The Conceptual

Framework
1  
U N I T

Learning Objectives
The objective of this chapter is to provide an
understanding of the corporate financial reporting
environment and the basic principles of financial
reporting. After reading this chapter, you will
develop understanding of the following:

How transactions and other events change

assets, liabilities and net worth of an entity

Difference between bookkeeping and
accounting

The role of Generally Accepted Accounting

Principles (GAAP) and accounting standards
in bringing comparability of financial
statements and consistency in applying
accounting principles and methods from year
to year

The purpose and content of balance sheet

and statement of profit and loss

Difference between equity capital and debt

capital

Firm structures, including limited liability

company and limited liability partnership

Importance of financial reporting

Financial Accounting
INTRODUCTION
Motivation for Learning Financial Accounting
NOTES
Every business entity issues financial statements periodically, at least annually. If you
visit the website of any listed company, in the section ‘investors’, financial statements for
the current period and earlier periods are available. This is so because anyone who has
an interest in the company wants to know the sustainability and the growth potential
of the company, and financial statements provide the information that is used as the
starting point to assess the same. If you aspire to be an entrepreneur after completing
Management Programme, you should have a clear understanding of how financiers (e.g.,
venture capitalist) and others use information given in financial statements to evaluate the
risks of funding of your venture or doing business with you. If, you want to make a career
in the finance sector (e.g., career as a financial analyst with a financial institution) you
must be proficient in using information provided in financial statements. If you decide to
make a career in non-finance sector (e.g., manufacturing and service sectors), you will be
required to analyse financial statements of the partners (e.g., vendors and customers) and
competitors of the company that you will serve in order to evaluate their sustainability
and growth, and strategy. Therefore, it is no surprise that every Management Programme
includes a compulsory course on Financial Accounting.
Although, like any other technical subject, financial accounting has its own jargons,
the accounting principles and methods are logical and flow from business transactions.
Therefore, it is not difficult to learn financial accounting. Financial accounting being a
business language, learning it is similar to learning any other language, which requires
learning vocabulary and grammar.
The accounting principles and methods discussed in this book are applicable to not-
for-profit organisations, with modifications.

NATURE OF FINANCIAL ACCOUNTING

Nature of Transactions and Other Events

Transaction refers to exchange of goods, services and funds. A transaction changes the
assets or/and liabilities. Assets are economic resources that is controlled by an entity (an
individual or an organisation). A liability is the amount that the entity owes to outsiders.
Outsiders, in case of an organisation, refers to entities other than owners. For example, you
have `1,00,000 and that is the only asset that you own. You buy a refrigerator on credit
for `40,000. The value of your assets has gone up to `1,40,000 and you have assumed a
liability of `40,000. The composition of your assets has also changed. Events, other than
transactions, also change assets and liabilities. For example, you were enjoying dinner with
your family in a fine dining restaurant in an upmarket close to your residence. A baby in
your family spoiled the costly attire of a lady sitting in the next table. You promised her to
compensate for the loss, which is estimated at `50,000. You have the reputation of always
honouring your commitments. Therefore, by promising the lady to compensate for the loss,
you have assumed a liability. Similarly, you may lose wealth due to fire in the premises
in which you kept your furniture or burglary in a bank in which the burglar emptied the
vault in which you kept your gold ornaments.
In effect, transactions and other events that affect your assets and liabilities might
change the value of your wealth. You measure your wealth by deducting the amount of
your liabilities from the value of your assets. Your wealth had reduced by `50,000 when
you promised the lady to compensate her for the loss estimated at `50,000.
Some transactions reduce assets or increase liabilities. For example, you pay `20,000
for a dinner hosted by you to your close friends to celebrate completion of your MBA
Programme successfully. This will reduce your assets (cash), if you paid the bill in cash
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2 Material
or increase your liabilities, if you paid the bill using your credit card. In any case, your The Conceptual
wealth is reduced by `20,000. Framework
A transaction or event does not change your wealth if, it equally affects your assets
and liabilities, wealth is neither reduced nor increased. For example, if you purchase a NOTES
refrigerator on credit, your wealth remains unchanged.
In financial accounting (hereafter, accounting) jargon, the term ‘net worth’ is used to
refer to that part of the wealth of the owners, which is invested in the business entity.
The terms net worth and equity are used interchangeably. The term net worth has also
come in common use. For example, we say ‘high net worth individuals’ to refer to affluent
individuals.

