FINANCIAL ACCOUNTING
Part 1 A conceptual framework: setting the scene 3
1 Who needs accounting? 4
2 A systematic approach to financial reporting:
the accounting equation 26
3 Financial statements from the accounting equation 50
4 Ensuring the quality of financial statements 73
Part 2 Reporting the transactions of a business 101
5 Accounting information for service businesses 102
6 Accounting information for trading businesses 131
Part 3 Recognition in financial statements 157
7 Published financial statements 158
8 Non-current (fixed) assets 196
9 Current assets 234
10 Current liabilities 263
11 Provisions and non-current (long-term) liabilities 282
12 Ownership interest 304
Part 4 Analysis and issues in reporting 333
13 Ratio analysis 334
14 Reporting corporate performance 361
15 Reporting cash flows 393
MANAGEMENT ACCOUNTING
Part 5 Setting the scene and defining the basic tools of
management accounting 421
16 Functions of management accounting 422
17 Classification of costs 447
18 Product costs: materials, labour and overheads 469
Contents in brief
vi Contents in brief
Part 6 Product costs and stock valuation 505
19 Job costing 506
Part 7 Decision making 529
20 Breakeven analysis and short-term decision making 530
Part 8 Planning and control 559
21 Preparing a budget 560
22 Standard costs 598
23 Performance evaluation and feedback reporting 628
Part 9 Capital investment appraisal and business strategy 651
24 Capital investment appraisal 652
25 Business strategy and management accounting 682
Financial accounting terms defined G1
Management accounting terms defined G11
Appendices
I Information extracted from annual report of Safe and
Sure plc, used throughout Financial Accounting A1
II Solutions to numerical and technical questions in
Financial Accounting A15
III Solutions to numerical and technical questions in
Management Accounting A39
Index I1
Preface to the fourth edition xx
Guided tour of the book xxvi
Publisher’s acknowledgements xxviii
FINANCIAL ACCOUNTING
Part 1 A conceptual framework: setting the scene
Chapter 1 Who needs accounting? 4
Real World Case 4
Learning outcomes 5
1.1 Introduction 5
1.2 The development of a conceptual framework 7
1.3 Framework for the preparation and presentation of
financial statements 8
1.4 Types of business entity 8
1.5 Users and their information needs 12
1.6 General purpose or specific purpose financial statements? 17
1.7 Stewards and agents 17
1.8 Who needs financial statements? 18
1.9 Summary 19
Further reading 20
Questions 20
A Test your understanding 20
B Application 21
C Problem solving and evaluation 21
Activities for study groups 22
Notes and references 22
Supplement: Introduction to the terminology of business transactions 24
Test your understanding 25
Chapter 2 A systematic approach to financial reporting:
the accounting equation 26
Real World Case 26
Learning outcomes 27
2.1 Introduction 28
2.2 The accounting equation 28
Contents
viii Contents
2.3 Defining assets 29
2.4 Examples of assets 31
2.5 Recognition of assets 33
2.6 Defining liabilities 35
2.7 Examples of liabilities 36
2.8 Recognition of liabilities 37
2.9 Defining the ownership interest 39
2.10 Recognition 39
2.11 Changes in the ownership interest 39
2.12 Assurance for users of financial statements 41
2.13 Summary 42
Further reading 44
Questions 44
A Test your understanding 44
B Application 45
C Problem solving and evaluation 45
Activities for study groups 46
Notes and references 46
Supplement: Debit and credit bookkeeping 47
Test your understanding 49
Chapter 3 Financial statements from the accounting equation 50
Real World Case 50
Learning outcomes 51
3.1 Introduction 51
3.2 Who is in charge of the accounting rules? 52
3.3 The accounting period 52
3.4 The balance sheet 53
3.5 The income statement (profit and loss account) 57
3.6 The cash flow statement 59
3.7 Usefulness of financial statements 62
3.8 Summary 63
Questions 63
A Test your understanding 63
B Application 64
Activities for study groups 65
Supplement: Using the accounting equation to analyse transactions 66
Test your understanding 72
Chapter 4 Ensuring the quality of financial statements 73
Real World Case 73
Learning outcomes 74
4.1 Introduction 75
4.2 Qualitative characteristics of financial statements 75
4.3 Measurement in financial statements 79
4.4 Views on prudence 82
Contents ix
4.5 Regulation of financial reporting 84
4.6 Reviewing published financial statements 92
4.7 Summary 97
Further reading 98
Questions 98
A Test your understanding 98
B Application 99
C Problem solving and evaluation 99
Activities for study groups 100
Notes and references 100
Part 2 Reporting the transactions of a business
Chapter 5 Accounting information for service businesses 102
Real World Case 102
Learning outcomes 103
5.1 Introduction 103
5.2 Analysing transactions using the accounting equation 104
5.3 Illustration of accounting for a service business 107
5.4 A process for summarising the transactions: a spreadsheet 111
5.5 Financial statements as a means of communication 113
5.6 Summary 116
Questions 116
A Test your understanding 116
B Application 117
Supplement: Recording transactions in ledger accounts –
a service business 118
Test your understanding 130
Chapter 6 Accounting information for trading businesses 131
Real World Case 131
Learning outcomes 132
6.1 Introduction 133
6.2 Goods purchased for resale 133
6.3 Manufacturing goods for resale 135
6.4 Illustration of accounting for a trading business 138
6.5 A process for summarising the transactions: a spreadsheet 142
6.6 Financial statements of M. Carter, wholesaler 144
6.7 Summary 146
Questions 147
A Test your understanding 147
B Application 148
Supplement: Recording transactions in ledger accounts:
a trading business 149
Test your understanding 156
x Contents
Part 3 Recognition in financial statements
Chapter 7 Published financial statements 158
Real World Case 158
Learning outcomes 160
7.1 Introduction 160
7.2 International influences 161
7.3 Accounting framework 162
7.4 Balance sheet 166
7.5 Income statement (profit and loss account) 171
7.6 Cash flow statement 173
7.7 Group structure of companies 177
7.8 Group financial statements 179
7.9 Beyond the annual report 182
7.10 Summary 186
Further reading 187
Useful websites 187
Questions 187
A Test your understanding 187
B Application 189
C Problem solving and evaluation 189
Activities for study groups 189
Notes and references 190
Supplement 7.1: Information to be presented on the face of the
Balance Sheet, as required by IAS 1 191
Supplement 7.2: Balance sheet format 1, as prescribed by the
Companies Act 1985 192
Supplement 7.3: Information to be presented on the face of the
Income Statement as required by IAS 1 194
Supplement 7.4: UK Companies Act: Profit and loss account
format 1 – list of contents 195
Chapter 8 Non-current (fixed) assets 196
Real World Case 196
Learning outcomes 197
8.1 Introduction 198
8.2 Definitions 198
8.3 Recognition 200
8.4 Users’ needs for information 202
8.5 Information provided in the financial statements 203
8.6 Usefulness of published information 205
8.7 Depreciation: an explanation of its nature 206
8.8 Reporting non-current (fixed) assets and depreciation in
financial statements 211
8.9 Summary 219
Contents xi
Further reading 220
Questions 220
A Test your understanding 220
B Application 221
C Problem solving and evaluation 221
Activities for study groups 222
Notes and references 223
Supplement: Recording non-current (fixed) assets and depreciation 224
Test your understanding 233
Chapter 9 Current assets 234
Real World Case 234
Learning outcomes 236
9.1 Introduction 236
9.2 Definitions 236
9.3 The working capital cycle 237
9.4 Recognition 238
9.5 Users’ needs for information 241
9.6 Information provided in the financial statements 242
9.7 Measurement and recording 244
9.8 Inventories (stocks) of raw materials and finished goods 245
9.9 Receivables (debtors) 249
9.10 Prepayments 251
9.11 Revenue recognition 252
9.12 Summary 254
Questions 254
A Test your understanding 255
B Application 255
C Problem solving and evaluation 256
Activities for study groups 257
Notes and references 257
Supplement: Bookkeeping entries for (a) bad and doubtful debts;
and (b) prepayments 258
Test your understanding 262
Chapter 10 Current liabilities 263
Real World Case 263
Learning outcomes 264
10.1 Introduction 264
10.2 Definitions 265
10.3 Recognition 266
10.4 Users’ needs for information 267
10.5 Information provided in the financial statements 268
10.6 Measurement and recording 269
10.7 Accruals and the matching concept 271
10.8 Liabilities for taxation 274
10.9 Summary 275
xii Contents
Questions 276
A Test your understanding 276
B Application 276
C Problem solving and evaluation 277
Activities for study groups 277
Notes and references 278
Supplement: Bookkeeping entries for accruals 279
Test your understanding 281
Chapter 11 Provisions and non-current (long-term) liabilities 282
Real World Case 282
Learning outcomes 283
11.1 Introduction 284
11.2 Users’ needs for information 285
11.3 Information provided in the financial statements 285
11.4 Provisions 288
11.5 Deferred income 291
11.6 Non-current (long-term) liabilities 292
11.7 Summary 298
Questions 299
A Test your understanding 299
B Application 299
C Problem solving and evaluation 300
Activities for study groups 301
Notes and references 301
Supplement: Bookkeeping entries for provisions and deferred income 302
Test your understanding 303
Chapter 12 Ownership interest 304
Real World Case 304
Learning outcomes 305
12.1 Introduction 306
12.2 Definition and recognition 306
12.3 Presentation of ownership interest 307
12.4 Additional primary financial statements 314
12.5 Users’ needs for information 315
12.6 Information provided in the financial statements 315
12.7 Dividends 319
12.8 Issue of further shares on the Stock Exchange 320
12.9 Summary 323
Questions 324
A Test your understanding 324
B Application 324
C Problem solving and evaluation 325
Activities for study groups 327
Notes and references 327
Supplement: A spreadsheet for adjustment to a trial balance
at the end of the accounting period 328
Test your understanding 332
Contents xiii
Part 4 Analysis and issues in reporting
Chapter 13 Ratio analysis 334
Real World Case 334
Learning outcomes 335
13.1 Introduction 335
13.2 A note on terminology 336
13.3 Systematic approach to ratio analysis 336
13.4 Investors’ views on risk and return 343
13.5 Pyramid of ratios 346
13.6 Use and limitations of ratio analysis 347
13.7 Worked example of ratio analysis 348
13.8 Linking ratios to the cash flow statement 354
13.9 Summary 357
Questions 357
A Test your understanding 358
B Application 358
C Problem solving and evaluation 360
Chapter 14 Reporting corporate performance 361
Real World Case 361
Learning outcomes 363
14.1 Introduction 363
14.2 Operating and Financial Review (OFR) 363
14.3 Other guidance in analysis 367
14.4 Segmental information 371
14.5 Off-balance sheet finance 376
14.6 Corporate social responsibility 377
14.7 Corporate governance 380
14.8 Developing issues: ‘Present fairly’ and ‘true and fair view’ 381
14.9 Measurement of value 384
14.10 Developing issues: How valid is the stakeholder model 387
14.11 Summary 387
Questions 389
A Test your understanding 389
B Application 390
C Problem solving and evaluation 390
Activities for study groups 390
Notes and references 391
Chapter 15 Reporting cash flows 393
Real World Case 393
Learning outcomes 394
15.1 Introduction 394
15.2 Cash and cash equivalents 395
15.3 The direct method and the indirect method 395
15.4 Preparing a cash flow statement: the indirect method 399
15.5 Preparing a cash flow statement: the direct method 407
xiv Contents
15.6 Interpretation of cash flow information 408
15.7 Illustration 408
15.8 Summary 413
Further reading 413
Questions 413
A Test your understanding 414
B Application 414
C Problem solving and evaluation 415
Notes and references 417
MANAGEMENT ACCOUNTING
Part 5 Setting the scene and defining the basic tools of
management accounting
Chapter 16 Functions of management accounting 422
Real World Case 422
Learning outcomes 423
16.1 Introduction 424
16.2 Meeting the needs of internal users 426
16.3 Management functions 427
16.4 Role of management accounting 432
16.5 Judgements and decisions: case study illustrations 435
16.6 The language of management accounting 440
16.7 Summary 441
Further reading 441
Questions 441
A Test your understanding 441
B Application 442
C Problem solving and evaluation 443
Cases for study groups 446
Notes and references 446
Chapter 17 Classification of costs 447
Real World Case 447
Learning outcomes 448
17.1 Definition of a cost 448
17.2 The need for cost classification 449
17.3 The meaning of ‘activity’ and ‘output’ 449
17.4 Variable costs and fixed costs 450
17.5 Direct costs and indirect costs 454
17.6 Product costs and period costs 456
17.7 Cost classification for planning, decision making and control 458
17.8 Cost coding 461
17.9 Cost selection and reporting 462
17.10 Summary 463
Further reading 464
Contents xv
Questions 464
A Test your understanding 464
B Application 465
C Problem solving and evaluation 467
Cases for study groups 467
Chapter 18 Product costs: materials, labour and overheads 469
Real World Case 469
Learning outcomes 470
18.1 Introduction 471
18.2 Accounting for materials costs 472
18.3 Accounting for labour costs 476
18.4 Production overheads: traditional approach 478
18.5 Activity-based costing (ABC) for production overheads 488
18.6 Comparing traditional approach and ABC 496
18.7 Summary 498
Further reading 499
Questions 499
A Test your understanding 499
B Application 500
C Problem solving and evaluation 502
Cases for study groups 503
Notes and references 503
Part 6 Job costs and stock valuation
Chapter 19 Job costing 506
Real World Case 506
Learning outcomes 507
19.1 Introduction 507
19.2 Job cost records: an illustration 509
19.3 Job costing: applying the accounting equation to transactions 512
19.4 Absorption costing and marginal costing 517
19.5 Moving forward 521
19.6 Summary 522
Questions 523
A Test your understanding 524
B Application 524
C Problem solving and evaluation 526
Cases for study groups 527
Part 7 Decision making
Chapter 20 Breakeven analysis and short-term decision making 530
Real World Case 530
Learning outcomes 531
xvi Contents
20.1 Introduction 532
20.2 Cost behaviour: fixed and variable costs 532
20.3 Breakeven analysis 537
20.4 Using breakeven analysis 540
20.5 Limitations of breakeven analysis 543
20.6 Applications of cost-volume-profit analysis 543
20.7 Cases in short-term decision making 545
20.8 Pricing decisions 550
20.9 Summary 552
Questions 553
A Test your understanding 553
B Application 554
C Problem solving and evaluation 555
Cases for study groups 556
Part 8 Planning and control
Chapter 21 Preparing a budget 560
Real World Case 560
Learning outcomes 561
21.1 Introduction 562
21.2 Purpose and nature of a budget system 562
21.3 Administration of the budgetary process 565
21.4 The benefits of budgeting 569
21.5 Behavioural aspects of budgeting 572
21.6 Approaches to budgeting 575
21.7 Practical example – development of a budget 577
21.8 Shorter budget periods 587
21.9 Summary 590
Questions 591
A Test your understanding 591
B Application 592
C Problem solving and evaluation 594
Cases for study groups 597
Chapter 22 Standard costs 598
Real World Case 598
Learning outcomes 599
22.1 Introduction 600
22.2 Purpose of using standard costs 600
22.3 The level of output to be used in setting standards 601
22.4 The control process 602
22.5 Direct materials cost variance 603
22.6 Direct labour cost variance 605
22.7 Variable overhead cost variance 606
22.8 Fixed overhead expenditure variance 607
22.9 Case study: Allerdale Ltd 607
Contents xvii
22.10 Investigating variances 612
22.11 Flexible budgets and variance analysis 613
22.12 Case study: Brackendale Ltd 614
22.13 Is variance analysis, based on standard costs, a useful exercise? 618
22.14 A broader view of applications of variance analysis 619
22.15 Summary 620
Questions 620
A Test your understanding 621
B Application 621
C Problem solving and evaluation 624
Cases for study groups 626
Notes and references 627
Chapter 23 Performance evaluation and feedback reporting 628
Real World Case 628
Learning outcomes 629
23.1 Introduction 629
23.2 Preparing performance reports 631
23.3 Performance evaluation 632
23.4 Benchmarking 637
23.5 Non-financial performance measures 638
23.6 The balanced scorecard 640
23.7 Management use of performance measurement 642
23.8 Summary 644
Further reading 645
Questions 645
A Test your understanding 645
B Application 646
C Problem solving and evaluation 646
Cases for study groups 649
Part 9 Capital investment appraisal and business strategy
Chapter 24 Capital investment appraisal 652
Real World Case 652
Learning outcomes 653
24.1 Purpose of capital investment appraisal 654
24.2 Payback method 656
24.3 Accounting rate of return 658
24.4 Net present value method 660
24.5 Internal rate of return 665
24.6 Mutually exclusive projects 668
24.7 Which methods are used in practice? 670
24.8 Control of investment projects: authorisation and review 671
24.9 Advanced manufacturing technologies 672
24.10 Summary 673
Further reading 674
xviii Contents
Questions 674
A Test your understanding 674
B Application 675
C Problem solving and evaluation 676
Cases for study groups 679
Supplement: Table of discount factors 680
Chapter 25 Business strategy and management accounting 682
Real World Case 682
Learning outcomes 683
25.1 Introduction 683
25.2 Strategic management accounting 684
25.3 The just-in-time approach 685
25.4 Value chain analysis 686
25.5 Total quality management and cost of quality 687
25.6 Business process re-engineering 688
25.7 E-business and e-commerce 689
25.8 Summary 692
Further reading 692
Questions 693
A Test your understanding 693
B Application 693
C Problem solving and evaluation 694
Cases for study groups 694
Note and reference 694
Financial accounting terms defined G1
Management accounting terms defined G11
Appendices
I Information extracted from annual report of Safe and
Sure Group plc, used throughout Financial Accounting A1
II Solutions to numerical and technical questions in
Financial Accounting A15
III Solutions to numerical and technical questions in
Management Accounting A39
Index I1
Supporting resources
Visit www.pearsoned.co.uk/weetman to find valuable online resources.
Companion Website for students
l Multiple choice questions to test your learning
l Extensive links to valuable resources on the web
l An online glossary to explain key terms
For instructors
l Student handouts containing a skeleton outline of each chapter
l PowerPoint slides that can be downloaded and used as OHTs
l Suggested discussion answers to real world case studies
l Solutions to questions in the text
l Additional multiple choice questions and further graded questions in application of
knowledge and in problem solving
Also, the Companion Website provides the following features:
l Search tool to help locate specific items of content
l E-mail results and profile tools to send results of quizzes to instructors
l Online help and support to assist with website usage and troubleshooting
For more information please contact your local Pearson Education sales representative or
visit www.pearsoned.co.uk/weetman.
Introduction
The implementation of International Financial Reporting Standards (IFRS) in the
UK from January 2005 marked the start of an intensely interesting and challenging
period for those involved in preparing or using the annual reports and financial
statements of listed UK companies. It also brought a challenge for those involved in
accounting education, namely how to ensure that our students understand and can
apply the approach represented in IFRS while still being aware that many organisations
in the UK will continue to follow the UK tradition as set out in company law
and UK accounting standards. For listed companies, in their group accounts, IFRS
are mandatory. For all other companies the use of IFRS is a matter of choice with the
alternative being to cling to the UK tradition. For unincorporated businesses and for
the public sector the prospect of IFRS-related practice is probably still some way into
the future.
This book takes up the challenge by using the international framework as its primary
focus. This enables students in their early stages of study to understand and analyse
the published annual reports and financial statements of our largest businesses.
However it also explains the UK tradition, where this differs from the IFRS, so that
students will also understand and appreciate small business accounts or financial
statements of public sector entities and not-for-profit organisations.
The book is written for the first level of undergraduate degree study in accounting
and business studies, or equivalent introductory accounting courses for any professional
training where an understanding of accounting is a basic requirement. The fourth
edition is thoroughly revised to reflect International Financial Reporting Standards.
A new chapter on the interpretation and presentation of cash flow statements has been
added in response to requests. The underlying pedagogy of previous editions has
been retained in response to encouraging comments from reviewers and from users
of the book.
As institutions come under increasing scrutiny for the quality of the teaching and
learning experience offered, a textbook must do more than present the knowledge and
skills of the chosen subject. It must make explicit to the students what targets are to be
achieved and it must help them to assess realistically their own achievements of those
targets. It must help the class lecturer prepare, deliver, explain and assess the knowledge
and skills expected for the relevant level of study. This is achieved by stating
learning outcomes at the start of each chapter and by ensuring that the chapter headings
and the end-of-chapter questions address the stated outcomes.
The management accounting chapters continue the approach of previous editions
in taking some of the newer costing techniques into mainstream discussion, reflecting
their increasing acceptance in management accounting practice. Business strategy and
competitive position are recurring themes.
An accompanying website at www.pearsoned.co.uk/weetman provides the
lecturer with a complete resource pack for each chapter. Student handouts containing
a skeleton outline of each chapter, leaving slots for students to complete; overheadprojector
masters that match the lecture handouts, additional multiple-choice questions
Preface to the fourth edition
Preface to the fourth edition xxi
and further graded questions in application of knowledge and in problem solving; all
are new features for this fourth edition.
End-of-chapter questions are graded according to the skills being assessed. There
are tests of retained knowledge, tests of application of knowledge in straightforward
situations and tests of problem solving and evaluation using the acquired knowledge
in less familiar situations.
Overall the aim of the fourth edition is to provide an introduction to financial
accounting which engages the interest of students and encourages a desire for further
study. It also contributes to developing the generic skills of application, problem
solving, evaluation and communication, all emphasised by employers.
Subject coverage
Financial reporting is an essential component in the process of communication
between a business and its stakeholders. The importance of communication increases
as organisations become larger and more complex. Reporting financial information
to external stakeholders not involved in the day-to-day management of the business
requires a carefully balanced process of extracting the key features while preserving
the essential core of information. The participants in the communication process
cover a wide range of expertise and educational background, so far as accounting is
concerned. The range begins with those who prepare financial statements, who may
have a special training in accounting techniques, but it ends with those who may
be professional investors, private investors, investment advisers, bankers, employee
representatives, customers, suppliers and journalists.
One very significant group of stakeholders in any business is the internal management
of the organisation. Managers have access to a wealth of detailed financial information
and a responsibility for the careful management of the assets and operations of the
organisation. The way in which the managers of an organisation use financial information
is very much contingent on the purpose for which the information is intended.
Management accounting is a specialist area of study within accounting more generally.
Ideally, management accounting and financial accounting would coalesce if the
external users could be given access to all internal information, but that might damage
the competitive position of the business and would probably swamp the external
users in detail.
First-level degree courses in accounting are increasingly addressed to this broad
base of potential interest and this book seeks to provide such a broad base of understanding
while also supplying a sound technical base for those intending to pursue
specialised study of the subject further. In particular it makes use of the Framework for
the Preparation and Presentation of Financial Statements which is used by the International
Accounting Standards Board in developing and reviewing accounting standards.
That Framework is intended to help preparers, users and auditors of financial statements
to understand better the general nature and function of information reported in
financial statements.
Aim of the book
The fourth edition has been updated throughout. It aims to provide a full understanding
of the key aspects of the annual report, concentrating in particular on companies
in the private sector but presenting principles of wider application which are relevant
also to organisations operating in the public sector.
In the management accounting section, the book aims to establish a firm understanding
of the basic techniques, while recognising that more recent developments in
management accounting are becoming widespread. A contingency approach is adopted
which emphasises that the selection of management accounting techniques is conditional
xxii Preface to the fourth edition
on management’s purpose. To meet this purpose, the management accountant performs
the roles of directing attention, keeping the score and solving problems. Strategic management
accounting is emphasised from the outset so that students are aware that
management accounting must take an outward-looking approach. These themes are
reiterated throughout, concluding with an explanation of the role of management
accounting in business strategy, particularly e-business in the new economy. A student
who has completed this first-level study of management accounting will be aware
of many of the day-to-day practices of management accounting in business and the
relevance of those practices. It also provides a self-contained, broad introduction to
management accounting for business students who do not need to develop specialist
knowledge.
In particular
An international perspective reflects the convergence in accounting standards across the
European Union for listed companies. Features specific to the UK are retained where
these continue to be relevant to other enterprises.
Concepts of financial accounting are identified by applying the principles enunciated
by the Interational Accounting Standards Board in its Framework for the Preparation
and Presentation of Financial Statements. The Framework emphasises the desirability
of meeting the needs of users of financial statements and it takes a balance sheetoriented
approach. That approach is applied consistently throughout the book, with
some indication of the problems which may arise when it is clear that the established
emphasis on the matching of revenues and costs may give a more rational explanation
of existing practice.
User needs are explained in every chapter and illustrated by including first-person
commentary from a professional fund manager, holding a conversation with an audit
manager. The conversations are based on the author’s research in the area of communication
through the annual report.
The accounting equation is used throughout the financial accounting section for
analysis and processing of transactions. It is possible for students who do not seek
a technical specialism to complete the text without any reference to debit and credit
bookkeeping. It is, however, recognised that particular groups of students may wish
to understand the basic aspects of debit and credit bookkeeping and for this purpose
the end-of-chapter supplements revisit, on a debit and credit recording basis, material
already explored in the chapter. Debit and credit aspects of management accounting
are not covered since these are regarded as best reserved for later specialist courses
if the student so chooses.
Practical illustration is achieved by drawing on the financial information of a fictitious
major listed company, taking an overview in early chapters and then developing
the detailed disclosures as more specific matters are explored.
Interpretation of financial statements is a feature of all financial reporting chapters,
formally brought together in Chapters 13 and 14. The importance of the wider range
of corporate communication is reinforced in Chapter 14. This chapter also includes a
discussion of some current developments that are under debate in the context of international
convergence.
A running example of the fictitious company Safe and Sure plc provides illustration
and interpretation throughout the chapters. Safe and Sure plc is in the service
sector. The website contains a parallel example, Craigielaw plc, in the manufacturing
sector. On the website there are questions on Craigielaw to accompany most of the
chapters.
Self-evaluation is encouraged by setting learning outcomes at the start of each chapter
and reviewing these in the chapter summaries. Activity questions are placed at various
stages throughout each chapter. Self-testing questions at the end of the chapter may
be answered by referring again to the text. Further end-of-chapter questions provide a
Preface to the fourth edition xxiii
range of practical applications. Group activities are suggested at the end of each chapter
with the particular aim of encouraging participation and interaction. Answers are available
to all computational questions, either at the end of the book or on the website.
A sense of achievementis engendered in the reader of the financial accounting section
by providing a general understanding of the entire annual report by the end of
Chapter 7. Thereafter specific aspects of the annual report are explored in Chapters
8–12. Lecturers who wish to truncate a first-level course or leave specific aspects
to a later level will find Chapters 8–12 may be used on a selective basis.
A spreadsheet approach to financial accounting transactions is used in the body of the
relevant chapters to show processing of transactions using the accounting equation.
The author is firmly convinced, after years of trying every conceivable approach, that
the spreadsheet encourages students to apply the accounting equation analytically,
rather than trying to memorise T-account entries. Furthermore students now use spreadsheets
as a tool of analysis on a regular basis and will have little difficulty in applying
suitable software in preparing spreadsheets. In the bookkeeping supplementary sections,
the three-column ledger account has been adopted in the knowledge that school
teaching is moving increasingly to adopt this approach which cuts out much of the
bewilderment of balancing T-accounts. Computerised accounting systems also favour
the three-column presentation with continuous updating of the balance.
