The prime objectives of financial reporting are as follows:
· To provide meaningful information to, equity investors-present and potential, lenders, and creditors about the financial health and performance of the company, enabling them to evaluate/assess the value of the company
· To help the company raise finances
· To enable meet regulatory requirements about a true and fair picture of the financial health of the company
This article covers the following aspects.
A) An overview of different types of financial reports
B) Necessity of Chart of Accounts
C) Seven (7) essential features for all types of financial reports
D). Narration of 17- Revenue & expense heads (out of 62 heads in P&L heads) relevant to Income or revenue
E). Listing of Eleven (11) common operational + unethical operational + unethical Potential causes that affect the accuracy of financial reporting in P& L and Balance Sheet.
F) Identification of 65 potential causes that can adversely affect the financial reporting of 17 heads of Revenue or expense
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A)Overview
Different types of financial statements depict different purposes, as shown below.
· Income statement
· Balance sheet, including statement of stockholder’s equity
· Statement of cash flows.
These represent the following:
· The income statement =Net income i.e. Revenues less expenses
· Balance Sheet represents= Cash assets plus Non-cash assets
which is also equal to
Liabilities plus Contributed Capital plus Earned Capital
· Statement of cash flows equal to
cash flows from business operations
plus cash flow from investment activities
plus cash flow from financing activities
plus free cash flows
The statement of cash flows is not included in this article as already covered in the author’s other article dated Oct 27,2023, with the title “Developing KPIs for Finance & Accounts Functions” on my website.
The table below includes 62 Revenue & expense heads of Profit and Loss (P&L) accounts and 88 Line items of the Balance sheet (BS).
This article details the financial reporting aspects of “Income or revenue” as listed in the 1st column -1st row in the table below.
P&L- Revenue & Expense heads | Nos | BS -Line items | Nos | ||||
Income or revenue | 17 | Equity/Shareholder’s funds | 5 | ||||
Purchase related expenses | 4 | Non-current liabilities | 12 | ||||
Employee related expenses | 10 | Current liabilities | 4 | ||||
Manufacturing related expenses | 6 | Fixed assets-tangible | 6 | ||||
Sales & marketing-shipping & promotion expenses | 6 | Intangible assets | 11 | ||||
Finance & Accounts related expenses | 7 | Other non-current assets | 17 | ||||
Overheads related expenses | 12 | Current assets-current Investments | 9 | ||||
Current assets-Inventories | 6 | ||||||
Current assets-Receivables | 2 | ||||||
Current assets-Cash & cash equivalent | 6 | ||||||
Current assets-others | 10 | ||||||
Total Revenue or Expense heads | 62 | Total Balance sheet -Line items | 88 |
The above table is developed considering a typical large manufacturing and selling products company, but concepts apply to all industries. The F&A team can customise this to suit the company's industry and the applicable statutory requirements.
B) Necessity of chart of accounts
Before preparing any financial reports, it is essential that accounts are recorded properly in the General Ledger.
In any typical midsize or large organization with multiple products, plants, and diverse sale territories, thousands of accounts may be required.
A “Chart of accounts” is essential for this as it serves the following purposes.
Organizes accounts for recording financial transactions:
Provides a framework for financial reporting of financial statements like income statements and balance sheets.
Facilitates internal control procedures from authorisation perspectives:
Enables classification of transactions into meaningful categories:
Improves the accuracy and efficiency of financial recordkeeping:
An illustration of the chart of accounts (COA) capturing account titles/heads-(estimated 150 codes) and their description is tabulated below under five (5) categories (based on the above table)
· Revenue & income =17
· Expenses:estimated= 45
· Assets:estimated=67
· Liabilities:estimated=16
· Equity/shareholder funds=5
Category | Head | Descriptions of sub-heads | Illustrated Code for COA ** |
1 | Revenue & Income | 1Income from sales revenue-End products & Spares 2. Income from sales revenue-Services 3. Incentives paid to channel partners,customers (as an expense) 4. Rebates /discounts given to channel partners and customers (as an expense) 5. Revenue towards export incentives 6. Revenue towards dividend income from investments And so on | 101….
111…. 121……
131….
141…. 151 ….
And so on |
2 | Expense | 1. Purchase related expenses 2. Employee-related expenses 3. Manufacturing related expenses 4. Sales & marketing-shipping & promotion expenses 5. Finance & Accounts related expenses 6. Overheads related expenses And so on | 201…. 211… 221…. 231….
241…. 251 … And so on. |
3 | Assets | 1. Current assets-current Investments 2. Current assets-Inventories 3. Current assets-Receivables 4. Current assets-Cash & cash equivalent 5. Current assets-others 6. Other non-current assets 7. Fixed assets-tangible 8. Intangible assets and so on | 301…. 311.. 321…. 331… 341… 351… 361… 371…. And so on |
4 | Liabilities | 1. Non-current liabilities 2. Current liabilities And so on | 401… 451…. |
5 | Equity
| 1.Shareholder funds 2. Retained earnings And so on | 501…. 551… And so on |
Note: ** The estimated 150 Code number above for COA is just for simple understanding. Each ERP solution or accounting software can have unique code numbering schemes for COA, and the CFO can choose the coding schema at his/her absolute discretion.
