Presentation and Disclosure Standards
Weightage: Chapter 4 of ICAI's Paper 1 syllabus, roughly 12 marks. Seven standards grouped by one shared question. AS 3 and AS 20 are computational and heavily examined; the rest are disclosure standards that candidates under-prepare precisely because they look easy.
The question this group answers
What must the reader be told, over and above the numbers?
Every standard in this group takes the figures as given and asks what surrounds them. AS 1 asks which policies produced them. AS 3 asks where the cash went, which the profit figure cannot tell you. AS 17 asks how a diversified business's single set of numbers should be broken apart. AS 18 asks which counterparties were not at arm's length. AS 20 asks what the profit means per share. AS 24 asks which parts of the business are being shut. AS 25 asks how an interim period relates to a year.
Two of them — AS 3 and AS 20 — are genuinely computational and produce long questions. The other five produce short ones and are worth disproportionate marks per hour of study, because most candidates skim them.
AS 1 — Disclosure of Accounting Policies
The shortest standard in the group and the most foundational. Its requirement is simple: all significant accounting policies adopted in preparing and presenting financial statements should be disclosed, and they should be disclosed in one place.
Why one place matters. A reader adjusting for a difference in depreciation method needs to find the policy. If policies are scattered through the notes, comparability is nominal rather than real. AS 1 requires them collected, normally as the first note.
What counts as significant is a matter of judgement, but the standard indicates the areas: methods of depreciation and amortisation, valuation of inventories, valuation of investments, treatment of retirement benefits, recognition of profit on long-term contracts, valuation of fixed assets, treatment of contingent liabilities, translation of foreign currency items, treatment of goodwill, and treatment of expenditure during construction.
The three fundamental accounting assumptions are going concern, consistency and accrual. AS 1's treatment of them is elegant and is examined: if these assumptions are followed, no disclosure is required, because they are assumed. If any is not followed, the fact must be disclosed. Disclosure is required only for the departure, never for the compliance.
The three considerations governing selection of policies are prudence, substance over form, and materiality.
Change in policy. Any change that has a material effect must be disclosed, and the amount by which any item is affected by the change should be disclosed to the extent ascertainable. Where the amount is not ascertainable, wholly or in part, that fact should be stated. A change that has no material effect in the current period but is reasonably expected to have one in later periods must also be disclosed in the period of the change.
AS 3 — Cash Flow Statements
The one substantial computational chapter in this group, and worth real time.
Why it exists
Profit is an accrual number. A company can report handsome profit while running out of money — selling on long credit, capitalising costs, holding growing inventory — and a reader looking only at the profit and loss account will not see it coming. The cash flow statement reports the actual movement of cash and cash equivalents, classified so that the reader can see whether cash came from operations, from selling assets, or from borrowing.
Cash comprises cash on hand and demand deposits. Cash equivalents are short-term, highly liquid investments readily convertible into known amounts of cash and subject to an insignificant risk of change in value. An investment normally qualifies only if it has a short maturity of, say, three months or less from the date of acquisition. Equity investments are excluded, except in limited cases such as preference shares acquired shortly before their redemption date.
The three classifications
Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing. This is the residual category and the most informative one, because cash from operations is the cash the business generates by doing what it does.
Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
Financing activities are activities that result in changes in the size and composition of the owners' capital and borrowings.
The classification of interest and dividends is examined constantly and is worth fixing precisely, because the standard treats financial enterprises differently from others.
For a financial enterprise, interest paid, interest received and dividends received are all operating, because lending and investing are its business.
For other enterprises, interest paid is financing, interest received and dividends received are investing, and dividends paid are financing. Taxes paid are operating unless they can be specifically identified with investing or financing activities.
Direct and indirect methods
The direct method reports major classes of gross cash receipts and gross cash payments — cash received from customers, cash paid to suppliers, cash paid to employees. It is more informative and less commonly used.