Flexible course design
There was once a time when the academic year comprised three terms and we all knew
the length of a typical course unit over those three terms. Now there are semesters,
trimesters, modules and half-modules so that planning a course of study becomes an
exercise in critical path analysis. This text is written for one academic year comprising
two semesters of 12 weeks each but may need selective guidance to students for a
module of lesser duration.
In financial accounting, Chapters 1–4 provide an essential conceptual framework
which sets the scene. For a general appreciation course, Chapters 5 and 6 are practical
so that one or both could be omitted, leading directly to Chapter 7 as a guide to
published accounts. Chapters 8–12 are structured so that the explanation of principles
is contained early in each chapter, but the practical implementation is later in
each chapter. For a general appreciation course, it would be particularly important to
refer to the section of each chapter which analyses users’ needs for information and
discusses information provided in the financial statements. However, the practical
sections of these chapters could be omitted or used on a selective basis rather than
attempting full coverage. Chapters 13 and 14 are important to all readers for a sense
of interpretation and awareness of the range of material within corporate reports.
Chapter 15 takes the reader through a cash flow statement item-by-item with the
emphasis on understanding and interpretation.
In teaching and learning management accounting various combinations are possible,
depending on course design and aims. Chapters 16, 17 and 18 provide an essential set
of basic tools of analysis but thereafter some flexibility is feasible. For applications
in job costing, Chapter 19 provides further material. For concentrating on decision
making and awareness of business strategy, Chapters 20, 24 and 25 are recommended.
For concentrating on planning and control, Chapters 21, 22 and 23 give students
experience of the variety of techniques in use.
Approaches to teaching and learning
Learning outcomes
Targets for student achievement in relation to knowledge and understanding of the
subject are specified in learning outcomes at the head of each chapter. The achievements
xxiv Preface to the fourth edition
represented by these learning outcomes are confirmed against graded questions at the
end of each chapter. The achievement of some learning outcomes may be confirmed
by Activities set out at the appropriate stage within the chapter.
Skills outcomes
The end-of-chapter questions test not only subject-specific knowledge and technical
skills but also the broader general skills that are transferable to subsequent employment
or further training.
Graded questions
End-of-chapter questions are graded and each is matched to one or more learning
outcomes. Where a solution is provided to a question this is shown by an [S] after the
question number.
A series questions: Test your understanding
The A series questions confirm the application of technical skills. These are skills
specific to the subject of accounting which add to the specialist expertise of the student.
More generally they show the student’s capacity to acquire and apply a technical skill
of this type.
The answers to these questions can be found in relevant sections of the chapter, as
indicated at the end of each question.
B series questions: Application
The B series questions apply the knowledge gained from reading and practising
the material of the chapter. They resemble closely in style and content the technical
material of the chapter. Confidence is gained in applying knowledge in a situation that
is very similar to that illustrated. Answers are given in Appendix II or on the website.
These questions test skills of problem-solving and evaluation that are relevant to
many subjects and many activities in life, especially in subsequent employment. Some
initiative is required in deciding how to apply relevant knowledge and in solving
problems.
C series questions: problem solving and evaluation
The C series questions apply the knowledge gained from reading the chapter, but in
a varied style of question. Problem-solving skills are required in selecting relevant
data or in using knowledge to work out what further effort is needed to solve the
problem. Evaluation means giving an opinion or explanation of the results of the
problem-solving exercise. Some answers are given in Appendix II but others are on
the website so that they can be used in tutorial preparation or class work.
Group and individual cases
Cases apply knowledge gained from the chapter but they also test communication
skills. Communication may involve writing or speaking, or both. It may require, for
example, explanation of a technical matter to a non-technical person, or discussion
with other students to explore a controversial issue, or presentation of a report to a
business audience.
S series questions in supplementary sections
The S series questions test knowledge of the accounting records system (bookkeeping
entries) to confirm understanding by those who have chosen to study the supplementary
bookkeeping sections.
Preface to the fourth edition xxv
Website
A website is available at www.pearsoned.co.uk/weetman by password access to
lecturers adopting this book. It contains additional problem questions for each chapter,
with full solutions to these additional questions as well as any solutions not provided
in the book. The website includes basic tutorial instructions and overhead-projector
masters to support each chapter.
Target readership
This book is targeted at a broad-ranging business studies type of first-level degree
course. It is intended to support the equivalent of one semester of 12 teaching weeks.
There is sufficient basic bookkeeping (ledger accounts) in the end-of-chapter supplements
to make the book suitable for those intending to pursue a specialised study of
accounting beyond the first level but the bookkeeping material is optional for those
who do not have such special intentions. The book has been written with undergraduate
students particularly in mind, but may also be suitable for professional and
postgraduate business courses where financial reporting is taught at an introductory
level.
Acknowledgements
I am grateful to academic colleagues and to reviewers of the text for helpful comments
and suggestions. I am also grateful to undergraduate students of five universities who
have taken my courses and thereby helped in developing an approach to teaching
and learning the subject. Professor Graham Peirson and Mr Alan Ramsay of Monash
University provided a first draft of their text based on the conceptual framework in
Australia which gave valuable assistance in designing the structure of this book, which
was also guided from the publishing side by Pat Bond and Ron Harper. Professor Ken
Shackleton of the University of Glasgow helped plan the structure of the management
accounting chapters. The Institute of Chartered Accountants of Scotland gave permission
for use of some of the end-of-chapter questions.
Subsequently I have received valuable support in successive editions from the
editorial staff at Pearson Education. For this latest edition I am grateful to colleagues
and students who have used the book in their teaching and learning. I have also been
helped by constructive comments from reviewers and by guidance from Matthew
Smith, Acquisitions Editor, and Sarah Wild, Senior Desk Editor.
Guided tour of the book
Chapter 2
A systematic approach to financial reporting:
the accounting equation
REAL WORLD CASE
Balance sheet
Shareholders’ funds decreased by
£644 million to £4,374 million and
net debt improved by £640 million to
£1,397 million in the year, decreasing
gearing to 32% (2004: 41%). Return
on Group capital employed decreased
from 10.1% to 4.9% in the year reflecting
lower operating profit performance and
the disposal of Shaw’s.
Summary balance sheet
2005 Restated1,2 2004
£m £m
Fixed assets 7,299 8,452
Current assets 4,319 4,055
Creditors: amounts falling due within one year (5,097) (4,906)
Net current liabilities (778) (851)
Total assets less current liabilities 6,521 7,601
Creditors: amounts falling due after more than one year (1,730) (2,194)
Provisions for liabilities and charges (332) (308)
Total net assets 4,459 5,099
Total shareholders’ funds (including non-equity interests) 4,374 5,018
Equity minority interests 85 81
Capital employed 4,459 5,099
1 Restated for change in accounting policy in accordance with UITF Abstract 38 – Accounting for ESOP Trusts.
2 Restated for change in classification of Sainsbury’s Bank’s assets, liabilities and cash.
Source: Sainsbury Annual Review and Summary Financial Statement 2005, pp. 30–1.
Discussion points
1 How does this balance sheet reflect the accounting equation?
2 How does the group explain the main changes?
Chapter 2 A systematic approach to financial reporting: the accounting equation 27
Contents 2.1 Introduction 28
2.2 The accounting equation 28
2.2.1 Form of the equation: national preferences 28
2.2.2 International variation 29
2.3 Defining assets 29
2.3.1 Controlled by the entity 29
2.3.2 Past events 30
2.3.3 Future economic benefits 30
2.4 Examples of assets 31
2.5 Recognition of assets 33
2.5.1 Probable that economic benefits will flow 34
2.5.2 Reliability of measurement 34
2.5.3 Non-recognition 34
2.6 Defining liabilities 35
2.6.1 Present obligation 35
2.6.2 Past events 36
2.6.3 Outflow of economic benefits 36
2.7 Examples of liabilities 36
2.8 Recognition of liabilities 37
2.9 Defining the ownership interest 39
2.10 Recognition 39
2.11 Changes in the ownership interest 39
2.11.1 Revenue and expense 40
2.11.2 Position after a change has occurred 41
2.12 Assurance for users of financial statements 41
2.13 Summary 42
Supplement: Debit and credit bookkeeping 47
Learning
outcomes
After studying this chapter you should be able to:
l Define and explain the accounting equation.
l Define assets.
l Apply the definition to examples of assets.
l Explain and apply the rules for recognition of assets.
l Define liabilities.
l Apply the definition to examples of liabilities.
l Explain and apply the rules for recognition of liabilities.
l Define ownership interest.
l Explain how the recognition of ownership interest depends on the recognition of
assets and liabilities.
l Use the accounting equation to show the effect of changes in the ownership interest.
l Explain how users of financial statements can gain assurance about assets and
liabilities.
Additionally, for those who choose to study the Supplement:
l Explain how the rules of debit and credit recording are derived from the
accounting equation.
6 Part 1 A conceptual framework: setting the scene
Activity 1.2
Definition Accounting is the process of identifying, measuring and communicating financial
information about an entity to permit informed judgements and decisions by users of
the information.1
This definition may appear short but it has been widely quoted over a number of years
and is sufficient to specify the entire contents of this introductory textbook.
Taking the definition word by word, it leads to the following questions:
1 What is the process?
2 How is financial information identified?
3 How is financial information measured?
4 How is financial information communicated?
5 What is an entity?
6 Who are the users of financial information about an entity?
7 What types of judgements and decisions do these users make?
Writing the questions in this order is slightly dangerous because it starts by
emphasising the process and waits until the final question to ask about the use of
the information. The danger is that accountants may design the process first and
then hope to show that it is suitable to allow judgements and decisions by users.
This is what has often happened over many years of developing the process by
accountants.
In order to learn about, and understand, accounting by taking a critical approach
to the usefulness of the current processes and seeing its limitations and the potential
for improvement, it is preferable to reverse the order of the questions and start by
specifying the users of financial information and the judgements and decisions they
make. Once the users and their needs have been identified, the most effective forms
of communication may be determined and only then may the technical details of
measurement and identification be dealt with in a satisfactory manner.
Reversing the order of the questions arising from the definition of accounting is the
approach to be used in this book because it is the approach which has been taken by
those seeking to develop a conceptual framework of accounting.
This chapter outlines the meaning of the words conceptual framework and in
particular the Framework for the Preparation and Presentation of Financial Statements
which has been developed for international use in accounting practice. The chapter
explains the nature of three common types of business entity and concludes by
drawing on various views relating to the users of accounting information and their
information needs.
Because the understanding of users’ needs is essential throughout the entire text,
the chapter introduces David Wilson, a fund manager working for a large insurance
company. In order to balance the demands of users with the restrictions and constraints
on preparers of financial information, the chapter also introduces Leona Rees
who works as an audit manager with an accountancy firm. Both of them will offer
comments and explanations as you progress through the text.
How does this section compare with your initial notions of what accounting means?
If they are similar, then it is likely that the rest of this book will meet your expectations.
If they are different, then it may be that you are hoping for more than this book can
achieve. If that is the case, this may be a useful point at which to consult your lecturer,
tutor or some other expert in the subject to be sure that you are satisfied that this book
will meet your personal learning outcomes.
Chapter 3 Financial statements from the accounting equation 57
Exhibit 3.3
Balance sheet: Assets equal ownership interest plus liabilities
P. Mason’s legal practice
Balance sheet at 30 September Year 5
£ £
Non-current assets
Land and buildings 250,000
Office furniture 30,000
Total non-current assets 280,000
Current assets
Receivables for fees 1,200
Prepayment of insurance premium 540
Cash at bank 15,280
Total current assets 17,020
Total assets 297,020
Ownership interest 144,220
Non-current liabilities
Long-term loan 150,000
Current liabilities
Trade payables 2,800
Total ownership interest plus liabilities 297,020
A person using this balance sheet can again see at a glance that there is no problem
for the business in meeting its current liabilities from its resources of current assets.
The financing of the business is split almost equally between the non-current liabilities
and the ownership interest, a split which would not be regarded as excessively risky
by those who lend to businesses. The non-current assets used as a basis for generating
profits from one year to the next are collected together as a group, although the
balance sheet alone cannot show how effectively those assets are being used.
3.5 The income statement (profit and loss account)
For many years in the UK, profit and loss account was the only title used for the
financial statement reporting profit of the period. From 2005 many of those listed
groups following the IASB’s system have chosen to follow an example given by
the IASB which uses the heading income statement, found more commonly in US
company reports. It is not compulsory for listed group companies to use ‘income
statement’ and some retain the ‘profit and loss account’ heading. The income statement
(profit and loss account) reflects that part of the accounting equation which
defines profit:
Profit equals Revenue minus Expenses
The expenses of a period are matched against the revenue earned in that period. This
is described as the application of the matching concept in accounting.
As with the balance sheet, it is presented in a vertical form so that it can be read
down the page as a narrative (Exhibit 3.4).
Chapter contents
provide a quick and
easy reference to the
following section.
Learning outcomes are bullet points at
the start of each chapter to show what
you can expect to learn from that chapter,
highlighting the core coverage.
Key terms and definitions are emboldened where
they are first introduced, with a definition box to
provide a concise explanation where required.
Real world case studies
at the beginning of each
chapter are designed
to exemplify a typical
situation in which
financial or management
accounting can be
helpful.
Activities appear throughout each chapter to encourage
self-evaluation and help you to think about the application
of the subject in everyday life.
Exhibits, at frequent
intervals throughout
most chapters, provide
clear explanations of key
points and calculations.
Colour coding provides
a clear and accessible
guide to key aspects of
accounting equations.
Guided tour of the book xxvii
62 Part 1 A conceptual framework: setting the scene
Activity 3.3
Users of financial statements regard both the profit and the cash flow as interesting
items of information. The profit shows the overall increase in ownership claim which
contributes to the overall wealth of the business. The cash flow shows the ability of the
business to survive financially through planning the timing and amount of inflows
and outflows of cash.
3.7 Usefulness of financial statements
Here are Leona and David, still working on Leona’s flat, discussing the usefulness of
financial statements.
LEONA: Which financial statement is the most important for you?
DAVID: It has to be the income statement (profit and loss account). Profit creates wealth.
Future profit creates future wealth. I have to make a forecast of each company’s profit as
part of my planning to meet our overall investment strategy. Maybe I should qualify that by
adding that cash flow is also important, especially where there is high uncertainty about
future prospects. We talk about ‘quality of profits’ and regard some types of profit as of
higher quality than others. Cash flow support is one aspect of that quality. We have doubts
about some accounting amounts which don’t have a close relationship to cash. A business
cannot survive if it can’t pay its way.
LEONA: Where does that leave the balance sheet?
DAVID: I’m not sure. It is a list of resources and claims on those resources. We are shareholders
and so we have a claim on those resources but we don’t think about it to any great
extent because we are concentrating on the going concern aspects of the business, rather
than closing down and selling the assets. The balance sheet numbers don’t mean very
much because they are out of date.
LEONA: We studied research at university which suggested that cash flow is the answer
and income statements (profit and loss accounts) are too difficult to understand. It was
suggested that the balance sheet should show what the assets could be sold for. I don’t
think the ideas had caught on in practice, but they seemed to have some merits.
DAVID: I like to know the dynamics of the business. I like to see the movements of different
aspects and the interactions. I think I would feel that cash flow alone is concentrating
on only one aspect of the wealth of the business. I suppose the balance sheet is a useful
check on the position which has been reached as a result of making profits for the period.
One thing we do look at in the balance sheet is how much has been borrowed for use in
the business. We don’t like to see that become too high in comparison with the ownership
interest.
LEONA: At least you are admitting to seeing something in the financial statements. I still
have to persuade you that the auditors are important in giving you the reassurance you
obviously obtain.
Analyse your own view of wealth and changes in wealth. Which items would you include
in your personal balance sheet today? Which items would you include in your personal
‘profit and loss’ account for the past year? Which items would you include in your
personal cash flow statement? Has your view of ‘wealth’ been modified as a result of
reading these first three chapters? If so, how have your views changed?
Chapter 4 Ensuring the quality of financial statements 97
Activity 4.5 Read David’s explanation again and compare it carefully with the financial statements. It is
quite likely that you will not understand everything immediately because the purpose of
this book as a whole is to help you understand published financial statements and we are,
as yet, only at the end of Chapter 4. Make a note of the items you don’t fully understand
and keep that note safe in a file. As you progress through the rest of the book, look back
to that note and tick off the points which subsequently become clear. The aim is to have
a page full of ticks by the end of the book.
4.7 Summary
The objective of financial statements is to provide information about the financial
position, performance and changes in financial position of an entity that is useful to a
wide range of users in making economic decisions.
The four principal qualitative characteristics, as described by the IASB Framework, are:
l understandability
l relevance
l reliability
l comparability.
Relevance and reliability are twin targets which may cause some tension in deciding
the most appropriate way to report accounting information.
The accounting measurement principles that are most widely known in the UK are
found within the Companies Act 1985:
l going concern
l accruals
l consistency
l prudence.
Prudence in accounting means exercising a degree of caution when reporting assets,
liabilities and profits. Overstatement of assets causes the overstatement of profit.
Understatement of liabilities causes the overstatement of profit. Prudence requires
avoiding overstating profit but also avoiding deliberate understatement of profit.
Regulation of financial reporting in the UK comes from several sources.
l The IAS Regulation requires all listed groups of companies to prepare financial
statements using the system of the International Accounting Standards Board
(IASB system). Other companies may choose to follow the IASB system.
l Companies that do not follow the IASB system must comply with UK company law.
l The Financial Reporting Council regulates accounting and auditing matters under
the authority of UK company law.
l The Financial Reporting Council oversees the UK Accounting Standards Board which
sets accounting standards for companies that are complying with UK company law.
l The Financial Reporting Review Panel takes action against companies whose
annual reports do not comply with the relevant accounting system (IASB or UK
company law).
l The Financial Services Authority regulates a wide range of financial service activities
including the London Stock Exchange. It sets Listing Rules for companies listed on
the Stock Exchange.
l Auditors give an opinion on whether financial statements present a true and fair
view of the profit or loss of the period and the state of affairs at the end of the
period. They are professionally qualified accountants with auditing experience who
are members of a recognised professional body.
98 Part 1 A conceptual framework: setting the scene
l The UK tax system charges corporation tax on company profits. Her Majesty’s Revenue
and Customs (HMRC) start with the accounting profit in calculating the amount of
tax payable but there are some special rules of accounting for tax purposes.
Further reading
IASB (1989), Framework for the Preparation and Presentation of Financial Statements, International
Accounting Standards Board.
Paterson, R. (2002), ‘Whatever happened to Prudence?’, Accountancy, January, p. 105.
The website of the Financial Reporting Council explains the methods and nature of regulation
of financial reporting and the accountancy profession: www.frc.org.uk
QUESTIONS
The Questions section of each chapter has three types of question. ‘Test your understanding’
questions to help you review your reading are in the ‘A’ series of questions. You will find the
answers to these by reading and thinking about the material in the book. ‘Application’ questions
to test your ability to apply technical skills are in the ‘B’ series of questions. Questions requiring
you to show skills in problem solving and evaluation are in the ‘C’ series of questions. A letter
[S] indicates that there is a solution at the end of the book.
A Test your understanding
A4.1 Explain what is meant by each of the following: (section 4.2)
(a) relevance;
(b) reliability;
(c) faithful representation;
(d) neutrality;
(e) prudence;
(f ) completeness;
(g) comparability;
(h) understandability; and
(i) materiality.
A4.2 Explain the accounting measurement principles of each of the following: (section 4.3)
(a) going concern;
(b) accruals;
(c) consistency;
(d) the concept of prudence.
A4.3 Explain why companies should avoid overstatement of assets or understatement of
liabilities. (section 4.4)
A4.4 Explain the responsibilities of directors of a company towards shareholders in relation
to the financial statements of a company. (section 4.5.2)
A4.5 Explain the impact on financial statements of each of the following: (section 4.5)
(a) company law;
(b) the International Accounting Standards Board; and
(c) the UK tax law.
A4.6 Explain how the monitoring of financial statements is carried out by each of the following:
(section 4.5)
(a) the auditors; and
(b) the Financial Reporting Review Panel.
Chapter 7 Published financial statements 189
A7.19 Apart from the annual report, what other documents do companies use to communicate
financial statement information to investors, creditors and other users of financial statements?
(Section 7.9)
B Application
B7.1 [S]
Write a letter to the financial controller of a company advising on the factors which a company
should take into consideration when deciding how to arrange information in financial
statements.
B7.2 [S]
Write a note for financial analysts explaining how the published income statement (profit and
loss account) provides a useful indication of the financial performance of a company.
B7.3 [S]
What features are likely to make a balance sheet helpful to users?
B7.4 [S]
Could a cash flow statement be presented as the only financial statement reported by a
company? Explain your view.
C Problem solving and evaluation
C7.1 [S]
A listed company is of the view that shareholders might welcome a statement of highlights and
supplementary information as a leaflet to be inserted in the annual report. Give advice on the
principles to be followed in making such information useful to users.
Activities for study groups
Continuing to use the annual reports of companies which you obtained for Chapters 1 and 4,
find the financial statements (balance sheet, profit and loss account and cash flow statement)
and the notes to the accounts.
1 Compare the financial statements with the formats and presentations shown in this chapter,
and note any differences which you observe. Look at the notes to the accounts for items
which are required by the regulations but are included in the notes rather than the main
financial statements.
2 Find the Operating and Financial Review (sometimes named the finance director’s review)
and compare the cash flow discussion there with the FRS 1 presentation. Form a view on
how readily the discussion may be related to the financial statement.
3 In your group, take the list of qualitative characteristics listed at section 4.2 and use the
financial statements as a means of illustrating how the company has met those characteristics.
If you have a set of different annual reports, each member of the group should take the
role of a finance director pointing out the qualitative characteristics of their own company’s
financial statements. The group together should then decide on a ranking with a view to
nominating one of the annual reports for an award of ‘Communicator of the Year’.
Summaries at the
end of each chapter
highlight the material
that has been covered
and can be used as a
quick reminder of the
main issues.
Further reading sections
provide full details of
sources of information
referred to in the chapter.
Problem solving and evaluation (Series C) questions require
problem solving skills to select relevant data in order to work out
what further effort is needed to solve the problem. Evaluation
questions ask for your opinion surrounding the results of the
problem solving exercise. Some solutions are found at the end of
the book but others are in the Resources for Tutors section on the
Companion Website at www.pearsoned.co.uk/weetman, for use
in tutorial preparation or class work.
Activities for study groups at the end of
most chapters are designed to help you apply
the accounting skills and knowledge you have
acquired from the chapter to the real world.
Application (Series B) questions are questions that ask
you to apply the knowledge gained from reading and
practising the material in the chapter, and closely
resemble the style and content of the technical material.
Answers are given at the end of the book or in the
Resources for Tutors on the Companion Website at
www.pearsoned.co.uk/weetman.
Test your
understanding
(Series A) questions
are short questions to
encourage you to review
your understanding of the
main topics covered in
each chapter.
A conversation between two managers (consultants)
appears at intervals throughout the text to provide a
valuable insight into the type of interpretative comment
which you may find more taxing. These conversations
allow a more candid discussion of issues and problems
within the subject.
We are grateful to the following for permission to reproduce copyright material:
Photographs within real world case studies:
Chapters 1, 2 and 6 Alex Segre/Photographers Direct; Chapters 3, 4, 8, 9, 14 Alamy/
Royalty Free; Chapter 5 logo reproduced with kind permission from WPP; Chapter 7
Roger Howard/Photographers Direct; Chapter 10 Chris Batson/Photographers Direct;
Chapters 11, 12 and 13 Alex Segre/Photographers Direct; Chapter 15 Jeannette Tas/
Photographers Direct; Chapter 16 Alamy/ImageState; Chapter 17 Alamy/Renee Morris;
Chapter 18 Alamy/Comstock Images; Chapter 19 Alamy/ImageState; Chapter 20 courtesy
of Flying Brands; Chapter 21 Alamy/Photofusion Picture Library; Chapter 22 Alamy/
ImageState; Chapter 23 Corbis/Philip Gould; Chapter 24 Alamy/Dominic Burke; Chapter 25
Alamy/Photofusion Picture Library.
Text extracts in real world case studies:
Chapter 3 BAA for an extract from the BAA Annual Report 2004/5; Chapter 4 Signet Group
Plc for extracts from their Annual Report and Accounts 2005; Chapter 6 Matalan Plc for an
extract from their Annual Report and Financial Statements; Chapter 7 GUS Plc for tables
from the GUS Annual Report and Financial Statement 2005; Chapter 8 Ottakar’s Plc for
extracts from Ottakar’s Annual Report 2005; Chapter 10 The Carphone Warehouse Group
Plc for an extract and a table from The Carphone Warehouse Plc Annual Report 2005;
Chapter 11 BP Plc for an extract and a table from BP Annual Reports and Accounts 2004;
Chapter 12 Kingfisher Plc for extracts from Kingfisher Annual Report and Accounts
2004/5; Chapter 13 Thorntons Plc for an extract and a table from Thorntons Plc Annual
Report 2005; Chapter 14 Vodafone Group Plc for extracts and a table from the Vodafone
Group Plc Corporate Responsibility Report 2004/5; Chapter 15 Corus Group Plc for an
extract from the Corus Group Plc Interim Report 2005.
Exhibits:
4.1 and 7.2 from Statement of Principles for Financial Reporting, p.34 (ASB 1999). All ASB
material is reproduced by kind permission of The Accounting Standards Board Limited.
For further information please visit www.frc.org.uk/asb.
We are grateful to the Financial Times Limited for permission to reprint the following
material: Chapter 19 real world case study ‘Why a monster hit did not make giant profits’,
© Financial Times, 15 February 2005.
In some instances we have been unable to trace the owners of copyright material, and we
would appreciate any information that would enable us to do so.
Publisher’s acknowledgements
FINANCIAL ACCOUNTING

Part 1
A conceptual framework:
setting the scene
1 Who needs accounting?
2 A systematic approach to financial reporting:
the accounting equation
3 Financial statements from the accounting equation
4 Ensuring the quality of financial statements
Chapter 1
Who needs accounting?
REAL WORLD CASE
Summary financial highlights
Summary 2005 2004 % change
Retail Sales (£m) 708.7 672.5 +5%
Turnover (£m) 419.0 381.1 +10%
Operating Profit (£m) 36.2 30.3 +19%
Earnings per share (pence) 13.1 10.7 +22%
Dividend per share (pence) 5.7 5.7 0%
Net debt (£m) 4.7 9.4 −50%
Delivering value to stakeholders
The Body Shop has an established reputation as a socially and environmentally responsible company.
We believe that our values are consistent with strong and sustained financial performance, and that
profits with principles must be achieved in order to sustain the long-term future of the Group. The
Body Shop is committed to maintaining high standards of social and environmental performance.
We believe in doing business with integrity and transparency. This means using our ethical principles
to inform the way we do business, setting ourselves and our business partners clear standards of
practice. It also involves engaging stakeholders with our business aims and publicly reporting on
our performance within the overall context of our business strategy.
The overall strategic direction of the Group’s values is reviewed periodically by the Board in
consultation with the Director of Values. The Director of Values reports into the Chief Executive
Officer and has overall responsibility for directing the Group’s social and environmental programme.