Self-Test Questions
Self-test question 1.1
Fill in the blanks:
(i) The assets that S Limited (SL) owns is valued at `10,00,000 and the amount that it owes
to others (liabilities) is `2,00,000. The net worth of the company is `……………………. 8 lac
(ii) Preetam purchases an apartment for `2 crore. He partly finances the transaction by taking
0
a bank loan of `1.5 crore. Preetam’s net worth increases by `…………………………
(iii) Neetu paid her college fees of `15 lakhs. This…………………….. reduced her net worth by
`15 lakhs. [Choose the right word from reduced and increased].
Self-test question 1.2
Indicate whether the following statements are true (T) or false (F):
(i) Transactions necessarily change net worth.
(ii) Events other than transactions might affect assets and/or liabilities.
(iii) Increase in liabilities without change in the value of assets reduces net worth.
(iv) Credit purchase of an asset reduces net worth.
(v) Cash purchase of an asset increases net worth.

Bookkeeping and Accounting

Bookkeeping
Bookkeeping is the record keeping aspect of accounting. It is recording the economic effect
of transactions and other events on the assets, liabilities, and net worth of an entity. It is
the financial information infrastructure of an entity. Accurate bookkeeping facilitates day-
to-day operations and preparation of financial statements.

Accounting
Accounting refers to the process of preparation and presentation of financial statements
based on data accumulated, organised and stored through the bookkeeping process. It is
said that accounting begins where bookkeeping ends. However, with the increase in the
use of computer and accounting software (e.g., Tally), the distinction between bookkeeping
and accounting has blurred. The accounting software, which records the transactions
and events and produces financial statements in the given format, is extensively used by
small and mid-size entities. In large entities accounting is concerned with issues related
to formulation of accounting policy, measurement of assets and liabilities, and disclosures.
Measurement often involves estimation, which requires developing perceptions about the
economic consequences of complex transactions and events.

Accounting policy
Accountants formulate accounting policy. Accounting policies are the specific principles, Self-Learning
bases, conventions, rules and practices applied by an entity in preparing and presenting Material 3
Financial Accounting financial statements. For example, an entity formulates accounting policies on how stock of
finished goods at the end of the accounting period will be measured, and at what point in
the process of selling goods, revenue will be recognised and measured. Accounting policies
NOTES must conform to Generally Accepted Accounting Principles (GAAP).

GAAP
Generally Accepted Accounting Principles (GAAP) are codified in accounting
standards, which are issued by a designated body. In India, the Institute of
Chartered Accountants of India issues accounting standards. Accounting standards control
accounting policies. This ensures comparability of financial statements of different entities
operating in the same industry, as all the entities are required to apply the same accounting
principles and methods. Entities are not permitted to change accounting policies voluntarily.
Therefore, they apply the same accounting principles and methods consistently from year to
year. This ensures that financial statements for different years are comparable. Mandatory
application of GAAP facilitates analysing the performance and financial position of the
same entity over number of years and to compare the performance and financial position
of peers.

Accounting period and fiscal year

Usually, complete set of financial statements are prepared annually. The annual period
is called fiscal year. In India, companies are required adopt the fiscal year that begins on
April  1 and ends on March 31 of the next year. The fiscal year 2017–2018 refers to the
period from April 1, 2017 to March 31, 2018. Listed companies are required to prepare
abridged financial statements on quarterly and half-yearly basis. The generic term
‘accounting period’ is used to refer to the period for which the financial statements are
prepared.

Self-Test Questions
Self-test question 1.3
Indicate whether the following statements are true (T) or false (F):
(i) The boundary between bookkeeping and accounting has been blurred with the extensive
use of computer and accounting software.
(ii) In accounting, measurement of assets and liabilities does not involve estimation.
(iii) Net worth of an entity is affected by the management’s perception about the economic
consequences of transactions and other events.
(iv) Generally accepted accounting principles (GAAP) codified in accounting standards control
accounting policy.
(v) The terms ‘comparability’ and ‘consistency’ are used interchangeably.

Complete Set of Financial Statements

Basic financial statements are balance sheet and the statement of profit and loss. A complete
set of financial statements also includes statement of changes in equity, statement of cash
flows, and notes to accounts.