The indirect method starts from net profit before tax and extraordinary items and adjusts it back to cash. The adjustments fall into three families, and knowing the families is what makes the method reliable rather than memorised:
- Non-cash items charged or credited to profit are added back or deducted: depreciation added, amortisation added, provision for doubtful debts added, profit on sale of a fixed asset deducted, loss on sale added.
- Items belonging to another activity are removed from operating and shown where they belong: interest paid is added back here and shown under financing, interest and dividend income are deducted here and shown under investing.
- Changes in working capital are then applied: an increase in a current asset consumes cash and is deducted, a decrease releases cash and is added; an increase in a current liability provides cash and is added, a decrease uses cash and is deducted.
The result is cash generated from operations, from which taxes paid are deducted to give net cash from operating activities.
Points that produce marks
Non-cash transactions are excluded from the statement entirely and disclosed elsewhere. Issuing shares to acquire a business, or converting debentures into equity, moves no cash and does not appear.
Foreign currency cash flows are recorded at the exchange rate at the date of the flow. Unrealised gains and losses on translating cash held in foreign currency are not cash flows, but the effect is reported separately to reconcile opening and closing balances.
Extraordinary items are classified as operating, investing or financing as appropriate and disclosed separately.
AS 17 — Segment Reporting
A diversified group's consolidated numbers can conceal more than they reveal. A conglomerate reporting fifteen per cent margins may be running a thirty per cent business and a loss-making one. AS 17 requires the numbers broken apart.
Business segment is a distinguishable component engaged in providing an individual product or service or a group of related products or services, subject to risks and returns different from those of other business segments.
Geographical segment is a distinguishable component engaged in operations in a particular economic environment, subject to risks and returns different from components operating in other economic environments.
Primary and secondary formats. The dominant source and nature of the enterprise's risks and returns determines which is primary. If risks and returns are affected predominantly by differences in products and services, business segments are primary. If predominantly by operating in different countries, geographical segments are primary. Fuller disclosure is required for the primary format.
The identification thresholds are examined and should be memorised. A segment is a reportable segment if:
- its revenue from sales to external customers and from transactions with other segments is ten per cent or more of the total revenue of all segments; or
- its segment result, whether profit or loss, is ten per cent or more in absolute amount of the combined result of all segments in profit or of all segments in loss, whichever is greater in absolute amount; or
- its segment assets are ten per cent or more of the total assets of all segments.
If total external revenue attributable to reportable segments is less than seventy-five per cent of total enterprise revenue, additional segments must be identified until the seventy-five per cent threshold is reached, even if they fail the ten per cent tests.
AS 18 — Related Party Disclosures
A transaction with an unrelated party can be assumed to be at arm's length. A transaction with a related party cannot, and may have been struck on terms no independent party would accept. AS 18's purpose is disclosure, not prohibition — it does not stop related party transactions, it makes them visible.
Related party means parties where one has the ability to control the other or exercise significant influence over the other in making financial or operating decisions.
Control means ownership directly or indirectly of more than one half of the voting power, or control of the composition of the board of directors or corresponding governing body, or a substantial interest in voting power together with the power to direct the financial and operating policies.
Significant influence means participation in the financial or operating policy decisions but not control. A holding of twenty per cent or more of voting power is presumed to give significant influence unless it can be clearly demonstrated otherwise.
Key management personnel are those who have the authority and responsibility for planning, directing and controlling the activities of the reporting enterprise.
Relative, in relation to an individual, means the spouse, son, daughter, brother, sister, father and mother who may be expected to influence, or be influenced by, that individual in dealings with the reporting enterprise.
What is excluded is as examinable as what is included. AS 18 specifically excludes from the definition of related parties: two companies merely because they have a director in common, unless the director can affect the policies of both in their mutual dealings; a single customer, supplier, franchiser, distributor or general agent with whom the enterprise transacts a significant volume of business merely by virtue of the resulting economic dependence; and providers of finance, trade unions, public utilities and government departments in the course of their normal dealings.
