Business ManagementStudy ManualsDiploma inBusiness ManagementFINANCIALACCOUNTINGThe Association of Business Executives5th Floor, CI Tower St Georges Square High Street New MaldenSurrey KT3 4TE United KingdomTel: + 44(0)20 8329 2930 Fax: + 44(0)20 8329 2945E-mail: info@abeuk.com www.abeuk.com Copyright, 2008The Association of Business Executives (ABE) and RRC Business TrainingAll rights reservedNo part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form, or by any means, electronic, electrostatic, mechanical, photocopied or otherwise,without the express permission in writing from The Association of Business Executives.Diploma in Business ManagementFINANCIAL ACCOUNTINGContentsUnit Title Page1 The Nature and Purpose of Accounting 1The Scope of Accounting 3Users of Accounting Information 4Rules of Accounting (Accounting Standards) 6Accounting Periods 14The Main Characteristics of Useful Information 14The Twelve Traditional Accounting Concepts 17Important Accounting Terms 20Different Types of Business Entity 22Auditing in Business 252 Business Funding 31Capital of an Enterprise 33Dividends 40Debentures 41Types and Sources of Finance 44Management of Working Capital 483 Final Accounts and Balance Sheet 5355The Trial Balance 55Trading Account 57Manufacturing Account 59Profit and Loss Account 62Allocation or Appropriation of Net Profit 67The Nature of a Balance Sheet 69Assets and Liabilities in the Balance Sheet 71Distinction between Capital and Revenue 75Preparation of Balance Sheet 754 Presentation of Financial Statements 81Introduction 83The UK Companies Act 1985 and Accounting Requirements 83The Balance Sheet 87The Income Statement 93IAS 1: Statement of Changes in Equity 97Summary of Statements Required by IAS 1 99Narrative Statements Required in Published Financial Statements 99Appendix 1: Example of Statement of Accounting Policies 102Appendix 2: Example of Independent Auditors' Report 110Appendix 3: Example of Directors' Report 111Unit Title Page5 Profit and Cash Flow 115Availability of Profits for Distribution 116Cash Flow Statements 119Funds Flow Statements 1306 Valuation of Non-Current Assets and Inventories 135Valuation of Inventories 137Valuation of Long-Term Contracts 143The Importance of Inventory Valuation 146Depreciation 149Methods of Providing for Depreciation 153Borrowing Costs and IAS 23 154Leased Assets and IAS 17 154IAS 36: Impairment of Assets 156IAS 40: Investment Properties 1577 Further Accounting Standards and Concepts 165Introduction 167IAS 33: Earnings Per Share 167IAS 20: Accounting for Government Grants 168IAS 12: Income Taxes 169Accounting for Research and Development Expenditure 170IAS 10: Events after the Balance Sheet Date 171IAS 37: Provisions, Contingent Liabilities and Contingent Assets 173IAS 38: Intangible Assets 176IAS 18: Revenue 178IAS 24: Related Party Transactions 179Accounting for Inflation 1808 Assessing Financial Performance 189Interpretation of Accounts 191Ratio Analysis 193Profitability Ratios 196Liquidity Ratios 198Efficiency Ratios 200Capital Structure Ratios 202Investment Ratios 203Limitations of Accounting Ratios 205Worked Examples 207Issues in Interpretation 214Unit Title Page9 Sources and Costs of Finance 225Introduction 227Finance and the Smaller Business 227Finance and the Developing Business 230Finance for the Major Company 233The London Money Market 239The Cost of Finance 240Cost of Equity 241Cost of Preference Shares 243Cost of Debt Capital 243Weighted Average Cost of Capital (WACC) 244Cost of Internally Generated Funds 245Management of Factors Affecting Share Prices 247Factors Determining Capital Structure 249Advantages and Disadvantages of the Principal Financial Alternatives 25310 Financial Reconstruction 257Introduction 258Redemption of Shares 258Accounting Treatment 259Example of Redemption of Preference Shares 259Example of Redemption of Ordinary Shares 262Redemption of Debentures 26511 Group Accounts 1: Regulatory and Accounting Framework 269Introduction 270IAS 27: Consolidated and Separate Financial Statements 270IFRS 3: Business Combinations 272IAS 28: Investments in Associates 274IFRS 3: Fair Values in Acquisition Accounting 276Alternative Methods of Accounting for Group Companies 277Merger Accounting 28012 Group Accounts 2: The Consolidated Accounts 283Introduction 284The Consolidated Balance Sheet 284The Consolidated Income Statement 298Group Accounts Example 30613 Financial Accounting Examination The Compulsory Question 323The Financial Accounting Examination 324December 2007 Compulsory Question 325Specimen Examination Compulsory Question 3301 ABE and RRCStudy Unit 1The Nature and Purpose of AccountingContents PageA. The Scope of Accounting 3The Purpose of Accounting 3Financial Accounting and Management Accounting 3Money as the Common Denominator 3The Business Entity 4B. Users of Accounting Information 4Main Categories of Users 4Interests of Principal Users 5C. Rules of Accounting (Accounting Standards) 6Development of UK Accounting Standards 6International Accounting Standards 8Statements of Standard Accounting Practice 9D. Accounting Periods 14E. The Main Characteristics of Useful Information 14Underlying Assumptions 15Qualitative Characteristics of Financial Statements 16F. The Twelve Traditional Accounting Concepts 17Prudence 17Going Concern 18Consistency 18Money Measurement 18Duality 18Matching 19Cost 19Materiality 19Objectivity 19Realisation 19(Continued over)2 The Nature and Purpose of Accounting ABE and RRCBusiness Entity Concept 19Separate Valuation 20IAS 1: Presentation of Financial Statements 20G. Important Accounting Terms 20The Accounting Equation or Basic Formula 20Assets and Liabilities 21Capital v. Revenue Expenditure 22H. Different Types of Business Entity 22The Sole Trader 22Partnerships 23Limited Companies in the UK 23Accounting Differences Between Companies and Unincorporated Businesses 24Principle of Limited Liability 24Promoters and Legal Documents 24I. Auditing in Business 25What is an Audit? 25Types of Audit 25UK Law and External Audit 26External Audit Report 27External Audit Process 28Expectations Gap 28Answers to Questions for Practice 30The Nature and Purpose of Accounting 3 ABE and RRCA. THE SCOPE OF ACCOUNTINGThe Purpose of AccountingA business proprietor normally runs a business to make money. He or she needsinformation to know whether the business is doing well. The following questions might beasked by the owner of a business: How much profit or loss has the business made? How much money do I owe? Will I have sufficient funds to meet my commitments?The purpose of conventional business accounting is to provide the answers to suchquestions by presenting a summary of the transactions of the business in a standard form.Financial Accounting and Management AccountingAccounting may be split into Financial Accounting and Management Accounting.(a) Financial AccountingFinancial accounting comprises two stages: book-keeping, which is the recording of day-to-day business transactions; and preparation of accounts, which is the preparation of statements from the book-keeping records; these statements summarise the performance of the business usually over the period of one year.(b) Management AccountingManagement accounting is defined by the Chartered Institute of ManagementAccountants (CIMA) as follows:"The application of professional knowledge and skill in the preparation andpresentation of accounting information in such a way as to assistmanagement in the formulation of policies and in the planning and controlof the operations of the undertaking".Management accounting, therefore, seeks to provide information which will be used fordecision-making purposes (e.g. pricing, investment), for planning and control.Money as the Common DenominatorAccounting is concerned with money measurement it is only concerned with informationwhich can be given a monetary value. We put money values on items such as land,machinery and stock, and this is necessary for comparison purposes. For example, it is notvery helpful to say: "Last year we had four machines and 60 items of stock, and this year wehave five machines and 45 items of stock.". It is the money values which are useful to us.There are, though, limitations to the use of money as the common denominator.(a) Human Asset and Social Responsibility AccountingWe have seen that accounting includes financial accounting and managementaccounting. Both of these make use of money measurement. However, we may wantfurther information about a business: Are industrial relations good or bad? Is staff morale high? Is the management team effective?4 The Nature and Purpose of Accounting ABE and RRC What is the employment policy? Is there a responsible ecology policy?These questions will not be answered by conventional business accounting in moneyterms but by "human asset accounting" and "social responsibility accounting". Thesesubjects have not yet been fully developed and are outside the scope of your syllabus.(b) DevaluationThe value of money does not remain constant, and there is normally some degree ofinflation in the economy. We will look at the steps that have been taken to attempt toadjust accounting statements to the changing value of money later in the course.The Business EntityThe business as accounting entity refers to the separate identities of the business and itsowners. The Sole TraderThere must always be a clear distinction between the owner of the business and thebusiness itself. For example, if Mr X owns a biscuit factory, we are concerned withrecording the transactions of the factory. We are not concerned with what Mr Xspends on food and clothes. If Mrs Y, works at home, setting aside a room in herhouse, an apportionment may have to be made. PartnershipSimilarly, the partners in a business must keep the transactions of the businessseparate from their own personal affairs. CompaniesIn UK law, a company has a distinct "legal personality". This means that a companymay sue or be sued in its own right. The affairs of the shareholders must bedistinguished from the business of the company. The proprietor of a limited companyis therefore distinct from the company itself.We shall return to the issue of business entities later in the unit.B. USERS OF ACCOUNTING INFORMATIONWe need to prepare accounts in order to "provide a statement that will meet the needs of theuser, subject to the requirements of statute and case law and the accounting bodies, andaided by the experience of the reception of past reports".So if we prepare accounts to meet the needs of the user, who is the user?Main Categories of UsersThe main users of financial accounts are: Equity investors (shareholders, proprietors, buyers) Loan creditors (banks and other lenders) Employees Analysts/advisers Business contacts (creditors and debtors, competitors) The government (The Inland Revenue)The Nature and Purpose of Accounting 5 ABE and RRC The public Management (board of directors)Users can learn a lot about the running of a business entity from the examination of itsaccounts, but each category of user will have its own special perspective. We need to lookat some of these in more detail.Interests of Principal UsersWhat exactly do each of the users want