Balance sheet
Balance sheet provides information on assets, liabilities and equity of the entity at the
balance sheet date. Equity is viewed as the claim of owners on the assets of the entity.
Liabilities are viewed as claims of outsiders on the assets of the entity. As per the
contemporary generally accepted accounting principles (GAAP), all assets and liabilities do
not qualify for recognition in the balance sheet. For example, core competence (accumulated
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4 Material
institutional knowledge and unique processes), which provides competitive advantage to The Conceptual
a business firm is not recognised in the balance sheet. Intangible assets, except computer Framework
software, developed internally are not recognised in the balance sheet.
Increase in equity, adjusted (reduced/increased) for fresh investment and/or withdrawals NOTES
by owners, measures the profit or loss for the accounting period.
Recognition refers the process of including an item in basic financial statements (balance
sheet and statement of profit and loss). It is the depiction of the item in words and monetary
terms.

ILLUSTRATION 1.1 Profit or Loss

The equity of James Limited (JL) as at March 31, 2017 was `5,00,000. During 2017–18, owners
introduced fresh equity capital of `2,00,000. Equity as at March 31, 2018 was `9,00,000.
Required
How much profit JL earned during the accounting period 2017–1018?
Solution
During the accounting period 2017–18, JL earned a profit of (`9,00,000 – 2,00,000 – 5,00,000)
or `2,00,000.

Statement of profit and loss

Statement of profit and loss presents the operating result of the entity for the accounting
period covered by the statement. It details how the entity earned profit or incurred loss.
It provides information on income, expenses incurred to earn the income, finance cost
(e.g., interest on borrowings) and tax expense. Income of entities primarily comes from
revenue. Revenue is income arising in the course of an entity’s ordinary activities. For
example, revenue of an entity that operates in non-finance sector is the income from sale
of goods and services. Examples of expenses are cost of goods that were sold during the
accounting period, salaries and wages, travelling expenses, communication expenses and
electricity charges. Excess of total income over total expenses, including finance cost and
tax expense, is profit. Excess of total expenses, including finance cost and tax expense,
over total income is loss.
The term net income is often used to refer to profit. Negative net income represents loss.
Statement of profit and loss is discussed in detail in Chapter 4.

Statement of changes in equity for the period

Statement of changes in equity reconciles the equity as at the beginning of the accounting
period and the same as at the end of the accounting period.
Statement of changes in equity is discussed in detail in Chapter 3.

Cash flow statement

Cash flow statement presents cash inflows and outflows during the accounting period and
reconciles opening (at the beginning of the accounting period) and closing (at the end of
the accounting period) cash balances. It establishes a link between balance sheet and the
statement of profit and loss.

Notes to accounts
Notes provide summary of accounting policy; narrative descriptions or disaggregations of
items presented in balance sheet, changes in equity, statement of profit and loss and cash
flow statement; and information about items that do not qualify for recognition in those
statements.

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Material 5
Financial Accounting
Self-Test Questions
Self-test question 1.4
NOTES Fill in the blanks:
(i) The equity of Kasturi Limited (KL) as at March 31, 2017 was `6,00,000. During 2017–18,
owners introduced fresh equity capital of `2,00,000 and withdrawn `50,000. Equity as
at March 31, 2018 was `9,00,000. Profit earned by KL during the year 2017–18 was
`……………
(ii) The terms equity and …………………….are used interchangeably.
(iii) …………………assets generated internally are not recognised in the balance sheet.
(iv) Income from sale of goods and services by an entity operating in a non-finance sector is
called……………………….
Key Terms (v) The process of including an item in basic financial statements is called………………
Accounting,
Self-test question 1.5
accounting period,
accounting policy, Indicate whether the following statements are true (T) or false (F):
accounting standard, (i) The terms ‘income’ and ‘net income’ are used interchangeably.
asset, balance sheet, (ii) Computer software created internally is not recognised in the balance sheet.
bookkeeping, equity, (iii) Profit is the excess of total income over total expenses, excluding tax expense.
fiscal year, GAAP, (iv) Cash flow statement reconciles opening cash balance and closing cash balance.
liability, loss, net (v) Note to accounts is not a component of the complete set of financial statements.
income, net worth,
profit, recognition,
revenue, and SUMMARY
transaction
Transaction refers to exchange of goods, services and funds. A transaction changes the assets
or/and liabilities and might change net worth. Similarly, some events, other than transactions
change the assets or/and liabilities and might change net worth. A transaction or event does
not change the net worth if, it equally affects assets and liabilities, wealth is neither reduced
nor increased.
Bookkeeping is the record keeping aspect of accounting. Accounting refers to the process
of preparation and presentation of financial statements based on data accumulated, organised
and stored through the bookkeeping process. In large entities accounting is concerned with
issues related to formulation of accounting policy, measurement of assets and liabilities, and
disclosures. Measurement often involves estimation, which requires developing perceptions about
the economic consequence of complex transactions and events.
Accountants formulate accounting policy. Accounting policies must conform to Generally
Accepted Accounting Principles (GAAP), which are codified in accounting standards. This ensures
comparability and consistency.
Basic financial statements are balance sheet and the statement of profit and loss. A complete
set of financial statements also includes statement of changes in equity, statement of cash flows,
and notes to accounts.