Disclosure required where transactions have taken place: the name of the related party, the nature of the relationship, the nature of the transactions, the volume either as an amount or as a proportion, amounts outstanding at the balance sheet date, provisions for doubtful debts from such parties, and amounts written off or written back in respect of debts due from or to related parties. Items of a similar nature may be aggregated unless separate disclosure is necessary to understand the effects.
AS 20 — Earnings Per Share
The second computational standard in this group, and one where the arithmetic is straightforward and the traps are specific.
Basic EPS
The numerator is net profit or loss after tax and after preference dividends, including any attributable tax on those dividends. For cumulative preference shares, the dividend for the period is deducted whether or not it has been declared. For non-cumulative, only the dividend actually declared is deducted. This distinction is examined.
The denominator is a weighted average, weighted by the time the shares were outstanding. Shares issued for cash on 1 October in a year ending 31 March are outstanding for six months and count for half.
Bonus issues, share splits and rights issues are treated differently from cash issues, and this is where marks are won.
A bonus issue or a share split increases the number of shares without increasing resources. There is no new money and therefore no new earning capacity. The shares are treated as if they had been outstanding from the beginning of the earliest period reported, and the EPS of all prior periods presented is restated. Failing to restate comparatives is the classic error.
A rights issue at below market price is a hybrid: partly a genuine issue for cash, partly a bonus. It is handled by computing a theoretical ex-rights fair value per share and deriving an adjustment factor:
Shares outstanding before the rights issue are multiplied by this factor, and prior period EPS is restated.
Diluted EPS
Potential equity shares — convertible debentures, convertible preference shares, options, warrants — may become equity and dilute the existing holders' claim. Diluted EPS reports what EPS would be if they did.
The numerator is adjusted for the after-tax effect of amounts that would no longer be charged: interest on convertible debentures net of tax, dividends on convertible preference shares. The denominator is increased by the weighted average number of shares that would be issued on conversion.
Potential equity shares are included only if they are dilutive — that is, only if including them reduces EPS or increases loss per share. Anti-dilutive potential shares are ignored, and each class must be tested separately in order of dilutive effect, beginning with the most dilutive.
AS 24 — Discontinuing Operations
A reader forecasting future results needs to know which parts of the current results will not recur. AS 24 requires the discontinuing part to be separately visible.
A discontinuing operation is a component of an enterprise that the enterprise, pursuant to a single plan, is disposing of substantially in its entirety, or disposing of piecemeal, or terminating through abandonment; that represents a separate major line of business or geographical area of operations; and that can be distinguished operationally and for financial reporting purposes.
The standard is careful about what does not qualify: gradual or evolutionary phasing out of a product line or class of service, discontinuing several products within an ongoing line of business, shifting production or marketing activities from one location to another, and closing a facility to achieve productivity improvements are all excluded.
The initial disclosure event is the earlier of the enterprise entering into a binding sale agreement for substantially all of the assets attributable to the discontinuing operation, and the board of directors or similar governing body both approving a detailed formal plan for the discontinuance and making an announcement of the plan. Disclosure begins from the period in which the initial disclosure event occurs.
AS 25 — Interim Financial Reporting
An interim period is part of a year, and the central question is whether it should be measured as a standalone period or as a portion of the annual period.
AS 25 adopts the discrete approach in principle: measurements for interim reporting purposes should be made on a year-to-date basis, so that the frequency of an enterprise's reporting does not affect the measurement of its annual results. The practical consequences are examined:
- A cost that does not meet the definition of an asset at the end of an interim period is not deferred merely because it is expected to benefit later interim periods.
- Income tax expense is recognised in each interim period based on the best estimate of the weighted average annual income tax rate expected for the full year.
- A seasonal business does not smooth its revenue across interim periods; revenue received seasonally is recognised when it occurs.
Minimum components of an interim financial report are a condensed balance sheet, a condensed statement of profit and loss, a condensed cash flow statement, and selected explanatory notes.