from the accounts? ProprietorThe perspective of the business proprietor is explained above (but see below for theinterests of shareholders). Inland RevenueThe Inland Revenue will use the accounts to determine the liability of the business fortaxation. Banks and other Lending InstitutesThese require to know if the business is likely to be able to repay loans and to pay theinterest charged. But often the final accounts of a business do not tell the lender whathe or she wishes to know. They may be several months old and so not show the up-to-date position. Under these circumstances, the lender will ask for cash flowforecasts to show what is likely to happen in the business. This illustrates whyaccounting techniques have to be flexible and adaptable to meet users' needs. Creditors and DebtorsThese will often keep a close eye on the financial information provided by companieswith which they have direct contact through buying and selling, to ensure that their ownbusinesses will not be adversely affected by the financial failure of another. Anindicator of trouble in this area is often information withheld at the proper time, thoughrequired by law. Usually, the longer the silence, the worse the problem becomes. CompetitorsCompetitors will compare their own results with those of other businesses. A businesswould not wish to disclose information which would be harmful to its own business:equally, it would not wish to hide anything which would put it above its competitors. Board of DirectorsThe board of directors will want up-to-date, in-depth information so that it can draw upplans for the long term, the medium term and the short term, and compare results withits past decisions and forecasts. The board's information will be much more detailedthan that which is published. ShareholdersShareholders have invested money in the business and as such are the owners of thebusiness. Normally, the business will be run by a team of managers and theshareholders require the managers to account for their "stewardship" of the business,i.e. the use they have made of the shareholders' funds. EmployeesEmployees of the business look for, among other things, security of employment.6 The Nature and Purpose of Accounting ABE and RRC Prospective BuyerA prospective buyer of a business will want to see such information as will satisfy himor her that the asking price is a good investment.C. RULES OF ACCOUNTING (ACCOUNTING STANDARDS)As different businesses use different methods of recording transactions, the result might bethat financial accounts for different businesses would be very different in form and content.However, various standards for the preparation of accounts have been developed over theyears in order that users can be assured that the information they show can be relied on.We shall be looking at the layout of financial accounts later on in the course, but here we areconcerned with general underlying rules.With regard to UK companies, various rules have been incorporated into legislation (throughthe Companies Acts). UK Companies whose shares are listed on the Stock Exchange arealso subject to Stock Exchange rules. In addition, there are also "Statements of StandardAccounting Practice" (SSAPs) and Financial Reporting Statements (FRSs) which are issuedby the main UK professional accounting bodies through the Accounting Standards Board(ASB) which must be complied with.There are also rules and regulations for the preparation of financial accounts in othercountries of the world, and an international regulatory framework is gaining in importance.Global investment in business is becoming the norm in the 21st century and investors nowrequire comparable information between business entities from different countries of theworld. International regulation first began in 1973 with the establishment of the InternationalAccounting Standards CommitteeDevelopment of UK Accounting Standards(a) Historical DevelopmentIn 1942, the Institute of Chartered Accountants in England and Wales began to makerecommendations about accounting practices, and over time issued a series of 29Recommendations, in order to codify the best practice to be used in particularcircumstances. Unfortunately, these recommendations did not reduce the diversity ofaccounting methods. The Accounting Standards CommitteeIn the late 1960s, there was a lot of public criticism of financial reporting methodsand the accounting profession responded to this by establishing the AccountingStandards Committee (ASC) in 1970. The ASC comprised representatives of allthe six major accounting bodies, i.e. the Chartered Accountants of England andWales, of Scotland, and of Ireland, the Certified Accountants, the Cost andManagement Accountants, and the Chartered Institute of Public Finance andAccountancy.The Committee was set up with the object of developing definitive standards forfinancial reporting.A statement of intent produced in the 1970s identified the following objectives: To narrow the areas of difference in accounting practice To ensure disclosure of information on departures from definitive standards To provide a wide exposure for new accounting standards To maintain a continuing programme for improving accounting standards.The Nature and Purpose of Accounting 7 ABE and RRCThere are various accounting conventions (which we'll look at later) that lay downcertain "ground rules" for accounting. However, they do still permit a variety ofalternative practices to coexist. The lack of uniformity of practices made itdifficult for users of financial reports to compare the results of differentcompanies. There was therefore a need for standards of accounting practice, totry to increase the comparability of company accounts. Statements of Standard Accounting Practice (SSAP)The procedure for their establishment was for the ASC to produce an exposuredraft on a specific topic e.g. accounting for stocks and depreciation forcomment by accountants and other users of accounting information. A formalstatement was then drawn up, taking account of comments received, and issuedas a Statement of Standard Accounting Practice (SSAP). Once a statementhad been adopted by the accountancy profession, any material departures by acompany from the standard practice had to be disclosed in notes to the AnnualFinancial Accounts.These standards do not have the force of law to back them up, although allmembers of the accounting profession are required by their Code of Ethics toabide by them. The Dearing ReportAlthough the ASC had much success during its period of operation and issued 25SSAPs as well as a number of exposure drafts (EDs), Statements of Intent (SOI),and Statements of Recommended Practice (SORP), there were many seriouscriticisms of its work, leading to its eventual demise.In July 1987, the Consultative Committee of Accountancy Bodies (CCAB) set upa review of the standard-setting process under the chairmanship of Sir RonDearing. The Dearing Report subsequently made a number of very importantrecommendations. The government accepted all but one of them and in August1990 a new Standard Setting Structure was set up.(b) The Accounting Standards BoardThe following structure (Figure 1.1) was recommended by the Dearing Report, with theFinancial Reporting Council (FRC) acting as the policy-making body for accountingstandard-setting.The FinancialReporting Council(FRC)The ReviewPanelThe AccountingStandards Board(ASB)The Urgent IssuesTask Force (UITF)Figure 1.1: Standard Setting Structure8 The Nature and Purpose of Accounting ABE and RRCThis gave rise to a slightly different regime for the establishment of standards andthese are now embodied in Financial Reporting Standards (FRS). Financial Reporting Standards (FRS)The ASB is more independent than the ASC was and can issue standards knownas Financial Reporting Standards (FRS). The ASB accepted the SSAPs then inforce and these remain effective until replaced by an FRS. The ASB develops itsown exposure drafts along similar lines to the ASC; these are known as FREDs(Financial Reporting Exposure Drafts). Statements of Recommended Practice (SORP)Although the ASB believed that Statements of Recommended Practice (SORPs)had a role to play, it did not adopt the SORPs already issued. Not wishing to bediverted from its central task of developing accounting standards, the Board hasleft the development of SORPS to bodies recognised by the Board.The SORPs issued by the ASC from 1986 differed from SSAPs in that SSAPshad to be followed unless there were substantive reasons to prove otherwise,and non-compliance had to be clearly stated in the notes to the final accounts. ASORP simply sets out best practice on a particular topic for which a SSAP wasnot appropriate. However, the later SORPs are mandatory and cover a topic oflimited application to a specific industry (e.g. local authorities, charities, housingassociations). These SORPS do not deviate from the basic principles of thevarious SSAPs and FRSs currently in issue. Urgent Issues Task Force (UITF)This is an offshoot of the ASB which tackles urgent matters not covered byexisting standards or those which, if covered, were causing diversity ofinterpretation. In these circumstances, the UITF issues a "ConsensusPronouncement" in order to detect whether or not accounts give a true and fairview. Financial Reporting Review PanelThis examines contentious departures from accounting standards by largecompanies. The panel has the power to apply to the court for an order requiringa company's directors to revise their accounts.International Accounting Standards(a) Historical DevelopmentThe International Standards Committee (IASC), established in 1973, was anindependent private sector body and had no formal authority. It therefore had to relyon persuasion and the professionalism of others to encourage adoption of theInternational Accounting Standards (IASs) that it issued. The IASC operated under theumbrella of the International Federation of Accountants (IFAC), which is the worldwideorganisation of accountancy bodies and is independent of any country's government.All members of IFAC were originally members of IASC. One of the problems facingthe IASC was that it quite often had to issue standards that accommodated two ormore alternative acceptable accounting treatments. This situation arose becausethese alternative treatments were being practised in countries that were members ofthe IASC.In 1995 the IASC entered into an agreement with the International Organisation ofSecurities Commission (IOSCO) (the body representing stock exchanges throughoutthe world) to produce a core set of accounting standards. These standards were to beendorsed by IOSCO as an appropriate reporting regime for business entities in theThe Nature and Purpose of Accounting 9 ABE and RRCglobal marketplace for the raising of finance. This deal was to give IASC its muchneeded authority. However, to gain IOSCO's backing the IASC had to agree to arestructuring which occurred in 2000. The core standards were completed in 2000 andadopted by IOSCO in May 2000.The European Union, besides issuing Directives on company law (Fourth and SeventhDirectives), has also adopted the IASB standards for the preparation of financialstatements.