Use of Information in Balance Sheet and

CASE STUDY 1.1
Statement of Profit and Loss
Santosh started a fashion business (named it Santosh & Juthika, in short SJ) on April 1, 2015
with investment in cash of `10,00,000. SJ maintains accounting books to record transactions and
other events that would affect its assets and liabilities, and consequently, equity. It did well in
2015–16. Its equity during the period increased to `15,00,000. SJ’s balance sheet as at March
31, 2016, shows its assets and liabilities were `20,00,000 and `5,00,000, respectively. It had
Self-Learning no borrowing on that date. SJ’s statement of profit and loss for the year 2015–16 shows that
6 Material
the revenue for that year was `45,00,000 and expenses totalled `40,00,000. The net profit was The Conceptual
(`45,00,000 – `40,00,000) or `5,00,000. Assume tax expense was zero. Framework
SJ applied for loan from Small Industries Development Bank of India (SIDBI) for setting
up a small manufacturing unit. SIDBI sanctioned loan of `15,00,000 and disbursed the same NOTES
on April 1, 2016. As per the terms of the loan, interest at the rate of 10 percent is payable
annually on March 31 every year and the loan is repayable in five equal installment starting
from March 31, 2018.
SJ’s balance sheet as at March 31, 2017, shows its assets and liabilities were `45,00,000
and `20,00,000, respectively. Liabilities include outstanding balance (`15,00,000) of the amount
borrowed from SIDBI. SJ’s statement of profit and loss for the year 2016–17 shows that the
revenue for that year was `90,00,000 and expenses, including tax expense and finance cost,
totalled `80,00,000. The finance cost for the year was (`15,00,000 × 0.10) or `1,50,000. The
net profit was (`90,00,000 – `80,00,000) or `10,00,000. Assume tax expense was zero.
Santosh is scouting around for an angel investor who will invest in the equity capital of SJ.
Angel investors are high net worth (HNI) individuals who have high risk appetites and look for
opportunities to invest in start ups.
Question
What information in balance sheets and statements of profit and loss of SJ is useful to angel
investors in deciding whether to invest in the equity of SJ? What additional information angel
investors will require to decide whether to investment or not in the equity of SJ? [Assume that
the income tax rate was 40 percent of taxable income for both the years.]
Solution
(i) Angel investors are primarily interested to assess the growth potential of the business
and return on invested capital (ROIC). The capital invested in the business is the total
of equity capital and borrowings.
From the balance sheets of SJ we find that the amount of invested capital
as at March 31, 2016 was `15,00,000 and the same as at March 31, 2017 was
(`25,00,000 + 15,00,000) or `40,00,000. The invested capital at the commencement
of the business (April 1, 2015) was `10,00,000. Thus, average invested capital for
2015–16 was [(`10,00,000 + 15,00,000)/2] or `12,50,000; and average invested capital
for 2016–17 was [(`15,00,000 + 40,00,000)/2] or `27,50,000.
For computing the ROIC, we have to calculate the operating profit, which is the
profit before tax and finance cost. Therefore, the profit should be adjusted by finance
cost (net of tax). Thus, the operating profit was:
Year 2015–16: `5,00,000; and
Year 2016–17: [`10,00,000 + (1,50,000 – 1,50,000 × 0.40)] or `10,90,000
ROIC was:
Year 2015–16: [(`5,00,000/12,50,000) × 100] or 40%; and
Year 2016–17: [(`10,90,000/27,50,000) × 100] or 39.64%
Revenue growth for the year 2016–17 was [(90,00,000/45,000) × 100] or 200%
(ii) Information in (i) above is historical. It helps to assess the management’s ability to use
the resource (capital) productively. However, angel investors are interested in the future
of SJ. For this, they need to collect information to assess the future of the fashion
industry. Moreover, they will also compare the performance of SJ and other start-up
firms in the fashion industry to decide whether they would invest in SJ and if, they decide
to invest in SJ, what should be the amount that they should invest and the terms and
conditions of investment.
Investment in equity will give the angel investor ownership right and he/she will be the
co-owner of SJ with Santosh. He/she may or may not directly participate in the management. Self-Learning
Material 7
Financial Accounting
Activity Download the latest financial statements of a non-finance company of your choice
from its website and study the items in the balance sheet and the statement of
profit and loss. You may not be able to understand the sources of all the items.
NOTES But this will give you a general understanding of the nature of balance sheet and
the statement of profit and loss.

