Assets - Liabilities = Capital
The equation simplifies down to three items presented on the balance sheet. Operating surplus, as presented in the income statement is the difference between the capital as at the beginning of the accounting period and that at the end of the accounting period, adjusted for contribution from and distribution of profit to equity participants.
Operating surplus is the amount, distribution of which to equity participants will not impoverish the company.
The amount of capital on the balance sheet depends on the recognition and measurement of assets and liabilities.
Measurement of capital
Capital can be measured either in physical terms or in financial terms. Maintenance of physical capital or operating capital ensures that the business is no worse position in terms of the physical productive capacity at the end of the accounting period than it was at the beginning. For example, an entity starts the accounting period with 100 units of inventory which have cost of Rs. 50 per unit. Therefore, the opening inventory is valued at Rs. 5,000 represented by capital of the same amount. During the period the inventory is sold at Rs 7,000. At this date it will cost Rs. 5,600 to buy a further 100 units of identical items. The surplus generated is (Rs. 7,000 - Rs. 5,600) or Rs. 1,400.
When capital is measured using the concept of financial capital (nominal) maintenance, the profit for the period is (Rs 7,000 - Rs 5,000) or Rs 2,000. An alternative concept is measure financial capital in real terms. For example, if the price index at the beginning was 100 and that at the end of the accounting period was 110, the profit for the period is [Rs 7,000 - Rs 5000× (110/100)] or Rs 1,500.
As articulated in various pronouncements by accounting standard setters, contemporary accounting practice is to use the concept of financial capital (nominal) maintenance. However, in practice, assets and liabilities in the balance sheet are measured using mixed attributes. Some items are measured at historical cost, some are measured at fair value and others are measured at lower of cost and net realisable value. This leaves investors confused as to how capital is measured in financial statements.
Relevance and reliability
Pronouncements of accounting standard setters articulate that ‘decision usefulness’ is the overriding principle for the preparation and presentation of financial statements. Decision usefulness is viewed from the perspective of investors (equity participants and debt holders), who are the primary users of financial statements. Equity participants use ‘financial statements’ as the primary source of information for valuation of companies. Debt holders use the same to assess credit risk. Information is relevant if it has the potential to improve the valuation of companies or to improve the assessment of credit risk. Therefore, information that has the potential to improve the forecasting of future cash flows (amount, timing and uncertainty) and to confirm past forecasts is relevant to investors.
Standard setters trade off between relevance and reliability. Each measurement attribute has unique trade off in the context of different classes of assets and liabilities. For example, for most items of assets and liabilities, historical cost is more reliable but it loses relevance in subsequent measurement of assets and liabilities. Fair value, particularly when it is not based on observable prices in an active market, is less reliable but it is considered more relevant than the historical cost. The present focus is more on relevance than on reliability. Accounting standard setters (e.g., IASB) are now moving from the historical cost based measurement to fair value (or current value) measurement of assets and liabilities.
Business model
It has been argued by preparers of financial statements and academia that companies should have sufficient flexibility in formulating accounting policy so that numbers in financial statements reflect the business model being adopted by the company. At theoretical level, no strong argument can be built against this proposition. However, in practice, neither standard setters nor users of financial statements favour allowing this flexibility. The general perception is that if flexibility is allowed, companies will misuse it to formulate accounting policies which will facilitate smoothing of profit and earnings management.
It appears that standard setters are in a state of confusion. While arguing in favour of reducing allowable alternative accounting principles and methods, they allow alternative measurement for items for which no alternative was available earlier. For example, International Financial Reporting Standard (IFRS) provides a choice as regards measurement of property, plant and equipment (PPE). An entity is allowed to use either the cost model or the fair value model (revaluation model) in measuring items of PPE. It is difficult to understand how the use of fair value of in measuring items of PPE improves the relevance of profit and other information provided in financial statements, particularly for a going concern, business of which is surrounded by uncertainties. Information on fair value of items of PPE does not have the potential to improve cash flow forecast. Another example is the accounting standard on revenue recognition. IFRS provides inadequate guidance on how revenue should be recognised when the business model is complex, for example in telecommunication industry. IASB and FASB are working together to formulate a comprehensive standard on revenue recognition, but we are not sure if the new standard will reduce flexibility. In many other cases, such as in respect of accounting for intangibles and financial instruments, accounting standards do not allow any flexibility.
True and fair override
It may be argued ‘true and fair’ override, which allows deviation from accounting principles and methods stipulated in accounting standards, provides necessary flexibility. When a company deviates from accounting principles and methods stipulated in accounting standard, it has to explain how the application of those accounting principles and methods would distort the true and fair view. The task is onerous and most companies avoid deviation from accounting standards. Therefore, such deviations are rare and it is questionable if, in reality, the ‘true and fair override’ provides the necessary flexibility.
Tension between regulators and investors
Although investors are primary users of financial statements, regulators also use information in financial statements extensively. There is a palpable tension between regulators and standard setters. For example, regulators of financial institutions often argue against fair value (or mark-to-market) measurement of all financial instruments because it creates problems in regulating and managing capital adequacy. Similarly telecom regulators do not prefer deferment of revenue because that has implication in determining and recovering licensing fees. Many regulators believe that financial statements targeted at investors are not useful for their purpose.
Conclusions
It is quite clear that net profit determined using principles and methods stipulated in IFRS is not the divisible surplus as implied in the concept of capital maintenance. Therefore, local laws and regulations provide rules for determining divisible surplus. Moreover, the present tension among preparers, regulators and standard setters might lead to issuance of more than one set of financial statements by companies. Regulators might issue accounting rules for the preparation of financial statements for submission to them and companies will be tempted to issue proforma financial statements prepared using accounting policies formulated to reflect business model.