(b) International Accounting Standards Board (IASB)The IASC became known as the IASB under the required restructuring in 2000. It isgoverned by a group of 19 individual trustees, known as the IASC Foundation, withdiverse geographical and functional backgrounds. The current Chair of the trustees isPaul A. Volcker, the former chair of the US Federal Reserve Board. The trustees areresponsible for the governance, fundraising and public awareness of the IASB.The structure under the trustees comprises the IASB as well as a StandardsInterpretation Committee (SIC) and a Standards Advisory Council, as shown below.TrusteesStandardsAdvisoryCouncilIASB SICFigure 1.2: International Standards Setting StructureThe IASB has 12 full-time members and 2 part-time members all of whom haverelevant technical experience and expertise. The current chair of the IASB is Sir DavidTweedie, who was previously the chair of the UK ASB.The IASB's sole responsibility is to set International Financial Reporting Standards(IFRSs). (Note that the standards issued by the IASC were known as InternationalAccounting Standards (IASs) and several of these have been adopted by the IASB see the list of standards later in the unit). As such it is at the forefront of harmonisationof accounting standards across the world as it pushes for adoption of its standards withthe help of IOSCO.Within the UK this harmonisation process with IASs has already begun. Within the EUall stock exchange listed businesses have to comply with IASs for the publication oftheir consolidated financial statements as from 1 January 2005. Businesses not listed,which tend to form the majority, can still use the framework of standards established bythe individual country. However, within the EU, countries are converging their homestandards with the international standards and this process is occurring in other areasof the globe.Within this manual, we intend to use the international standards. You might, therefore,find it useful to have a look at the IASB web site www.iasb.co.uk.Statements of Standard Accounting PracticeNote that, with the issuing of new accounting standards by the IASB (IFRSs), there arecurrently both a number of IFRSs and IASs in force. You do not require a detailedknowledge of all the current standards, but you should be aware of what they cover and webriefly review them here. The standards specifically within the range of the syllabus for this10 The Nature and Purpose of Accounting ABE and RRCmodule will be dealt with in detail in later study units under their own topic headings. (Thosenot included in the syllabus for this module are indicated by ** in the following list.)International Financial Reporting Standards IFRS 1First-time Adoption of International Financial Reporting Standards ** (noUK equivalent)The objective of this standard is to ensure that an entity's first IFRS financialstatements contain high quality information that is transparent for users andcomparable over time, provides a suitable starting point for accounting under IFRSsand can be generated at a cost that does not exceed the benefits to users. IFRS 2Share-based Payment ** (UK equivalent is FRS 20)The objective of this standard is to specify the financial reporting by an entity when itundertakes a share-based transaction. Businesses often grant share options toemployees or other parties and until the issue of this standard there was concern overthe measurement and disclosure of such transactions. IFRS 3Business Combinations (FRS 6 UK similar, but not identical)The objective of this standard is to specify the financial reporting by an entity when itundertakes a business combination. It covers the preparation of consolidatedaccounting staements using the puchase method (acquisition method) and will be dealtwith in detail in study units 11 and 12. IFRS 4Insurance Contracts ** (FRS 27 UK similar, but not identical)The objective of this standard is to specify the financial reporting for insurancecontracts issued by an entity. An insurance contract ia a contract under which oneparty, the insurer, accepts significant insurance risk from another party, thepolicyholder, by agreeing to compensate the policyholder if a specified uncertain futureevent adversely affects the policyholder. IFRS 5Non-current Assets Held for Sale and Discontinued Operations ** (no UKequivalent)The objective of this standard is to specify the accounting for assets held for sale, andfor the presentation and disclosure of discontinued operations. IFRS 6Exploration for and evaluation of Mineral Resources ** (no UKequivalent)This standard covers the accounting requirements for expenditure incurred in theexploration for and evaluation of mineral resources and whether such expenditureshould be regarded as a non-current asset. It also specifies the impairment treatmentfor such expenditure. IFRS 7Financial Instruments: Disclosures ** (FRS 29 UK)This standard is partnered with IAS 32 Financial Instruments: Presentation. IFRS 7deals with the disclosures that must be made by a business when it has in issue afinancial instrument defined as any contract that gives rise to a financial asset of oneentity and a financial liability or equity instrument of another entity. IFRS 8Operating Segments ** (SSAP 25 UK similar, but not identical)This is basically a disclosure statement identifying when and how information shouldbe disclosed in the financial statements in respect of business segments.The Nature and Purpose of Accounting 11 ABE and RRCInternational Accounting Standards IAS 1 Presentation of Financial Statements (FRS 3 UK similar, but not identical)We will cover this is some detail in study unit 4. The standard sets out overallrequirements for the presentation of financial statements, guidelines for their structureand minimum requirements for their content. It specifies that a complete set offinancial statements comprises: a balance sheet an income statement (profit and loss statement) a statement of changes in equity a cash flow statement notes and specified disclosure requirements IAS 2 Inventories (SSAP 9 UK similar, but not identical)We will deal with this in study unit 6. A primary issue in the accounting for inventoriesis the amount of cost to be recognised as an asset and carried forward until the relatedrevenues are recognised. Inventories are assets held for sale in the process of production for such sale in the form of materials or supplies to be consumed in the production process orthe rendering of services.The standard does not cover contruction contracts. These are dealt with under IAS 11 IAS 7 Cash Flow Statements (FRS 1 revised UK similar, but not identical)We will cover this in study unit 5. The standard deals with the preparation of one of theprimary financial statements as specified by IAS 1. It deals with cash flows during theperiod rather the matching of revenue and expenses and, therefore, provides furtherinformation to users in terms of performance and liquidity in addition to informationprovided in the income statement. IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (FRS18 UK similar, but not identical)The objective of the standard is to prescribe the criteria for selecting and changingaccounting policies used in the preparation of financial statements. Its use shouldenhance the relevance and reliability of the financial statements produced. Thisstandard is dealt with in study unit 4 IAS 10 Events After the Balance Sheet Date (FRS 21 UK)This is dealt with in study unit 7. The standard deals with events that occur after thebalance sheet date and whether these affect the financial statements prepared and/orwhether information on these events should be provided in the notes to the accounts. IAS 11 Construction Contracts (SSAP 9 UK similar, but not identical)Dealt with in study unit 6. The primary issue in dealing with construction contracts thatcover more than one accounting period is the allocation of contract revenue andcontract costs to the appropriate acconting period.12 The Nature and Purpose of Accounting ABE and RRC IAS 12 Income Taxes (FRS 16 and 19 UK similar, but not identical)Dealt with in study unit 7. Income taxes are all domestic and foreign taxes which arebased on taxable profits. The standard deals with the accounting of both current taxesand deferred taxes. IAS 16 Property, Plant and Equipment (FRS 15 UK similar, but not identical)Dealt with in study unit 6. The principal issues in accounting for property, plant andequipment (tangible fixed assets) are the recognition of the assets, the determinationof their carrying amounts and the depreciation charges and impairment losses to berecognised in relation to them. IAS 17 Leases (SSAP 21 UK similar, but not identical)This forms part of study unit 6. Businesses do not always purchase the fixed assetsthey require but, rather,; quite often lease them from another party. These leasedassets in substance can be used by the business as if they had purchased them and,therefore, the standard details the recognition and accounting for such leased assets.This is an example of accounting for substance over form. IAS 18 Revenue ( FRS 5 UK similar, but not identical)Dealt with in study unit 7. Income, as defined in the Framework for the Preparationand Presentation of Financial Statements (see study unit 4), is increases in economicbenefits during the accounting period. It further states that income encompasses bothrevenues and gains. So what is revenue? This standard answers that question andexplains how it should be measured. IAS 19 Employee Benefits ** (FRS 17 UK similar, but not identical)Many businesses, in addition to wages/salaries, provide further benefits to theiremployees. Such benefits include: retirement plans insurance plans such as hospital, dental, life and disability insurance stock options profit sharing plans recreational programmes vacation schemes, etc.This standard deals with the accounting for all employee benefits except those dealtwith under a specific standard. The standard requires the recognition of a liabilitywhen an employee has provided service in exchange for employee benefits to be paidin the future and the recognition of an expense when the entity consumes theeconomic benefit arising from service by an employee in exchange for employeebenefit. IAS 20 Accounting for Government Grants and Disclosure of GovernmentAssistance (SSAP 4 UK similar, but not identical)Dealt with in study unit 7. Government grants should be recognised in the incomestatement so as to match the expenditure to which they relate. Capital grants relatingto capital expenditure should be credited to revenue over the expected usefuleconomic life of the asset. IAS 21 The Effects of Changes in Foreign Exchange Rates ** (SSAP 20 UKsimilar, but not identical)The Nature and Purpose of Accounting 13 ABE and RRCA business may carry on foreign activities in two ways it may have transactions inforeign currencies or it may have foreign operations. The objective of this standard isto presribe how to deal with such activities in the financial statements. IAS 23 Borrowing Costs (no UK equivalent)Dealt with in study unit 6. Businesses often borrow acquire loans, to purchase