CAPITAL AND FIRM STRUCTURES

Capital

Translating a business idea, which is developed by an entrepreneur, into a business venture

requires resources (capital). If, the entrepreneur’s own resource is insufficient to finance the
business, he/she convinces others to invest in the venture by explaining the high probability
of the venture’s success and growth in investment. At the early stage of the venture,
investment is exposed to high risk, because the chance of failure is high. At that stage
the entrepreneur gets the support from family members, friends, angel investors (affluent
individuals) and venture capitalist (a type of private equity). As the venture succeeds,
initial investors, particularly angel investors and venture capitalists exit the venture and
new investors, who are willing to take moderate risks, join as owners by contributing to
the equity capital of the entity. Capital is also provided by lenders and other creditors,
who do not want to take business risks. Capital provided by lenders is often referred as
‘debt capital’.

BOX 1.1  Equity Capital and Debt Capital

Capital provided by owners is called ‘equity capital’ and capital provided by lenders is called ‘debt
capital’.
Investment in equity capital is defined as the residual interest in the assets of the entity after
deduction of liabilities. In a situation of liquidation, assets are first used to settle liabilities and
residual assets are distributed to owners. It is exposed to business risks, in the sense that return
on investment in equity capital depends on the business performance.
Return on investment in debt capital (interest) is predetermined. Investment in debt capital is
exposed to credit risks, that is, the risk that the entity may fail to honour its commitment to pay
interest and repay the loan as per terms and conditions of the contract.

Self-Test Questions
Self-test question 1.6
Fill in the blanks:
(i) Economic resources being used in a business entity are called………………….
(ii) Affluent individuals who have high risk appetites and invest in start up are called………………..
(iii) Investors in start ups are the entrepreneur, affluent individuals and …………………………
(iv) Investment in the equity capital of a firm is exposed to …………………………risks.
(v) Investment in the debt capital of a firm is exposed to …………………………risks.

Firm Structures

Choice of the firm structure depends on the amount of capital required at different stages
of the venture’s growth and the entrepreneur’s strategy to share the risks and rewards
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8 Material
incidental to the business with other investors. In this section, we shall briefly discuss The Conceptual
different firm structures. Framework

Sole proprietorship NOTES

If a venture requires small amount of capital, the entrepreneur floats a sole-proprietorship
firm. In the case of a sole-proprietorship firm, an individual (the entrepreneur) provides
the equity capital (owners capital) and other investors (e.g., financial institutions) provide
debt capital. The proprietor has personal liability for all obligations assumed by the firm.
The liability of the proprietor is unlimited, in the sense that it is not limited to his/her
equity contribution to the firm. Creditors, including lenders, can recover their claims from
the personal estate of the owner. This firm structure is suitable for small businesses, such
as a kirana store (a small shop selling groceries and sundries).

Self-Test Questions
Self-test question 1.7
Fill in the blanks:
(i) In sole-proprietorship business equity capital is provided by …………………….
(ii) The liability of the owner is ………………………..[Choose between the words ‘limited’
and ‘unlimited’.]

Partnership firm
Partnership structure is suitable for professional firms and other small business firms,
which require small amount of capital. More than one individual (called partners) provide
equity capital. Partnerships are governed by the Indian Partnership Act, 1938. Every partner
is jointly and severally liable for all obligations assumed by the firm. The liability of the
each partner is unlimited. Internal governance (e.g., capital contribution, profit sharing and
retirement) is regulated by an agreement between the partners.

Self-Test Questions
Self-test question 1.8
Fill in the blanks:
(i) In a partnership firm capital is provided by …………………….
(ii) The liability of the a partner is ………………………..[Choose between the words ‘limited’
and ‘unlimited’.]

Limited Liability Partnership (LLP)

Limited liability partnership (LLP) is governed by Limited Liability Partnership Act, 2008.
LLP is a legal entity separate from partners. It enjoys perpetual succession. Each partner is
an agent of the LLP. The liability of partners is limited in the sense that the liability of the
LLP is met out of the property of the LLP and partners are not required to inject additional
capital to settle the liabilities of the firm. A partner is personally liable for his/her wrongful
acts or admissions. But he/she is not liable for wrongful acts or omissions of other partners.
An LLP is run like a general partnership and has similar degree of management flexibility.
It facilitates partnership among individuals who operate in different geographic locations
and may not be closely known to each other. Most large professional firms of accountants,
lawyers etc. adopt the LLP structure.

