Limited Liability Company

Limited liability:

Liability of investors in equity is limited to their commitment to contribute to the capital. A company can sue or be sued in its own name.
Existence of a company is not affected by change in shareholders Signature of the company
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Juridical person

Perpetual succession

Common seal:

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Classification of Limited Liability Companies

Private limited company

Prohibition on inviting public to contribute to equity capital Prohibition on having more than 50 members (equity share holders) Low compliance cost

Public limited company Listed company

Significant disclosure requirements High compliance cost

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Governance of Public Limited Company

As per law

Shareholders use their voting rights to elect directors. The board of directors appoints the CEO. The board of directors provides direction to the company and monitors the CEO. The incumbent management elects its nominees to the board.
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In practice

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Capital

Capital represents the amount invested in the business. Capital provided to the company belongs to the company. Capital providers provide capital in exchange of their claim on the assets (economic resources).

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Types of Capital

Debt capital (Loan Fund)

The company has an obligation to repay the capital and to pay return on capital as per agreed terms. If, the company fails to meet its commitment, debt holders have the right to take legal recourse for winding up the company. Assets of the company are sold on winding up of the company and the debt and outstanding return on capital is settles to the extent possible. Investment in debt capital is exposed to credit risk
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Types of Capital (Contd.)

Equity Capital

Equity capital represents owners capital. It is the residual interest in the assets of the company after deducting all its liabilities. Equity is the total of contributed capital and retained profit.

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Types of Capital (Contd.)

Net profit, that is profit after deduction of interest and tax expense belongs to shareholders There is prohibition on distribution of contributed capital. This is to protect the interest of creditors. The company has unconditional discretion to distribute the profit to shareholders. Investment in equity is exposed to business risks.

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Balance sheet

Sources of Funds (Claims on economic resources)

Equity (Contributed capital + Retained profit): Residual claim Rs. 100,000 Debt (Loan Fund) Rs. 100,000 Rs. 200,000

Application of Fund
Economic resources (Assets) Figures are hypothetical

Rs. 200,000

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Equity: Return of Capital and Return on Capital

Distribution of dividend is at the discretion of the company. Contributed capital cannot be returned. Shareholders can sell shares to others in the capital market. Return to shareholders = [D1+(P1 P0)] P0 P1 depends on investors expectation about the future performance of the company
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Equity: Return of Capital and Return on Capital

Assume share purchased at Rs. 100. After a year market price Rs. 120. Dividend received Rs.5 Return to shareholders = [5+(120 100)] 100 = 25%

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Purpose of Financial Statements

The primary purpose is to provide financial information that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers. The secondary objective is to provide information to evaluate management in its stewardship responsibilities.

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Complete Set of Financial Statements

Balance sheet

It provides information on the financial position of the company at the end of the accounting period It provides information on the performance of the company during the accounting period It reconciles the equity as at the beginning of the period and the same as at the end of the period.
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Profit and loss account

Statement of changes in equity

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Complete Set of Financial Statements (Contd.)

Statement of cash flows

It provides information on cash inflows and outflows during the accounting period It summarise accounting policies and provide explanatory information.

Notes to accounts

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Entity Convention

According to the entity convention all transactions are recorded from the point of view of the entity itself and not from the perspective of other stake holders (e.g. owners). Therefore, an entity records the amount due to owners as claims (equity capital) on assets it controls.

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Money Measurement Convention

According to the money measurement convention all transactions and events should be measured in terms of money. Current accounting rules require companies to measure transactions and events at nominal amount, without any adjustment for inflation.

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Going Concern Convention

Assets and liabilities at the balance sheet date are measured with the assumption that the entity is a going concern, unless there is evidence to suggest otherwise. An entity is a going concern if, it is not expected to close down or curtail the scale of operation, intentionally or otherwise, in the foreseeable future.

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Going Concern (Contd.)

This convention is important because entities hold assets that are valuable to the entity only and have relatively significantly low value to others. If the company ceases to exist or curtails its activity level materially, the value is lost. A different measurement base may be used if the company ceases to be a going concern.