assets.Normally the interest costs on such assets should be expensed to the incomestatement in accordance with the matching principle. However, it is possible to putforward an alternative argument that such borrowing costs, the interest, should becapitalised as part of the cost of the asset. This standard deals with the accounting forborrowing costs and whether the alternative treatment can be permitted. IAS 24 Related Party Disclosures (FRS 8 UK similar, but not identical)Dealt with in study unit 7. The objective of this standard is to ensure that a business'sfinancial statements contain the disclsoures necessary to draw attention to thepossibility that its financial position and profit or loss may have been affected by theexistence of related parties and by transactions and outstanding balances with suchparties. This disclsoure is necessary because quite often such transactions would notbe entered into with unrelated parties. IAS 26 Accounting and Reporting by Retirement Benefit Plans ** (FRS 17 UK,similar but not identical)This standard deals with the preparation of financial statements by retirement benefitplan (pension schemes) entities. IAS 27 Consolidated and Separate Financial Statements (FRS 2 UK similar, butnot identical)This forms the basis of study units 11 and 12 where we deal with the preparation offinancial statements for holding and subsidiary businesses. IAS 28 Investments in Associates (FRS 9 UK similar, but not identical)Again this is dealt with in study units 11 and 12. IAS 29 Financial Reporting in Hyperinflationary Economies ** (FRS 24 UK)In an hyperinflationary economy, financial statements are only useful if they areexpressed in terms of the measuring unit current at the balance sheet date. Thus, thestandard requires restatement of financial statements of businesses operating in anhyperinflationary economy. IAS 31 Interests in Joint Ventures** (FRS 9 UK similar, but not identical) IAS 32 Financial Instruments: Presentation ** (FRS 25 UK) IAS 33 Earnings per Share (FRS 22UK)Dealt with in study unit 7. This statement specifies the determination and presentationof the earnings per share figure/s in the financial statements. IAS 34 Interim Financial Reporting ** (ASB statement interim reports IAS 36 Impairment of Assets (FRS 11 UK similar, but not identical)Dealt with in study unit 6. The objective of this standard is to prescribe the proceduresthat a business applies to ensure that its assets are carried at no more than theirrecoverable amount. An asset is carried at more than its recoverable amount if itscarrying value exceeds the amount to be recovered through the use or sale of theasset. If this is the case, the asset is described as impaired and the standard requiresthe business to recognise an impairmemt loss.14 The Nature and Purpose of Accounting ABE and RRC IAS 37 Provisions, Contingent Liabilities and Contingent Assets (FRS 12 UK,similar but not identical)See study unit 7. The standard deals with the appropriate recognition andmeasurement of provisions and contingencies. It defines a provision as a liability ofuncertain timing or amount. IAS 38 Intangible Assets (FRS 10 UK similar, but not identical)See study unit 7. The standard only permits the recognition of intangible assets ifcertain criteria are met. An intangible asset is defined as an identifiable non-monetaryasset without physical substance, such as research and development costs,broadcasting licences, airline route authority, patents, copyrights, etc. IAS 39 Financial Instruments: Recognition and Measurement ** (FRS 26 UK) IAS 40 Investment Property (SSAP 19 UK similar, but not idemtical)See study unit 6. An investment property is property held by a business to earn rentalsor for capital appreciation or both, rather than for use in the production or supply ofgoods or services. The standard deals with the accounting treatment of suchinvestment properties. IAS 41 Agriculture **D. ACCOUNTING PERIODSAn owner of a business will require financial information at regular intervals. As we havenoted, he or she will want to be able to check periodically how well or badly the business isdoing. Financial accounts are normally prepared on an annual basis, e.g. twelve months tothe 31 March. Preparing accounts on an annual basis facilitates comparisons between oneyear and previous years and assists forecasting the next year. For example, there may beseasonal factors affecting the business, which will even out over the year. An ice-creamvendor will expect to make more sales in the summer months than in the winter months. Hewould not be able to tell if business is improving by looking at accounts for six months ended31 March 20XX and comparing them with accounts for the six months ended 30 September20XX. True comparison of profit/loss can be gained only when he examines his accounts forthe years (say) 31 March 20X1 and 31 March 20X2.Accounts normally have to be prepared annually for tax purposes as tax is assessed onprofits of a 12-month accounting period. In the case of limited companies, accounts areprepared annually to the "accounting reference date". It is necessary to calculate annuallythe amount of profit available for distribution to shareholders by way of dividend.E. THE MAIN CHARACTERISTICS OF USEFULINFORMATIONA number of attempts have been made since the 1970s to create some form of conceptualframework for financial accounting. The IASBs version, the Framework for the Preparationand Presentation of Financial Statements, was issued in 1989. This document is separatefrom the IASs and IFRSs and basically assembles the body of accounting theory so thatstandards are formulated on a consistent basis and not in an ad hoc manner. Theframework has several sections, but the two we will discuss here are the underlyingassumptions in the preparation of financial statements and the qualitative characteristics ofsuch statements.The Nature and Purpose of Accounting 15 ABE and RRCUnderlying AssumptionsThese are twofold accruals and going concern(a) AccrualsAccruals is taking into account or matching income and expenditure occurring withinan accounting period, whether actual cash is received or paid during the time or not.The reasoning behind the assumption is that profit for the period should represent fairlythe earnings of the time covered and, in view of the dynamic nature of any business, itis unlikely that all invoices will have been paid. However, they should be accounted forto give a true picture.A distinction is made between the receipt of cash and the right to receive cash, andbetween the payment of cash and the legal obligation to pay cash. The accrualsassumption requires the accountant to include as expenses or income those sumswhich are due and payable.You need to remember what the following terms mean: Receipt the receipt of cash or cheques by the business, normally in return forgoods or services rendered. The receipt may relate to another financial period,e.g. it may be for goods sold at the end of the previous period. Payment the payment of cash or cheques by the business in return for goodsor services received. Again, a payment may be in respect of goods purchased inthe previous financial year or a service to be rendered in the future, e.g. ratespayable in advance.Additionally, the term "capital receipt" is used to describe amounts received from thesale of fixed assets or investments, and similarly "capital payment" might relate to anamount paid for the purchase of a fixed (i.e. long-term) asset. Revenue income the income which a business earns when it sells its goods.Revenue is recognised when the goods pass to the customer, NOT when thecustomer pays. Expenses these include all resources used up or incurred by a businessduring a financial year irrespective of when they are paid for. They includesalaries, wages, rates, rent, telephone, stationery, etc.To help you understand the significance of these terms, here are a few examples(financial year ending 31 December): Telephone bill 200 paid January Year 2 relating to previous quarter = PaymentYear 2; Expense Year 1. Debtors pay 500 in January Year 2 for goods supplied (sales) in Year 1 =Receipt Year 2; Revenue Income Year 1. Rent paid 1,000 July Year 1 for the period 1 July Year 1 to 30 June Year 2 =Payment 1,000 Year 1; Expense Year 1 500, Expense Year 2 500.In a later study unit we will see how these matters are dealt with in the final accounts.(b) Going ConcernThis assumption infers that the business is going on steadily trading from year to yearwithout reducing its operations.You can often see if an organisation is in financial trouble, for example if it lacksworking capital, and in these circumstances it would not be correct to follow thisconcept. It would probably be better to draw up a statement of affairs, valuing assetson a break-up basis rather than reflecting the business as a going concern (i.e. on the16 The Nature and Purpose of Accounting ABE and RRCbasis of a sudden sale of all the assets, where the sale prices of the assets would beless than on ordinary sale).Inclusion of other potential liabilities might be necessary to reflect the situation properly for example, payments on redundancy, pensions accrued, liabilities arising becauseof non-completion of contracts.Thus, the going concern concept directly influences values, on whatever basis they aremeasuredQualitative Characteristics of Financial StatementsThese characteristics are the attributes that make the information provided useful to users.The IASB state that there are four principal characteristics understandability, relevance,reliability and comparability. We will deal with each of these in turn.(a) UnderstandabilityInformation provided to users must not be so complex that a user with a reasonableknowledge of business and economic activities and accounting, and a willingness tostudy the information with reasonable diligence, would not be able to understand it.There is a fine balancing act needed here by preparers of financial statements toensure that all information relevant to users is given to them even though it may becomplex.(b) RelevanceTo be useful, information must be relevant to the decision-making needs of users.Relevance is closely related to its predictive role that is the extent to which theinformation helps users to predict the organisation's future and so make decisionsabout it. For example, the attempt by a potential investor to predict future profitabilityand dividend levels will be at least partly based on the financial statements. A subcharacteristic to relevance is materiality Information is material and therefore relevantif its omission or mis-statement could influence the economic decisions of users.Materiality depends of the size of the item or error judged in the particularcircumstances.