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Financial Accounting
BOX 1.2  Perpetual Succession
Perpetual succession is the continuation of an incorporated entity, such as LLP and limited liability
NOTES
company (discussed below), despite the death, bankruptcy, insanity of a owner (member in case
of a company, and partner in case of LLP) or change in owners or an exit from the business of
any owner, or any transfer of shares.

Self-Test Questions
Self-test question 1.9
Indicate whether the following statements are true (T) or false (F):
(i) The liability of partners in a limited liability partnership (LLP) is unlimited.
(ii) A limited liability partnership (LLP) enjoys perpetual succession.
(iii) A partner is not personally liable for his/her wrongful acts or omissions or the acts or
omissions of other partners.

Limited Liability Company

Limited liability companies (also called joint stock companies) in India are governed by the
Companies Act, 2013. The liability of a limited liability company (here after, company) is
limited to the value of assets that it holds. Consequently, the liability of equity shareholders,
who are deemed owners, is limited to the unpaid amount of the contribution to the equity
capital of the company committed by him or her. In other words, the liability is limited
to the unpaid amount on the number of equity shares issued to him or her. Investors in
equity capital are called ‘members’.

ILLUSTRATION 1.2 Limited Liability

Sewa Limited (SL) allotted 100 shares to Rumela. The issue price of each share is `150. As per the
terms of issue Rumela paid `100 and `50 is payable, as when the company will call for payment.
Required
What is the liability of Rumela?
Solution
Rumela’s liability is limited to `50 per share or `5,000 in total, which is the uncalled amount on
shares allotted to her.

A company incorporated under the Companies Act, 2013 is a juridical person. It

has an identity separate from investors in the company. It enjoys perpetual succession.
Therefore, shareholders can freely transfer their shares without the permission of the
company. A company can enter into contracts and can sue and be sued in its own name.
A company acts through its Board of Directors, which delegate some powers, particularly
those related to day-to-day operation, to the Chief Executive Officer (CEO). Directors are
elected by equity shareholders using their voting rights. Under the Indian Companies Act,
one share has one vote. Memorandum of Association, which is the most important public
document, specifies among other things, the objects that the company will pursue and the
address of its registered office. Internal governance of a company is guided by its Articles
of Association.
Capital provided to a company belongs to the company. Use of the capital is decided
by the company. Investors provide capital to a company in exchange of claims on economic
resources (assets) of the company.
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 Companies can be classified into three categories: private companies, public limited The Conceptual
companies and listed public companies. One person company is considered as a private Framework
limited company.
NOTES
Private limited company
Private limited companies are also called closely-held companies. The Companies Act, 2013
does not allow a private limited company to have more than 200 members and does not
allow it to invite public to invest in its equity capital. Therefore, its growth might be
constrained by shortage of capital. The cost to comply with regulations of a private limited
company is much lower than that of a public company.

One person company

One Person Company (OPC) means a company which has only one member. OPC gives
the young businessman all benefits of a private limited company. It means they will have
access to credits, bank loans, limited liability, legal protection for business, access to market
etc. all in the name of a separate legal entity. The compliance cost is quite low as OPC
enjoys large number of exemptions from complying with the provisions of the Companies
Act, 2013.

Public limited company

A public limited company is allowed to invite public to contribute to its equity capital
and there is no restriction on the number of members. However, the Companies Act
2013 stipulates large number of prescriptions, proscriptions and disclosure requirements
to protect the interest of shareholders, who cannot participate in the management of the
company directly. Therefore, the compliance cost is higher than that in the case of a private
limited company.

Listed company
A share in a company is liquid and hence attractive if, a seller can always find a buyer and
a buyer can always find a seller. Therefore, public limited companies usually list shares
issued by them in recognised stock exchanges (e.g., the Bombay Stock Exchange and the
National Stock Exchange). A company whose securities are listed in a recognised stock
exchange is called a listed company or a publicly traded company. Securities and Exchange
Board of India (SEBI) is responsible for protecting the interest of shareholders of a listed
company and efficient operation of capital markets (stock exchanges). A listed company
is required to comply with all the regulations issued by SEBI, including the Code of
Corporate Governance, in addition to the requirements under the Companies Act 2013.
Therefore, the compliance cost of a listed company is much higher than that of an un-
listed company.