Strategic values objectives are aligned with the business objectives as well as stakeholder
perceptions and expectations. These objectives are fully embraced by the senior management team,
who have responsibility for balancing the interests of all key stakeholder groups.
Sub-committees help direct the social and environmental approach of the business. These include
an Issues Management Group, which reports into the Risk Committee; a Corporate Health and Safety
Strategy Group; an Environmental Steering Group; and an Animal Protection Steering Group.
Source: The Body Shop International PLC, Annual Report and Accounts 2005, p. 1 (Table) and p. 20 (Text).
Discussion points
1 Who might be included in the ‘key stakeholder groups’ mentioned the extract?
2 To what extent does the ‘Summary’ meet the needs of users of financial statements?
Chapter 1 Who needs accounting? 5
Contents 1.1 Introduction 5
1.2 The development of a conceptual framework 7
1.3 Framework for the preparation and presentation of financial statements 8
1.4 Types of business entity 8
1.4.1 Sole trader 9
1.4.2 Partnership 9
1.4.3 Limited liability company 10
1.5 Users and their information needs 12
1.5.1 Management 13
1.5.2 Owners as investors 13
1.5.3 Employees 14
1.5.4 Lenders 15
1.5.5 Suppliers and other trade creditors 15
1.5.6 Customers 15
1.5.7 Governments and their agencies 16
1.5.8 Public interest 16
1.6 General purpose or specific purpose financial statements? 17
1.7 Stewards and agents 17
1.8 Who needs financial statements? 18
1.9 Summary 19
Supplement: Introduction to the terminology of business transactions 24
Learning
outcomes
After studying this chapter you should be able to:
l Define, and explain the definition of, accounting.
l Explain what is meant by a conceptual framework.
l Explain the distinguishing features of a sole trader, a partnership and a limited
company.
l List the main users of financial information and their particular needs.
l Discuss the usefulness of financial statements to the main users.
Additionally, for those who choose to study the Supplement:
l Define the basic terminology of business transactions.
Activity 1.1
1.1 Introduction
Before starting to read this section, write down one paragraph stating what you think the
word ‘accounting’ means. Then read this section and compare it with your paragraph.
There is no single ‘official’ definition of accounting but for the purposes of this text the
following wording will be used:
6 Part 1 A conceptual framework: setting the scene
Activity 1.2
Definition Accounting is the process of identifying, measuring and communicating financial
information about an entity to permit informed judgements and decisions by users of
the information.1
This definition may appear short but it has been widely quoted over a number of years
and is sufficient to specify the entire contents of this introductory textbook.
Taking the definition word by word, it leads to the following questions:
1 What is the process?
2 How is financial information identified?
3 How is financial information measured?
4 How is financial information communicated?
5 What is an entity?
6 Who are the users of financial information about an entity?
7 What types of judgements and decisions do these users make?
Writing the questions in this order is slightly dangerous because it starts by
emphasising the process and waits until the final question to ask about the use of
the information. The danger is that accountants may design the process first and
then hope to show that it is suitable to allow judgements and decisions by users.
This is what has often happened over many years of developing the process by
accountants.
In order to learn about, and understand, accounting by taking a critical approach
to the usefulness of the current processes and seeing its limitations and the potential
for improvement, it is preferable to reverse the order of the questions and start by
specifying the users of financial information and the judgements and decisions they
make. Once the users and their needs have been identified, the most effective forms
of communication may be determined and only then may the technical details of
measurement and identification be dealt with in a satisfactory manner.
Reversing the order of the questions arising from the definition of accounting is the
approach to be used in this book because it is the approach which has been taken by
those seeking to develop a conceptual framework of accounting.
This chapter outlines the meaning of the words conceptual framework and in
particular the Framework for the Preparation and Presentation of Financial Statements
which has been developed for international use in accounting practice. The chapter
explains the nature of three common types of business entity and concludes by
drawing on various views relating to the users of accounting information and their
information needs.
Because the understanding of users’ needs is essential throughout the entire text,
the chapter introduces David Wilson, a fund manager working for a large insurance
company. In order to balance the demands of users with the restrictions and constraints
on preparers of financial information, the chapter also introduces Leona Rees
who works as an audit manager with an accountancy firm. Both of them will offer
comments and explanations as you progress through the text.
How does this section compare with your initial notions of what accounting means?
If they are similar, then it is likely that the rest of this book will meet your expectations.
If they are different, then it may be that you are hoping for more than this book can
achieve. If that is the case, this may be a useful point at which to consult your lecturer,
tutor or some other expert in the subject to be sure that you are satisfied that this book
will meet your personal learning outcomes.
Chapter 1 Who needs accounting? 7
Activity 1.3
1.2 The development of a conceptual framework
A conceptual framework for accounting is a statement of principles which provides
generally accepted guidance for the development of new reporting practices and for
challenging and evaluating the existing practices. Conceptual frameworks have been
developed in several countries around the world, with the UK arriving a little late
on the scene. However, arriving late does give the advantage of learning from what
has gone before. It is possible to see a pattern emerging in the various approaches to
developing a conceptual framework.
The conceptual frameworks developed for practical use by the accountancy
profession in various countries all start with the common assumption that financial
statements must be useful. The structure of most conceptual frameworks is along
the following lines:
l Who are the users of financial statements?
l What are the information needs of users?
l What types of financial statements will best satisfy their needs?
l What are the characteristics of financial statements which meet these needs?
l What are the principles for defining and recognising items in financial statements?
l What are the principles for measuring items in financial statements?
The most widely applicable conceptual framework is the Framework for the Preparation
and Presentation of Financial Statements produced by the International Accounting
Standards Board (IASB). This Framework was issued in 1989 and either reflects, or is
reflected in, national conceptual frameworks of the USA, Canada, Australia and the
UK. The thinking in all those documents can be traced to two discussion papers of
the 1970s in the UK and the USA. In the UK, The Corporate Report2 was a slim but
highly influential document setting out the needs of users and how these might be
met. Two years earlier the Trueblood Report3 in the USA had taken a similar approach
of identifying the needs of users, although perhaps coming out more strongly in
support of the needs of shareholders and creditors than of other user groups. In
the UK, various documents on the needs of users have been prepared by individuals
invited to help the process4 or those who took it on themselves to propose radical
new ideas.5
Since January 2005, all listed companies in member states of the European Union
(EU) have been required by an accounting regulation called the IAS regulation6 to
use a system of international financial reporting standards set by the International
Accounting Standards Board. The UK ASB has been influential in the development of
these international reporting standards and, over a period of years, has been moving
UK accounting practice closely into line with the international standards. For unlisted
companies and other organisations not covered by the IAS regulation of the EU,
the UK ASB has a conceptual framework of its own, called the Statement of Principles.7
This document has many similarities to the IASB’s Framework.
Most conceptual frameworks start with the question: Who are the users of financial
statements? Write down a list of the persons or organisations you think would be
interested in making use of financial statements, and their possible reasons for being
interested. Have you included yourself in that list? Keep your list available for comparing
with a later section of this chapter.
8 Part 1 A conceptual framework: setting the scene
Activity 1.4
1.3 Framework for the preparation and presentation of
financial statements
The IASB’s Framework has seven main sections.
1 Introduction – purpose of the Framework, users and their information needs.
2 The objective of financial statements.
3 Underlying assumptions.
4 Qualitative characteristics of financial statements.
5 The elements of financial statements.
6 Recognition of the elements of financial statements.
7 Measurement of the elements of financial statements.
Sections 1 and 2 of the Framework are written at a general level and a reader would find
no difficulty in reviewing these at an early stage of study, to gain a flavour of what is
expected of financial statements. The remaining sections are a mixture of general principles,
which are appropriate to first-level study of the subject, and some quite specific
principles which deal with more advanced problems. Some of those problems need an
understanding of accounting which is beyond a first level of study. This book will refer
to aspects of the various sections of the Framework, as appropriate, when particular
issues are dealt with. You should be aware, however, that this book concentrates on
the basic aspects of the Framework and does not explore every complexity.
A conceptual framework is particularly important when practices are being developed
for reporting to those who are not part of the day-to-day running of the business. This
is called external reporting or financial accounting and is the focus of the Financial
Accounting half of this book. For those who are managing the business on a day-to-day
basis, special techniques have been developed and are referred to generally as internal
reporting or management accounting. That is the focus of the Management Accounting
half of this book.
Before continuing with the theme of the conceptual framework, it is useful to pause
and consider the types of business for which accounting information may be required.
Visit the website of the International Accounting Standards Board at
www.iasb.org.uk and find the link to the IASB Framework. (You may have to
follow the link to ‘standards’ although the Framework is not a formal standard.)
What does the IASB say about the purpose of the Framework? How was it
developed? What are the similarities and differences between the ASB and IASB
in the way each describes its conceptual framework?
Visit the website of the Accounting Standards Board at www.asb.org.uk and find the
link to the Statement of Principles. What does the ASB say about the purpose of the
Statement of Principles? How was it developed?
1.4 Types of business entity
The word entity means ‘something that exists independently’. A business entity is a
business that exists independently of those who own the business. There are three main
categories of business which will be found in all countries, although with different titles
in different ones. This chapter uses the terminology common to the UK. The three
main categories are: sole trader, partnership and limited liability company. This list is
by no means exhaustive but provides sufficient variety to allow explanation of the
usefulness of most accounting practices and their application.
web
activity
Chapter 1 Who needs accounting? 9
Activity 1.5 Before reading the next sections, take out a newspaper with business advertisements
or a business telephone directory, or else take a walk down your local high street or
drive round the trading estate. Write down the names of five businesses, shops or
other organisations. Then read the sections and attempt to match your list against the
information provided in each.
1.4.1 Sole trader
An individual may enter into business alone, either selling goods or providing a service.
Such a person is described as a sole trader. The business may be started because the
sole trader has a good idea which appears likely to make a profit, and has some cash to
buy the equipment and other resources to start the business. If cash is not available, the
sole trader may borrow from a bank to enable the business to start up. Although this
is the form in which many businesses have started, it is one which is difficult to expand
because the sole trader will find it difficult to arrange additional finance for expansion.
If the business is not successful and the sole trader is unable to meet obligations to
pay money to others, then those persons may ask a court of law to authorise the sale
of the personal possessions, and even the family home, of the sole trader. Being a sole
trader can be a risky matter and the cost of bank borrowing may be at a relatively
unfavourable rate of interest because the bank fears losing its money.
From this description it will be seen that the sole trader’s business is very much
intertwined with the sole trader’s personal life. However, for accounting purposes,
the business is regarded as a separate economic entity, of which the sole trader is the
owner who takes the risk of the bad times and the benefit of the good times. Take as
an example the person who decides to start working as an electrician and advertises
his or her services in a newspaper. The electrician travels to jobs from home and has
no business premises. Tools are stored in the loft at home and the business records
are in a cupboard in the kitchen. Telephone calls from customers are received on the
domestic phone and there are no clearly defined working hours. The work is inextricably
intertwined with family life.
For accounting purposes that person is seen as the owner of a business which provides
electrical services and the business is seen as being separate from the person’s
other interests and private life. The owner may hardly feel any great need for accounting
information because he or she knows the business very closely, but accounting
information will be needed by other persons or entities, mainly the government (in the
form of HM Revenue and Customs) for tax collecting purposes. It may also be required
by a bank for the purposes of lending money to the business or by another sole trader
who is intending to buy the business when the existing owner retires.
1.4.2 Partnership
One method by which the business of a sole trader may expand is to enter into
partnership with one or more people. This may permit a pooling of skills to allow
more efficient working, or may allow one person with ideas to work with another who
has the money to provide the resources needed to turn the ideas into a profit. There
is thus more potential for being successful. If the business is unsuccessful, then the
consequences are similar to those for the sole trader. Persons to whom money is owed
by the business may ask a court of law to authorise the sale of the personal property
of the partners in order to meet the obligation. Even more seriously, one partner may
be required to meet all the obligations of the partnership if the other partner does not
have sufficient personal property, possessions and cash. This is described in law as
joint and several liability and the risks have to be considered very carefully by those
entering into partnership.
10 Part 1 A conceptual framework: setting the scene
Partnership may be established as a matter of fact by two persons starting to work
together with the intention of making a profit and sharing it between them. More
often there is a legal agreement, called a partnership deed, which sets out the rights
and duties of each partner and specifies how they will share the profits. There is also
partnership law, which governs the basic relationships between partners and which
they may use to resolve their disputes in a court of law if there is no partnership deed,
or if the partnership deed has not covered some aspect of the partnership.
For accounting purposes the partnership is seen as a separate economic entity, owned
by the partners. The owners may have the same intimate knowledge of the business
as does the sole trader and may therefore feel that accounting information is not very
important for them. On the other hand, each partner may wish to be sure that he or
she is receiving a fair share of the partnership profits. There will also be other persons
requesting accounting information, such as HM Revenue and Customs, banks who
provide finance, and individuals who may be invited to join the partnership so that
it may expand even further.
1.4.3 Limited liability company
The main risk attached to either a sole trader or a partnership is that of losing personal
property and possessions, including the family home, if the business fails. That risk
would inhibit many persons from starting or expanding a business. Historically, as
the UK changed from a predominantly agricultural to a predominantly industrial
economy in the nineteenth century, it became apparent that owners needed the protection
of limited liability. This meant that if the business failed, then the owners might
lose all the money they had put into the business but their personal wealth would
be safe.
There are two forms of limited liability company. The private limited company
has the word ‘Limited’ (abbreviated to ‘Ltd’) in its title. The public limited company
has the abbreviation ‘plc’ in its title. The private limited company is prohibited by law
from offering its shares to the public, so it is a form of limited liability appropriate
to a family-controlled business. The public limited company is permitted to offer its
shares to the public. In return it has to satisfy more onerous regulations. Where the
shares of a public limited company are bought and sold on a stock exchange, the
public limited company is called a listed company because the shares of the company
are on a list of share prices.
In either type of company, the owners are called shareholders because they share
the ownership and share the profits of the good times and the losses of the bad times
(to the defined limit of liability). Once they have paid in full for their shares, the
owners face no further risk of being asked to contribute to meeting any obligations
of the business. Hopefully, the business will prosper and the owners may be able to
receive a share of that prosperity in the form of a cash dividend. A cash dividend
returns to the owners, on a regular basis and in the form of cash, a part of the profit
created by the business.
If the company is very small, the owners may run the business themselves. If it is
larger, then they may prefer to pay someone else to run the business. In either case,
the persons running the business on a day-to-day basis are called the directors.
Because limited liability is a great privilege for the owners, the company must meet
regulations set out by Parliament in the form of a Companies Act. At present the
relevant law is the Companies Act 1985.
For accounting purposes the company is an entity with an existence separate from
the owners. In the very smallest companies the owners may not feel a great need for
accounting information, but in medium or large size companies, accounting information
will be very important for the shareholders as it forms a report on how well the
directors have run the company. As with other forms of business there will be a need
Chapter 1 Who needs accounting? 11
to provide accounting information to HM Revenue and Customs for tax-collecting
purposes. The list of other users will expand considerably because there will be a
greater variety of sources of finance, the company may be seeking to attract more
investors, employees will be concerned about the well-being of the business, and even
the customers and suppliers may want to know more about the financial strength of
the company.
Although the law provides the protection of limited liability, this has little practical
meaning for many small family-controlled companies because a bank lending money
to the business will ask for personal guarantees from the shareholder directors. Those
personal guarantees could involve a mortgage over the family home, or an interest in
life assurance policies. The potential consequences of such personal guarantees, when
a company fails, are such that the owners may suffer as much as the sole trader whose
business fails.
Exhibit 1.1 summarises the differences between a partnership and a limited liability
company that are relevant for accounting purposes.
Exhibit 1.2 identifies the differences between the public limited company and the
private limited company that are relevant for accounting purposes.
Exhibit 1.1
Differences between a partnership and a limited liability company
Formation
Running the
business
Accounting
information
Meeting
obligations
Powers to
carry out
activities
Status in law
Partnership
Formed by two or more
persons, usually with written
agreement but not
necessarily in writing.
All partners are entitled to
share in the running of the
business.
Partnerships are not obliged
to make accounting
information available to the
wider public.
All members of a general
partnership are jointly and
severally liable for money
owed by the firm.
Partnerships may carry out
any legal business activities
agreed by the partners.
The partnership is not a
separate legal entity (under
English law), the partnership
property being owned by the
partners. (Under Scots law
the partnership is a separate
legal entity.)
Limited liability company
Formed by a number of persons
registering the company under the
Companies Act, following legal
formalities. In particular there must be
a written memorandum and articles
of association setting out the powers
allowed to the company.
Shareholders must appoint directors
to run the business (although
shareholders may appoint themselves
as directors).
Companies must make accounting
information available to the public
through the Registrar of Companies.
The personal liability of the owners
is limited to the amount they have
agreed to pay for shares.
The company may only carry out the
activities set out in its memorandum
and articles of association.
The company is seen in law as a
separate person, distinct from its
members. This means that the
company can own property, make
contracts and take legal action or be
the subject of legal action.
12 Part 1 A conceptual framework: setting the scene
Exhibit 1.2
Brief comparison of private and public companies
Running the
business
Ownership
Accounting
information
Public company
Minimum of two directors.
Must have a company secretary
who holds a relevant qualification
(responsible for ensuring the
company complies with the
requirements of company law).
Shares may be offered to the
public, inviting subscription.
Minimum share capital £50,000.
Extensive information required
on transactions between directors
and the company.
Information must be made public through the Registrar of Companies.
Provision of financial information to the public is determined by size
of company, more information being required of medium and large
companies.
Accounting information must be sent to all shareholders.
Private company
Minimum of one director.
The sole director may also act
as the company secretary and
is not required to have a formal
qualification.
Shares must not be offered to
the public. May only be sold by
private arrangements.
No minimum share capital.
Less need for disclosure of
transactions between directors
and the company.
Activity 1.6 Look at the list of five organisations which you prepared before reading this section.
Did the list match what you have just read? If not, there are several possible explanations.
One is that you have written down organisations which are not covered by this book.
That would apply if you have written down ‘museum’, ‘town hall’ or ‘college’. These are
examples of public sector bodies that require specialised financial statements not covered
by this text. Another is that you did not discover the name of the business enterprise.
Perhaps you wrote down ‘Northern Hotel’ but did not find the name of the company
owning the hotel. If your list does not match the section, ask for help from your lecturer,
tutor or other expert in the subject so that you are satisfied that this book will continue to
meet your personal learning outcomes.
1.5 Users and their information needs
Who are the users of the information provided by these reporting entities? This section
shows that there is one group, namely the management of an organisation, whose
information needs are so specialised that a separate type of accounting has evolved
called management accounting. However, there are other groups, each of which may
believe it has a reasonable right to obtain information about an organisation, that
do not enjoy unrestricted access to the business and so have to rely on management to
supply suitable information. These groups include the owners, where the owners are
not also the managers, but extend further to employees, lenders, suppliers, customers,
government and its branches, and the public interest. Those in the wider interest
groups are sometimes referred to as stakeholders.
Chapter 1 Who needs accounting? 13
Definition Stakeholder A general term to indicate all those who might have a legitimate interest in
receiving financial information about a business because they have a ‘stake’ in it.
1.5.1 Management
Many would argue that the foremost users of accounting information about an
organisation must be those who manage the business on a day-to-day basis. This
group is referred to in broad terms as management, which is a collective term for all
those persons who have responsibilities for making judgements and decisions within
an organisation. Because they have close involvement with the business, they have
access to a wide range of information (much of which may be confidential within the
organisation) and will seek those aspects of the information which are most relevant
to their particular judgements and decisions. Because this group of users is so broad,
and because of the vast amount of information potentially available, a specialist branch
of accounting has developed, called management accounting, to serve the particular
needs of management.
It is management’s responsibility to employ the resources of the business in an
efficient way and to meet the objectives of the business. The information needed by
management to carry out this responsibility ought to be of high quality and in an
understandable form so far as the management is concerned. If that is the case, it would
not be unreasonable to think that a similar quality (although not necessarily quantity)
of information should be made available more widely to those stakeholders who do
not have the access available to management.8 Such an idea would be regarded as
somewhat revolutionary in nature by some of those who manage companies, but more
and more are beginning to realise that sharing information with investors and other
stakeholders adds to the general atmosphere of confidence in the enterprise.
1.5.2 Owners as investors
Where the owners are the managers, as is the case for a sole trader or a partnership,
they have no problem in gaining access to information and will select information
appropriate to their own needs. They may be asked to provide information for other
users, such as HM Revenue and Customs or a bank which has been approached to
provide finance, but that information will be designed to meet the needs of those
particular users rather than the owners.
Where the ownership is separate from the management of the business, as is the
case with a limited liability company, the owners are more appropriately viewed as
investors who entrust their money to the company and expect something in return,
usually a dividend and a growth in the value of their investment as the company
prospers. Providing money to fund a business is a risky act and investors are concerned
with the risk inherent in, and return provided by, their investments. They need
information to help them decide whether they should buy, hold or sell.9 They are also
interested in information on the entity’s financial performance and financial position
that helps them to assess both its cash-generation abilities and the stewardship of
management.10
Much of the investment in shares through the Stock Exchange in the UK is carried
out by institutional investors, such as pension funds, insurance companies, unit trusts
and investment trusts. The day-to-day business of buying and selling shares is carried
out by a fund manager employed by the institutional investor. Private investors are in
the minority as a group of investors in the UK. They will often take the advice of an
equities analyst who investigates and reports on share investment. The fund managers
and the equities analysts are also regarded as users of accounting information.
14 Part 1 A conceptual framework: setting the scene
The kinds of judgements and decisions made by investors could include any or all
of the following:
(a) Evaluating the performance of the entity.
(b) Assessing the effectiveness of the entity in achieving objectives (including compliance
with stewardship obligations) established previously by its management,
its members or owners.
(c) Evaluating managerial performance, efficiency and objectives, including investment
and dividend distribution plans.
(d) Ascertaining the experience and background of company directors and officials
including details of other directorships or official positions held.
(e) Ascertaining the economic stability and vulnerability of the reporting entity.
(f) Assessing the liquidity of the entity, its present or future requirements for additional
working capital, and its ability to raise long-term and short-term finance.
(g) Assessing the capacity of the entity to make future reallocations of its resources for
economic purposes.
(h) Estimating the future prospects of the entity, including its capacity to pay dividends,
and predicting future levels of investment.
(i) Making economic comparisons, either for the given entity over a period of time or
with other entities at one point in time.
(j) Estimating the value of present or prospective interests in or claims on the entity.
(k) Ascertaining the ownership and control of the entity.11
That list was prepared in 1975 and, while it is a valid representation of the needs of
investors, carries an undertone which implies that the investors have to do quite a
lot of the work themselves in making estimates of the prospects of the entity. Today
there is a stronger view that the management of a business should share more of
its thinking and planning with the investors. The list may therefore be expanded by
suggesting that it would be helpful for investors (and all external users) to know:
(a) the entity’s actual performance for the most recent accounting period and how
this compares with its previous plan for that period;
(b) management’s explanations of any significant variances between the two; and
(c) management’s financial plan for the current and forward accounting periods, and
explanations of the major assumptions used in preparing it.12
If you look through some annual reports of major listed companies you will see that
this is more a ‘wish list’ than a statement of current practice, but it is indicative of the
need for a more progressive approach. In the annual reports of large companies you
will find a section called the Operating and Financial Review (or similar title). This is
where the more progressive companies will include forward-looking statements which
stop short of making a forecast but give help in understanding which of the trends
observed in the past are likely to continue into the future.
1.5.3 Employees
Employees and their representatives are interested in information about the stability
and profitability of their employers. They are also interested in information that helps
them to assess the ability of the entity to provide remuneration, retirement benefits
and employment opportunities.13 Employees continue to be interested in their employer
after they have retired from work because in many cases the employer provides a
pension fund.
The matters which are likely to be of interest to past, present and prospective
employees include: the ability of the employer to meet wage agreements; management’s
intentions regarding employment levels, locations and working conditions;
the pay, conditions and terms of employment of various groups of employees; job
Chapter 1 Who needs accounting? 15
security; and the contribution made by employees in other divisions of the organisation.
Much of this is quite specialised and detailed information. It may be preferable
to supply this to employees by means of special purpose reports on a frequent basis
rather than waiting for the annual report, which is slow to arrive and more general in
nature. However, employees may look to financial statements to confirm information
provided previously in other forms.
1.5.4 Lenders
Lenders are interested in information that enables them to determine whether their
loans, and the related interest, will be paid when due.14
Loan creditors provide finance on a longer-term basis. They will wish to assess
the economic stability and vulnerability of the borrower. They are particularly concerned
with the risk of default and its consequences. They may impose conditions
(called loan covenants) which require the business to keep its overall borrowing
within acceptable limits. The financial statements may provide evidence that the loan
covenant conditions are being met.
Some lenders will ask for special reports as well as the general financial statements.
Banks in particular will ask for cash flow projections showing how the business plans
to repay, with interest, the money borrowed.
1.5.5 Suppliers and other trade creditors
Suppliers of goods and services (also called trade creditors) are interested in information
that enables them to decide whether to sell to the entity and to determine whether
amounts owing to them will be paid when due. Suppliers (trade creditors) are likely
to be interested in an entity over a shorter period than lenders unless they are dependent
upon the continuation of the entity as a major customer.15 The amount due to be
paid to the supplier is called a trade payable or an account payable.
Trade creditors supply goods and services to an entity and have very little protection
if the entity fails because there are insufficient assets to meet all liabilities. They
are usually classed as unsecured creditors, which means they are a long way down
the queue for payment. So they have to exercise caution in finding out whether the
business is able to pay and how much risk of non-payment exists. This information
need not necessarily come from accounting statements; it could be obtained by reading
the local press and trade journals, joining the Chamber of Trade, and generally
listening in to the stories and gossip circulating in the geographic area or the industry.
However, the financial statements of an entity may confirm the stories gained from
other sources.
In recent years there has been a move for companies to work more closely with
their suppliers and to establish ‘partnership’ arrangements where the operational and
financial plans of both may be dovetailed by specifying the amount and the timing of
goods and services required. Such arrangements depend heavily on confidence, which
in turn may be derived partly from the strength of financial statements.
1.5.6 Customers
Customers have an interest in information about the continuance of an entity, especially
when they have a long-term involvement with, or are dependent upon, its prosperity.
16 In particular, customers need information concerning the current and future
supply of goods and services offered, price and other product details, and conditions
of sale. Much of this information may be obtained from sales literature or from sales
staff of the enterprise, or from trade and consumer journals.17
16 Part 1 A conceptual framework: setting the scene
Activity 1.7
The financial statements provide useful confirmation of the reliability of the
enterprise itself as a continuing source of supply, especially when the customer is
making payments in advance. They also confirm the capacity of the entity in terms
of non-current assets (also called fixed assets) and working capital and give some
indication of the strength of the entity to meet any obligations under guarantees or
warranties.18
1.5.7 Governments and their agencies
Governments and their agencies are interested in the allocation of resources and,
therefore, in the activities of entities. They also require information in order to regulate
the activities of entities, assess taxation and provide a basis for national income and
economic statistics.19
Acting on behalf of the UK government’s Treasury Department, HM Revenue
and Customs collects taxes from businesses based on profit calculated according to
commercial accounting practices (although there are some specific rules in the taxation
legislation which modify the normal accounting practices). HM Revenue and Customs
has the power to demand more information than appears in published financial statements,
but will take these as a starting point.