(c) ReliabilityInformation has the quality of reliability when it is free from material error and bias andcan be depended upon by users to represent faithfully that which it either purports torepresent or could reasonably be expected to represent.There is quite often a conflict between relevant and reliable information. Informationmay be relevant, but so unreliable in nature or representation that its recognition maybe potentially misleading. For example, if the validity and amount of a claim fordamages under a legal action are disputed, it may be inappropriate for the business torecognise the full amount of the claim in the balance sheet as this would provideunreliable information. However, to ensure relevance, it would be appropriate todisclose the amount and circumstances of the claim in a note to the accounts.Reliable information also requires several sub-characteristics to be present as follows: Faithful representation information provided must represent faithfully thosetransactions and other events it purports to represent. Substance over form transactions need to be accounted for in accordance withtheir substance not merely their legal form. Substance is not always consistentwith legal form. For example, a business may dispose of an asset to anotherparty in such a way that documentation purports to pass legal ownership to thatparty; nevertheless, though, agreements may exist that ensure that the businessThe Nature and Purpose of Accounting 17 ABE and RRCcontinues to enjoy the future economic benefits within the asset. In suchcircumstances a sale would not represent faithfully the transaction entered into.Such agreements are generally referred to as "sale and buy back". Anotherexample of substance over form is a finance lease which we will refer to later. Neutrality information must be neutral, that is free from bias and provided in anobjective manner. This also ensures that the characteristic of prudence must notoverride all other characteristics Prudence as preparers have to contend with the uncertainties that inevitablysurround many events and transactions, then a degree of caution must bebrought to bear when making judgements on such events and transactions. Thisdegree of caution is required such that assets or income are not overstated andliabilities or expenses are not understated. For example, when assessing theuseful life of plant and equipment, preparers must be cautious in their estimatebut not deliberately pessimistic. The exercise of prudence does not allow thecreation of hidden reserves or excessive provisions as this would result in theaccounts not being neutral. Completeness for information to be reliable it must be complete within thebounds of materiality and cost. An omission can cause information to be false ormisleading and thus unreliable and deficient in terms of its relevance.(d) ComparabilityUsers need to be able to compare financial statements of a business through time inorder to identify trends in its financial position and performance. Users also need to beable to compare one business with another and, therefore, the measurement anddisplay of the financial effect of transactions and other events must be carried out in aconsistent way for different entities. Thus, we have the need for accounting standardsfrom this characteristic.In can be quite difficult to ensure that all four main characteristics and theirsubcharacteristics are applied when preparing financial statements. In practice, a balancingor trade-off between the characteristics is often necessary. Generally, the aim is to achievean appropriate balance among the characteristics in order to meet the objectives of financialstatements which is to provide useful information to users.F. THE TWELVE TRADITIONAL ACCOUNTING CONCEPTSOver a period of time a number of conventions/concepts have been postulated by variousbodies interested in financial statements. Many of these are incorporated in the abovecharacteristics, but for completeness of your study we provide them here. These conceptsare incorporated by preparers in current financial statements.PrudencePrudence is proper caution in measuring profit and income.Where sales are made for cash, profit and income can be accounted for in full. Where salesare made on a credit basis, however, the question of the certainty of profits or incomesarises. If there is not a good chance of receiving money in full, no sales are made on creditanyway; but if, in the interval between the sale and the receipt of cash, it becomes doubtfulthat the cash will be received, prudence dictates that a full provision for the sum outstandingshould be made. A provision being an amount which is set aside via the profit and lossaccount.18 The Nature and Purpose of Accounting ABE and RRCThe two main aspects of this concept are that: Income should not be anticipated and all possible losses should be provided for. The method of valuation of an asset which gives the lesser value should always bechosen.Prudence is often exercised subjectively on grounds of experience and is likely, in general, tolead to an understatement of profit. The subjectivity involved can lead to variation betweenaccountants in the amount of provision for bad debts, etc. and is bound to create differencesbetween results obtained by the same general method of measurement. Users are thereforeprovided with pictures of various businesses which although apparently comparable, in factconceal individual distortions.In long-term credit arrangements, such as hire-purchase agreements, difficulties arise in theactual realisation of income and profit. The date of the sale, whether on a cash or creditbasis, is usually regarded as the date of realisation; but if you have money coming in overtwo or three years, measurement of the actual sum realised is subject to controversy.Going ConcernAs noted above, this concept assumes that the business is going on steadily trading fromyear to year without reducing its operations.ConsistencyThis is one of the most useful concepts from the point of view of users who need to followaccounting statements through from year to year. Put simply, it involves using unvaryingaccounting treatments from one accounting period to the next for example, in respect ofstock valuation, etc.You can only identify a trend with certainty if accounts are consistent over long periods;otherwise, the graph of a supposed trend may only reflect a lack of precision or a change ofaccounting policies. However, there will usually be changes or inconsistencies in accountingpolicies over the years and in public accounts it is essential to stress these changes so thatusers can make proper allowance for differences.Money MeasurementWhether in historic or current terms, money is used as the unit of account to expressinformation on a business and, from analysis of the figures, assumptions can be made bythe users.As we have seen, though, this concept of a common unit goes only some way towardsmeeting user needs, though, and further explanation is often needed on non-monetaryrequirements such as the experience of the management team, labour turnover, socialpolicy.DualityEach item in a business has two accountancy aspects, reflected in its accounting treatmentas follows: Double-entry book-keeping requires each transaction to be entered twice once as adebit and once as a credit. The debit represents an increase in the assets of thecompany or an expense, and the credit entry represents a reduction in the cashbalance to pay for the item, or an increase in the level of credit taken. The assets of a business are shown in one section of a balance sheet and the liabilitiesin another.The Nature and Purpose of Accounting 19 ABE and RRCThere is little to criticise in this duality, but we are looking behind the framework at theefficiency of the system and judging it by its success in meeting user needs. Duality fallsshort in the same sphere as money measurement, because there are areas in which it is notrelevant.MatchingOften considered the same as the accruals concept, matching calls for the revenue earnedin a period to be linked with related costs. This gives rise to accruals and prepaymentswhich account for the difference between cash flow and profit and loss information. Thisdistinction will be clarified when you look at examples later.CostAs money is used to record items in the business accounts, each item has a cost.Accountants determine the value of an asset by reference to its purchase price, not to thevalue of the returns which are expected to be realised. Many problems are raised by thisconvention, particularly in respect of the effect of inflation upon asset values.This can also be considered as the historic cost concept.MaterialityAccounting for every single item individually in the accounts of a multi-million pound concernwould not be cost-effective.A user would gain no benefit from learning that a stock figure of 200,000 included 140work-in-progress as distinct from raw materials. Neither would it make much difference thatproperty cost 429,872 rather than 430,000. Indeed, rounded figures give clarity topublished statements. So, when they are preparing financial statements, accountants do notconcern themselves with minor items. They attempt rather to prepare clear and sensibleaccounts.The concept of materiality leaves accounts open to the charge that they are not strictlyaccurate, but generally the advantages outweigh this shortcoming.ObjectivityFinancial statements should be produced free from bias (not a rosy picture to a potentiallender and a poor result for the taxman, for instance). Reports should be capable ofverification a difficult problem with cash forecasts.RealisationAny change in the value of an asset may not be recognised until the moment the firmrealises or disposes of that asset. For example, even if a sale is on credit, we recognisethe revenue as soon as the goods are passed to the customer.However, unrealised gains, such as increases in the value of stock prior to resale, are nowwidely recognised by non-accountants (e.g. bankers) and this can lead to problems with thisconcept.Business Entity ConceptThe affairs of the business are distinguished from the personal affairs of the owner(s). Thusa separate capital account is maintained in the business books, which records the business'sindebtedness to the owner(s).20 The Nature and Purpose of Accounting ABE and RRCIt is important to draw a clear distinction between the owner of a business and the businessitself. As far as accountancy is concerned, the records of the business are kept with a viewto controlling and recording the affairs of the business and not for any benefit to the owner,although the completed accounts will be presented to the owners for their information.However, it is sometimes hard to divorce the two interests, especially when you are dealingwith a sole trader, whose affairs are intertwined with the business he/she owns and isoperating. So if, for example, Pauline owns a sweetshop and takes and eats a bar ofchocolate, she is anticipating her profits as much as she is if she takes a few pence fromthe till to pay for some private purchase and such activities should be recorded. Her morepersonal affairs, however, such as the cost of food, clothing and heat and light for her privateresidence, must be kept separately from the business records.When we look at the partnership the distinction becomes a little clearer; and when we lookat limited companies, where the owners or shareholders may take no part in running thecompany and the law gives the company a distinct legal personality of its own, then we havea