BOX 1.3  Preference Share Capital

Companies can issue preference shares. Investors in preference shares have a preferential claim
(relative to the claim of equity share holders) on assets of the company and on profit. They are
entitled for a pre-determined dividend if the company earns profit. Their claim is senior to the claim
of equity shareholders but subordinate to the claim of creditors (including investors in debt capital).
A senior claim gets preference in settlement over a subordinate claim. Under Indian Accounting
Standards (Ind AS), preference shares are classified as debt or equity, depending on the terms
of the issue. Redeemable preference shares are classified as debt. In India companies cannot issue
preference shares other than redeemable preference shares.

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Financial Accounting
Self-Test Questions
Self-test question 1.10
NOTES Indicate whether of the following statements are true (T) or false (F):
(i) A limited liability company can sue and can be sued in its own name.
(ii) A private limited company can invite public to contribute to its equity capital;
(iii) Compliance cost of a public limited company is higher than that of a private limited
company.
(iv) Investment in equity shares of a listed company is attractive because it is liquid.
(v) Redeemable preference share capital is a component of equity capital of a company.

Key Terms SUMMARY

Angel investors, articles
of association, board
of directors, business
risks, capital, closely
held company, credit
risks, debt capital, joint
stock company, juridical
person, limited liability
company, limited
liability partnership,
listed company,
memorandum of
association, one
person company,
partner, perpetual
succession, preference
share capital, private
equity, private limited
company, public limited
company, publicly
traded company, sole
proprietor
Translating a business idea into a business venture requires resources (capital). At the early stage
of the venture, investment is exposed to high risk. At that stage the entrepreneur gets the support
from family members, friends, angel investors and venture capitalist (a type of private equity). As
the venture succeeds, initial investors, particularly angel investors and venture capitalists exit the
venture and new investors, who are willing to take moderate risks, join as owners by contributing
to the equity capital of the entity. Debt capital is also provided by lenders. Investment in equity
capital of a business entity is exposed to business risks. Investment in debt capital of a business
entity is exposed to credit risk.
Choice of the firm structure depends on the amount of capital required at different stages
of the venture’s growth and the entrepreneur’s strategy to share the risks and rewards incidental
to the business with other investors. In sole proprietorship equity capital is provided by one
individual. In partnership equity capital is provided by more than one individual called partners.
The liability of the sole proprietor and partners is unlimited. A limited liability partnership (LLP)
enjoys perpetual succession and the liability of the partners is limited. A limited liability company
(hereafter, company) is a juridical person and enjoys perpetual succession. It acts through board
of directors. The liability of equity shareholders (called members) is limited. A private limited
company cannot invite public to contribute to its shareholders and cannot have more than 200
members. There is no such restriction for a public limited company. A public limited company
whose shares are listed in a stock exchange is called a listed company (also called publicly traded
company). A one person company is a private limited company.

FINANCIAL STATEMENTS
Objectives of Financial Reporting

The objective of financial reporting is to provide financial information, which is useful

in making decisions about providing resources to the entity, to existing and potential
investors, lenders and other creditors. Those decisions involve: (i) decisions to buy, sell or
hold equity and debt instruments (e.g., Corporate bond); (ii) decisions to provide or settle
loans and other forms of credit; and (iii) decisions needed to exercise rights while holding
investments, such as in the case of a company, rights of equity shareholders to vote on or
otherwise influence management’s actions.
Investors and potential investors, lenders and creditors use information in financial
statements along with other information, such as general economic conditions and
expectations, political events and political climate, and industry and company outlooks,
in deciding resource allocation.

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 The Conceptual
Self-Test Questions Framework
Self-test question 1.11
Indicate whether the following statements are true (T) or false (F): NOTES
(i) The primary objective of financial reporting is to provide financial information to the
management and the board of directors of the company.
(ii) Financial statements provide information that is sufficient to decide buy, hold or sell equity
shares and corporate bonds.
(iii) Equity shareholders of a company use information provided in financial statements to
decide voting on various decisions placed before them.
(iv) Equity shareholders of a company use information provided in financial statements to
evaluate management in its stewardship function.

Users of Financial Statements

Table 1.1 provides the list of users of financial statements:

TABLE 1.1
List of Users of Financial Statements

S. No. Users Objectives

A. Primary Users
1. Investors and potential The objectives are to: (i) value the equity of the company in
investors, and their order to assess whether the equity share of the company is
advisors overvalued or undervalued; (ii) forecast the possible movement
in equity share prices of the company and its peers; and
(iii) evaluate the management of the company in its stewardship
function.
2. Lenders and other The objective is to assess credit risks in lending or providing
creditors credit over different time frames (e.g., short-term and long-
term).