Other agencies include the regulators of the various utility companies. Examples are
Ofcom20 (the Office of Communications) and Ofgem21 (the Office of Gas and Electricity
Markets). They use accounting information as part of the package by which they monitor
the prices charged by these organisations to consumers of their services. They also
demand additional information designed especially to meet their needs.
1.5.8 Public interest
Enterprises affect members of the public in a variety of ways. For example, enterprises
may make a substantial contribution to the local economy by providing employment
and using local suppliers. Financial statements may assist the public by providing
information about the trends and recent developments in the prosperity of the entity
and the range of its activities.22
A strong element of public interest has been aroused in recent years by environmental
issues and the impact of companies on the environment. There are costs imposed on
others when a company pollutes a river or discharges harmful gases into the air. It
may be perceived that a company is cutting corners to prune its own reported costs
at the expense of other people. Furthermore, there are activities of companies today
which will impose costs in the future. Where an oil company has installed a drilling
rig in the North Sea, it will be expected one day to remove and destroy the rig safely.
There is a question as to whether the company will be able to meet that cost. These
costs and future liabilities may be difficult to identify and quantify, but that does not
mean that companies should not attempt to do so. More companies are now including
descriptions of environmental policy in their annual reports, but regular accounting
procedures for including environmental costs and obligations in the financial statements
have not yet been developed.
Look back to the list of users of financial statements which you prepared earlier in this
chapter. How closely does your list compare with the users described in this section?
Did you have any in your list which are not included here? Have you used names which
differ from those used in the chapter? Are there users in the chapter which are not in
your list? If your list does not match the section, ask for help from your lecturer, tutor or
other expert in the subject so that you are satisfied that this book will continue to meet
your personal learning outcomes.
Chapter 1 Who needs accounting? 17
1.6 General purpose or specific purpose financial
statements?
Some experts who have analysed the needs of users in the manner set out in the
previous section have come to the conclusion that no single set of general purpose
financial statements could meet all these needs. It has been explained in the previous
section that some users already turn to special reports to meet specific needs. Other
experts hold that there could be a form of general purpose financial statements which
would meet all the needs of some user groups and some of the needs of others.
This book is written on the assumption that it is possible to prepare a set of general
purpose financial statements which will have some interest for all users. The existence
of such reports is particularly important for those who cannot prescribe the information
they would like to receive from an organisation. That is perhaps because they
have no bargaining power, or because they are many in number but not significant in
economic influence.
Preparers of general purpose financial statements tend to regard the owners and
long-term lenders as the primary users of the information provided. There is an expectation
or hope that the interests of these groups will overlap to some extent with the
interests of a wider user group and that any improvements in financial statements will
be sufficient that fewer needs will be left unmet.23
The primary focus of the Framework is on general purpose financial statements.24 It
takes the view that many users have to rely on the financial statements as their major
source of financial information. Financial statements should be prepared with their
needs in mind. The Framework assumes that if financial statements meet the needs of
investors, they will also meet the needs of most other users.25
1.7 Stewards and agents
In an earlier section, the needs of investors as users were listed and the word
‘stewardship’ appeared. In the days before an industrial society existed, ‘stewards’
were the people who looked after the manor house and lands while the lord of the
manor enjoyed the profits earned. Traditionally, accounting has been regarded as
having a particular role to play in confirming that those who manage a business on
behalf of the owner take good care of the resources entrusted to them and earn a
satisfactory profit for the owner by using those resources.
As the idea of a wider range of users emerged, this idea of the ‘stewardship’
objective of accounting was mentioned less often (although its influence remains
strong in legislation governing accounting practice). In the academic literature it has
been reborn under a new heading – that of agency. Theories have been developed
about the relationship between the owner, as ‘principal’, and the manager, as ‘agent’.
A conscientious manager, acting as an agent, will carry out his or her duties in the best
interest of the owners, and is required by the law of agency to do so. However, not
all agents will be perfect in carrying out this role and some principals will not trust
the agent entirely. The principal will incur costs in monitoring (enquiring into) the
activities of the agent and may lose some wealth if the interests of the agent and the
interests of the principal diverge. The view taken in agency theory is that there is an
inherent conflict between the two parties and so they spend time agreeing contracts
which will minimise that conflict. The contracts will include arrangements for the
agent to supply information on a regular basis to the principal.
While the study of agency theory in all its aspects could occupy a book in itself, the
idea of conflicts and the need for compromise in dealing with pressures of demand for,
18 Part 1 A conceptual framework: setting the scene
and supply of, accounting information may be helpful in later chapters in understanding
why it takes so long to find answers to some accounting issues.
1.8 Who needs financial statements?
In order to keep the flavour of debate on accounting issues running through this text,
two people will give their comments from time to time. The first of these is David
Wilson, a fund manager of seven years’ experience working for an insurance company.
He manages a UK equity portfolio (a collection of company shares) and part
of his work requires him to be an equities analyst. At university he took a degree in
history and has subsequently passed examinations to qualify as a chartered financial
analyst (CFA).26
The second is Leona Rees, an audit manager with a major accountancy firm. She has
five years’ experience as a qualified accountant and had previously spent three years
in training with the same firm. Her university degree is in accounting and economics
and she has passed the examinations to qualify for membership of one of the major
accountancy bodies.
David and Leona had been at school together but then went to different universities.
More recently they have met again at workout sessions at a health club, relaxing
afterwards at a nearby bar. David is very enthusiastic about his work, which demands
long hours and a flexible attitude. He has absorbed a little of the general scepticism of
audit which is expressed by some of his fund manager colleagues.
Leona’s main role at present is in company audit and she is now sufficiently experienced
to be working on the audit of one listed company as well as several private
companies of varying size. For two years she worked in the corporate recovery department
of the accountancy firm, preparing information to help companies find sources
of finance to overcome difficult times. She feels that a great deal of accounting work is
carried out behind the scenes and the careful procedures are not always appreciated
by those who concentrate only on the relatively few well-publicised problems.
We join them in the bar at the end of a hectic working week.
DAVID: This week I’ve made three visits to companies, attended four presentations of
preliminary announcements of results, received copies of the projector slides used for five
others that I couldn’t attend, and collected around 20 annual reports. I have a small mound
of brokers’ reports, all of which say much the same thing but in different ways. I’ve had
to read all those while preparing my monthly report to the head of Equities Section on the
performance of my fund and setting out my strategy for three months ahead consistent
with in-house policy. I think I’m suffering from information overload and I have reservations
about the reliability of any single item of information I receive about a company.
LEONA: If I had to give scores for reliability to the information crossing your desk, I would
give top marks to the 20 annual reports. They have been through a very rigorous process
and they have been audited by reputable audit firms using established standards of auditing
practice.
DAVID: That’s all very well, but it takes so long for annual reports to arrive after the balance
sheet date that they don’t contain any new information. I need to get information at the
first available opportunity if I’m to keep up the value of the share portfolio I manage. The
meetings that present the preliminary announcements are held less than two months after
the accounting year-end. It can take another six weeks before the printed annual report
appears. If I don’t manage to get to the meeting I take a careful look at what the company
sends me in the way of copies of projector slides used.
Chapter 1 Who needs accounting? 19
Activity 1.8
LEONA: Where does accounting information fit in with the picture you want of a company?
DAVID: It has some importance, but accounting information is backward-looking and I
invest in the future. We visit every company in the portfolio once a year and I’m looking for
a confident management team, a cheerful-looking workforce and a general feeling that
things are moving ahead. I’ll also ask questions about prospects: how is the order book;
which overseas markets are expanding; have prices been increased to match the increase
in raw materials?
LEONA: Isn’t that close to gaining insider information?
DAVID: No – I see it as clarification of information which is already published. Companies
are very careful not to give an advantage to one investor over another – they would be in
trouble with the Stock Exchange and perhaps with the Financial Services Authority if they
did give price-sensitive information. There are times of the year (running up to the year-end
and to the half-yearly results) when they declare a ‘close season’ and won’t even speak to
an investor.
LEONA: So are you telling me that I spend vast amounts of time auditing financial statements
which no one bothers to read?
DAVID: Some people would say that, but I wouldn’t. It’s fairly clear that share prices are
unmoved by the issue of the annual report, probably because investors already have that
information from the preliminary announcement. Nevertheless, we like to know that there
is a regulated document behind the information we receive – it allows us to check that
we’re not being led astray. Also I find the annual report very useful when I want to find out
about a company I don’t know. For the companies I understand well, the annual report tells
me little that I don’t already know.
LEONA: I’ll take that as a very small vote of confidence for now. If your offer to help me
redecorate the flat still stands, I might try to persuade you over a few cans of emulsion that
you rely on audited accounts more than you realise.
As a final activity for this chapter, go back to the start of the chapter and make a note of
every word you have encountered for the first time. Look at the Glossary at the end of the
book for the definition of each technical word. If the word is not in the Glossary it is
probably in sufficiently general use to be found in a standard dictionary.
1.9 Summary
This chapter has explained that accounting is intended to provide information that is
useful to a wide range of interested parties (stakeholders).
Key points are:
l Accounting is the process of identifying, measuring and communicating financial
information about an entity to permit informed judgements and decisions by users
of the information.
l A conceptual framework for accounting is a statement of principles which provides
generally accepted guidance for the development of new reporting practices
and for challenging and evaluating the existing practices.
l The Framework of the IASB provides broad principles that guide accounting practice
in many countries.
20 Part 1 A conceptual framework: setting the scene
l The Statement of Principles of the UK ASB has many similarities to the IASB’s
Framework.
l Since January 2005, all listed companies in member states of the EU have been
required by an accounting regulation to use a system of international financial
reporting standards (IFRS) set by the IASB.
l Business entities in the UK are either sole traders, partnerships or limited liability
companies.
l Users of accounting information include management, owners, employees, lenders,
suppliers, customers, governments and their agencies, and the public interest.
l Stakeholders are all those who might have a legitimate interest in receiving financial
information about a business because they have a ‘stake’ in it.
l General purpose financial statements aim to meet the needs of a wide range of
users.
l The relationship between the owner, as ‘principal’, and the manager, as ‘agent’ is
described in the theory of agency relationships. Accounting information helps to
reduce the potential conflicts of interest between principal and agent.
Further reading
IASB (1989) Framework for the Preparation and Presentation of Financial Statements, International
Accounting Standards Board.
ASSC (1975) The Corporate Report, Accounting Standards Steering Committee.
Beattie, V. (ed.) (1999) Business Reporting: The Inevitable Change?, Research Committee of
The Institute of Chartered Accountants of Scotland.
ICAS (1988) Making Corporate Reports Valuable, discussion paper of the Research Committee
of The Institute of Chartered Accountants of Scotland.
Marston, C. (1999) Investor Relations Meetings: Views of Companies, Institutional Investors and
Analysts, Research Committee of The Institute of Chartered Accountants of Scotland.
Weetman, P. and Beattie, A. (eds) (1999) Corporate Communication: Views of Institutional
Investors and Lenders, Research Committee of The Institute of Chartered Accountants of
Scotland.
The Questions section of each chapter has three types of question. ‘Test your understanding’
questions to help you review your reading are in the ‘A’ series of questions. You will find the
answers to these by reading and thinking about the material in the book. ‘Application’ questions
to test your ability to apply technical skills are in the ‘B’ series of questions. Questions requiring
you to show skills in problem solving and evaluation are in the ‘C’ series of questions. A letter
[S] indicates that there is a solution at the end of the book.
A Test your understanding
A1.1 Define ‘accounting’ and identify the separate questions raised by the definition. (Section 1.1)
A1.2 The following technical terms appear for the first time in this chapter. Check that you
know the meaning of each. (If you can’t find them again in the text, there is a Glossary
at the end of the book.)
QUESTIONS
Chapter 1 Who needs accounting? 21
l accounting standards l HM Revenue and Customs
l agency l limited liability company
l annual report l liquidity
l broker l loan covenants
l business entity l management accounting
l capital l partnership
l cash flow projections l portfolio [of investment]
l conceptual framework l portfolio of shares
l directors l Registrar of Companies
l entity l share capital
l equities analyst l shareholders
l external reporting l sole trader
l financial accounting l specific purpose financial statements
l financial information l stakeholders
l financial statements l stewardship
l fund manager l unsecured creditors
l general purpose financial statements
B Application
B1.1
Brian and Jane are planning to work in partnership as software consultants. Write a note
(100–200 words) to explain their responsibilities for running the business and producing
accounting information about the financial position and performance of the business.
B1.2
Jennifer has inherited some shares in a public company which has a share listing on the Stock
Exchange. She has asked you to explain how she can find out more about the financial position
and performance of the company. Write a note (100–200 words) answering her question.
B1.3
Martin is planning to buy shares in the company that employs him. He knows that the directors
of the company are his employers but he wonders what relationship exists between the directors
and the shareholders of the company. Write a note (100–200 words) answering his question.
C Problem solving and evaluation
C1.1
The following extracts are typical of the annual reports of large listed companies. Which of these
extracts satisfy the definition of ‘accounting’? What are the user needs that are most closely
met by each extract?
(a) Suggestions for improvements were made by many employees, alone or in teams. Annual
savings which have been achieved total £15m. The best suggestion for improvement will
save around £0.3m per year for the next five years.
(b) As of 31 December, 3,000 young people were learning a trade or profession with the company.
This represents a studentship rate of 3.9%. During the reporting period we hired 1,300
young people into training places. This is more than we need to satisfy our employment
needs in the longer term and so we are contributing to improvement of the quality of labour
supplied to the market generally.
(c) During the year to 31 December our turnover (sales) grew to £4,000 million compared to
£2,800 million last year. Our new subsidiary contributed £1,000 million to this increase.
(d) It is our target to pay our suppliers within 30 days. During the year we achieved an average
payment period of 33 days.
22 Part 1 A conceptual framework: setting the scene
(e) The treasury focus during the year was on further refinancing of the group’s borrowings to
minimise interest payments and reduce risk.
(f ) Our plants have emission rates that are 70% below the national average for sulphur dioxide
and 20% below the average for oxides of nitrogen. We will tighten emissions significantly
over the next ten years.
C1.2
Explain how you would class each of the following – as a sole trader, partnership or limited company.
List any further questions you might ask for clarification about the nature of the business.
(a) Miss Jones works as an interior decorating adviser under the business name ‘U-decide’.
She rents an office and employs an administrative assistant to answer the phone, keep files
and make appointments.
(b) George and Jim work together as painters and decorators under the business name ‘Painting
Partners Ltd’. They started the business ten years ago and work from a rented business unit
on a trading estate.
(c) Jenny and Chris own a hotel jointly. They operate under the business name ‘Antler Hotel
Company’ and both participate in the running of the business. They have agreed to share
profits equally.
Activities for study groups (4 or 5 per group)
Obtain the annual report of a listed company. Each member of the group should choose a
different company. Most large companies will provide a copy of the annual report at no charge
in response to a polite request – or you may know someone who is a shareholder and receives
a copy automatically. Many companies have websites with a section for ‘Investor Relations’
where you will find a document file containing the annual report.
1 Look at the contents page. What information does the company provide?
2 Find the financial highlights page. What are the items of accounting information which the
company wants you to note? Which users might be interested in this highlighted information,
and why?
3 Is there any information in the annual report which would be of interest to employees?
4 Is there any information in the annual report which would be of interest to customers?
5 Is there any information in the annual report which would be of interest to suppliers?
6 Find the auditors’ report. To whom is it addressed? What does that tell you about the intended
readership of the annual report?
7 Note the pages to which the auditors’ report refers. These are the pages which are regulated
by company law, accounting standards and Stock Exchange rules. Compare these pages with
the other pages (those which are not regulated). Which do you find more interesting? Why?
8 Each member of the group should now make a five-minute presentation evaluating the
usefulness of the annual report examined. When the presentations are complete the group
should decide on five criteria for judging the reports and produce a score for each. Does the
final score match the initial impressions of the person reviewing it?
9 Finally, as a group, write a short note of guidance on what makes an annual report useful to
the reader.
Notes and references
1. AAA (1966), A Statement of Basic Accounting Theory, American Accounting Association, Evanston, Ill.,
p. 1.
2. ASSC (1975), The Corporate Report, Accounting Standards Steering Committee.
3. AICPA (1973), Report of a Study Group on the Objectives of Financial Statements (The Trueblood
Committee), American Institute of Certified Public Accountants.
Chapter 1 Who needs accounting? 23
4. Solomons, D. (1989), Guidelines for Financial Reporting Standards, Research Board of The Institute of
Chartered Accountants in England and Wales.
5. ICAS (1988), Making Corporate Reports Valuable, Research Committee of The Institute of Chartered
Accountants of Scotland.
6. The IAS Regulation (2002) – see Chapter 4.
7. ASB (1999), Statement of Principles for Financial Reporting, Accounting Standards Board.
8. ICAS (1988), para. 3.3.
9. IASB (1989), para. 9(a).
10. IASB (1989), para. 14.
11. ASSC (1975), para. 2.8.
12. ICAS (1988), para. 3.12.
13. IASB (1989), para. 9(b).
14. Ibid., para. 9(c).
15. Ibid., para. 9(d).
16. Ibid., para. 9(e).
17. ASSC (1975), para. 2.25.
18. Ibid., para. 2.26.
19. IASB (1989), para. 9(f).
20. www.ofcom.org.uk
21. www.ofgem.gov.uk
22. IASB (1989), para. 9(g).
23. ICAS (1988), para. 3.7.
24. IASB (1989), Introduction, para. 6.
25. IASB (1989), para. 10.
26. www.cfainstitute.org
Introduction to the terminology of
business transactions
The following description explains the business terminology which will be encountered
frequently in describing transactions in this textbook. The relevant words are highlighted in
bold lettering. These technical accounting terms are defined in the Financial Accounting
Terms Defined section at the end of the book.
Most businesses are established with the intention of earning a profit. Some do so by
selling goods at a price greater than that paid to buy or manufacture the goods. Others
make a profit by providing a service and charging a price greater than the cost to them
of providing the service. By selling the goods or services the business is said to earn
sales revenue.
Profit arising from transactions relating to the operation of the business is measured
by deducting from sales revenue the expenses of earning that revenue.
Revenue from sales (often abbreviated to ‘sales’ and sometimes referred to as
‘turnover’) means the value of all goods or services provided to customers, whether
for cash or for credit. In a cash sale the customer pays immediately on receipt of goods
or services. In a credit sale the customer takes the goods or service and agrees to pay at
a future date. By agreeing to pay in the future the customer becomes a debtor of the
business. The amount due to be collected from the debtor is called a trade receivable
or an account receivable. The business will send a document called a sales invoice to
the credit customer, stating the goods or services provided by the business, the price
charged for these and the amount owing to the business.
Eventually the credit customer will pay cash to settle the amount shown on the invoice.
If (s)he pays promptly the business may allow a deduction of discount for prompt
payment. This deduction is called discount allowed by the business. As an example, if
the customer owes £100 but is allowed a 5% discount by the business, he will pay £95.
The business will record cash received of £95 and discount allowed of £5.
The business itself must buy goods in order to manufacture a product or provide
a service. When the business buys goods it purchases them and holds them as an
inventory of goods (also described as a ‘stock’ of goods) until they are used or sold.
The goods will be purchased from a supplier, either for cash or for credit. In a credit
purchase the business takes the goods and agrees to pay at a future date. By allowing
the business time to pay, the supplier becomes a creditor of the business. The name
creditor is given to anyone who is owed money by the business. The business will
receive a purchase invoice from the supplier describing the goods supplied, stating the
price of the goods and showing the amount owed by the business.
Eventually the business will pay cash to settle the amount shown on the purchase
invoice. If the business pays promptly the supplier may permit the business to deduct
a discount for prompt payment. This is called discount received by the business. As
an example, if the business owes an amount of £200 as a trade payable but is permitted
a 10% discount by the supplier, the business will pay £180 and record the remaining
£20 as discount received from the supplier.
The purchase price of goods sold is one of the expenses of the business, to be
deducted from sales revenue in calculating profit. Other expenses might include wages,
Supplement to Chapter 1
Chapter 1 Who needs accounting? 25
salaries, rent, rates, insurance and cleaning. In each case there will be a document
providing evidence of the expense, such as a wages or salaries slip, a landlord’s bill
for rent, a local authority’s demand for rates, an insurance renewal note or a cleaner’s
time sheet. There will also be a record of the cash paid in each case.
Sometimes an expense is incurred but is not paid for until some time later. For
example, electricity is consumed during a quarter but the electricity bill does not
arrive until after the end of the quarter. An employee may have worked for a week
but not yet have received a cash payment for that work. The unpaid expense of the
business is called an accrued expense and must be recorded as part of the accounting
information relevant to the period of time in which the expense was incurred.
On other occasions an expense may be paid for in advance of being used by the
business. For example, a fire insurance premium covering the business premises is
paid annually in advance. Such expenditure of cash will benefit a future time period
and must be excluded from any profit calculation until that time. In the meantime it is
recorded as a prepaid expense or a prepayment.
Dissatisfaction may be expressed by a customer with the quantity or quality of
goods or service provided. If the business accepts that the complaint is justified it may
replace goods or give a cash refund. If the customer is a credit customer who has not
yet paid, then a cash refund is clearly inappropriate. Instead the customer would be
sent a credit note for sales returned, cancelling the customer’s debt to the business for
the amount in dispute. The credit note would record the quantity of goods or type of
service and the amount of the cancelled debt.
In a similar way the business would expect to receive a credit note from a supplier
for purchases returned where goods have been bought on credit terms and later returned
to the supplier because of some defect.
S Test your understanding
S1.1 The following technical terms appear for the first time in this Supplement. Check that
you know the meaning of each.
l Profit l Credit purchase
l Sales revenue l Creditor
l Cash sale l Trade payable
l Credit sale l Discount received
l Debtor l Expense
l Trade receivable l Accrued expense
l Discount allowed l Prepaid expense
l Purchases l Credit note for sales returned
l Cash purchase l Credit note for purchases returned
Chapter 2
A systematic approach to financial reporting:
the accounting equation
REAL WORLD CASE
Balance sheet
Shareholders’ funds decreased by
£644 million to £4,374 million and
net debt improved by £640 million to
£1,397 million in the year, decreasing
gearing to 32% (2004: 41%). Return
on Group capital employed decreased
from 10.1% to 4.9% in the year reflecting
lower operating profit performance and
the disposal of Shaw’s.
Summary balance sheet
2005 Restated1,2 2004
£m £m
Fixed assets 7,299 8,452
Current assets 4,319 4,055
Creditors: amounts falling due within one year (5,097) (4,906)
Net current liabilities (778) (851)
Total assets less current liabilities 6,521 7,601
Creditors: amounts falling due after more than one year (1,730) (2,194)
Provisions for liabilities and charges (332) (308)
Total net assets 4,459 5,099
Total shareholders’ funds (including non-equity interests) 4,374 5,018
Equity minority interests 85 81
Capital employed 4,459 5,099
1 Restated for change in accounting policy in accordance with UITF Abstract 38 – Accounting for ESOP Trusts.
2 Restated for change in classification of Sainsbury’s Bank’s assets, liabilities and cash.
Source: Sainsbury Annual Review and Summary Financial Statement 2005, pp. 30–1.
Discussion points
1 How does this balance sheet reflect the accounting equation?
2 How does the group explain the main changes?
Chapter 2 A systematic approach to financial reporting: the accounting equation 27
Contents 2.1 Introduction 28
2.2 The accounting equation 28
2.2.1 Form of the equation: national preferences 28
2.2.2 International variation 29
2.3 Defining assets 29
2.3.1 Controlled by the entity 29
2.3.2 Past events 30
2.3.3 Future economic benefits 30
2.4 Examples of assets 31
2.5 Recognition of assets 33
2.5.1 Probable that economic benefits will flow 34
2.5.2 Reliability of measurement 34
2.5.3 Non-recognition 34
2.6 Defining liabilities 35
2.6.1 Present obligation 35
2.6.2 Past events 36
2.6.3 Outflow of economic benefits 36
2.7 Examples of liabilities 36
2.8 Recognition of liabilities 37
2.9 Defining the ownership interest 39
2.10 Recognition 39
2.11 Changes in the ownership interest 39
2.11.1 Revenue and expense 40
2.11.2 Position after a change has occurred 41
2.12 Assurance for users of financial statements 41
2.13 Summary 42
Supplement: Debit and credit bookkeeping 47
Learning
outcomes
After studying this chapter you should be able to:
l Define and explain the accounting equation.
l Define assets.
l Apply the definition to examples of assets.
l Explain and apply the rules for recognition of assets.
l Define liabilities.
l Apply the definition to examples of liabilities.
l Explain and apply the rules for recognition of liabilities.
l Define ownership interest.
l Explain how the recognition of ownership interest depends on the recognition of
assets and liabilities.
l Use the accounting equation to show the effect of changes in the ownership interest.
l Explain how users of financial statements can gain assurance about assets and
liabilities.
Additionally, for those who choose to study the Supplement:
l Explain how the rules of debit and credit recording are derived from the
accounting equation.
28 Part 1 A conceptual framework: setting the scene
2.1 Introduction
Chapter 1 considered the needs of a range of users of financial information and
summarised by suggesting that they would all have an interest in the resources available
to the business and the obligations of the business to those outside it. Many of
these users will also want to be reassured that the business has an adequate flow
of cash to support its continuation. The owners of the business have a claim to the
resources of the business after all other obligations have been satisfied. This is called
the ownership interest or the equity interest. They will be particularly interested in
how that ownership interest grows from one year to the next and whether the resources
of the business are being applied to the best advantage.
Accounting has traditionally applied the term assets to the resources available to
the business and has applied the term liabilities to the obligations of the business to
persons other than the owner. Assets and liabilities are reported in a financial statement
called a balance sheet. The balance sheet is a statement of the financial position of the
entity at a particular point in time. It may be described by a very simple equation.
2.2 The accounting equation
The accounting equation as a statement of financial position may be expressed as:
Assets minus Liabilities equals Ownership interest
The ownership interest is the residual claim after liabilities to third parties have been
satisfied. The equation expressed in this form emphasises that residual aspect.
Another way of thinking about an equation is to imagine a balance with a bucket
on each end. In one bucket are the assets (A) minus liabilities (L). In the other is the
ownership interest (OI).
If anything happens to disturb the assets then the balance will tip unevenly unless
some matching disturbance is applied to the ownership interest. If anything happens
to disturb the liabilities then the balance will tip unevenly unless some matching disturbance
is applied to the ownership interest. If a disturbance applied to an asset is
applied equally to a liability, then the balance will remain level.
2.2.1 Form of the equation: national preferences
If you have studied simple equations in a maths course you will be aware that there
are other ways of expressing this equation. Those other ways cannot change the magnitudes
of each item in the equation but can reflect a different emphasis being placed
on the various constituents. The form of the equation used in this chapter is the
sequence which has, for many years, been applied in most balance sheets reported to
external users of accounting information in the UK. The balance sheets that have been
reported to external users in some Continental European countries are better represented
by another form of the equation:
Chapter 2 A systematic approach to financial reporting: the accounting equation 29
Activity 2.1
Assets equals Ownership interest plus Liabilities
The balance analogy remains applicable here but the contents of the buckets have been
rearranged.