C) Seven (7) essential features for financial reports of all types (including Income or revenue)
i)Investor Protection & Transparency by applying appropriate accounting standards for ensuring.
1. Relevance & Reliability
2. Comparability
3. Disclosure Requirements
ii)Financial Statement Construction must be based on:
4. Going Concern Assumption
5. Accrual Accounting based on revenue earned and expenses incurred
6. Materiality Principle
iii)Ensure shareholder Reliance & Decision Making:
7. Investment Decisions based on the company's financial health, profitability, and growth potential.
D)Narration of 17 Income or revenue heads for reporting
(out of 62 heads of revenue and expenses in P&L heads)
1. Income from sales revenue-End products & Spares
2. Income from sales revenue-Services
3. Incentives paid to channel partners/customers (as an expense)
4. Rebates /discounts given to channel partners,customers (as an expense)
5. Revenue towards export incentives
6. Revenue towards dividend income from investments
7. Revenue towards the sale of investments
8. Revenue towards the sale of investments in foreign currency
9. Revenue towards. interest on deposits
10. Revenue towards. interest on loans & advances given by our
company
11. Revenue towards. interest on receivables
12. Revenue towards interest income on current investments in
Subsidiaries or JV or associate cos
13. Revenue towards rental income on properties
14. Revenue towards rental income on equipment leased
15. Revenue towards the sale of fixed assets
16. Revenue towards the sale of scrap
17. Revenue towards miscellaneous income
E) List of 11 common operational + unethical Potential causes that can affect the accuracy of financial reporting of P & L or Balance Sheet(including Income or revenue)
1. Lack of transparency in the computation of value
2. Missing out a few transactions inadvertently.
3. Inconsistency in financial reporting from year to year
4. Insufficient or non-availability of supporting documents for proper accounting.
5. Insufficient disclosures
6. Non-implementation of segregation of duties in terms of the maker-checker-approver concept
7. Applying incorrect accounting standards
8. Weak internal controls
9.Deliberate manipulation of the following (as applicable to line item) in the algorithm that determines value by ERP or software solution vis a vis
§ Selling Prices, Purchase rates or Tax rates (GST, income tax, customs duty, etc, as relevant ), or Deductions or additions in the formula/conditions, Classification, Accounting heads in the General ledger, and Other commercial terms impacting financial and so on
10. Maliciously accessing & making unauthorised changes in the following
a)Master data tables and field
b)Configuration tables and fields
c)Data tables from the back end and fields
d)Financial Accounting documents and fields from the back end
11. Compromises on statutory compliances.
For additional inputs on various heads captured in 1st table ( Profit and Loss (P&L) accounts and of the Balance sheet (BS).), please refer to my second book, Profitability and Ethics: The Key Ingredients for Business Success, is available on Amazon, as per the links below.
Paper back-amazon link: India
Paper back-amazon link: Global
F) Identification of 65 potential causes that can adversely affect the financial reporting of 17 heads in “Income or revenue” in the P &L accounts
1) Revenue head - Income from sales revenue-End products & Spares
Potential Cause =6
· 1. Not ensuring that revenue or income is correctly reported without overstating revenue by premature reporting
2. Likewise, ensuring that the sale invoice is promptly raised (to avoid under-reporting sales)for items that have already been shipped out against the gate pass is important.
3. Pursuing billing even if the physical sale is held back (not yet shipped) and not reversing any such sale invoice where end products or spares are yet to be shipped
4. Likewise, for export sales, counting sales merely based on the company’s invoice rather than after the shipping bill for “boarding on the ship” is prepared
5. Not recognizing the sales revenue after it is earned & after associated costs are incurred
6. Non-prompt accounting for all authorised sales returns
2) Revenue head -Income from sales revenue-Services
Potential Cause =2
· 1. Similar aspects apply to services rendered as above, substituting the word “Service” for “End product.”
and
2. Inaccurate Measurement of Service Value, particularly services that are complex and are rendered on a long-term basis
3)Expense head – Deduction towards Incentives paid to channel partners/customers
Potential Cause =3
1. Allowing incentives without ensuring that criteria for qualifying is met
2. Allowing incentive schemes, though not applicable for the reporting period
3. Non-validation of Complex computation done by channel partner/customer vis a vis incentive scheme
4) Expense head – Deduction towards rebates /discounts given to channel partners/customers
Potential Cause =1
1. The same points apply here as for incentives. Therefore, substitute “rebate/discount ” for “incentive” in line item 3
5) Revenue head – Addition revenue towards export incentives
Potential Cause =4
1. Reporting not-eligible incentives receivable for the applicable reporting period, i.e., the actual export period.
2. Calculating the incentive amount inaccurately for claiming in the Incentive application to be made to the Government body
3. Making insufficient financial disclosure of the export incentives
· 4. Applying the incorrect foreign currency conversion factor
6) Revenue head – Addition revenue towards dividend income from investments
Potential Cause =4
· 1Dividend income should be treated as the return on investments and not part of regular revenue income.