clear-cut division and it is easy to distinguish owner and business.Separate ValuationThis concept can be best explained by an example.Assume that A has sold goods on credit to B worth 1000. Thus in A's accounts, B shows upas a debtor for 1000. Meanwhile, B has sold goods on credit to A for 750. Thus, in A'saccounts, B shows up as a creditor for 750. No agreement has been made between A andB about setting off one amount against the other. What should we show in the accounts of Ain relation to B?You could argue that we should simply show the net debtor of 250 as a current asset.However, this would not show the entire picture in relation to A and B and therefore a trueand fair view would not be presented. The traditional concept of separate valuation requiresthat both the debtor and creditor be shown in A's accounts.IAS 1: Presentation of Financial StatementsThis standard requires that financial statements present fairly the financial position, financialperformance and cash flows of an entity. The standard specifies the need to presentinformation in a manner that provides relevant, understandable, comparable and reliableinformation thus incorporating the four essential characteristics from the Frameworkdocument. The standard also requires the use of going concern, accruals/matching,consistency, materiality, separate valuation, business entity, etc. In other words, IAS 1ensures that all the four characteristics and the twelve concepts detailed above in sections Eand F must be applied in the preparation of financial statements for users.G. IMPORTANT ACCOUNTING TERMSThe Accounting Equation or Basic FormulaIn any business there are two entities: the business and its owner/s. Capital is provided bythe owners in the form of cash or goods, and this capital is used by the business to acquireassets and finance its operations. When accounts are drawn up, the balance sheet willshow the assets of the business, net of any liabilities not yet settled, balanced against theowners' capital. We can therefore say that:Capital = Net Assets (i.e. Total Assets Total Liabilities)The Nature and Purpose of Accounting 21 ABE and RRCThe capital is what belongs to the owner/s, and the net assets are the assets used in thebusiness. Should the business cease those net assets would be used to raise the cash torepay the owners' capital.As a business progresses both the net assets and the owner's capital increase. Let usassume that an owner invests 10,000 in a business. The opening balance sheet willtherefore show:Capital 10,000 = Net assets (cash at bank) 10,000If a business is successful over the years, the figures will increase, so that after a period wemay see, for example:Capital 20,000 = Net assets 20,000This equation is known as the basic formula and you will notice that both sides have equalvalues. This is because all modern accounting is based on the principle of double entry.This means that every transaction in the accounts must have two entries, a debit entry inone account and a credit in another.Assets and LiabilitiesNet assets represent the assets of the business after deducting outstanding liabilities due tothird parties. To calculate the net assets we take the total assets and deduct the liabilities. Assets are the property of the business and include land and buildings, cash, debtorsand money in the bank. Liabilities are what the business owes to outside firms for goods or services supplied,loans made or expenses.You can relate this to your own situation. You probably own various assets perhaps a flat,a car, and some household effects. At the same time you may well owe money to a creditcard company, the newsagent or a finance company. If you are an employee then youremployer will owe you money by way of salary or wages. When you are in business then thebusiness will owe you money by way of your capital and profits.The treatment and classification of assets and liabilities in the accounts is of fundamentalimportance: Assets involve expenditure and are always shown as debit entries in the accounts.There are two main classes of assets:(i) Non-current assets/Fixed assets, which comprise land and buildings, plant andmachinery, motor vehicles, fixtures and fittings in fact any assets which are tobe used in the business for a reasonable period of time generally taken to begreater than one year.(ii) Current assets, which consist of stock for resale, debtors, cash/bank. Currentassets are short-term assets, not intended to be retained in the business for long.(Note that expenses also involve expenditure and are always shown as debit entries.) Liabilities consist of money owing for:(i) Goods purchased on credit(ii) Expenses owing for items like telephone bills, unpaid garage bills, etc.(iii) Loans from, say, the bank, building societies, hire purchase, etc.22 The Nature and Purpose of Accounting ABE and RRCCapital v. Revenue ExpenditureWhen assets such as buildings, plant and machinery, motor vehicles, tools, etc. are bought,they are purchased not for resale but for use in running the business. This type of asset isknown as a non-current asset/fixed asset. Non-current assets help to create profit, andexpenditure on them is known as capital expenditure.As well as the cost of the asset there are additional costs such as carriage on machinery orthe legal costs of acquiring land and buildings. If a prefabricated building is erected, therewould be additional costs such as the materials used (cement and bricks for thefoundations), and the labour costs incurred to erect the building. All these costs are includedin the cost of the building and are referred to as capital expenditure. This class ofexpenditure is kept separate from revenue expenditure, which relates to the day-to-dayrunning of the business. Examples of revenue expenditure include expenses such as petrolfor the delivery vans, telephone charges for the sales department, etc.You should have no difficulty in distinguishing between capital and revenue expenditure.Remember that capital is spent to buy fixed assets which are used to create profits, whilerevenue is spent in the creation of profit. We will remind you of the difference between thesetwo types of expenditure in later study units.Effects of not Complying with the RuleIf we include non-current assets in revenue expenditure, we will reduce the profit and at thesame time fail to disclose the non-current assets. This in turn means that any depreciation(see later in course) will not be taken. If we add revenue items in the non-current assets, wehave the opposite effect, i.e. more profit and depreciation incorrectly charged.The UK Companies Act 1989 includes the following directive in relation to publishedcompany accounts:"The balance sheet shall give a true and fair view of the state of affairs as at theend of the financial year. The profit and loss account shall give a true and fairview of the profit or loss of the company for the financial year."If we mix capital and revenue expenditure, not only will the accounts be incorrect but they willalso contravene the law.H. DIFFERENT TYPES OF BUSINESS ENTITYWe can now return to the issue of business entities and distinguish them in moresophisticated ways.The Sole TraderA sole trader is a business person trading on his or her own account. A sole trader bearstotal responsibility for business debts and, if in difficulty, may even need to sell personalassets to discharge liabilities.A sole trader is a business which is owned by one person, although we should rememberthat the business may employ several others. Capital is introduced by the owner and theprofits will be used in two main ways: As drawings (the proprietor's wages). As retention of profits which will be used to finance the business in future.The Nature and Purpose of Accounting 23 ABE and RRCPartnershipsA partnership is a group of people working together with a view to generating a profit. Thebasic structure of a partnership is governed in the UK by the Partnership Act 1890. Therewill often be a deed of partnership which lays down in writing the rights and responsibilities ofthe individual partners, but there is no legal requirement for any partnership agreement to beput into writing.There are two types of partnership:(a) Ordinary or General PartnershipThis consists of a group of ordinary partners, each of whom contributes an agreedamount of capital, with each being entitled to participate in the business activity and toshare profits within an agreed profit-sharing ratio. Each partner is jointly liable fordebts of the partnership unless there is some written agreement to the contrary. Thisis the most common form of partnership.(b) Limited PartnershipThis must consist of at least one ordinary partner to take part in the business, and tobe fully liable for debts as if it were an ordinary partnership. Some partners are limitedpartners who may take no part in the business activity and whose liability is limited tothe extent of the capital which they have agreed to put in. Such firms must beregistered and are not common.Limited Companies in the UKThere are four main characteristics which distinguish a limited company: The legal nature of the business Statutory rules governing the form and content of published accounts Separation of ownership from the management of the business Limited liability of the shareholdersA company is completely separate in law from its shareholders and as such it may be sued inthe courts. On its formation the shareholders subscribe for shares in the company in returnfor money (or money's worth). The shareholders then collectively own the company and areentitled to share in the profits generated by it.Several types of limited companies exist:(a) Private companiesThese must comprise one or more members (shareholders) and may not offer sharesto the public at large. A private company's name must end with "Limited" or "Ltd".(b) Public companiesA public company is a company limited by shares which must have at least twomembers and an authorised capital of at least 50,000, at least one quarter of whichmust be paid up. There is no maximum number of members prescribed and thecompany can offer its shares to the public. A public company's name must end withthe words "public limited company" or "plc".(c) Quoted companiesQuoted (listed) companies are those whose shares are bought and sold on arecognised stock exchange. Large organisations may have a full listing on the LondonStock Exchange, whilst smaller firms may be listed on the Alternative InvestmentMarket. The latter was established to provide a market for younger companies which24 The Nature and Purpose of Accounting ABE and RRCcould not afford the costs of a full listing on the Stock Exchange. Quoted companiesmust be public companies, although not all public companies will have a stockexchange listing.