A disturbance on one side of the balance will require a corresponding disturbance on
the other side if the balance is to be maintained.
2.2.2 International variation
The International Accounting Standards Board (IASB) has developed a set of accounting
standards which together create an accounting system which in this book
is described as the IASB system. The IASB offers no indication as to which of the
above forms of the accounting equation is preferred. That is because of the different
traditions in different countries. Consequently, for companies reporting under the
IASB system, the form of the equation used in any particular situation is a matter
of preference related to the choice of presentation of the balance sheet. That is a
communication issue which will be discussed later. This chapter will concentrate
on the nature of the various elements of the equation, namely assets, liabilities and
ownership interest.
Make a simple balance from a ruler balanced on a pencil and put coins on each side.
Satisfy yourself that the ruler only remains in balance if any action on one side of the
balance is matched by an equivalent action on the other side of the balance. Note also
that rearranging the coins on one side will not disturb the balance. Some aspects of
accounting are concerned with taking actions on each side of the balance. Other aspects
are concerned with rearranging one side of the balance.
2.3 Defining assets
An asset is defined as:
a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity.1
To understand this definition fully, each phrase must be considered separately.
2.3.1 Controlled by the entity
Control means the ability to obtain the economic benefits and to restrict the access
of others. The items which everyone enjoys, such as the benefit of a good motorway
giving access to the business or the presence of a highly skilled workforce in a nearby
town, provide benefits to the business which are not reported in financial statements
because there would be considerable problems in identifying the entity’s share of the
benefits. If there is no control, the item is omitted.
30 Part 1 A conceptual framework: setting the scene
Activity 2.2
The condition of control is also included to prevent businesses from leaving out
of the balance sheet some items which ought to be in there. In past years, practices
emerged of omitting an asset and a corresponding liability from a balance sheet on the
grounds that there was no effective obligation remaining in respect of the liability. At
the same time, the business carefully retained effective control of the asset by suitable
legal agreements. This practice of omitting items from the balance sheet was felt to
be unhelpful to users because it was concealing some of the resources used by the
business and concealing the related obligations.
The strongest form of control over an asset is the right of ownership. Sometimes,
however, the entity does not have ownership but does have the right to use an item.
This right may be very similar to the right of ownership. So far as the user of accounting
information is concerned, what really matters is the availability of the item to the
entity and how well the item is being used to earn profits for the business. Forms of
control may include an agreement to lease or rent a resource, and a licence allowing
exclusive use of a resource.
2.3.2 Past events
Accounting depends on finding some reasonably objective way of confirming that the
entity has gained control of the resource. The evidence provided by a past transaction
is an objective starting point. A transaction is an agreement between two parties which
usually involves exchanging goods or services for cash or a promise to pay cash.
(The supplement to Chapter 1 explains basic business transactions in more detail.)
Sometimes there is no transaction but there is an event which is sufficient to give
this objective evidence. The event could be the performance of a service which, once
completed, gives the right to demand payment.
2.3.3 Future economic benefits
Most businesses use resources in the expectation that they will eventually generate
cash. Some resources generate cash more quickly than others. If the business manufactures
goods in order to sell them to customers, those goods carry a future economic
benefit in terms of the expectation of sale. That benefit comes to the entity relatively
quickly. The business may own a warehouse in which it stores the goods before they
are sold. There is a future economic benefit associated with the warehouse because it
helps create the cash flow from sale of the goods (by keeping them safe from damage
and theft) and also because at some time in the future the warehouse could itself be
sold for cash.
The example of the warehouse is relatively easy to understand, but in other cases
there may be some uncertainty about the amount of the future economic benefit.
When goods are sold to a customer who is allowed time to pay, the customer becomes
a debtor of the business (a person who owes money to the business) and the amount
of the trade receivable is regarded as an asset. There may be some uncertainty as
to whether the customer will eventually pay for the goods. That uncertainty does not
prevent the trade receivable being regarded as an asset but may require some caution
as to how the asset is measured in money terms.
Write down five items in your personal possession which you regard as assets. Use the
definition given in this section to explain why each item is an asset from your point of
view. Then read the next section and compare your list with the examples of business
assets. If you are having difficulty in understanding why any item is, or is not, an asset
you should consult your lecturer, tutor or other expert in the subject area for a discussion
on how to apply the definition in identifying assets.
Chapter 2 A systematic approach to financial reporting: the accounting equation 31
2.4 Examples of assets
The following items are commonly found in the assets section of the balance sheet of
a company:
l land and buildings owned by the company
l buildings leased by the company on a 50-year lease
l plant and machinery owned by the company
l equipment leased (rented) by the company under a finance lease
l vehicles
l raw materials
l goods for resale
l finished goods
l work-in-progress
l trade receivables (amounts due from customers who have promised to pay for
goods sold on credit)
l prepaid insurance and rentals
l investments in shares of other companies
l cash held in a bank account.
Do all these items meet the definition of an asset? Exhibits 2.1 and 2.2 test each item
against the aspects of the definition which have already been discussed. Two tables
have been used because it is conventional practice to separate assets into current
assets and non-current assets. Current assets are held with the intention of converting
Exhibit 2.1
Analysis of some frequently occurring non-current assets (fixed assets)
Land and
buildings
owned by the
company
Buildings leased
(rented) by the
company on a
50-year lease
Plant and
machinery
owned by the
company
Equipment
used under a
finance lease
Vehicles owned
by the company
Controlled by the
entity by means of
Ownership.
Contract for
exclusive use as a
tenant.
Ownership.
Contract for
exclusive use.
Ownership.
Past event
Signing the contract
as evidence of
purchase of land
and buildings.
Signing a lease
agreeing the rental
terms.
Purchase of plant
and equipment,
evidenced by
receiving the goods
and a supplier’s
invoice.
Signing lease
agreeing rental
terms.
Purchase of
vehicles, evidenced
by taking delivery
and receiving a
supplier’s invoice.
Future economic
benefits
Used in continuing
operations of the
business; potential
for sale of the item.
Used in continuing
operations of the
business.
Used in continuing
operations of the
business.
Used in continuing
operations of the
business.
Used in continuing
operations of the
business.
32 Part 1 A conceptual framework: setting the scene
them into cash within the business cycle. Non-current assets, also called fixed assets,
are held for continuing use in the business. The business cycle is the period (usually
12 months) during which the peaks and troughs of activity of a business form a pattern
which is repeated on a regular basis. For a business selling swimwear, production
will take place all winter in preparation for a rush of sales in the summer. Painters and
decorators work indoors in the winter and carry out exterior work in the summer.
Because many businesses are affected by the seasons of the year, the business cycle is
Exhibit 2.2
Analysis of some frequently occurring current assets
Raw materials
Goods
purchased
from supplier
for resale
Finished goods
(manufactured
by the entity)
Work-inprogress
(partly
finished goods)
Trade
receivables
(amounts due
from customers)
Prepaid
insurance
premiums
Investments in
shares of other
companies
Cash held in a
bank account
Controlled by the
entity by means of
Ownership.
Ownership.
Ownership.
Ownership.
Contract for
payment.
Contract for
continuing benefit
of insurance cover.
Ownership.
Ownership.
Past event
Receiving raw
materials into the
company’s store,
evidenced by goods
received note.
Receiving goods
from supplier into
the company’s store,
evidenced by the
goods received note.
Transfer from
production line to
finished goods
store, evidenced by
internal transfer form.
Evaluation of the
state of completion
of the work,
evidenced by work
records.
Delivery of goods
to the customer,
obliging customer to
pay for goods at a
future date.
Paying insurance
premiums in
advance, evidenced
by cheque payment.
Buying the shares,
evidenced by
broker’s contract
note.
Depositing cash
with the bank,
evidenced by bank
statement or
certificate.
Future economic
benefits
Used to
manufacture
goods for sale.
Expectation of sale.
Expectation of sale.
Expectation of
completion and
sale.
Expectation that
the customer will
pay cash.
Expectation of
continuing
insurance cover.
Expectation of
dividend income
and growth in value
of investment, for
future sale.
Expectation of
using the cash to
buy resources
which will create
further cash.
Chapter 2 A systematic approach to financial reporting: the accounting equation 33
normally 12 months. Some of the answers are fairly obvious but a few require a little
further comment here.
First, there are the items of buildings and equipment which are rented under a
lease agreement. The benefits of such leases are felt to be so similar to the benefits
of ownership that the items are included in the balance sheet as assets. Suitable wording
is used to describe the different nature of these items so that users, particularly
creditors, are not misled into believing that the items belong to the business.
Second, it is useful to note at this stage that partly finished items of output may
be recorded as assets. The term ‘work-in-progress’ is used to describe work of the
business which is not yet completed. Examples of such work-in-progress might be:
partly finished items in a manufacturing company; a partly completed motorway
being built by a construction company; or a continuing legal case being undertaken
by a firm of lawyers. Such items are included as assets because there has been an event
in the partial completion of the work and there is an expectation of completion and
eventual payment by a customer for the finished item.
Finally, it is clear that the relative future economic benefits of these assets have
a wide variation in potential risk. This risk is a matter of great interest to those who
use accounting information, but there are generally no accounting techniques for
reporting this risk in financial statements. Consequently, it is very important to have
adequate descriptions of assets. Accounting information is concerned with the words
used to describe items in financial statements, as well as the numbers attributed
to them.
Definitions An asset is a resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow.2
A current asset is an asset that satisfies any of the following criteria:
(a) it is expected to be realised in, or is intended for sale or consumption in, the entity’s
normal operating cycle;
(b) it is held primarily for the purpose of being traded;
(c) it is expected to be realised within 12 months after the balance sheet date;
(d) it is cash or a cash equivalent.3
A non-current asset is any asset that does not meet the definition of a current asset.4
Non-current assets include tangible, intangible and financial assets of a long-term nature.
These are also described as fixed assets.5
2.5 Recognition of assets
When an item has passed the tests of definition of an asset, it has still not acquired the
right to a place in the balance sheet. To do so it must meet further tests of recognition.
Recognition means reporting an item by means of words and amounts within the
main financial statements in such a way that the item is included in the arithmetic
totals. An item which is reported in the notes to the accounts is said to be disclosed
but not recognised.
The conditions for recognition have been expressed in the following words:
An asset is recognised in the balance sheet when:
it is probable that the future economic benefits will flow to the entity and the asset
has a cost or value that can be measured reliably.6
34 Part 1 A conceptual framework: setting the scene
2.5.1 Probable that economic benefits will flow
To establish probability needs evidence. What evidence is sufficient? Usually more
than one item of evidence is looked for. In the case of non-current assets (fixed assets)
which have a physical existence, looking at them to make sure they do exist is a useful
precaution which some auditors have in the past regretted not taking. Checking on
physical existence is not sufficient, however, because the enterprise may have no control
over the future economic benefit associated with the item. Evidence of the benefit
from non-current assets may lie in: title deeds of property; registration documents for
vehicles plus the purchase invoice from the supplier; invoices from suppliers of plant
and equipment or office furniture; a written lease agreement for a computer or other
type of equipment; and also the enterprise’s internal forecasts of the profits it will
make by using these non-current assets. This is the kind of evidence which the auditor
seeks in forming an opinion on the financial statements.
For current assets the evidence of future benefit comes when the assets are used within
the trading cycle. A satisfactory sales record will suggest that the present inventory
(stock) of finished goods is also likely to sell. Analysis of the time that credit customers
have taken to pay will give some indication of whether the trade receivables should
be recognised as an asset. Cash can be counted, while amounts deposited in banks
may be confirmed by a bank statement or bank letter. Internal projections of profit and
cash flow provide supporting evidence of the expected benefit from using current
assets in trading activities.
2.5.2 Reliability of measurement
Reliable measurement of assets can be quite a problem. For the most part, this book
will accept the well-tried practice of measuring an asset at the cost of acquiring it,
allowing for any reduction in value through use of the asset (depreciation) or through
it falling out of fashion (obsolescence). The suitability of this approach to measurement
will be discussed in Chapter 14 as one of the main unresolved problems of
accounting.
2.5.3 Non-recognition
Consider some items which pass the definition test but do not appear in a balance
sheet:
l the workforce of a business (a human resource)
l the strength of the management team (another human resource)
l the reputation established for the quality of the product
l the quality of the regular customers
l a tax refund which will be claimable against profits in two years’ time.
These items all meet the conditions of rights or other access, future economic benefits,
control and a past transaction or event. But they all have associated with them a high
level of uncertainty and it could be embarrassing to include them in a balance sheet of
one year, only to remove them the following year because something unexpected had
happened.
All these items fail one of the recognition tests and some fail both. The workforce as
a whole may be reliable and predictable, but unexpected circumstances can come to all
and the illness or death of a member of the management team in particular can have
a serious impact on the perceived value of the business. A crucial member of the workforce
might give notice and leave. In relation to the product, a reputation for quality
may become well established and those who would like to include brand names in the
balance sheet argue for the permanence of the reputation. Others illustrate the relative
Chapter 2 A systematic approach to financial reporting: the accounting equation 35
transience of such a reputation by bringing out a list of well-known biscuits or sweets
of 30 years ago and asking who has heard of them today. Reliable customers of
good quality are valuable to a business, but they are also fickle and may change their
allegiance at a moment’s notice. The tax refund may be measurable in amount, but will
there be taxable profits in two years’ time against which the refund may be claimed?
It could be argued that the assets which are not recognised in the financial statements
should be reported by way of a general description in a note to the accounts.
In practice, this rarely happens because accounting tries to avoid raising hopes which
might subsequently be dashed. This cautious approach is part of what is referred to
more generally as prudence in accounting practice.
2.6 Defining liabilities
A liability is defined as: ‘a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits’.7 This wording reads somewhat tortuously but has
been designed to mirror the definition of an asset.
The most familiar types of liabilities arise in those situations where specific amounts
of money are owed by an entity to specific persons called creditors. There is usually
no doubt about the amount of money owed and the date on which payment is due.
Such persons may be trade creditors, the general name for those suppliers who have
provided goods or services in return for a promise of payment later. Amounts due
to trade creditors are described as trade payables. Other types of creditors include
bankers or other lenders who have lent money to the entity.
There are also situations where an obligation is known to exist but the amount due
is uncertain. That might be the case where a court of law has found an entity negligent
in failing to meet some duty of care to a customer. The company will have to pay compensation
to the customer but the amount has yet to be determined.
Even more difficult is the case where an obligation might exist if some future
event happens. Neither the existence nor the amount of the obligation is known with
certainty at the balance sheet date. An example would arise where one company has
guaranteed the overdraft borrowing of another in the event of that other company
defaulting on repayment. At the present time there is no reason to suppose a default
will occur, but it remains a possibility for the future.
The definition of a liability tries to encompass all these degrees of variation and
uncertainty. It has to be analysed for each separate word or phrase in order to understand
the full implications.
2.6.1 Present obligation
A legal obligation is evidence that a liability exists because there is another person or
entity having a legal claim to payment. Most liabilities arise because a legal obligation
exists, either by contract or by statute law.
However, a legal obligation is not a necessary condition. There may be a commercial
penalty faced by the business if it takes a certain action. For example, a
decision to close a line of business will lead to the knowledge of likely redundancy
costs long before the employees are actually made redundant and the legal obligation
becomes due. There may be an obligation imposed by custom and practice, such as
a condition of the trade that a penalty operates for those who pay bills late. There
may be a future obligation caused by actions and events of the current period where,
for example, a profit taken by a company now may lead to a taxation liability at a
later date which does not arise at this time because of the wording of the tax laws.
36 Part 1 A conceptual framework: setting the scene
Activity 2.3
2.6.2 Past events
A decision to buy supplies or to acquire a new non-current asset is not sufficient to
create a liability. It could be argued that the decision is an event creating an obligation,
but it is such a difficult type of event to verify that accounting prefers not to rely too
much on the point at which a decision is made.
Most liabilities are related to a transaction. Normally the transaction involves
receiving goods or services, receiving delivery of new non-current assets such as
vehicles and equipment, or borrowing money from a lender. In all these cases there is
documentary evidence that the transaction has taken place.
Where the existence of a liability is somewhat in doubt, subsequent events may
help to confirm its existence at the balance sheet date. For example, when a company
offers to repair goods under a warranty arrangement, the liability exists from
the moment the warranty is offered. It may, however, be unclear as to the extent
of the liability until a pattern of customer complaints is established. Until that time
there will have to be an estimate of the liability. In accounting this estimate is called a
provision. Amounts referred to as provisions are included under the general heading
of liabilities.
2.6.3 Outflow of economic benefits
The resource of cash is the economic benefit transferable in respect of most obligations.
The transfer of property in settlement of an obligation would also constitute a transfer
of economic benefits. More rarely, economic benefits could be transferred by offering
a resource such as labour in settlement of an obligation.
Write down five items in your personal experience which you regard as liabilities. Use the
definition given in this section to explain why each item is a liability from your point of
view. Then read the next section and compare your list with the examples of business
liabilities. If you are having difficulty in understanding why any item is, or is not, a liability
you should consult your lecturer, tutor or other expert in the subject area for a discussion
on how to apply the definition in identifying liabilities.
2.7 Examples of liabilities
Here is a list of items commonly found in the liabilities section of the balance sheets of
companies:
l bank loans and overdrafts
l trade payables (amounts due to suppliers of goods and services on credit terms)
l taxation payable
l accruals (amounts owing, such as unpaid expenses)
l provision for deferred taxation
l long-term loans.
The first five items in this list would be classified as current liabilities because they
will become due for payment within one year of the balance sheet date. The last item
would be classified as non-current liabilities because they will remain due by the
business for longer than one year.
Chapter 2 A systematic approach to financial reporting: the accounting equation 37
Definitions A liability is a present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying
economic benefits.8
A current liability is a liability which satisfies any of the following criteria:
(a) it is expected to be settled in the entity’s normal operating cycle;
(b) it is held primarily for the purpose of being traded;
(c) it is due to be settled within 12 months after the balance sheet date.9
A non-current liability is any liability that does not meet the definition of a current
liability.10 Non-current liabilities are also described as long-term liabilities.
2.8 Recognition of liabilities
As with an asset, when an item has passed the tests of definition of a liability it may
still fail the test of recognition. In practice, because of the concern for prudence, it is
much more difficult for a liability to escape the balance sheet.
The condition for recognition of a liability uses wording which mirrors that used
for recognition of the asset. The only difference is that the economic benefits are
now expected to flow from the enterprise. The conditions for recognition have been
expressed in the following words:
A liability is recognised in the balance sheet when:
l it is probable that an outflow of resources embodying economic benefits will result
from the settlement of a present obligation and
l the amount at which the settlement will take place can be measured reliably.11
What kind of evidence is acceptable? For current liabilities there will be a payment
soon after the balance sheet date and a past record of making such payments on time.
For non-current liabilities (long-term liabilities) there will be a written agreement stating
the terms and dates of repayment required. The enterprise will produce internal
forecasts of cash flows which will indicate whether the cash resources will be adequate
to allow that future benefit to flow from the enterprise.
Reliable measurement will normally be based on the amount owing to the claimant.
If goods or services have been supplied there will be an invoice from the supplier
stating the amount due. If money has been borrowed there will be a bank statement
or some other document of a similar type, showing the lender’s record of how much
the enterprise owes.
In cases which fail the recognition test, the documentary evidence is likely to
be lacking, probably because there is not sufficient evidence of the existence or the
measurable amount. Examples of liabilities which are not recognised in the balance
sheet are:
l a commitment to purchase new machinery next year (but not a firm contract)
l a remote, but potential, liability for a defective product, where no court action has
yet commenced
l a guarantee given to support the bank overdraft of another company, where there
is very little likelihood of being called upon to meet the guarantee.
Because of the prudent nature of accounting, the liabilities which are not recognised
in the balance sheet may well be reported in note form under the heading contingent
liabilities. This is referred to as disclosure by way of a note to the accounts.
38 Part 1 A conceptual framework: setting the scene
Looking more closely at the list of liabilities which are not recognised, we see that
the commitment to purchase is not legally binding and therefore the outflow of
resources may not occur. The claim based on a product defect appears to be uncertain
as to occurrence and as to amount. If there has been a court case or a settlement out of
court then there should be a provision for further claims of a similar nature. In the case
of the guarantee the facts as presented make it appear that an outflow of resources is
unlikely. However, such appearances have in the past been deceiving to all concerned
and there is often interesting reading in the note to the financial statements which
describes the contingent liabilities.
An analysis of some common types of liability is given in Exhibit 2.3.
Exhibit 2.3
Analysis of some common types of liability
Type of liability
Bank loans and
overdrafts
(repayable on
demand or in the
very short term)
Trade payables
(amounts due to
suppliers of goods
and services)
Taxation payable
(tax due on
company profits
after the balance
sheet date)
Accruals (a term
meaning ‘other
amounts owing’,
such as unpaid
bills)
Provision for
deferred taxation
(tax due in respect
of present profits
but having a
delayed payment
date allowed by
tax law)
Long-term loans
(sometimes called
debenture loans)
Obligation
The entity must repay
the loans on the due
date or on demand.
Suppliers must be
paid for the goods
and services supplied,
usually about one month
after the supplier’s
invoice is received.
Cash payable to
the Inland Revenue.
Penalties are charged
if tax is not paid on
the due date.
Any expense incurred
must be reported as
an accrued liability
(e.g. electricity used,
gas used, unpaid
wages), if it has not
been paid at the
balance sheet date.
Legislation allows
companies to defer
payment of tax in some
cases. The date of
future payment may
not be known as yet.
Balance sheet will
show repayment dates
of long-term loans
and any repayment
conditions attached.
Transfer of
economic
benefits
Cash,
potentially
within a short
space of time.
Cash within a
short space of
time.
Cash.
Cash.
Cash
eventually,
but could be
in the longer
term.
Cash.
Past transaction
or event
Receiving the
borrowed funds.
Taking delivery of
the goods or
service and
receiving the
supplier’s invoice.
Making profits in
the accounting year
and submitting an
assessment of tax
payable.
Consuming
electricity or gas,
using employees’
services, receiving
bills from suppliers
(note that it is not
necessary to receive
a gas bill in order to
know that you owe
money for gas used).
Making profits or
incurring
expenditure now
which meets
conditions of
legislation allowing
deferral.
Received borrowed
funds.
Chapter 2 A systematic approach to financial reporting: the accounting equation 39
2.9 Defining the ownership interest
The ownership interest is defined in the Framework as equity. Equity is the residual
interest in the assets of the entity after deducting all its liabilities.12
The term net assets is used as a shorter way of saying ‘total assets less total
liabilities’. Because the ownership interest is the residual item, it will be the owners
of the business who benefit from any increase in assets after liabilities have been
met. Conversely it will be the owners who bear the loss of any decrease in assets after
liabilities have been met. The ownership interest applies to the entire net assets. It
is sometimes described as the owners’ wealth, although economists would take a view
that the owners’ wealth extends beyond the items recorded in a balance sheet.
If there is only one owner, as in the sole trader’s business, then there is no problem as
to how the ownership interest is shared. In a partnership, the partnership agreement
will usually state the profit-sharing ratio, which may also be applied to the net assets
shown in the balance sheet. If nothing is said in the partnership agreement, the profit
sharing must be based on equal shares for each partner.
In a company the arrangements for sharing the net assets depend on the type of
ownership chosen. The owners may hold ordinary shares in the company, which entitle
them to a share of any dividend declared and a share in net assets on closing down the
business. The ownership interest is in direct proportion to the number of shares held.
Some investors like to hold preference shares, which give them a preference
(although not an automatic right) to receive a dividend before any ordinary share
dividend is declared. The rights of preference shareholders are set out in the articles
of association of the company. Some will have the right to share in a surplus of net
assets on winding up, but others will only be entitled to the amount of capital originally
contributed.
Definitions The ownership interest is called equity in the IASB Framework.
Equity is the residual interest in the assets of the entity after deducting all its liabilities.
Net assets means the difference between the total assets and the total liabilities of the
business: it represents the amount of the ownership interest in the entity.
2.10 Recognition
There can be no separate recognition criteria for the ownership interest because it is
the result of recognising assets and recognising liabilities. Having made those decisions
on assets and liabilities the enterprise has used up its freedom of choice.
2.11 Changes in the ownership interest
It has already been explained that the owner will become better off where the net assets
are increasing. The owner will become worse off where the net assets are decreasing. To
measure the increase or decrease in net assets, two accounting equations are needed:
At time t = 0 Assets(t0) – Liabilities(t0) equals Ownership interest(t0)
At time t = 1 Assets(t1) – Liabilities(t1) equals Ownership interest(t1)
40 Part 1 A conceptual framework: setting the scene
Taking one equation away from the other may be expressed in words as:
Change in (assets – liabilities) equals Change in ownership interest
or, using the term ‘net assets’ instead of ‘assets – liabilities’:
Change in net assets equals Change in ownership interest
The change in the ownership interest between these two points in time is a measure
of how much better off or worse off the owner has become, through the activities of the
business. The owner is better off when the ownership interest at time t = 1 is higher
than that at time t = 0. To calculate the ownership interest at each point in time requires
knowledge of all assets and all liabilities at each point in time. It is particularly interesting
to know about the changes in assets and liabilities which have arisen from the
day-to-day operations of the business.
The term revenue is given to any increase in the ownership interest arising from
the operations of the business and caused by an increase in an asset which is greater
than any decrease in another asset (or increase in a liability). The term expense
is given to any reduction in the ownership interest arising from the operations of the
business and caused by a reduction in an asset to the extent that it is not replaced by
a corresponding increase in another asset (or reduction in a liability).
The owner or owners of the business may also change the amount of the ownership
interest by deciding to contribute more cash or other resources in order to finance the
business, or deciding to withdraw some of the cash and other resources previously
contributed or accumulated. The amount contributed to the business by the owner
is usually referred to as capital. Decisions about the level of capital to invest in the
business are financing decisions. These financing decisions are normally distinguished
separately from the results of operations.
So another equation may now be derived as a subdivision of the basic accounting
equation, showing analysis of the changes in the ownership interest.
Change in ownership
equals
Capital contributed/withdrawn by the
interest ownership plus Revenue minus Expenses
The difference between revenue and expenses is more familiarly known as profit.
So a further subdivision of the basic equation is:
Profit equals Revenue minus Expenses
2.11.1 Revenue and expense
Revenue is created by a transaction or event arising during the operations of the
business which causes an increase in the ownership interest. It could be due to
an increase in cash or trade receivables, received in exchange for goods or services.
Depending on the nature of the business, revenue may be described as sales, turnover,
fees, commission, royalties or rent.
An expense is caused by a transaction or event arising during the operations of
the business which causes a decrease in the ownership interest. It could be due to an
outflow or depletion of assets such as cash, inventory (stock) or non-current assets
(fixed assets). It could be due to a liability being incurred without a matching asset
being acquired.
Chapter 2 A systematic approach to financial reporting: the accounting equation 41
Definitions Revenue is created by a transaction or event arising during the ordinary activities of the
entity which causes an increase in the ownership interest. It is referred to by a variety of
different names includiing sales, fees, interest, dividends, royalties and rent.13
An expense is caused by a transaction or event arising during the ordinary activities of
the business which causes a decrease in the ownership interest.14
2.11.2 Position after a change has occurred
At the end of the accounting period there will be a new level of assets and liabilities
recorded. These assets and liabilities will have resulted from the activities of the business
during the period, creating revenue and incurring expenses. The owner may also
have made voluntary contributions or withdrawals of capital as a financing decision.
