What is a Financial Statement?
Q: What guides a preparation of a financial statement?
A: Financial Reporting Standards guides the preparation and presentation of financial statement.
Q: What guides a preparation and presentation of a financial statement in Nepal?
A: Nepal Financial Reporting Standards (NFRS), application guidelines and interpretation notes, issued by Institute of Chartered Accountants of Nepal (NFRS) guides the preparation and presentation of financial statements in Nepal.
Q: What is a financial statement?
A: A basic answer to what is a financial statement is given in IAS 01: Presentation of Financial Statements. It states that “financial statement” are general purpose financial statements and an entity applies the standards in preparing and presenting general purpose financial statements in accordance with Financial Reporting Standards. General purpose financial statements (referred to as ‘financial statements’) are those intended to meet the needs of users who are not in a position to require an entity to prepare reports tailored to their particular information needs.
Q: Who prepares a financial statement?
A: The management of the entity prepares the financial statements.
What is the criteria for recognition of Income, Expense, Asset and Liability?
The Conceptual Framework for Financial Reporting provides the general criteria for recognition of Income, Expense, Asset and Liability:
Income is recognised in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities (for example, the net increase in assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver of a debt payable).
The procedures normally adopted in practice for recognising income, for example, the requirement that revenue should be earned, are applications of the recognition criteria in this Conceptual Framework. Such procedures are generally directed at restricting the recognition as income to those items that can be measured reliably and have a sufficient degree of certainty.
Expenses are recognised in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets (for example, the accrual of employee entitlements or the depreciation of equipment).
Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events; for example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods. However, the application of the matching concept under this Conceptual Framework does not allow the recognition of items in the balance sheet which do not meet the definition of assets or liabilities.
When economic benefits are expected to arise over several accounting periods and the association with income can only be broadly or indirectly determined, expenses are recognised in the income statement on the basis of systematic and rational allocation procedures. This is often necessary in recognising the expenses associated with the using up of assets such as property, plant, equipment, goodwill, patents and trademarks; in such cases the expense is referred to as depreciation or amortisation. These allocation procedures are intended to recognise expenses in the accounting periods in which the economic benefits associated with these items are consumed or expire.
An expense is recognised immediately in the income statement when an expenditure produces no future economic benefits or when, and to the extent that, future economic benefits do not qualify, or cease to qualify, for recognition in the balance sheet as an asset.
An expense is also recognised in the income statement in those cases when a liability is incurred without the recognition of an asset, as when a liability under a product warranty arises.
An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably.
An asset is not recognised in the balance sheet when expenditure has been incurred for which it is considered improbable that economic benefits will flow to the entity beyond the current accounting period. Instead such a transaction results in the recognition of an expense in the income statement. This treatment does not imply either that the intention of management in incurring expenditure was other than to generate future economic benefits for the entity or that management was misguided. The only implication is that the degree of certainty that economic benefits will flow to the entity beyond the current accounting period is insufficient to warrant the recognition of an asset.
A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. In practice, obligations under contracts that are equally proportionately unperformed (for example, liabilities for inventory ordered but not yet received) are generally not recognised as liabilities in the financial statements. However, such obligations may meet the definition of liabilities and, provided the recognition criteria are met in the particular circumstances, may qualify for recognition. In such circumstances, recognition of liabilities entails recognition of related assets or expenses.
An item that meets the definition of an element should be recognised if:
a. it is probable that any future economic benefit associated with the item will flow to or from the entity; and
b. the item has a cost or value that can be measured with reliability.
In assessing whether an item meets these criteria and therefore qualifies for recognition in the financial statements, regard needs to be given to the materiality considerations and Qualitative characteristics of useful financial information. The interrelationship between the elements means that an item that meets the definition and recognition criteria for a particular element, for example, an asset, automatically requires the recognition of another element, for example, income or a liability.
Probability of flow of economic resources
The concept of probability is used in the recognition criteria to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity. The concept is in keeping with the uncertainty that characterises the environment in which an entity operates. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the financial statements are prepared. For example, when it is probable that a receivable owed to an entity will be paid, it is then justifiable, in the absence of any evidence to the contrary, to recognise the receivable as an asset. For a large population of receivables, however, some degree of non-payment is normally considered probable; hence an expense representing the expected reduction in economic benefits is recognised.
Reliability of measurement
The second criterion for the recognition of an item is that it possesses a cost or value that can be measured with reliability. In many cases, cost or value must be estimated; the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. When, however, a reasonable estimate cannot be made the item is not recognised in the balance sheet or income statement. For example, the expected proceeds from a lawsuit may meet the definitions of both an asset and income as well as the probability criterion for recognition; however, if it is not possible for the claim to be measured reliably, it should not be recognised as an asset or as income; the existence of the claim, however, would be disclosed in the notes, explanatory material or supplementary schedules.
So disclosure in financial statement amouts to legally owning an asset or owing a liability?
It is worth noting the following things before drawing a conclusion:
- “Financial Statement” as the name suggests is a statement. A statement of facts derived from activities, contracts, legal titles, assumptions and etcetra. It isn’t infact itself a evidence of anything. Some other workings, contracts, evidence, titles, assumptions provides the basis for the disclosure in the statemnt. It could as well be viewed as secondary information.
- It is also worth noting that the recognition criteria in the financial statement is not always parallel to the legal title or legal liability. The framework defines asset in terms of control rather than ownership. While control is generally evidenced through ownership, this may not always be the case. Therefore, an asset may be recognized in the financial statement of the entity even if ownership of the asset belongs to someone else. This illustrates the use of Substance Over Form whereby the economic substance of the transaction takes precedence over the legal aspects of a transaction in order to present a true and fair view.
- As stated above, an item is recognised if it is probable that any future economic benefit associated with the item will flow to or from the entity; Meaning, the recognition criteria involves recognizing the probability of an event. This is a subjective item and depends on the view, research, discretion and criteria employed by the management.
- As stated above, the item subject to recognition, has a cost or value that can be measured with reliability. One person’s estimation of reliability of an asset may not be viewed as another person’s liability, the timing, nature and extent of judgement and facts involved in the estimation could also be significant. Thus, when personal accounts are involved, it is not always certain, two entities mutually reflect their corresponding assets and liabilites, as there could be difference in perception of reliability of estimates, impairment policy and assumptions