(d) Unquoted companiesThese are companies which do not have a full listing on a recognised stock exchange.An unquoted company may be a private or a public company and some shares may betraded through the Alternative Investment Market.Accounting Differences Between Companies and Unincorporated BusinessesThe following table summarises the main accounting differences between the alternativetypes of business:Item Sole Traders andPartnershipsCompaniesCapital introduced To the capital account As issued share capitalProfits withdrawn by the owners As drawings As dividendsProfits left in the business In a capital account As a revenue reserveLoans made from outsideinvestorsAs loan accounts As loan accountsPrinciple of Limited LiabilityThe principle of limited liability means that a member agrees to take shares in a company upto a certain amount, and once he has paid the full price for those shares he is notresponsible for any debts that the company may incur, even if it becomes insolvent within afew months of his becoming a member.This provides a safeguard against the private personal estate of a member being attached tomake good the company's debts. (Remember sole traders and partners in suchcircumstances can lose the whole of their business and private wealth.)Promoters and Legal DocumentsPromoters are the people who comply with the necessary formalities of companyregistration. They find directors and shareholders, acquire business assets and negotiatecontracts. They draw up the memorandum and articles of the new company and registerthem with the Registrar of Companies.The memorandum of association is said to be the "charter" of the company and it muststate the company's objects as well as other details such as its name and address anddetails of authorised capital.The articles of association are the internal regulations or by-laws of the company, dealingwith such matters as the issue and forfeiture of shares, procedure at meetings, shareholders'voting powers, appointment, qualification, remuneration and removal of directors.When the promoters have arranged all the formalities and satisfied themselves that thestatutory regulations have been complied with, they apply for a certificate of incorporationwhich brings the company into existence as a legal being, known as a registered company.The Nature and Purpose of Accounting 25 ABE and RRCI. AUDITING IN BUSINESSWhat is an Audit?An audit is a process by which an independent suitably qualified third party expresses anopinion on whether a set of financial statements of a business represent a true and fair viewof its financial affairs for an accounting period.Not all businesses are required to have an audit. In the UK, only large companies and somepublic bodies are required by law to have an audit. So why are small companies,partnerships and sole traders, for example, not audited by law? The answer to this questionis in the very nature of an audit. The audit is a check on the truth and fairness of thefinancial statements prepared by the management of the organisation for the users. One ofthe key users of these financial statements, as we saw earlier, is the owners and they needto know that the statements have been prepared competently, with integrity and are freefrom mistakes as best they can be. If the management and the owners are the samepeople, as is the case with sole traders, partnerships and generally small companies, thenthere is no need for such an audit.It has been known for those involved in the preparation of financial statements to bend therules of accounting, as detailed in accounting standards, in order to provide a morefavourable picture of the entity. There can be many reasons for them doing this forexample: their salary or bonus may be based on the profit figure declared; they may not wish information that shows a poor liquidity position to be in the publicdomain; to protect the organisation from liquidation.You might like to gather information from the internet on the demise of Enron and WorldComto illustrate the above points.Types of AuditThere are two types of audit external audit and internal audit.(a) External auditAn external audit is carried out by persons from outside the organisation whoinvestigate the accounting systems and transactions and ensure, as far as they areable, that the financial statements have been prepared in accordance with theunderlying books, the law and applicable accounting standards. The external auditorneeds, from his investigation, to place him/herself in a position to express an opinionwhether the financial statements being reported upon show a true and fair view or not.This opinion, if positive, provides considerable reassurance to users of financialstatements, particularly the current shareholders, the owners, that these accounts arereliable.It is important to identify what an external audit is not. It is not an attempt to find fraud,and it is not a management control. Fraud may be discovered during an audit, and theauditor will usually be well placed to give advice to management about potentialimprovements in the internal control system, but these benefits are incidental.(b) Internal auditInternal audit forms part of the internal management control system of a business. It iscarried out at management discretion and is not imposed by law. Many organisationsset up an internal audit function to check on financial records, quality or cost control toensure the organisation achieves the best performance it can. Internal auditors, who26 The Nature and Purpose of Accounting ABE and RRCdo not need to be qualified accountants, report to management not the owners. Thefunctions of internal audit can include: Ensuring the adequacy of internal controls Reviewing the reliability of records and books Preventing fraud, waste and extravagance Enforcing management decisions Undertaking ad hoc investigations Securing the asset base Substituting for external auditors under their supervision Undertaking value for money auditsRelationship between internal and external auditWhen carrying out an external audit the auditor may make use of the internal audit functionduring the course of the audit. If the external auditor does rely on the work of internal audit,he will have to assure him/herself that the work has been: Carried out by suitably competent and proficient people Well documented and evidenced in accordance with findings Used appropriate audit tests and techniques, such that reasonable conclusions havebeen drawn and acted upon Carried out without undue influence from othersThe external auditor will need to test the work of the internal audit function to confirm itsadequacy.UK Law and External AuditWithin the UK the 1985 Companies Act requires that all limited companies, except smallcompanies, are required to have an audit which they pay for. Thus, a private family-runcompany, as long as it is not defined as small, will require an external audit as will a large plcsuch as Tesco or BT.A small company is defined as a private limited company, which is not part of a larger group,and is not a banking or insurance company. Its turnover must be 5.6m or less, its balancesheet totals 2.8m or less and it should employ fewer than 50 people.The 1985 Companies Act also states that external auditors must be a member of aRecognised Supervisory body (RSB). The current RSBs in the UK are: Institute of Chartered Accountants in England and Wales (ICAEW) Institute of Chartered Accountants in Scotland (ICAS) Institute of Chartered Accountants in Ireland (ICAI) Association of Chartered Certified Accountants (ACCA) Association of Authorised Public Accountants (AAPA)The Act also states that a person may not be an auditor if he/she is an officer or employee ofthe company, or is in business partnership with an officer or employee of the company beingaudited.This is the extent to which specified individuals are excluded from acting as an externalauditor. So, could you think of anyone who may have a close relationship with a companywho could be an auditor of that company?The Nature and Purpose of Accounting 27 ABE and RRCWell, to start with, a shareholder of the client company can audit that company, as can adebtor or creditor of the client company. In addition, in law, the spouse, for example, of adirector of the client company can audit that company. However, RSBs impose stricterguidelines than the law on who can audit and a spouse would be specifically excluded undertheir rules.By law external auditors are appointed by and report to the shareholders, the owners, of thecompany. In practice, though, the choice of auditor is delegated to directors withshareholders voting on that choice, on a simple majority basis, at the annual generalmeeting, AGM, of the company.The Companies Act also provides the external auditor with several rights during the audit.These are the right to: Have access to all of the client's records Require from officers of the client, any information and explanations as they thinknecessary Attend any general meetings of the client Receive a copy of any written resolutions Speak at general meetings Require the calling of a general meeting for the purpose of laying the accounts andreports for the company.External Audit ReportThe audit report, as we have previously stated, is addressed to the shareholders of thecompany and is the auditor's opinion as to whether the financial statements show a true orfair view. The report should also: State which financial statements have been audited Place emphasis on the fact that it is management's responsibility to prepare thefinancial statements and the auditor's purely to audit them State that compliance with auditing standards in carrying out the audit has beenadhered to Provide a brief overview of the work done to provide the auditor with the evidence forthe opinion Provide details of the auditor and the date of the report Provide details of "emphasis of matter" this is where an issue arises during the auditthat does not affect the opinion, but the auditor believes it should be brought to theattention of recipients of the report.An auditor may not be able to state that the financial statements provide a true and fair viewafter his audit, in which case he must provide a modified report to that effect.The external report is included within the published financial statements. You might find ituseful to obtain several sets of financial statements you will find many freely availableunder a company's website on the internet and read the audit report. You will also findthese published financial statements useful reference points for other topics we will deal within this manual.28 The Nature and Purpose of Accounting ABE and RRCExternal Audit ProcessThe steps an auditor will take to carry out the audit from the time he/she is appointed untilsigning off the audit report are as follows: Find out as much as possible about the potential client before accepting the audit Carry out detailed investigations and document the client's structure, management,systems and accounting processes Draft a programme of audit work Carry out investigations and receive explanations necessary to support the auditopinionAn audit syllabus would cover all of these steps in much detail. However, with the financialaccounting syllabus, the detail of these steps is not required.Expectations GapFinally in this section on auditing, we need to deal with what an audit is not. This is bestillustrated by considering the "expectations gap". The expectations gap is the name given tothe difference between what the public think auditors do and what