The equation in the following form reflects that story:
Assets minus Liabilities equals Ownership interest at the start of the
at the end of the period period plus Capital contributed/
withdrawn in the period plus Revenue of
the period minus Expenses of the period
2.12 Assurance for users of financial statements
The definitions of assets and liabilities refer to expected flows into or out of the
business. The recognition conditions refer to the evidence that the expected flows in
or out will occur. The directors of a company are responsible for ensuring that the
financial statements presented by them are a faithful representation of the assets and
liabilities of the business and of the transactions and events relating to those assets
and liabilities. Shareholders need reassurance that the directors, as their agents, have
carried out this responsibility with sufficient care. To give themselves this reassurance,
the shareholders appoint a firm of auditors to examine the records of the business and
give an opinion as to whether the financial statements correspond to the accounting
records and present a true and fair view. (Chapter 1 explained the position of
directors as agents of the shareholders. Chapter 4 explains the regulations relating to
company financial statements and the appointment of auditors.)
Meet again David and Leona as they continue their conversation on the work of the
auditor and its value to the shareholder as a user of accounting information provided
by a company.
DAVID: I’ve now coated your ceiling with apple green emulsion. In return you promised
to convince me that I rely on audited accounting information more than I realise. Here is
your chance to do that. I was looking today at the annual report of a company which is
a manufacturing business. There is a production centre in the UK but most of the production
work is carried out in Spain where the operating costs are lower. The distribution
operation is carried out from Swindon, selling to retail stores all over the UK. There is an
export market, mainly in France, but the company has only scratched the surface of that
market. Let’s start with something easy – the inventories (stocks) of finished goods which
are held at the factory in Spain and the distribution depot in Swindon.
LEONA: You’ve shown right away how limited your understanding is, by choosing the asset
where you need the auditor’s help the most. Everything can go wrong with inventories
(stocks)! Think of the accounting equation:
Assets − Liabilities = Ownership interest
42 Part 1 A conceptual framework: setting the scene
If an asset is overstated, the ownership interest will be overstated. That means the profit
for the period, as reported, is higher than it should be. But you won’t know that because
everything will appear to be in order from the accounts. You have told me repeatedly that
you buy the future, not the past, but I know you look to the current profit and loss account
as an indicator of future trends of profit. And so do all your friends.
DAVID: How can the asset of finished goods inventories be overstated? It’s quite a solid item.
LEONA: There are two types of potential error – the physical counting of the inventory and
the valuation placed on it. There are two main causes of error, one being carelessness and
the other an intention to deceive. I’ve seen situations where the stocktakers count the
same stack of goods twice because they don’t have a marker pen to put a cross on the
items counted. I’ve also heard of situations where items are counted twice deliberately. We
always attend the end-of-year counting of the inventory and observe the process carefully.
I wish there weren’t so many companies with December year-ends. Counting inventory
on 2 January is never a good start to the new year.
DAVID: I suppose I can believe that people lose count but how does the valuation go
wrong? All companies say that they value inventories at cost as the usual rule. How can
the cost of an item be open to doubt?
LEONA: Answering that question needs a textbook in itself. The subject comes under the
heading of ‘management accounting’. Take the goods that you know are manufactured in
Spain. There are costs of materials to make the goods, and labour to convert raw materials
into finished goods. There are also the running costs of the production unit, which are
called the overheads. There is an unbelievable variety of ways of bringing those costs
together into one item of product. How much does the company tell you about all that?
I know the answer – nothing.
DAVID: Well, I could always ask them at a briefing meeting. I usually ask about the profit
margin on the goods sold, rather than the value of the goods unsold. But I can see that if
the inventories figure is wrong then so is the profit margin. Do you have a systematic procedure
for checking each kind of asset?
LEONA: Our magic word is CEAVOP. That stands for:
Completeness of information presented.
Existence of the asset or liability at a given date.
Amount of the transaction is correctly recorded.
Valuation reported for assets and liabilities is appropriate.
Occurrence of the transaction or event took place in the period.
Presentation and disclosure is in accordance with regulations and accounting standards
or other comparable regulations.
Every aspect of that list has to be checked for each of the assets and liabilities you see
in the balance sheet. We need good-quality evidence of each aspect before we sign off
the audit report.
DAVID: I probably believe that you do a great deal of work with your CEAVOP. But next time
I come round to paint your kitchen I’ll bring a list of the situations where the auditors don’t
appear to have asked all the questions in that list.
2.13 Summary
This chapter has set out the accounting equation for a situation at any one point in time:
Assets minus Liabilities equals Ownership interest
Chapter 2 A systematic approach to financial reporting: the accounting equation 43
Key points are:
l An asset is a resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow.
l A current asset is an asset that satisfies any of the following criteria:
(a) it is expected to be realised in, or is intended for sale or consumption in, the
entity’s normal operating cycle;
(b) it is held primarily for the purpose of being traded;
(c) it is expected to be realised within twelve months after the balance sheet date;
(d) it is cash or a cash equivalent.15
l A non-current asset is any asset that does not meet the definition of a current asset.
Non-current assets include tangible, intangible and financial assets of a long-term
nature. These are also described as fixed assets.
l A liability is a present obligation of the entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources
embodying economic benefits.
l A current liability is a liability which satisfies any of the following criteria:
(a) it is expected to be settled in the entity’s normal operating cycle;
(b) it is held primarily for the purpose of being traded;
(c) it is due to be settled within 12 months after the balance sheet date.
l A non-current liability is any liability that does not meet the definition of a current
liability. Non-current liabilities are also described as long term liabilities.
l The ownership interest is called equity in the IASB Framework.
l Equity is the residual interest in the assets of the entity after deducting all its
liabilities.
l Net assets means the difference between the total assets and the total liabilities
of the business: it represents the amount of the ownership interest in the entity.
l Recognition means reporting an item in the financial statements, in words and in
amounts, so that the amounts are included in the arithmetic totals of the financial
statements. Any other form of reporting by way of note is called ‘disclosure’. The
conditions for recognition of assets and liabilities are similar in wording.
l At the end of an accounting period the assets and liabilities are reported in a
balance sheet. Changes in the assets and liabilities during the period have caused
changes in the ownership interest through revenue and expenses of operations. The
owner may also have voluntarily added or withdrawn capital. The final position is
explained on the left-hand side of the equation and the movement to that position
is explained on the right-hand side:
Assets minus Liabilities equals Ownership interest at the start of the
at the end of the period period plus Capital contributed/
withdrawn in the period plus Revenue of
the period minus Expenses of the period
l As with any equation, it is possible to make this version more complex by adding
further details. That is not necessary for the purpose of explaining the basic processes,
but the equation will be revisited later in the book when some of the problems
of accounting are opened up. The helpful aspect of the accounting equation is
that it can always be used as a basis for arguing a feasible answer. The limitation is
that it cannot give an opinion on the most appropriate answer when more than one
option is feasible.
44 Part 1 A conceptual framework: setting the scene
In Chapter 3 there is an explanation of how the information represented by the
accounting equation is displayed in a form which is useful to the user groups
identified in Chapter 1.
Further reading
IASB (1989) Framework for the Preparation and Presentation of Financial Statements, section 5
‘The Elements of Financial Statements’ and section 6 ‘Recognition of the Elements of
Financial Statements’, International Accounting Standards Board.
The Questions section of each chapter has three types of question. ‘Test your understanding’
questions to help you review your reading are in the ‘A’ series of questions. You will find the
answers to these by reading and thinking about the material in the book. ‘Application’ questions
to test your ability to apply technical skills are in the ‘B’ series of questions. Questions requiring
you to show skills in problem solving and evaluation are in the ‘C’ series of questions. A letter
[S] indicates that there is a solution at the end of the book.
A Test your understanding
A2.1 Write out the basic form of the accounting equation. (Section 2.2)
A2.2 Define an asset and explain each part of the definition. (Section 2.3)
A2.3 Give five examples of items which are assets. (Section 2.4)
A2.4 Use the definition to explain why each of the items in your answer to A.2.3 is an asset.
(Section 2.4)
A2.5 Explain what ‘recognition’ means in accounting. (Section 2.5)
A2.6 State the conditions for recognition of an asset. (Section 2.5)
A2.7 Explain why an item may pass the definition test but fail the recognition test for an asset.
(Section 2.5)
A2.8 Give three examples of items which pass the definition test for an asset but fail the
recognition test. (Section 2.5)
A2.9 Some football clubs include the players in the balance sheet as an asset. Others do not.
Give the arguments to support each approach. (Section 2.5)
A2.10 Define a liability and explain each part of the definition. (Section 2.6)
A2.11 Give five examples of items which are liabilities. (Section 2.7)
A2.12 Use the definition to explain why each of the items in your answer to A2.11 is a liability.
(Section 2.7)
A2.13 State the conditions for recognition of a liability. (Section 2.8)
A2.14 Explain why an item may pass the definition test but fail the recognition test for a liability.
(Section 2.8)
A2.15 Define the term ‘equity’. (Section 2.9)
A2.16 Explain what is meant by ‘net assets’. (Section 2.9)
A2.17 Set out the accounting equation for a change in the ownership interest. (Section 2.11)
QUESTIONS
Chapter 2 A systematic approach to financial reporting: the accounting equation 45
A2.18 Define ‘revenue’ and ‘expenses’. (Section 2.11.1)
A2.19 Set out the accounting equation which represents the position after a change has occurred.
(Section 2.11.2)
A2.20 Explain the auditor’s approach to giving assurance about assets and liabilities.
(Section 2.12)
B Application
B2.1 [S]
Classify each of the items in the following list as: asset; liability; neither an asset nor a liability.
(a) cash at bank
(b) loan from the bank
(c) letter from the bank promising an overdraft facility at any time in the next three months
(d) trade receivable (an amount due from a customer who has promised to pay later)
(e) trade receivable (an amount due from a customer who has promised to pay later but has
apparently disappeared without leaving a forwarding address)
(f ) trade payable (an amount due to a supplier of goods who has not yet received payment
from the business)
(g) inventory of finished goods (fashion clothing stored ahead of the spring sales)
(h) inventory of finished goods (fashion clothing left over after the spring sales)
(i) investment in shares of another company where the share price is rising
(j) investment in shares of another company where the share price is falling
(k) lender of five-year loan to the business
(l) customer to whom the business has offered a 12-month warranty to repair goods free of
charge
(m) a motor vehicle owned by the business
(n) a motor vehicle rented by the business for one year
(o) an office building owned by the business
(p) an office building rented by the business on a 99-year lease, with 60 years’ lease period
remaining.
B2.2 [S]
Explain whether each of the items from question B.2.1 above which you have identified as
assets and liabilities would also meet the conditions for recognition of the item in the balance
sheet.
B2.3 [S]
Explain why each of the following items would not meet either the definition or the recognition
conditions of an asset of the business:
(a) a letter from the owner of the business, addressed to the bank manager, promising to
guarantee the bank overdraft of the business
(b) a list of the customers of the business
(c) an order received from a customer
(d) the benefit of employing a development engineer with a high level of ‘know-how’ specifically
relevant to the business
(e) money spent on an advertising campaign to boost sales
(f ) structural repairs to a building.
C Problem solving and evaluation
C2.1
The following information has been gathered from the accounting records of Pets Parlour:
46 Part 1 A conceptual framework: setting the scene
Assets and liabilities at 31 December Year 4
£
Cash at bank 500
Borrowings 6,000
Trade receivables (debtors) 5,000
Property, plant and equipment 29,000
Revenue and expenses for the year ended 31 December Year 4
£
Fees charged for work done 20,000
Interest paid on borrowings 1,000
Administration costs incurred 1,500
Salaries paid to employees 14,000
Required
Using the accounting equation, calculate:
(a) The amount of ownership interest at 31 December Year 4.
(b) The amount of net profit for the year.
(c) The amount of the ownership interest at 1 January Year 4.
Activities for study groups
Obtain the annual report of a listed company. From the balance sheet list the items shown as
assets and liabilities. (This will require you to look in detail at the notes to the accounts using
the references on the face of the balance sheet.) Share out the list of assets and liabilities so
that each person has four or five assets and four or five liability items.
1 Separately, using the definitions and recognition criteria, prepare a short statement explaining
why each item on your list passes the tests of definition and recognition. State the evidence
you would expect to see, as auditor, to confirm the expected future inflow of economic
benefit from any asset and the expected future outflow of benefit from any liability.
2 Present your explanations to the group and together prepare a list of assets and a separate
list of liabilities in order of the uncertainty which attaches to the expected future benefit.
3 Read the ‘contingent liability’ note, if there is one, to find examples of liabilities which have
not been recognised but have been disclosed. Why will you not find a ‘contingent asset’ note?
Notes and references
1. IASB (1989), Framework for the Preparation and Presentation of Financial Statements, para. 49(a).
2. IASB (1989), Framework for the Preparation and Presentation of Financial Statements, para. 49(a).
3. IAS 1 (2004), para. 57.
4. IAS 1 (2004), para. 57.
5. IAS 1 para. 58 permits the use of alternative descriptions for non-current assets provided the
meaning is clear.
6. IASB (1989), Framework, para. 89.
7. IASB (1989), Framework, para. 49(b).
8. IASB (1989), Framework, para. 49(b).
9. IAS 1 (2004), para. 60.
10. Ibid.
11. IASB (1989), Framework, para. 91.
12. IASB (1989), Framework, para. 49(c).
13. IASB (1989), Framework, para. 74.
14. IASB (1989), Framework, para. 78.
15. IAS 1 (2004), para. 57.
Supplement to Chapter 2
Debit and credit bookkeeping
You do not have to read this supplement to be able to progress through the rest of the textbook.
In the main body of each chapter the explanations are all given in terms of changes in elements
of the accounting equation. However, for those who would like to know how debits and credits
work, each chapter will have a supplement putting into debit and credit form the material contained
in the chapter.
Recording in ledger accounts
The double entry system of bookkeeping records business transactions in ledger
accounts. It makes use of the fact that there are two aspects to every transaction when
analysed in terms of the accounting equation.
A ledger account accumulates the increases and reductions either in a category of
business activities such as sales or in dealings with individual customers and suppliers.
Ledger accounts may be subdivided. Sales could be subdivided into home sales and
export sales. Separate ledger accounts might be kept for each type of non-current asset,
e.g. buildings and machinery. The ledger account for machinery might be subdivided
as office machinery and production machinery.
Ledger accounts for rent, business rates and property insurance might be kept
separately or the business might instead choose to keep one ledger account to record
transactions in all of these items, giving them the collective name administrative
expenses. The decision would depend on the number of transactions in an accounting
period and on whether it was useful to have separate records.
The managers of the business have discretion to combine or subdivide ledger
accounts to suit the information requirements of the business concerned.
Using the accounting equation
Before entries are made in ledger accounts, the double entry system of bookkeeping
assigns to each aspect of a business transaction a debit or a credit notation, based on
the analysis of the transaction using the accounting equation.
In its simplest form the accounting equation is stated as:
Assets minus Liabilities equals Ownership interest
To derive the debit and credit rules it is preferable to rearrange the equation so that
there is no minus sign.
Assets equals Liabilities plus Ownership interest
There are three elements to the equation and each one of these elements may either
increase or decrease as a result of a transaction or event. The six possibilities are set out
in Exhibit 2.4.
48 Part 1 A conceptual framework: setting the scene
The double entry bookkeeping system uses this classification (which preserves the
symmetry of the equation) to distinguish debit and credit entries as shown in
Exhibit 2.5.
It was shown in the main body of the chapter that the ownership interest may be
increased by:
l earning revenue; and
l new capital contributed by the owner;
and that the ownership interest may be decreased by:
l incurring expenses; and
l capital withdrawn by the owner.
So the ‘ownership interest’ section of Exhibit 2.5 may be expanded as shown in
Exhibit 2.6.
That is all you ever have to know about the rules of bookkeeping. All the rest
can be reasoned from this table. For any transaction there will be two aspects. (If
you find there are more than two, the transaction needs breaking down into simpler
steps.) For each aspect there will be a ledger account. Taking each aspect in turn you
ask yourself: Is this an asset, a liability, or an aspect of the ownership interest? Then you ask
yourself: Is it an increase or a decrease? From Exhibit 2.6 you then know immediately
whether to make a debit or a credit entry.
Examples of the application of the rules of debit and credit recording are given in
the supplement to Chapter 5 for a service business and in the supplement to Chapter
6 for a manufacturing business. They will also be used in later chapters to explain
how particular transactions are reported.
Exhibit 2.4
Combinations of increases and decreases of the main elements of transactions
Left-hand side of the equation
Assets Increase Decrease
Right-hand side of the equation
Liabilities Decrease Increase
Ownership interest Decrease Increase
Exhibit 2.5
Rules of debit and credit for ledger entries, basic accounting equation
Debit entries in a Credit entries in a
ledger account ledger account
Left-hand side of the equation
Asset Increase Decrease
Right-hand side of the equation
Liability Decrease Increase
Ownership interest Decrease Increase
Chapter 2 A systematic approach to financial reporting: the accounting equation 49
S Test your understanding
(The answer to each of the following questions is either debit or credit)
S2.1 What is the bookkeeping entry for an increase in an asset?
S2.2 What is the bookkeeping entry for a decrease in a liability?
S2.3 What is the bookkeeping entry for an increase in an expense?
S2.4 What is the bookkeeping entry for a withdrawal of owner’s capital?
S2.5 What is the bookkeeping entry for an increase in revenue?
Exhibit 2.6
Rules of debit and credit for ledger entries, distinguishing different aspects of
ownership interest
Debit entries in a Credit entries in a
ledger account ledger account
Left-hand side of the equation
Asset Increase Decrease
Right-hand side of the equation
Liability Decrease Increase
Ownership interest Expense Revenue
Capital withdrawn Capital contributed
Chapter 3
Financial statements from the
accounting equation
REAL WORLD CASE
Cash flow
After deducting interest, tax and
dividend payments, £467 million of
operating cash flow was available to
fund our capital investment programme,
demonstrating BAA’s continued strong
conversion of operating profit to cash.
The APP joint venture and the other
investment property sales generated
a further cash inflow of £625 million.
The balance of the £1,403 million capital
investment during the year was funded
by increased net debt. The table below
summarises the Group’s cash flow
movements during the year.
Summary cash flow (£ million)
2005 2004
Cash flow from operating activities 957 853
Interest, tax and dividends (490) (447)
Net cash flow from operations 467 406
Capital expenditure and investment (1,433) (1,266)
Cash impact of property transactions 625 (7)
Other 31 15
Increase in net debt (net of issue costs) (310) (825)
Source: BAA Annual Report 2004/5, p. 34.
Discussion points
1 What do we learn about cash flow from the information in the table?
2 How does the description in words help the user to understand the information in the table?
Chapter 3 Financial statements from the accounting equation 51
Contents 3.1 Introduction 51
3.2 Who is in charge of the accounting system? 52
3.3 The accounting period 52
3.4 The balance sheet 53
3.4.1 Focus on the ownership interest 53
3.4.2 Balancing assets and claims on assets 55
3.4.3 Example of balance sheet presentation 55
3.5 The income statement (profit and loss account) 57
3.5.1 Example of presentation 58
3.5.2 Comment 58
3.6 The cash flow statement 59
3.6.1 Example of cash flow presentation 60
3.6.2 Comment 60
3.7 Usefulness of financial statements 62
3.8 Summary 63
Supplement: Using the accounting equation to analyse transactions 66
Learning
outcomes
After studying this chapter you should be able to:
l Explain the benefits and problems of producing annual financial statements.
l Explain the purpose and structure of the balance sheet.
l Explain the purpose and structure of the income statement (profit and loss
account).
l Explain the purpose and structure of the cash flow statement.
l Comment on the usefulness to users of the financial statements prepared.
Additionally for those who choose to study the Supplement:
l Apply the debit and credit form of analysis to the transactions of a short period
of time, summarising them in a list which may be used for preparation of simple
financial statements.
3.1 Introduction
In the previous chapter the accounting equation was developed as a representation
of the relationships among key items of accounting information: assets, liabilities and
the ownership interest. An understanding of the accounting equation and the various
elements of the equation provides a systematic approach to analysing transactions
and events, but it gives no guidance as to how the results should be communicated
in a manner which will be helpful and meaningful to users. The accounting equation
is used in this chapter as a basis for explaining the structure of financial statements.
Ideas beyond the accounting equation are required as to what qualities are expected
of financial statements.
The various financial statements produced by enterprises for the owners and other
external users are derived from the accounting equation. The Framework identifies the
52 Part 1 A conceptual framework: setting the scene
purposes of financial reporting as producing information about the financial position,
performance and financial adaptability of the enterprise. The three most familiar
primary financial statements, and their respective purposes, are:
Primary financial statement Purpose is to report
Balance sheet Financial position
Income statement (Profit and loss account) Performance
Cash flow statement Financial adaptability
This chapter explains the general shape and content of each of these financial statements.
3.2 Who is in charge of the accounting system?
Since 2005 two different accounting systems have existed for companies in the UK,
depending on the type of company. When you look at the name of a company listed on
the Stock Exchange, such as Vodaphone, BskyB, Cadbury Schweppes and Dixons, you
are really looking at a family group of companies all owned by one parent company.
One set of financial statements representing all the companies in the group. Under the
law of the European Union (EU), these group financial statements for listed companies
must apply the accounting system set out by the International Accounting Standards
Board (IASB system). Other companies in the UK may choose to follow the IASB
system of standards but there is no requirement to do so. All companies in the UK that
do not apply the IASB system must apply the accounting system set out by the UK
Accounting Standards Board (ASB). The ASB’s system is also used by many bodies in
the UK public sector such as town and city councils, hospital trusts and universities.
Fortunately for those studying the subject, the ASB and the IASB have been working
closely together for many years and there are relatively few differences between the
two systems. However there is a potential difference in the appearance and the wording
of financial statements. Companies applying the UK ASB’s accounting system
must use specifications of the sequence and content of items (called formats of financial
statements) set out in UK company law which is based on EU directives. Companies
applying the IASB’s system to their listed group reporting have a choice in how they
present their financial statements. As a consequence we are now seeing variety in the
content and sequence of financial statements published in the annual reports of groups
listed on the Stock Exchange. This chapter gives you a flavour of the formats that
you might see in financial statements. Where there are differences in words used,
this chapter gives the wording of the IASB system first, followed by the wording of
UK company law and ASB standards in brackets. As an example, the description:
income statement (profit and loss account)
means that the IASB system uses income statement in its illustrations of a profit
statement, while UK law and ASB standards use profit and loss account in their
illustrations of a profit statement.
3.3 The accounting period
In the far-away days of traders sailing out of Italian ports on three-year voyages,
the accounting period was determined by the date of return of the ship, when the
accounts could be prepared for the whole voyage. That rather leisurely view of the
Chapter 3 Financial statements from the accounting equation 53
scale of time would not be tolerated in an industrial and commercial society where
there is always someone demanding information. The convention is that businesses
should prepare financial statements at least once in every calendar year. That convention
is a requirement of law expressed in the Companies Act 1985 in the case
of limited liability companies. Where companies have a Stock Exchange listing they
are required to produce an interim report six months into the accounting year.
Some companies voluntarily produce quarterly reports to shareholders, reflecting
the practice of listed companies in the USA. For internal management accounting
purposes, a business may produce reports more frequently (e.g. on a monthly or a
weekly basis).
Businesses may choose their accounting date as a time convenient to their activities.
Many companies choose 31 December for the year-end, but others (including many of
the utility companies which were formerly owned by the government) use 31 March.
Some prefer a September or October date after the peak of the summer sales has
passed. Whatever the choice, companies are expected to keep the same date from one
year to the next unless there is a strong reason for changing.
The use of a 12-month accounting period should not be too much of a problem
where the trading cycle fits neatly into a year. If the business is seasonal, there will
be a peak of production to match the seasonal peak of sales and the pattern will be
repeated every year. There could be a few technical problems of deciding exactly how
to close the door on 31 December and whether transactions towards the end of the
year are to be included in that year or carried to the next period. These problems
can be dealt with by having systematic ‘cut-off’ rules. There is a bigger problem for
those companies whose trading cycle is much longer. It could take two years to build
a section of a motorway or three years to build a bridge over a wide river estuary. Such
a company will have to subdivide the work on the main contract so that some can be
reported each year.
The use of the 12-month accounting period also causes problems for recognition
of assets and liabilities. Waiting for the ship to arrive was much safer evidence for the
Venetian traders than hoping it was still afloat or relying on reported sightings. For
today’s business the equivalent situation would be waiting for a property to be sold or
for a large customer to pay the amount due as a debt. However, in practice the balance
sheet cannot wait. Notes to the accounts give additional explanations to help users of
financial statements evaluate the risk, but it is all quite tentative.
3.4 The balance sheet
The balance sheet reflects the accounting equation. You saw in Chapter 2 that there
is more than one way to write the accounting equation. That means there is more
than one way to present a balance sheet. You will find throughout your study of
accounting that there is often more than one approach to dealing with an activity or
solving a problem. This is the first time but there will be more. It means that you need
to be flexible in your approach to reading and using financial statements.
3.4.1 Focus on the ownership interest
One form of the accounting equation focuses on the ownership interest as the result of
subtracting liabilities from assets. The equation is as follows:
Assets minus Liabilities equals Ownership interest
54 Part 1 A conceptual framework: setting the scene
UK companies who apply this form of the equation will present the balance sheet in a
narrative form, reading down the page, as follows:
Assets
minus
Liabilities
equals
Ownership interest
The assets are subdivided into current assets and non-current assets (defined in
Chapter 2), while the liabilities are subdivided into current liabilities and non-current
liabilities (also defined in Chapter 2). The ownership interest may also be subdivided
to show separately the capital contributed or withdrawn and the profit of the period.
Because current assets and current liabilities are closely intertwined in the day-to-day
operations of the business, they are grouped close to each other in the balance sheet
(Exhibit 3.1).
Exhibit 3.1
Structure of a balance sheet
Non-current assets
plus
Current assets
minus
Current liabilities
minus
Non-current liabilities
equals
Capital at start of year
plus/minus
Capital contributed or withdrawn
plus
Profit of the period
Exhibit 3.1 represents a format set out in the Companies Act 1985 (although
with more detail) as one of the permitted formats. For many years it has been the
format most commonly used by UK companies and continues to be used by some
UK companies that have moved to the IASB system of accounting. Most companies
will try to confine the balance sheet to a single side of A4 paper but there is
not much space on one sheet of A4 paper to fit in all the assets and liabilities of a
company. Consequently a great deal of use is made of notes to the accounts which
explain the detail. The balance sheet shows only the main categories of assets and
liabilities.
Chapter 3 Financial statements from the accounting equation 55
Activity 3.1
3.4.2 Balancing assets and claims on assets
Another form of the accounting equation focuses on balancing the assets against the
claims on assets. The claims on assets come from the ownership interest and from
liabilities of all types. The equation is as follows:
Assets equals Ownership interest plus Liabilities
UK companies who apply this form of the equation will present the balance sheet
vertically on one sheet of paper but the sequence will be different:
Assets
equals
Ownership interest
plus
Liabilities
In some countries there is a preference for lining up the balance sheet horizontally to
match the accounting equation even more closely.