B. Others
3. Managers and board of The objectives are: (i) to evaluate the effectiveness of their
directors decisions in organising and allocating resources and the
effectiveness of risk management; and (ii) to identify candidates
for mergers and acquisitions, usually with the help of investment
bankers.
4. Employees The objective is to assess the stability and growth of the
company, as employees’ career prospect, future bonus and
variable pay depend on the same.
5. Citizens and The objectives are to assess: (i) the stability and growth of the
government companies, as their discontinuance might have a significant
social impact; (ii) the impact of the policy decisions (e.g.,
providing subsidy) on the performance of companies operating
in a particular industry; and (iii) whether a company has avoided
paying duties and taxes payable by it.

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Financial Accounting
Self-Test Questions
Self-test question 1.12
NOTES
Indicate whether the following statements are true (T) or false (F):
(i) The primary users of financial statements are investors, potential investors, lenders and
other creditors.
(ii) Investors and potential investors use the information provided in financial statements to
value equity.
(iii) Lenders and other creditors use the information provided in financial statements to assess
business risks.
(iv) Board of directors use the information provided in financial statements to evaluate
effectiveness of its decision to allocate resources.
(v) Lower-level employees do not find the information provided in financial statements
relevant.

SUMMARY
The objective of financial reporting is to provide information to investors, potential investors,
lenders and other creditors. Investors and potential investors use the information provided in
financial statements to value equity, and lenders and other creditors use the information to
evaluate credit risks. However, information available in financial statements is not sufficient
for their decision-making. They collect additional information about the business environment
(economic, legal, political, technological and social) and use the same along with information
available in financial statements for taking economic decisions. Other users of financial statements
are managers and board of directors, employees, citizens and government.

ANSWERS TO SELF-TEST QUESTIONS

1.1 (i) `8,00,000; (ii) Zero; (iii) Reduced
1.2 (i) F; (ii) T; (iii) T; (iv) F; (v) F
1.3 (i) T; (ii) F; (iii) T; (iv) T; (v) F
1.4 (i) `1,50,000; (ii) Net worth; (iii) Intangible; (iv) Revenue; (v) Recognition
1.5 (i) F; (ii) F; (iii) F; (iv) T; (v) F
1.6 (i) Capital; (ii) Angel investors; (iii) Venture capital funds; (iv) business; (v) Credit
1.7 (i) Individual; (ii) Unlimited
1.8 (i) Partners; (ii) Unlimited
1.9 (i) F; (ii) T; (iii) F
1.10 (i) T; (ii) F; (iii) T; (iv) T; (v) F
1.11 (i) F; (ii) F; (iii) T; (iv) T
1.12 (i) T; (ii) T; (iii) F; (iv) T; (v) F

ASSIGNMENTS
Multiple Choice Questions
1. Indicate which of the following statements are true (T) and which are false (F):
(i) Company financial report is primarily targeted towards existing and potential
investors and creditors.
(ii) The liability of an equity shareholder of private limited company is unlimited.
(iii) A limited liability partnership does not enjoy perpetual succession.
(iv) Interest-free credits do not form part of invested capital of a firm.
(v) Net worth of a business entity may be viewed as owners’ claim on the assets of the
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 (vi) Events other than transactions entered by a business entity might affect the assets The Conceptual
and liabilities of the entity. Framework
(vii) Publicly traded companies should necessarily be public limited companies.
(viii) Venture capital funds invest in the equity capital of startups with a plan to exit at
a later date. NOTES

2. Fill in the blanks:

(i) A private limited company is also known as ……………… company.
(ii) A private limited company cannot have more than ……………… members.
(iii) The claim of owners on the assets of a business entity is called ……………… .
(iv) The terms equity and ……………… are used interchangeably.
(v) Financial statements are primarily aimed at ……………… .
(vi) The equity capital, long-term debt and short-term debt of a company as at March
31, 2018 were `5,00,000, `3,00,000, and `2,00,000, respectively. The interest-free credit
on that date was `1,00,000. The invested capital in the company as at March 31 2018
was ……………… .
potential investors, lenders and other creditors; (vi) `10,00,000
2. (i) Closely held; (ii) 200; (iii) Equity/Net worth; (iv) Net worth; (v) investors,
1. (i) T; (ii) F; (iii) F; (iv) T; (v) T; (vi) T; (vii) T; (viii) T
Answers to Multiple Choice Questions

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