP and the Companies Act format 1 and format 2 requirements continue to apply and indeed a company may present a “balance sheet” which is the Companies Act definition.

The definition of assets and liabilities are similar to old UK GAAP definitions however they also must be probable and measured reliably to be recognised in the financial statements.

Assets and liabilities are measured using historical cost being the amount of cash or cash equivalent paid or fair value of consideration given at the time of acquisition of an asset or the amount of cash or cash equivalent received or fair value of non-cash assets received in exchange for obligations when incurred. Where fair value is the amount for which an asset could be exchanged in an arms-length transaction.

Statement of comprehensive income and income statement

Performance is the relationship of income and expenses. The standard allows two approaches being (i) a single statement of comprehensive income or (ii) an income statement (profit and loss) and a statement of comprehensive income (the first line being the profit or loss and reporting income and expenses not dealt with in the profit and loss).

Again, the Companies Act format 1 (presentation of expenses by function) and format 2 (presentation of expenses by type) requirements continue to apply.

Income comprises both revenue (from ordinary activities) and gains (from income not considered revenue or from enhancement of assets or decrease in liabilities, for example, from increase in value of investment property or rent from an investment property which is not part of ordinary activities).

Special consideration of material and exceptional items relevant to an understanding of performance should be disclosed on the face of the financial statement (but as part of operating activities) for example from the effect of significant provisions or asset impairments.

Statement of changes in equity and statement of income and retained earnings

A separate statement is required where there are equity transactions, for example issue or purchase of own shares, other than dividends.   If the only change in equity arises from the profit and loss and payment of dividends then a single statement of income and retained earnings could be presented.

Statement of cash flows

The standard differs from old UK GAAP in that cash flows are presented under 3 headings being:

  • Operating activities – generally being those cash flows in arriving at profit or loss in the income statement;
  • Investing activities arising from acquisition and disposal of long-term assets;
  • Financing activities being cash flows arising from changes in equity and debt;
  • Separately the effect of foreign exchange movements on cash.

Therefore the allocation of cash flows may require judgement to determine the appropriate presentation.

Cash flows should include both “cash” being cash on hand and demand deposits and “cash equivalents” being short term, highly liquid investments that readily convertible to known amounts cash with insignificant risk of change in value.

Notes to the above financial statements

The Companies Act applies to disclosures required in the notes however the standard seeks to provide a greater understanding of items presented in the primary financial statements above in the following order:

  • Statement of compliance with FRS102;
  • Significant accounting policies, including the measurement basis, and other accounting policies relevant to an understanding of the financial statements;
  • Information presented in the primary statements in the sequence of each item in the financial statement.

Disclosure of “Significant” policies is to avoid disclosing immaterial information. Disclosure of “Other” policies is to ensure users understanding where there is say a choice under a specific policy.

A new requirement of the standard is the requirement to disclose Judgements made by management (apart from those involving estimation) in applying accounting policies and to disclose Estimation Uncertainty concerning the future if there is a significant risk of material adjustment to the carrying value of an asset or liability within the next financial reporting period.

For example, selecting a method of depreciation that reflects the pattern of expected consumption of an asset’s economic benefit is a management judgement whereas assessment of residual value requires estimating the value that could be currently obtained from disposing of the asset if it were of an age or condition expected at the end of its useful life. Estimation of residual value may need to be revised in the next financial year if for example there was a technological advance that impacted on market price of the asset. The assessment of risk would therefore consider the likelihood of a technological advance.

Where prescribed under the standard accounting policies must be adopted. Where not covered policies must conform to the qualitative characteristics of the standard as noted above.

Small entities

The standard is applicable to large and medium-sized entities however small entities, can adopt FRS102. Whilst recognition and measurement requirements of the standard apply in full section 1A of the standard sets out the information to be presented and disclosed in small entities financial statements.

Conclusion

Whilst fundamental principles of accounting continue to apply, as noted above, there are some significant presentational and disclosure differences. However, the concise nature of the new standard together with focus on qualitative characteristics represents an opportunity to review an entities accounting policies most appropriate to its financial position, financial performance or cash flows.

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