Ownership interest
Assets plus
Liabilities
Before reading further, make sure that you can explain why each item in the accounting
records is an asset or a liability, as shown in the foregoing list. If you have any doubts,
read Chapter 2 again before proceeding with this chapter.
3.4.3 Example of balance sheet presentation
The following list of assets and liabilities of P. Mason’s legal practice was prepared
from the accounting records of transactions summarised at 30 September Year 5:
£
Land and buildings 250,000
Office furniture 30,000
Receivables (debtors) for fees 1,200
Prepayment of insurance premium 540
Cash at bank 15,280
Total assets (A) 297,020
Trade payables (creditors) 2,800
Long-term loan 150,000
Total liabilities (L) 152,800
Ownership interest (A − L) 144,220
Exhibit 3.2 shows how this would appear in a balance sheet based on the ‘ownership
interest’ form of the equation. Exhibit 3.3 shows how the same information would
appear in a balance sheet based on the ‘claims on assets’ form of the equation.
56 Part 1 A conceptual framework: setting the scene
The balance sheet in Exhibit 3.2 is more informative than the list of assets and
liabilities from which it was prepared because it has been arranged in a helpful
format. The first helpful feature is the use of headings (shown in Exhibit 3.2 in bold)
for similar items grouped together, such as non-current assets, current assets, current
liabilities and non-current liabilities. The second helpful feature is the use of subtotals
(identified in Exhibit 3.2 by descriptions in italics and shaded) for similar items
grouped together. The subtotals used in this example are those for: total non-current
assets; total current assets; and current assets less current liabilities. There are no
standard rules on use of subtotals. They should be chosen in a manner most appropriate
to the situation.
A person using this balance sheet can see at a glance that there is no problem for
the business in meeting its current liabilities from its resources of current assets. The
financing of the business is split almost equally between the non-current liabilities
and the ownership interest, a split which would not be regarded as excessively risky
by those who lend to businesses. The non-current assets used as a basis for generating
profits from one year to the next are collected together as a group, although the
balance sheet alone cannot show how effectively those assets are being used. For that,
an income statement (profit and loss account) is needed.
The balance sheet in Exhibit 3.3 is again more informative than the list of assets
and liabilities from which it was prepared because it has been arranged in a helpful
format. It offers a helpful feature in the use of headings (in bold) for similar items
grouped together. It is also helpful in providing subtotals (identified by descriptions
in italics and shaded) for similar items grouped together. The subtotals used in this
example are those for: total non-current assets and total current assets. There could
also be subtotals for the current assets less current liabilities. There are no standard
rules on use of subtotals. They should be chosen in a manner most appropriate to the
situation.
Exhibit 3.2
Balance sheet: Assets minus liabilities equals ownership interest
P. Mason’s legal practice
Balance sheet at 30 September Year 5
£ £
Non-current assets
Land and buildings 250,000
Office furniture 30,000
Total non-current assets 280,000
Current assets
Receivables (debtors) for fees 1,200
Prepayment of insurance premium 540
Cash at bank 15,280
Total current assets 17,020
Current liabilities
Trade payables (creditors) (2,800)
Current assets less current liabilities 14,220
294,220
Non-current liabilities
Long-term loan (150,000)
Net assets 144,220
Ownership interest 144,220
Chapter 3 Financial statements from the accounting equation 57
Exhibit 3.3
Balance sheet: Assets equal ownership interest plus liabilities
P. Mason’s legal practice
Balance sheet at 30 September Year 5
£ £
Non-current assets
Land and buildings 250,000
Office furniture 30,000
Total non-current assets 280,000
Current assets
Receivables for fees 1,200
Prepayment of insurance premium 540
Cash at bank 15,280
Total current assets 17,020
Total assets 297,020
Ownership interest 144,220
Non-current liabilities
Long-term loan 150,000
Current liabilities
Trade payables 2,800
Total ownership interest plus liabilities 297,020
A person using this balance sheet can again see at a glance that there is no problem
for the business in meeting its current liabilities from its resources of current assets.
The financing of the business is split almost equally between the non-current liabilities
and the ownership interest, a split which would not be regarded as excessively risky
by those who lend to businesses. The non-current assets used as a basis for generating
profits from one year to the next are collected together as a group, although the
balance sheet alone cannot show how effectively those assets are being used.
3.5 The income statement (profit and loss account)
For many years in the UK, profit and loss account was the only title used for the
financial statement reporting profit of the period. From 2005 many of those listed
groups following the IASB’s system have chosen to follow an example given by
the IASB which uses the heading income statement, found more commonly in US
company reports. It is not compulsory for listed group companies to use ‘income
statement’ and some retain the ‘profit and loss account’ heading. The income statement
(profit and loss account) reflects that part of the accounting equation which
defines profit:
Profit equals Revenue minus Expenses
The expenses of a period are matched against the revenue earned in that period. This
is described as the application of the matching concept in accounting.
As with the balance sheet, it is presented in a vertical form so that it can be read
down the page as a narrative (Exhibit 3.4).
58 Part 1 A conceptual framework: setting the scene
3.5.1 Example of presentation
The accounting records of P. Mason’s legal practice at 30 September Year 5 showed
that the ownership interest could be explained as follows (using brackets to show negative
items):
£
Increases in ownership interest
Capital contributed at start of month 140,000
Fees 8,820
Decreases in ownership interest
Computer rental and on-line searches (1,500)
Gas (100)
Electricity (200)
Telephone/fax (1,000)
Salary of assistant (1,800)
Ownership interest at end of month 144,220
The statement of profit is quite simple, as shown in Exhibit 3.5.
3.5.2 Comment
The income statement (profit and loss account) improves on the mere list of constituent
items by providing headings (shown in bold) for each main category. As this
Exhibit 3.4
Structure of an income statement
(profit and loss account)
Revenue
minus
Expenses
equals
Profit
Exhibit 3.5
Financial statement of profit, in a useful format
P. Mason’s legal practice
Income statement (profit and loss account) for the month of September
£ £
Revenues
Fees 8,820
Expenses
Computer rental and on-line searches (1,500)
Gas (100)
Electricity (200)
Telephone/fax (1,000)
Salary of assistant (1,800)
Total expenses (4,600)
Net profit of the month 4,220
Chapter 3 Financial statements from the accounting equation 59
Activity 3.2
is a very simple example, only two headings and one subtotal are required. Headings
and subtotals are most useful where there are groups of items of a similar nature. The
resulting net profit shows how the revenues and expenses have contributed overall
to increasing the ownership interest during the month.
Taking each item of the income statement (profit and loss account) in turn, explain to an
imaginary friend why each item of revenue and expense is regarded as increasing or
decreasing the ownership interest. If necessary, look back to the definitions of revenue
and expense in Chapter 2. Make sure that you feel confident about the income statement
(profit and loss account) before you move on.
3.6 The cash flow statement
It was shown in Chapter 1 that liquidity is of interest to more than one user group, but
of particular interest to creditors of the business.
Liquidity is measured by the cash and near-cash assets and the change in those
assets, so a financial statement which explains cash flows should be of general interest
to user groups:
Cash flow equals
Cash inflows to the enterprise minus
Cash outflows from the enterprise
The cash flow statement will appear in a vertical form:
Cash inflows
minus
Cash outflows
equals
Change in cash assets
In a business there will be different factors causing the inflows and outflows of
cash. The enterprise will try to make clear what the different causes are. Subdivisions
are commonly used for operating activities, investing activities and financing
activities:
l Operating activities are the actions of buying and selling goods, or manufacturing
goods for resale, or providing a service to customers.
l Investing activities are the actions of buying and selling non-current assets for longterm
purposes.
l Financing activities are the actions of raising and repaying the long-term finance of
the business.
Exhibit 3.6 sets out the basic structure of a basic cash flow statement.
60 Part 1 A conceptual framework: setting the scene
3.6.1 Example of cash flow presentation
The cash transactions of P. Mason’s legal practice for the month of September were
recorded as follows:
Accounting records
Year 5 £
Cash received
Sept. 1 Capital contributed by P. Mason 140,000
Sept. 1 Loan from bank 150,000
Sept. 19 Fees received from clients 7,620
Total cash received 297,620
Cash paid
Sept. 1 Land and buildings 250,000
Sept. 5 Prepayment of insurance premium 540
Sept. 26 Supplier for office furniture 30,000
Sept. 30 Salaries 1,800
Total cash paid 282,340
Cash remaining at 30 September 15,280
The cash flow statement would be presented as shown in Exhibit 3.7.
3.6.2 Comment
The cash flows, listed at the start of section 3.5.1 in the accounting records for the legal
practice, relate to three different types of activity which are brought out more clearly
in the cash flow statement by the use of headings and subtotals. The headings are
shown in bold and the subtotals are highlighted by italics and shading. The story
emerging from the cash flow statement is that the owner put in £140,000 and the
bank lent £150,000, providing a total of £290,000 in start-up finance. Of this amount,
£280,000 was used during the month to pay for non-current assets. That left £10,000
which, when added to the positive cash flow from operations, explains why the cash
resources increased by £15,280 over the month.
Exhibit 3.6
Structure of a cash flow statement
Operating activities
Cash inflows
minus
Cash outflows
plus
Investing activities
Cash inflows
minus
Cash outflows
plus
Financing activities
Cash inflows
minus
Cash outflows
equals
Change in cash assets
Chapter 3 Financial statements from the accounting equation 61
It is quite common to compare the increase in ownership claim caused by making a
profit with the increase in the cash resources of a business caused by operations. In this
case the profit is £4,220 (Exhibit 3.5) but the operations have added £15,280 to the cash
assets of the business.
To make the comparison, Exhibit 3.8 takes the income statement (profit and loss
account) of Exhibit 3.5 and sets alongside it the cash flows relating to operations.
Exhibit 3.8 shows that the cash flow from fees was £1,200 less than the fee revenue
earned because some customers had not paid at the month end. This is the amount
shown in the balance sheet (Exhibit 3.2) as receivables for fees. Exhibit 3.8 also shows
that expenses of rental, gas, electricity and telephone amounting to £2,800 in total had
not been paid at the month end. These are shown as trade payables in the balance
sheet. The cash flow from operations is reduced by the payment for the insurance
premium which does not affect the income statement (profit and loss account) for
the month.
Exhibit 3.7
Financial statement showing cash flows of an enterprise
P. Mason’s legal practice
Cash flow statement for the month of September Year 5
Operating activities £
Inflow from fees 7,620
Outflow to insurance premium (540)
Outflows to salaries (1,800)
Net inflow from operations 5,280
Investing activities
Payment for land and building (250,000)
Payment for office furniture (30,000)
Net outflow for investing activities (280,000)
Financing activities
Capital contributed by owner 140,000
Five-year loan from bank 150,000
Net inflow from financing activities 290,000
Increase in cash at bank over period 15,280
Exhibit 3.8
Comparison of profit and cash flow for the month of September
P. Mason’s legal practice
Profit Cash flow
£ £
Revenues
Fees/cash received 8,820 7,620
Expenses
Computer rental and on-line searches (1,500) nil
Gas (100) nil
Electricity (200) nil
Telephone/fax (1,000) nil
Salary of assistant (1,800) (1,800)
Payment for insurance premium nil (540)
Total expenses/total cash paid 4,600 (2,340)
Net profit of the month 4,220
Increase in cash in the month 5,280
62 Part 1 A conceptual framework: setting the scene
Activity 3.3
Users of financial statements regard both the profit and the cash flow as interesting
items of information. The profit shows the overall increase in ownership claim which
contributes to the overall wealth of the business. The cash flow shows the ability of the
business to survive financially through planning the timing and amount of inflows
and outflows of cash.
3.7 Usefulness of financial statements
Here are Leona and David, still working on Leona’s flat, discussing the usefulness of
financial statements.
LEONA: Which financial statement is the most important for you?
DAVID: It has to be the income statement (profit and loss account). Profit creates wealth.
Future profit creates future wealth. I have to make a forecast of each company’s profit as
part of my planning to meet our overall investment strategy. Maybe I should qualify that by
adding that cash flow is also important, especially where there is high uncertainty about
future prospects. We talk about ‘quality of profits’ and regard some types of profit as of
higher quality than others. Cash flow support is one aspect of that quality. We have doubts
about some accounting amounts which don’t have a close relationship to cash. A business
cannot survive if it can’t pay its way.
LEONA: Where does that leave the balance sheet?
DAVID: I’m not sure. It is a list of resources and claims on those resources. We are shareholders
and so we have a claim on those resources but we don’t think about it to any great
extent because we are concentrating on the going concern aspects of the business, rather
than closing down and selling the assets. The balance sheet numbers don’t mean very
much because they are out of date.
LEONA: We studied research at university which suggested that cash flow is the answer
and income statements (profit and loss accounts) are too difficult to understand. It was
suggested that the balance sheet should show what the assets could be sold for. I don’t
think the ideas had caught on in practice, but they seemed to have some merits.
DAVID: I like to know the dynamics of the business. I like to see the movements of different
aspects and the interactions. I think I would feel that cash flow alone is concentrating
on only one aspect of the wealth of the business. I suppose the balance sheet is a useful
check on the position which has been reached as a result of making profits for the period.
One thing we do look at in the balance sheet is how much has been borrowed for use in
the business. We don’t like to see that become too high in comparison with the ownership
interest.
LEONA: At least you are admitting to seeing something in the financial statements. I still
have to persuade you that the auditors are important in giving you the reassurance you
obviously obtain.
Analyse your own view of wealth and changes in wealth. Which items would you include
in your personal balance sheet today? Which items would you include in your personal
‘profit and loss’ account for the past year? Which items would you include in your
personal cash flow statement? Has your view of ‘wealth’ been modified as a result of
reading these first three chapters? If so, how have your views changed?
Chapter 3 Financial statements from the accounting equation 63
3.8 Summary
This chapter has explained the structure of the main financial statements produced by
business and non-business entities.
Key points are:
l An accounting period of 12 months is common for financial reporting.
l The primary financial statements produced by a wide range of entities are the
balance sheet, the income statement (profit and loss account) and the cash flow
statement.
l A balance sheet presents financial position at a point in time. The format of the
balance sheet will vary depending on which version of the accounting equation is
preferred by the entity preparing the balance sheet.
l An income statement (profit and loss account) presents the performance over a
period of time. The income statement (profit and loss account) presents financial
performance by matching revenue and expenses to arrive at a profit of the period.
l A cash flow statement presents the financial adaptability over a period of time. It
explains changes in the cash position over a period caused by operating cash flows,
investing cash flows and financing cash flows.
l Since 2005 two different accounting systems (consisting of accounting standards
and legislation) have existed for companies in the UK, depending on the type
of company. The IASB system applies to the group financial statements of listed
companies. Other companies may choose voluntarily to follow the IASB system.
The UK system, based on UK law and the standards of the UK ASB, applies to all
companies that do not follow the IASB system.
l The accounting standards of the UK ASB are very similar to those of the IASB.
The Questions section of each chapter has three types of question. ‘Test your understanding’
questions to help you review your reading are in the ‘A’ series of questions. You will find the
answers to these by reading and thinking about the material in the book. ‘Application’ questions
to test your ability to apply technical skills are in the ‘B’ series of questions. Questions requiring
you to show skills in problem solving and evaluation are in the ‘C’ series of questions. A letter
[S] indicates that there is a solution at the end of the book.
A Test your understanding
A3.1 Explain why an accounting period of 12 months is used as the basis for reporting to
external users of financial statements. (Section 3.3)
A3.2 Explain how the structure of the balance sheet corresponds to the accounting equation.
(Section 3.4)
A3.3 Explain how the structure of the income statement (profit and loss account) represents
a subsection of the accounting equation. (Section 3.5)
A3.4 Explain how the structure of the cash flow statement represents another subsection of
the accounting equation. (Section 3.6)
QUESTIONS
64 Part 1 A conceptual framework: setting the scene
A3.5 List three features of a balance sheet format which are particularly useful in making the
format helpful to readers. (Section 3.4.3)
A3.6 List three features of an income statement (profit and loss account) format which are
particularly useful in making the format helpful to readers. (Section 3.5.1)
A3.7 List three features of a cash flow statement format which are particularly useful in
making the format helpful to readers. (Section 3.6.1)
B Application
B3.1 [S]
John Timms is the sole owner of Sunshine Wholesale Traders, a company which buys fruit from
farmers and sells it to supermarkets. All goods are collected from farms and delivered to supermarkets
on the same day, so no inventories (stocks) of fruit are held. The accounting records
of Sunshine Traders at 30 June Year 2, relating to the year then ended, have been summarised
by John Timms as follows:
£
Fleet of delivery vehicles, after deducting depreciation 35,880
Furniture and fittings, after deducting depreciation 18,800
Trade receivables 34,000
Bank deposit 19,000
Trade payables (creditors) 8,300
Sales 294,500
Cost of goods sold 188,520
Wages and salaries 46,000
Transport costs 14,200
Administration costs 1,300
Depreciation of vehicles, furniture and fittings 1,100
Required
(a) Identify each item in the accounting records as either an asset, a liability, or ownership interest
(identifying separately the expenses and revenues which contribute to the change in the
ownership interest).
(b) Prepare a balance sheet at 30 June Year 2.
(c) Prepare a profit and loss statement for the year ended 30 June Year 2.
B3.2 [S]
Prepare a balance sheet from the following list of assets and liabilities, regarding the ownership
interest as the missing item.
£
Trade payables (creditors) 43,000
Cash at bank 9,000
Inventories (stocks) of goods for resale 35,000
Land and buildings 95,000
Wages due to employees but not paid 2,000
Vehicles 8,000
Five-year loan from a bank 20,000
Explain how the balance sheet will change for each of the following transactions:
(a) The wages due to the employees are paid at £2,000.
(b) One-quarter of the inventory (stock) of goods held for resale is destroyed by fire and there
is no insurance to cover the loss.
(c) Goods for resale are bought on credit at a cost of £5,000.
There are no questions in the C series for this chapter.
Chapter 3 Financial statements from the accounting equation 65
Activities for study groups
Return to the annual reports your group obtained for the exercise in Chapter 1. Find the balance
sheet, income statement (profit and loss account) and cash flow statement. Use the outline
formats contained in this chapter to identify the main areas of each of the published statements.
Work together in preparing a list of features which make the formats useful to the reader. Note
also any aspects of the presentation which you find unhelpful at this stage. (It may be useful to
look back on this note at the end of the course as a collective check on whether your understanding
and awareness of annual report items has improved Using the accounting equation to
analyse transactions
In the main body of the chapter the transactions of P. Mason’s legal practice are set out in
summary form and are then presented in financial statements. This supplement goes back one
stage and looks at the transactions and events for the month of September which resulted in the
summary and financial statements shown in the chapter.
The list of transactions and events is as follows:
Sept. 1 P. Mason deposits £140,000 in a bank account to commence the business
under the name P. Mason’s legal practice.
Sept. 1 P. Mason’s legal practice borrows £150,000 from a finance business to
help with the intended purchase of a property for use as an office.
The loan is to be repaid in five years’ time.
Sept. 1 A property is purchased at a cost of £75,000 for the land and £175,000
for the buildings. The full price is paid from the bank account.
Sept. 3 Office furniture is purchased from Stylecraft at a cost of £30,000. The
full price is to be paid within 90 days.
Sept. 5 An insurance premium of £540 is paid in advance. The insurance cover
will commence on 1 October.
Sept. 8 An applicant is interviewed for a post of legal assistant. She agrees to
start work on 10 September for a salary of £24,000 per annum.
Sept. 11 Invoices are sent to some clients for work done in preparing contracts
for them. The total of the invoiced amounts is £8,820. Clients are allowed
up to 30 days to pay.
Sept. 19 Cheques received from clients in payment of invoices amount to
£7,620.
Sept. 26 Payment is made to Stylecraft for the amount due for office furniture,
£30,000.
Sept. 28 Bills are received as follows: for computer rental and on-line searches,
£1,500; gas, £100; electricity, £200; and telephone/fax, £1,000.
Sept. 30 Legal assistant is paid salary of £1,800 for period to end of month.
In the Supplement to Chapter 2 a table was prepared, based on the accounting
equation, showing the classification used for debit and credit bookkeeping entries.
As a reminder, the form of the equation used to derive the debit and credit rules is:
Assets equals Liabilities plus Ownership interest
As a further reminder, the rules are set out again in Exhibit 3.9. Each of the transactions
of P. Mason’s legal practice for the month of September is now analysed in
terms of the effect on the accounting equation and the resulting debit and credit
entries which would be made in the accounting records.
Chapter 3 Financial statements from the accounting equation 67
Exhibit 3.9
Rules for debit and credit recording
Debit entries in a ledger Credit entries in a ledger
account account
Left-hand side of the equation
Asset Increase Decrease
Right-hand side of the equation
Liability Decrease Increase
Ownership interest Expense Revenue
Capital withdrawn Capital contributed
Analysis of each transaction
Sept. 1 P. Mason deposits £140,000 in a bank account to commence the business
under the name P. Mason’s legal practice.
The business acquires an asset (cash in the bank) and an ownership interest is created
through contribution of capital.
Transaction number: 1 Debit Credit
Asset Bank £140,000
Ownership interest Capital contributed
£140,000
Sept. 1 P. Mason’s legal practice borrows £150,000 from a finance business to
help with the intended purchase of a property for use as an office. The
loan is to be repaid in five years’ time.
The business acquires an asset of cash and a long-term liability is created.
Transaction number: 2 Debit Credit
Asset Bank £150,000
Liability Long-term loan £150,000
Sept. 1 A property is purchased at a cost of £75,000 for the land and £175,000 for
the buildings. The full price is paid from the bank account.
The business acquires an asset of land and buildings (£250,000 in total) and the asset
of cash in the bank is reduced.
Transaction number: 3 Debit Credit
Asset Land and buildings Bank £250,000
£250,000
68 Part 1 A conceptual framework: setting the scene
Sept. 3 Office furniture is purchased from Stylecraft at a cost of £30,000. The full
price is to be paid within 90 days.
The business acquires an asset of furniture and also acquires a liability to pay the
supplier, Stylecraft. The liability is called a trade payable (creditor).
Transaction number: 4 Debit Credit
Asset Furniture £30,000
Liability Trade payable (Stylecraft)
£30,000
Sept. 5 An insurance premium of £540 is paid in advance. The insurance cover
will commence on 1 October.
The business acquires an asset of prepaid insurance (the benefit of cover exists in the
future) and the asset of cash at bank is reduced.
Transaction number: 5 Debit Credit
Asset Prepayment £540 Bank £540
Sept. 8 An applicant is interviewed for a post of legal assistant. She agrees to
start work on 10 September for a salary of £24,000 per annum.
The successful outcome of the interview is an event and there is an expected future
benefit from employing the new legal assistant. The employee will be controlled by
the organisation through a contract of employment. The organisation has a commitment
to pay her the agreed salary. It could be argued that the offer of employment,
and acceptance of that offer, create an asset of the human resource and a liability equal
to the future salary. That does not happen because the recognition conditions are
applied and it is felt too risky to recognise an asset when there is insufficient evidence
of the future benefit. Commercial prudence dictates that it is preferable to wait until
the employee has done some work and pay her at the end of the month for work done
during the month. The accounting process is similarly prudent and no accounting
recognition takes place until the payment has occurred. Even then it is the expense of
the past which is recognised, rather than the asset of benefit for the future.
Sept. 11 Invoices are sent to some clients showing fees due for work done in
preparing contracts for them. The total of the invoiced amounts is
£8,820. Clients are allowed up to 30 days to pay.
Earning fees is the main activity of the legal practice. Earning fees makes the owner
better off and is an example of the more general activity of increasing the ownership
interest by creating revenue. The clients have not yet paid and therefore the business
has an asset called a trade receivable (debtor).
Transaction number: 6 Debit Credit
Asset Trade receivables £8,820
Ownership interest Fees for work done £8,820
(revenue)
Chapter 3 Financial statements from the accounting equation 69
Sept. 19 Cheques received from clients in payment of invoices amount to £7,620.
When the customers pay, the amount due to the business from debtors will be
decreased. So the asset of trade receivables decreases and the asset of cash in the bank
increases.
Transaction number: 7 Debit Credit
Asset Bank £7,620 Trade receivables £7,620
Sept. 26 Payment is made to Stylecraft for the amount due for office furniture,
£30,000.
The asset of cash in the bank decreases and the liability to Stylecraft decreases to nil.
Transaction number: 8 Debit Credit
Asset Bank £30,000
Liability Trade payable (Stylecraft)
£30,000
Sept. 28 Bills are received as follows: for computer rental and on-line searches,
£1,500; gas, £100; electricity, £200; and telephone/fax £1,000 (total £2,800).
The computer rental, on-line searches, gas, electricity and telephone have been used
up during the period and are all expenses which reduce the ownership interest. They
are unpaid and, therefore, a liability is recorded.
Transaction number: 9 Debit Credit
Liability Trade payables £2,800
Ownership interest Expenses £2,800
Sept. 30 Legal assistant is paid salary of £1,800 for period to end of month.
The asset of cash at bank decreases and the salary paid to the legal assistant is an
expense of the month.
Transaction number: 10 Debit Credit
Asset Bank £1,800
Ownership interest Expense £1,800
Summarising the debit and credit entries
The formal system of bringing together debit and credit entries is based on ledger
accounts. These are explained in the supplement to Chapter 5. For the present it will
be sufficient to use a spreadsheet (Exhibit 3.10) to show how the separate debit and
credit entries analysed in this Supplement lead to the list of items used in the main
part of the chapter as the basis for the financial statements presented there.
70 Part 1 A conceptual framework: setting the scene
Exhibit 3.10
Spreadsheet of transactions for P. Mason’s legal practice, during the month of September
Assets Liabilities Ownership interest
Date Land and Office Trade Pre- Cash at Trade Bank loan Revenue Expenses Owner’s capital
buildings furniture receivables payments bank payables contributed
£ £ £ £ £ £ £ £ £ £
1 Sept. 140,000 Dr 140,000 Cr
1 Sept. 150,000 Dr 150,000 Cr
1 Sept. 250,000 Dr 250,000 Cr
3 Sept. 30,000 Dr 30,000 Cr
5 Sept. 540 Dr 540 Cr
11 Sept. 8,820 Dr 8,820 Cr
19 Sept. 7,620 Cr 7,620 Dr
26 Sept. 30,000 Cr 30,000 Dr
28 Sept. 2,800 Cr 2,800 Dr
30 Sept. 1,800 Cr 1,800 Dr
Total debit entries in each column
250,000 Dr 30,000 Dr 8,820 Dr 540 Dr 297,620 Dr 30,000 Dr nil nil 4,600 Dr nil
Total credit entries in each column
nil nil 7,620 Cr nil 282,340 Cr 32,800 Cr 150,000 Cr 8,820 Cr nil 140,000 Cr
Surplus of debits over credits (or credits over debits)
250,000 Dr 30,000 Dr 1,200 Dr 540 Dr 15,280 Dr 2,800 Cr 150,000 Cr 8,820 Cr 4,600 Dr 140,000 Cr
Chapter 3 Financial statements from the accounting equation 71
In the spreadsheet there are dates which correspond to the dates of the foregoing
ten separate analyses of transactions. The debit and credit entries are shown with Dr
or Cr alongside to distinguish them. For each column all the debit entries are totalled
and all the credit entries are totalled separately. The surplus of debits over credits (or
credits over debits) is calculated and shown in the final line. This allows a summarised
list to be prepared as shown in Exhibit 3.11.