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Cost Convention

Traditionally, financial statements are prepared and presented based on historical cost. Under historical cost system, assets are recorded at acquisition cost and liabilities are recorded at the amount of proceeds received in exchange for an obligation. The current accounting practice is to use mixed attributes (e.g. historical cost and fair value) to measure assets and liabilities.
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Realisation Convention

The realisation convention is closely related to the cost convention. According to this convention, an asset should be recorded at historical cost and any change in value should be recognised at the time the firm realises or disposes of the asset. An unrealised gain should not be recognised.

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Accrual Convention

According to the accrual convention, income is recognised as it is earned and expenditure is recognised, either as an asset or as an expense, when it is incurred. In other words income is recognised when the right to receive cash arises and expenditure is recognised when the obligation to pay cash arises without waiting for actual receipt or payment of cash.
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Matching Convention

According to the matching convention, income and expenses should be matched, to the extent possible. In past, focus was on the profit and loss account, and matching principle was the overriding principle. However, with shift of focus from the profit and loss account to balance sheet, matching principle is no more the overriding principle.
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Periodicity Convention

The indefinite life of a firm is subdivided into smaller time unit to measure and understand its performance and financial position. The convention is to issue complete set of financial statements at an interval of 12 months. publicly traded companies are required to publish abridged financial statements on quarterly basis.
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Conservatism Convention

According to the conservatism convention, in a situation of uncertainty, it is preferable to understate profit and assets rather than overstating the same. The operating rules are:

An entity should not anticipate income and should provide for all estimated losses; and Face with the choice between two methods of valuing an asset, the accountant should choose a method that leads to the lesser value.
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Fundamental Qualitative Characteristics

Relevance Faithful representation

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Relevance

Information is relevant when it influences economic decisions of users by helping them to evaluate past, present or future events or confirming or correcting their past evaluations.

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Relevance: Materiality

The relevance of a financial statement gets enhanced if material items are shown separately. Information is material if its misstatement or omission could influence the economic decisions of users taken on the basis of the financial statements. Materiality is assessed taking into account both quantitative and qualitative factors.
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Faithful Representation

Faithful representation is attained when the depiction of an economic phenomenon is complete, neutral, and free from material error. Financial information that faithfully represents an economic phenomenon depicts the economic substance of the underlying transaction, event or circumstances, which is not always the same as its legal form.
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Enhancing Qualitative Characteristics

Enhancing qualitative characteristics are complementary to the fundamental qualitative characteristics. Enhancing qualitative characteristics distinguish more useful information from less useful information. The enhancing qualitative characteristics are comparability, verifiability, timeliness and understandability.
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Understandability

Understandability implies that information is presented in a manner that a user can comprehend the meaning easily. Understandability is enhanced when information is classified, characterised and presented clearly and concisely. Comparability also enhances understandability.

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Understandability (Contd.)

It is assumed to that users have a reasonable knowledge of business and economic activities and have financial and accounting literacy. In making decisions, users are expected to review and analyse the information with reasonable diligence. It is incorrect to assume that financial statements are aimed at retail investors.
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Constraints in Financial Reporting

Materiality Cost

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Materiality

Information is material if its omission or misstatement could influence the decisions that users make on the basis of an entitys financial information. The materiality of an item should be assessed in terms of its nature and amount.

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Cost

Financial reporting imposes costs; the benefits of financial reporting should justify those costs. Assessing whether the benefits of providing information justify the related costs will usually be more qualitative than quantitative.

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Cost (Contd.)

In applying the cost constraint standard setters assess whether the benefits of reporting information are likely to justify the costs incurred to provide and use that information. When making this assessment, they consider whether one or more qualitative characteristics might be sacrificed to some degree to reduce cost.
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True and Fair View

Generally financial statements provide a true and fair view if

It is free from any material error and bias; It is prepared using the appropriate accounting policy and applicable accounting standards; and It is prepared in the format prescribed by the regulator or in absence of a prescribed format it is prepared in a manner that facilitates analyses of the financial position and the performance of the reporting enterprise.
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Internal Control

Internal control is a process designed to provide reasonable assurance regarding achievement of objectives in the following categories:

Effectiveness and efficiency of operations Reliability of financial reporting Compliance with applicable rules and regulations