2. Export incentives receivable are not reported as applicable to the reporting period /the actual export period.
3. Improper accounting of withholding tax on dividends
4. Not making adequate disclosures about the source and amount of dividends to assess a company's investment performance
7) Revenue head – Addition revenue towards the sale of investments
Potential Cause =4
1. Inappropriate recording of the sale of an investment (gain vs revenue )
2. Improper classifying the type of investment sale (e.g., short-term vs. long-term) for tax purposes
3. Incorrect timing of recognition, ie too early or too late,
4. Inaccurately stating the dividend income received after incorporating foreign exchange fluctuations.
8) Revenue head – Addition revenue towards the sale of investments in foreign currency
Potential Cause =5
1. Incorrectly treating foreign currency dividends (revenue vs return of capital)
2. Converting foreign currency sales realization proceeds to the INR /reporting currency using an incorrect exchange rate.
3. If the company uses a hedge to mitigate currency risk, the gain or loss on the hedge must be offset against the gain or loss on the foreign currency investment sale itself. Not ensuring this.
4. Not treating income on a net basis after subtracting costs towards commissions, bank fees, etc.
· 5. Not ensuring compliance with accounting standards in other countries
9) Revenue head – Addition revenue towards. interest on deposits
Potential Cause =5
1. Including interest income on deposits in the financing activity rather than in sales revenue.
2. Improper accounting for withholding taxes applied to the interest income.
3. Not ensuring recording of accrued interest income (not yet received) at the end of the accounting period.
4. Calculate the interest earned due using incorrect interest rates or periods.
5. Improperly capitalizing interest costs earned on deposits, wherever applicable
10) Revenue head – Addition revenue towards. interest on loans & advances given by our company
Potential Cause =7
1. Misclassifying interest on loans and advances in the financing activity rather than as sales revenue.
2. Using the incorrect interest rate to calculate the interest
3. Not accounting for any bad debts associated with loans and advances
4. Not recording accrued interest on loans and advances at the end of the accounting period, i.e., interests due but not yet received
5. Improperly netting interest income on loans and advances given with interest expense on loans taken.
6. Including interest income from non-performing loans and advances, as likely to be received.
7. Improper disclosures of likely provisions
11)Revenue head – Addition revenue towards. interest on receivables
Potential Cause =4
· 1Including interest income on receivables in financing activity rather than sales revenue.
2. Not accounting for uncollectible receivables that may reduce interest income.
3. Calculate the interest earned using an incorrect interest rate or period.
4. Making inaccurate interest rate assumptions
12) Revenue head – Addition revenue towards interest income on current investments in subsidiaries or JV or associate co
Potential Cause =4
· 1 Mis-classifying the interest income as investment income, not sales revenue.
· 2 Using an unfair valuation method for the investment
· 3 Improper accounting for impairment of the investment.
· 4 Considering foreign currency fluctuations incorrectly
13) Revenue head – Addition revenue towards rental income on properties
Potential Cause =4
1. Under-reporting or Overstating rental income
2. Improper accounting for accrued rentals
3. Considering security deposits from tenants as income, as it is refundable
4. Not ensuring deductions towards repair and maintenance and insurance of property rented from rental income
14) Revenue head – Addition revenue towards rental income on equipment leased
Potential Cause =5
1. The same points apply as in line item 13th
and
2. If the lease agreement transfers equipment ownership to the lessee at the end of the term, the lessor does not record the residual value as an asset in the P&L account.
3. Asset valuation not done precisely
4. Not reporting potential risks of unearned rent or repossession of equipment due to issues at the lessee.
5. If the leased equipment is owned by the lessor and subject to depreciation, the lessor does not ensure proper accounting for depreciation expenses while computing rental income.
15) Revenue head – Addition revenue towards the sale of fixed assets
Potential Cause =3
1. Improper Classification of income from fixed asset sale as non-operating income rather than operating income
2. Not giving disclosures about the details on the sale of fixed assets, like the type of asset sold, its age, and the reason for disposal
3. Inaccurate Calculation of Gain or Loss due by improper valuation of the net fixed asset cost
16) Revenue head – Addition revenue towards the sale of scrap
Potential Cause =2
1. Not subtracting disposal Costs such as transportation or labor for sorting, etc, while reporting income from the sale of scrap
2. Reporting scrap income by not ensuring the scrap sale is against a proper invoice and payment is made through cheque /UPI/Online method, not cash.
17)Revenue head – Addition revenue towards miscellaneous income
Potential Cause =2
1. Not providing adequate details related to description/sub-description and associated tax implications
2. Not ensuring consistency in financial reporting from year to year
Thus, this article has identified 65 potential causes that can adversely impact financial reporting of “ Income or revenue. “
The financial reporting aspects for the remaining 45 (62-17) P&L heads and 88 Balance sheet heads will be covered in separate articles in the future.