they actually do. Whenlarge organisations such as Enron, Worldcom, Parmalat, etc., fail or get in to difficulties,whether through poor management or fraud, auditors are often the first people the publicblame. They are often criticised in the press for failing to meet the expectations of thepublic. However, these expectations are quite often unrealistic and do not form part of theexternal auditors' duties.The general public, research has shown, think that auditors check every single transaction,prepare the financial statements, guarantee that financial statements are correct (whatevercorrect means), are responsible for finding and reporting frauds however small, and areresponsible for detecting illegal acts by directors. You should be able to see from the shortreview of auditing here that none of this is realistic and/or correct.One important legal case in the UK that sets out the role of the external auditor was theKingston Cotton Mill case in 1896. The judge in the case established that the auditor's rolewas similar to that of a "watchdog not a bloodhound". The judge further elaborated on thisfamous phrase, stating that an auditor had to use reasonable skill and judgementappropriate to the circumstances in carrying out his audit, but that he was not expected toinvestigate every transaction and should use his /her professional abilities to support theaudit opinion given. Thus, we can conclude that it is the job of the auditor to ensure thatenough testing work is carried out to support the audit opinion and to be alert to thepossibility of fraud. If during their work they discover omissions or frauds, then they must ofcourse investigate and report them.Questions for PracticeAs this is the only point in the study manual that we will consider the topic of audit, you mightfind it useful to consider the following two questions. We provide brief answers on thefollowing page, but do try and answer them without looking at these answers.1. Many companies within the UK have to undergo an external audit by law. Non-statutory audits are quite often undertaken by other organisations, but they are costly.What would persuade a partnership to undergo a non-statutory external audit?The Nature and Purpose of Accounting 29 ABE and RRC2. What is a qualified audit report? Outline the likely effect on a UK company of such areport.30 The Nature and Purpose of Accounting ABE and RRCANSWERS TO QUESTIONS FOR PRACTICE1. The following circumstances/issues might persuade a partnership to undergo aexternal audit: To settle the profit sharing between partners equitably especially if complicatedprofit sharing arrangements exist To provide credibility to figures within the financial statements after assetrevaluations or creation of non-purchased goodwill on the death or retirement ofa partner, or other change in the partnership arrangement To support an application to third parties for loan finance To enhance the credibility of the accounts provided to tax authorities The need for financial advice from a expert/professional to advance the businessYou might well have thought of other reasons as well.2. A qualified audit report is one in which the auditor has reservations and which have amaterial effect on the financial statements. Circumstances under which a qualifiedaudit report might occur are: Where there has been limitation on the scope of the audit, and hence anunresolvable uncertainty, which prevents the auditor from forming an opinion, or Where the auditor is able to form an opinion but, even after negotiation with thedirectors, disagrees with the financial statements.The likely effect of a qualified audit report will be to significantly reduce the reliability ofthe financial statements in the eyes of any user of such statements. This may wellthen impact on the company's ability to raise finance or trade on credit. This could leadto a fall in share price and eventual liquidation.31 ABE and RRCStudy Unit 2Business FundingContents PageA. Capital of an Enterprise 33Features of Share Capital 33Types of Share 33Types of Capital 34Share Issues 35Bonus Issues 37Rights Issues 37Redeemable Shares 38Purchase of Own Shares 40Advantage of Purchasing/Redeeming Shares 40B. Dividends 40Preference Dividends 40Ordinary Dividends 40Interim Dividends 41C. Debentures 41Types of Debenture 41Rights of Debenture Holders 42Gearing 42Issues at Par and at a Discount 42Redemption of Debentures 43Restrictions on Borrowings 43D. Types and Sources of Finance 43Balancing Fixed and Working Capital 43Types of Business and Capital Structure 44Long-term Funds 44Shorter-term Funds 46Interest Rate Exposure 46Sources of External Finance 46Examples of Business Financing 47(Continued over)32 Business Funding ABE and RRCE. Management of Working Capital 48Working Capital Cycle 48Striking the Right Balance 49Business Funding 33 ABE and RRCA. CAPITAL OF AN ENTERPRISE(Within this unit all references to companies are UK based in respect of terminology andlegal requirements)Virtually every enterprise must have capital subscribed by its proprietors to enable it tooperate. In the case of a partnership, the partners contribute capital up to agreed amountswhich are credited to their accounts and shown as separate liabilities in the balance sheet.A limited company obtains its capital, up to the amount it is authorised to issue, from itsmembers. A public company, on coming into existence, issues a prospectus inviting thepublic to subscribe for shares. The prospectus advertises the objects and prospects of thecompany in the most tempting manner possible. It is then up to the public to decide whetherthey wish to apply for shares.A private company is not allowed to issue a prospectus and obtains its capital by means ofpersonal introductions made by the promoters.Once the capital has been obtained, it is lumped together in one sum and credited to sharecapital account. This account does not show how many shares were subscribed by A or B;such information is given in the register of members, which is a statutory book that allcompanies must keep but which forms no part of the double-entry book-keeping.Features of Share Capital Once it has been introduced into the company, it generally cannot be repaid to theshareholders (although the shares may change hands). An exception to this isredeemable shares. Each share has a stated nominal (sometimes called par) value. This can be regardedas the lowest price at which the share can be issued. Share capital of a company may be divided into various classes, and the articles ofassociation define the respective rights of the various shares as regards, for example,entitlement to dividends or voting at company meetings.Types of Share(a) Ordinary SharesThe holder of ordinary shares in a limited company possesses no special right otherthan the ordinary right of every shareholder to participate in any available profits. If nodividend is declared for a particular year, the holder of ordinary shares receives noreturn on his shares for that year. On the other hand, in a year of high profits he mayreceive a much higher rate of dividend than other classes of shareholders. Ordinaryshares are often called equity share capital or just equities.Deferred ordinary shareholders are entitled to a dividend after preferred ordinaryshares.(b) Preference SharesHolders of preference shares are entitled to a prior claim, usually at a fixed rate, onany profits available for dividend. Thus when profits are small, preferenceshareholders must first receive their dividend at the fixed rate per cent, and any surplusmay then be available for a dividend on the ordinary shares the rate per centdepending, of course, on the amount of profits available. So, as long as the businessis making a reasonable profit, a preference shareholder is sure of a fixed return eachyear on his investment. The holder of ordinary shares may receive a very low dividendin one year and a much higher one in another.34 Business Funding ABE and RRCPreference shares can be divided into two classes: Cumulative Preference SharesWhen a company is unable to pay dividends on this type of preference share inany one year, or even in successive years, all arrears are allowed to accumulateand are payable out of future profits as they become available. Non-cumulative Preference SharesIf the company is unable to pay the fixed dividend in any one year, dividends onnon-cumulative preference shares are not payable out of profits in future years.(c) Redeemable SharesThe company's articles of association may authorise the issue of redeemable shares.These are issued with the intention of being redeemed at some future date. Onredemption the company repays the holders of such shares (provided they are fullypaid-up) out of a special reserve fund of assets or from the proceeds of a new issue ofshares which is made expressly for the purpose of redeeming the shares previouslyissued. Redeemable shares may be preference or ordinary shares.(d) Participating Preference SharesThese are preference shares which are entitled to the usual dividend at the specifiedrate and, in addition, to participate in the remaining profits. As a general rule, theparticipating preference shareholders take their fixed dividend and then the preferredordinary shareholders take their fixed dividend, and any balance remaining is sharedby the participating preference and ordinary shareholders in specified proportions.(e) Deferred, Founders or Management SharesThese normally rank last of all for dividend. Such shares are usually held by theoriginal owner of a business which has been taken over by a company, and they oftenform part or even the whole of the purchase price. Dividends paid to holders ofdeferred shares may fluctuate considerably, but in prosperous times they may be at ahigh rate.You should note that this type of share has nothing to do with employee shareschemes, where employees are given or allowed to buy ordinary shares in thecompany for which they work, at favourable rates i.e. at less than the marketquotation on the Inventory Exchange.Types of Capital(a) Authorised, Registered or NominalThese terms are synonymously used for capital that is specified as being the maximumamount of capital which the company has power to issue. Authorised capital must bestated in detail as a note to the balance sheet.(b) Issued (Allotted) or Subscribed CapitalIt is quite a regular practice for companies to issue only part of their authorised capital.The term "issued capital" or "subscribed capital" is used to refer to the amount ofcapital which has actually been subscribed for. Capital falling under this heading willcomprise all shares issued to the public for cash and those issued as fully-paid-up tothe vendors of any business taken over by the company.(c) Called-up CapitalThe payment of the amount due on each share is not always made in full on issue, butmay be made in stages for example, a specified amount on application and a furtherBusiness Funding 35 ABE and RRCamount when the shares are actually allotted, with the balance in one or moreinstalments known as calls. Thus, payment for a 1 share may be made as follows: 25p on application 25p on allotment 25p on first call 15p on second call