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Internal Control

Internal control is a process, which helps an enterprise to achieve its objectives and avoid pitfalls and surprises in its operation. However, it cannot ensure success or even survival, because it cannot change inherently poor managers into good managers and cannot change variables (in the business environment), which affect the performance of the enterprise, but are beyond the control of the management.
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Internal Control: Control environment

Control environment provides the discipline and structure and it is the foundation of other components of internal control. Control environment factors include integrity, ethical values and competence of people; managements philosophy and operating style; the way management assigns authority and responsibility, and organizes and develops people; and the attention and direction provided by board of directors.
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Risk Assessment

Risk assessment is the identification and analysis of relevant risks to achievement of enterprises objectives. It forms the basis for determining how the risks should be managed. Internal control provides mechanisms to identify and deal with special risks that arise from a change in the business environment including technological environment and socio-political environment.
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Internal Control: Control Activities

Control activities are the policies and procedures that ensure that management activities are carried out efficiently and effectively. Control activities occur throughout the organisation, at all levels and in all functions. They include approvals, authorisations, verifications, and reconciliations, reviewing of operating performance, security of assets and segregation of duties.
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Internal Control: Information and Communication

Pertinent information should be identified, captured and communicated in a form and timeframe that enable people to carry out their responsibilities. The information and communication system should deal with internal data and external activities, events, and conditions relevant to the business. Information and communication should flow seamlessly across, down and up the organisation.

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Internal Control: Monitoring

Regular monitoring is essential to ensure that the internal control system is adequate and operating effectively.

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Internal Audit

Independent, objective assurance and consulting activity designed to add value and improve an organisations operations. It helps an organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance process.

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External Audit

The auditor of financial statements provides a reasonable assurance (and not absolute assurance) that financial statements provide true and fair view of the financial position and operating results of the enterprise. Auditors unqualified opinion should not be viewed as an assurance as to the future viability of the enterprise or the efficiency or effectiveness with which the management has conducted the affairs of the enterprise.
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Accounting Policy

Accounting policy refers to the specific accounting principles and the methods of applying those principles adopted by an entity in the preparation and presentation of financial statements. Selection of the accounting policy is not left to the individual firms. A firm selects accounting principles and methods from the alternatives provided in accounting standards.
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Accounting Standards

Accounting standards are regulations that govern accounting policy of companies. In India, the Institute of Chartered Accountants of India (ICAI) issue accounting standards and the government makes it mandatory for limited liability companies through notification.

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International Financial Reporting Standards

IFRSs are issued by the International Accounting Standards Board (IASB). More than 100 countries have adopted IFRS. India has decided to adopt IFRS from April 1, 2011 European Union (EU) has adopted IFRS from the year 2005. USA has prepared a road map for adoption of IFRS from the year 2014.
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Events Occurring After the Balance Sheet Date

To a significant extent, financial reporting information is based on estimates, judgements and models of the financial effects on an entity of transactions and other events and circumstances that have happened or that exist, rather than on exact depictions of those effects.

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Events Occurring After the Balance Sheet Date

Management develop its perception about the economic consequences of transactions and other events based on information collected by it using reasonable efforts. Information gathered by it is likely to be incomplete.

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Events Occurring After the Balance Sheet Date

Therefore, management takes into consideration additional evidence (about the conditions at the balance sheet date) provided by events unfolded after the balance sheet date but before approval by the board of directors for issuance. Events that provide the additional evidence are called adjusting events.

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Non-adjusting Events

Events that are indicative of conditions that arose after the balance sheet date are nonadjusting events. Assets and liabilities should not be adjusted for non-adjusting events. Companies disclose non-adjusting events, if material, in the financial report, usually in the board of directors report. The disclosure provides information about the nature of the event and estimate of its financial effect.
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Non-adjusting Events:Examples

Major business combination after the balance sheet date; Announcing a plan to discontinue an operation; Major purchase or disposal of assets, or acquisition of major assets by the government; Commencement of a major restructuring; Major change in exchange rates; Major change in tax rates; Issuance of significant guarantees on behalf of third parties; and
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