A spreadsheet is useful where there are not too many entries, but ledger accounts
become essential when the volume of information increases.
Activity 3.4
Note: The totals of each column have no particular meaning, but they should always
be equal because of the symmetry of the debit and credit records, and so are useful as
an arithmetic check that no item has been omitted or recorded incorrectly.
Turning the spreadsheet back to a vertical listing, using the debit column for items
where the debits exceed the credits, and using the credit column for items where the
credits exceed the debits, the list becomes as in Exhibit 3.11. You will see that this list
is the basis of the information provided about P. Mason’s legal practice in the main
body of the chapter, except that the debit and credit notation was not used there.
The most serious problem faced by most students, once they have understood the
basic approach, is that of making errors. Look back through this Supplement and think
about the errors which might have been made. What type of error would be detected by
finding totals in Exhibit 3.11 which were not in agreement? What type of error would not
be detected in this way because the totals would be in agreement despite the error?
Types of error will be dealt with in the supplement to Chapter 5.
Exhibit 3.11
Summary of debit and credit entries for each category of asset, liability and
ownership interest
Debit Credit
£ £
Assets
Land and buildings 250,000
Office furniture 30,000
Trade receivables (debtors) 1,200
Prepayment 540
Cash at bank 15,280
Liabilities
Trade payables (creditors) 2,800
Long-term loan 150,000
Ownership interest
Revenue 8,820
Expenses 4,600
Capital contributed 140,000
Totals 301,620 301,620
72 Part 1 A conceptual framework: setting the scene
S Test your understanding
S3.1 [S] Analyse the debit and credit aspect of each transaction listed at (a), (b) and (c) of
question B3.2.
S3.2 Prepare a spreadsheet similar to that presented in Exhibit 3.10, setting out on the first
line the items contained in the list of assets and liabilities of question B3.2 and then on
lines 2, 3 and 4 adding in the transactions (a), (b) and (c). Calculate the totals of each
column of the spreadsheet and show that the accounting equation remains equal on
both sides.
Chapter 4
Ensuring the quality of financial statements
REAL WORLD CASE
2004/05 Group highlights
Reported At constant
basis exchange
rates(1)(2)
Like for like sales up 5.0%
Sales £1,614.4m up 0.6%(2) up 7.8%
Operating profit £218.9m up 4.1%(2) up 11.3%
Profit before tax £210.3m up 5.3%(2) up 12.1%
Earnings per share(3) 8.2p up 9.3%(2) up 15.5%
Dividend per share 3.0p up 20.0%
Return on capital 26.5% up from 25.9%(2)
employed(3)
Gearing(3) 11.3% down from 11.8%(2)
(1) See page 29 for reconciliation to Generally Accepted Accounting
Principles (‘GAAP’) figures.
(2) 2000/01 to 2003/04 restated for the implementation in 2004/05
of the amendment to FRS 5, ‘Application Note G – Revenue Recognition’.
(3) Earnings per share, return on capital employed and gearing are defined on page 130.
(4) 53 week year.
Introduction
The key drivers of operating profitability are the:
l rate of sales growth,
l balance between like for like sales growth and sales from new store space,
l achieved gross margin,
l level of cost increases experienced by the Group,
l level of net bad debt charge relating to the in-house credit card in the US, and
l movements in the US dollar to pound sterling exchange rate, since the majority of the Group’s
profits are generated in the US and the Group reports in pounds sterling.
Source: Signet Group plc Annual Report and Accounts 2005, inside cover and p. 24.
Discussion points
1 How does the company present the information it regards as most relevant to the needs of readers?
2 The group provides information ‘at constant exchange rates’ to eliminate the effects of exchange
rate fluctuations. How relevant is this information to the needs of users?
74 Part 1 A conceptual framework: setting the scene
Contents 4.1 Introduction 75
4.2 Qualitative characteristics of financial statements 75
4.2.1 Understandability 75
4.2.2 Relevance 76
4.2.3 Reliability 76
4.2.4 Comparability 77
4.2.5 Constraints on relevant and reliable information 79
4.2.6 UK ASB 79
4.3 Measurement in financial statements 79
4.3.1 Going concern 80
4.3.2 Accruals 80
4.3.3 Consistency 81
4.3.4 Prudence 81
4.3.5 Realisation 81
4.4 Views on prudence 82
4.5 Regulation of financial reporting 84
4.5.1 The IAS Regulation 84
4.5.2 UK company law 85
4.5.3 The Financial Reporting Council 86
4.5.4 UK Accounting Standards Board 87
4.5.5 Auditing Practices Board 88
4.5.6 Professional Oversight Board for Accountancy 88
4.5.7 Financial Reporting Review Panel 88
4.5.8 Accountancy Investigation and Discipline Board 89
4.5.9 Committee on Corporate Governance 89
4.5.10 The Financial Services Authority 89
4.5.11 Auditors 89
4.5.12 The tax system 91
4.5.13 Is regulation necessary? 91
4.6 Reviewing published financial statements 92
4.6.1 Income statement (profit and loss account) 93
4.6.2 Balance sheet 94
4.6.3 Cash flow statement 96
4.7 Summary 97
Learning
outcomes
After studying this chapter you should be able to:
l List and explain the qualitative characteristics desirable in financial statements.
l Explain the approach to measurement used in financial statements.
l Explain why there is more than one view on the role of prudence in accounting.
l Understand and explain how and why financial reporting is regulated or
influenced by external authorities.
l Be aware of the process by which financial statements are reviewed by an
investor.
Chapter 4 Ensuring the quality of financial statements 75
4.1 Introduction
The previous chapter used the accounting equation as a basis for explaining the structure
of financial statements. It showed that design of formats for financial statements
is an important first step in creating an understandable story from a list of accounting
data.
The objective of financial statements is to provide information about the financial
position, performance and changes in financial position of an entity that is useful to a
wide range of users in making economic decisions.1
Information about financial position is provided in a balance sheet. Information
about performance is provided in an income statement (profit and loss account).2
Information about changes in the cash position is provided in a cash flow statement.
These three statements were explained in outline in Chapter 3. Information about
changes in financial position is also provided in a separate statement, described in
Chapter 12. Notes to the financial statements provide additional information relevant
to the needs of users. These notes may include information about risks and uncertainties
relating to assets, liabilities, revenue and expenses.3
4.2 Qualitative characteristics of financial statements
The IASB Framework sets out qualitative characteristics that make the information provided
in financial statements useful to users. The four principal qualitative characteristics
are:
l understandability
l relevance
l reliability
l comparability.4
The principal qualitative characteristics of relevance and reliability have further subheadings,
as follows:
l relevance
– materiality
l reliability
– faithful representation
– substance over form
– neutrality
– prudence
– completeness.
Each of these characteristics is now described.
4.2.1 Understandability
It is essential that the information provided in financial statements is readily understandable
by users.5 Users are assumed to have a reasonable knowledge of business
and economic activities and accounting, and a willingness to study the information
with reasonable diligence. Information on complex matters should not be omitted
from financial statements merely on the grounds that some users may find it difficult
to understand.
76 Part 1 A conceptual framework: setting the scene
4.2.2 Relevance
Information has the quality of relevance when it influences the economic decisions of
users by helping them evaluate past, present or future events or confirming, or correcting,
their past evaluations.6
Information has a predictive role in helping users to look to the future. Predictive
value does not necessarily require a forecast. Explaining unusual aspects of current
performance helps users to understand future potential. Information also has a confirmatory
role in showing users how the entity has, or has not, met their expectations.7
Materiality
Information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements. Materiality depends
on the size of the item or error judged in the particular circumstances of its omission
or misstatement.8
The IASB Framework takes the view that materiality is a cut-off point in deciding
whether information is important to users. The description of an item may make it
material. The amount of an item may make it material.
For example, the balance sheet of a business shows inventories of raw materials
and inventories of finished goods as two separate items. That is because the users of
financial statements are interested in the types of inventory held as well as the amount
of each. The risks of holding raw materials are different from the risks of holding
finished goods. However the inventory of finished goods is not separated into the
different types of finished goods because that would give too much detail when the
risks of holding finished goods are relatively similar for all items.
4.2.3 Reliability
Information has the quality of reliability when it is free from material error and bias
and can be depended upon by users to represent faithfully what it either purports to
represent or could reasonably be expected to represent.9
Information may be relevant but so unreliable that it could be misleading (e.g.
where a director has given a highly personal view of the value of an investment). On
the other hand, it could be reliable but quite non-relevant (e.g. the information that a
building standing in the centre of a major shopping street was bought for 50 guineas
some 300 years ago).
Faithful representation
Faithful representation is important if accounting information is to be reliable. Faithful
representation involves the words as well as the numbers in the financial statements.
Sometimes it may be difficult for the managers of an entity to find the right words to
describe a transaction and convey the problems of making reliable measurement. In
such cases it will be important to disclose the risk of error surrounding recognition
and measurement.10
Substance over form
If information is to meet the test of faithful representation, then the method of accounting
must reflect the substance of the economic reality of the transaction and not
merely its legal form.
For example, a company has sold its buildings to a bank to raise cash and then pays
rent for the same buildings for the purpose of continued occupation. The company
carries all the risks and problems (such as repairs and insurance) that an owner would
carry. One view is that the commercial substance of that sequence of transactions is
Chapter 4 Ensuring the quality of financial statements 77
comparable to ownership. Another view is that the legal form of the transaction is a
sale. The characteristic of substance over form requires that the information in the
financial statements should show the commercial substance of the situation.11
Neutrality
The information contained in financial statements must be neutral. This is also
described as being ‘free from bias’. Financial statements are not neutral if, by the
selection and presentation of information, they influence the making of a decision or
judgement in order to achieve a predetermined result or outcome.12
This condition is quite difficult to enforce because it has to be shown that the entity
producing the financial statements is trying to influence the decisions or judgements
of all members of a class of users of the information. It would be impractical to know
the decision-making process of every individual user.
Prudence
The preparers of financial statements have to contend with uncertainty surrounding
many events and circumstances. The existence of uncertainties is recognised by the
disclosure of their nature and extent and by the exercise of prudence in the preparation
of the financial statements. Prudence is the inclusion of a degree of caution in the
exercise of the judgements needed in making the estimates required under conditions
of uncertainty, such that gains and assets are not overstated and losses and liabilities
are not understated.13
Completeness
It almost goes without saying that information cannot be reliable if it is not complete.
The information in financial statements must be complete, within the bounds of
materiality and cost. An omission can cause information to be false or misleading and
thus to lack reliability and relevance.14
4.2.4 Comparability
Comparability means that users must be able to compare the financial statements of
an enterprise over time to identify trends in its financial position and performance.
Users must also be able to compare the financial statements of different enterprises
to evaluate their relative financial position, performance and changes in financial
position.15 Financial statements should show corresponding information for the previous
period.16
Consistency
This concerns the measurement and display of the financial effect of like transactions
and other events being carried out in a consistent way throughout an entity within
each accounting period and from one period to the next, and also in a consistent way
by different entities.17
However, the need for consistency should not be allowed to become an impediment
to the introduction of improved accounting practices. Consistency does not require
absolute uniformity.18
Disclosure of accounting policies
This is another important aspect of comparability. Disclosure means that users of
financial statements must be informed of the accounting policies employed in the preparation
of financial statements. Managers must also disclose changes in accounting
policies and the effect of those changes.19
78 Part 1 A conceptual framework: setting the scene
Source: ASB (1999), Statement of Principles for Financial Reporting, p. 34. Reproduced with the permission of the Accounting Standards Board.
Exhibit 4.1
UK ASB: Relationships of the qualitative characteristics of financial information
Chapter 4 Ensuring the quality of financial statements 79
Activity 4.1
The annual report of a company will usually have a separate section headed
‘Accounting policies’. It will be located immediately after the primary financial statements,
leading into the detailed notes to the accounts. The statement of accounting
policies is essential reading for any user of the annual report.
4.2.5 Constraints on relevant and reliable information
Relevance and reliability are twin targets which may cause some tension in deciding the
most appropriate way to report accounting information. There is a trade-off between
relevance and reliability when it comes to ensuring that information is delivered in a
timely manner so that it is still relevant, and when it comes to deciding whether the
costs of producing further information exceed the benefits.
Timeliness
If information is provided in a timely way, the reliability may be less than 100% because
some aspects of a transaction are not yet complete. If reporting is delayed until all
aspects of a transaction are known then the relevance may be less than 100% because
investors have become tired of waiting. The balance of timeliness is achieved by considering
how best to serve the needs of users in making economic decisions.20
Benefit and cost
The benefits derived from information should be greater than the costs of providing
it. The analysis is complicated because the benefits fall mainly on the users, while the
costs fall mainly on the provider. It is important for standard-setters to consider the
benefits and costs as a whole.21
4.2.6 UK ASB
The UK ASB’s representation of the relationships between the various qualitative
characteristics is set out in Exhibit 4.1.22
In many ways the ideas of the UK ASB reflect those of the IASB which were
written ten years earlier. However during that ten-year period the ASB had time to
benefit by thinking about ways of clarifying some aspects of the IASB’s ideas. One
difference in presentation is that the ASB suggests that materiality is a test to be
applied at the threshold of considering an item. If any information is not material,
it does not need to be considered further.
Look back to Exhibit 4.1. Is there any aspect of that diagram which came as no surprise
to you? Is there any aspect of that diagram which was a surprise to you? Having read the
explanations in this section, do you hold the same surprise that you did at the outset?
With the benefit of hindsight, can you explain why you were surprised or not surprised?
Has this analysis caused you to modify your own objectives for what you hope to learn
from this book?
4.3 Measurement in financial statements
You have seen in Chapter 2, sections 2.5 and 2.8, that the recognition of assets and
liability requires reliability of measurement. You have seen in Chapter 3 the methods
of presentation of accounting information containing numbers that represent measurement.
We now need to know more about the accounting measurement principles
80 Part 1 A conceptual framework: setting the scene
that establish reliability and about the disclosure of information that allows users of
financial statements to understand the measurement process.
The accounting measurement principles that are most widely known in the UK are
found within the Companies Act 1985:23
l going concern
l accruals
l consistency
l prudence.
The IASB Framework describes the accrual basis and going concern as ‘underlying
assumptions’ in the preparation of financial statements. It describes prudence as a
‘constraint’ on relevance and reliability. Consistency is an aspect of comparability.
4.3.1 Going concern
Definition The financial statements are normally prepared on the assumption that an entity is a
going concern and will continue in operation for the foreseeable future. Hence, it is
assumed that the entity has neither the intention nor the need to liquidate or curtail
materially the scale of its operations; if such an intention or need exists the financial
statements may have to be prepared on a different basis and, if so, the basis used is
disclosed.24
The UK Companies Act statement on going concern is rather like a crossword clue, in
being short and enigmatic. It states: ‘The company shall be presumed to be carrying
on business as a going concern.’ More guidance is needed on measurement.
For companies applying UK accounting standards there is guidance in FRS 18. It
requires an entity to prepare its financial statements on a going concern basis unless the
entity is being liquidated or has ceased trading, when a ‘break-up’ valuation may be
more appropriate. On a forced sale, very little is obtained for the assets of a business.
If the company is still operating but the directors are aware of conditions that cast
doubts on the company’s ability to continue as a going concern, they should disclose
those uncertainties. They must take into account all available information about the
‘foreseeable future’.
If the company is staying in business then the directors are allowed to use valuations
that reflect continuity. They do not have to report ‘break-up’ values, which are values
for immediate sale of assets. Investors are probably quite happy when the company is
continuing as a going concern. They will be more concerned about the risk that it will
not continue. For that reason, the directors are required to make a statement in their
report to confirm that the business remains a ‘going concern’ for the foreseeable future.
There is no readily available definition of ‘foreseeable future’ but the guidance given
in the UK to directors and auditors points towards considering a period of 12 months
from the balance sheet date.
4.3.2 Accruals (also called ‘matching’)
Definition Under the accruals basis, the effects of transactions and other events are recognised
when they occur (and not as cash or its equivalent is received or paid) and they are
recorded in the accounting records and reported in the financial statements of the
periods to which they relate.25
The IASB explains that financial statements prepared on the accruals basis are useful
for stewardship purposes because they report past transactions and events but are also
Chapter 4 Ensuring the quality of financial statements 81
helpful to users for forward-looking information because they show obligations to pay
cash in the future and resources that represent cash to be received in the future.
The UK Companies Act explains the accruals concept as a requirement that all
income and charges (i.e. expenses) relating to the financial year shall be taken into
account, without regard to the date of receipt or payment.
The word ‘accrue’ means ‘to fall due’ or ‘to come as a natural result’. If, during
a year, a company sells £100m of goods but collects only £80m from customers, it
records sales as £100m in the profit and loss account. The cash yet to be collected
from customers is reported as an asset called ‘debtor’ in the balance sheet. If, during
the year, it uses electricity costing £50m but has only paid £40m so far, it records the
expense of £50m in the profit and loss account. The unpaid electricity bill is reported
as a liability called ‘accruals’ in the balance sheet.
The idea of matching is also used in applying the idea of accruals. Matching has two
forms, matching losses or gains against time and matching expenses against revenue.
Time matching occurs when a gain or loss is spread over the relevant period of time,
such as receiving interest on a loan or paying rent on a property. Matching of revenues
and expenses occurs when costs such as labour are matched against the revenue
earned from providing goods or services.
4.3.3 Consistency
Consistency is described in the IASB Framework as an aspect of comparability (see
section 4.2.4). The UK Companies Act requires that accounting policies shall be applied
consistently within the same accounts and from one period to the next.
4.3.4 Prudence
The Companies Act does not define prudence but uses the word prudent in relation
to measurement. It requires that the amount of any item shall be determined on a
prudent basis, and in particular:
(a) only profits realised at the balance sheet date shall be included in the profit and
loss account; and
(b) all liabilities and losses which have arisen or are likely to arise in respect of the
financial year shall be taken into account, including those which only become
apparent between the balance sheet date and the date on which it is signed by the
board of directors.
The UK ASB has said that decisions about recognition of income or assets and of
expenses or liabilities require evidence of existence and reliability of measurement.
Stronger evidence and greater reliability of measurement are required for assets and
gains than for liabilities and losses.26
4.3.5 Realisation
There is no clear statement of the conditions that will make a profit realised. It is not
specifically defined in the IASB system. It is an example of an idea that is so widely
used that it appears to be almost impossible to explain. If you turn to a dictionary you
will find ‘realise’ equated to ‘convert into cash’. The accounting standard FRS 1827
confirms that it is the general view that profits shall be treated as realised when
evidenced in the form of cash or other assets whose cash realisation is reasonably
certain. However, the standard avoids linking realisation to ‘prudence’, explaining
that a focus on cash does not reflect more recent developments in financial markets.
Evidence of ‘reasonable certainty’ in such markets does not necessarily require cash.
It is based on confidence in the reliable operation of the market.
82 Part 1 A conceptual framework: setting the scene
Activity 4.2
Activity 4.3
Take a piece of paper having two wide columns. Head the left-hand column ‘My thoughts
on measurement in accounting’ and head the right-hand column ‘What the book tells me
about measurement’. Fill in both columns and then exchange your paper with a fellow
student. Discuss with each other any similarities and differences in the left-hand column
and relate these to your personal views and prior experience. Discuss with each other any
similarities and differences in the right-hand column and evaluate the extent to which
different people see books differently. Finally, discuss with each other the extent to which
reading this section has changed your views on measurement as a subject in accounting.
4.4 Views on prudence
The Companies Act makes an explicit link between prudence and realisation that
reflects UK accounting practice when the Companies Act was written. The IASB’s
Framework avoids mentioning realisation and describes prudence in terms of ‘a degree
of caution’.28 From the UK ASB, the standard FRS 18 acknowledges the meaning of
realisation but breaks the link between realisation and prudence.29 Because FRS 18
is relatively new, it is not possible to say whether it will change the entrenched conservatism
of accounting practice which tends towards understatement on grounds
of caution. Where does that leave the student of accounting who wants to understand
the meaning of prudence?
The most important message for students of accounting (and for many practitioners)
is contained in the IASB’s Framework:30
. . . the exercise of prudence does not allow . . . the deliberate understatement of assets or income,
or the deliberate overstatement of liabilities or expenses, because the financial statements
would not be neutral and, therefore, not have the quality of reliability.
Why are there different views on understatement and overstatement, depending on
the item being reported? Here is your first chance to use the accounting equation to
solve a problem:
Assets minus Liabilities equals Capital contributed/withdrawn plus Profit
Profit equals Revenue minus Expenses
Ask yourself what will happen to profit in the accounting equation if the amount of an
asset is increased while the liabilities and the capital contributed remain the same.
Then ask yourself what will happen to profit in the accounting equation if the amount
of a liability is decreased while the assets and the capital contributed remain the same.
Next ask yourself what will happen to profit if revenue is overstated. Finally ask yourself
what will happen to profit if expenses are understated.
Assuming that capital contributed/withdrawn remains constant, overstating assets
will overstate profit. Understating liabilities will overstate profit. Overstating revenue
will overstate profit. Understating expenses will overstate profit.
Examples
A market trader buys £100 of stock on credit, promising to pay the supplier at the end
of the day. The trader sells three-quarters of the stock at a price of £90 and takes the
Chapter 4 Ensuring the quality of financial statements 83
rest home to keep for next week’s market. At the end of the day the trader has £90 in
cash, one-quarter of the stock which cost £25, and owes £100 to the supplier. How
much profit has the trader made? The answer is that the profit is £15 (£90 received for
the sale of stock less the cost of the items sold, £75, being three-quarters of the stock
purchased). The accounting equation is:
Assets minus Liabilities equals Ownership interest at the start of the
at the end of the period period plus Capital contributed/
withdrawn plus Revenue of the period
minus Expenses of the period
stock £25 + cash £90 − equals nil + nil + revenue £90 − expenses £75
liability £100
£15 equals £15
1 Supposing the trader ‘forgets’ part of the liability and thinks it is only £84 owing,
rather than £100. The assets remain at stock £25 + cash £90, which equals £115. The
liability is now thought to be £84 and therefore the equation becomes:
£25 + £90 − £84 equals nil + nil + revenue £90 − expenses £75
+ [?] £16 [?]
£31 equals £31
For the equation to be satisfied there must be a total of £31 on both sides. The
total of £31 is therefore written in. The recorded profit is still only £15, calculated as
revenue £90 minus expenses £75, so there is a ‘hole’ amounting to £16 on the righthand
side of the equation. The accounting equation has to balance so the extra £16
is written in, surrounded by question marks, on the right-hand side. It is assumed
on the right-hand side that the trader has either forgotten to record revenue of £16
or has recorded too much expense, so that the amount appears to represent an
unexplained profit. Thus understating a liability will overstate profit. That favourable
news might mislead a competitor or investor. It might be bad news when the Inland
Revenue demands tax on profit of £31. Also there is the unpaid supplier who may
not be entirely patient when offered £84 rather than £100.
2 Supposing instead that the trader ‘forgets’ there is some unsold stock left. The
only recorded asset would be the cash at £90 and there would be a liability of £100.
This gives negative net assets of (£10) and, because the accounting equation has to
balance, suggests that there is a ‘forgotten’ expense of £25 on the right-hand side.
The equation then becomes:
£90 − £100 equals nil + nil + £90 − £75 − [?] £25 [?]
(£10) equals (£10)
This would cause the Inland Revenue to ask a lot of questions as to why there
was no record of stock remaining, because they know that omitting stock from
the record is a well-tried means of fraudulently reducing profits and therefore
reducing tax bills. Understating an asset will understate profit.
These two examples have illustrated the meaning of the warning that deliberate
understatement or overstatement is not acceptable. The general message of prudence
is: avoid overstating profit. In down-to-earth terms, don’t raise the readers’ hopes too
high, only to have to tell them later that it was all in the imagination.
84 Part 1 A conceptual framework: setting the scene
4.5 Regulation of financial reporting
Because the external users of accounting information do not have day-to-day access to
the records of the business, they rely on the integrity and judgement of management
to provide suitable information of a high quality. But will the management be honest,
conscientious and careful in providing information? In an ideal world there should be
no problem for investors in a company because, as shareholders, they appoint the
directors and may dismiss them if dissatisfied with the service provided. However, the
world is not ideal. Some companies are very large and they have many shareholders
whose identity changes as shares are bought and sold. Over the years it has been
found that regulation is needed particularly for financial reporting by companies. The
general regulation of companies in the UK is provided by parliamentary legislation,
through the Companies Act 1985.
However since 2005 the regulation of financial reporting by UK companies has
taken two separate routes depending on the type of company.
The group financial statements of listed companies must comply with the IAS
Regulation set by the European Commission. The IAS Regulation takes precedence over
the relevant sections of the Companies Act. The IAS Regulation was issued in 2002,
requiring listed group financial statements from 2005 to apply approved International
Financial Reporting Standards, IFRS (previously called International Accounting
Standards, IAS). The UK government subsequently permitted individual companies
and non-listed groups to choose to apply IFRS. Any companies not taking up this
choice must continue to apply the relevant sections of the Companies Act and follow
the accounting standards set by the UK Accounting Standards Board (ASB). Other
organisations that are not companies (such as sole traders, partnership, public sector
bodies) have to look to the regulations that govern their operations to decide which
accounting guidance to follow.
So how can we tell which accounting system has been applied in any situation?
Look first for the audit report, if there is one. That will include a paragraph starting
‘In our opinion’. In that paragraph the auditors will specify the accounting system
on which their opinion is based. If there is no auditors’ report, look for the Note on
Accounting Policies. There will usually be a paragraph stating the accounting system
that has been applied.
4.5.1 The IAS Regulation
In 2002 the European Commission issued the IAS Regulation which took effect from
1 January 2005. Its purpose is to harmonise the financial information presented by
public listed companies in order to ensure a high degree of transparency and comparability
of financial statements. The Regulation is relatively short but has been
extended and clarified by a trail of subsequent documents. The European Commission
publishes all documents on its website31 in the languages of all Member States but
that is more detail than is necessary for a first year course.
A Regulation is directly applicable in Member States. It has a higher status than
a Directive, which is an instruction to Member States on the content of their national
laws. Before the Regulation was issued, the company law of Member States was
harmonised by following the Fourth and Seventh Directives on company law. Companies
in Member States did not need to know the Directives because the national
company law applied the Directives. Now that the IAS Regulation is directly applicable,
Member States must ensure that they do not seek to apply to a company any
additional elements of national law that are contrary to, conflict with or restrict a
company’s compliance with IASs.
Chapter 4 Ensuring the quality of financial statements 85
The Commission decides on the applicability of IFRS within the Community. It is
assisted by an Accounting Regulatory Committee and is advised by a technical group
called the European Financial Reporting and Accounting Group EFRAG.32 The tests
for adoption of IFRS are that the standards:
(a) do not contradict specific principles of the Fourth and Seventh Directive,
(b) are conducive to the European public good, and
(c) meet the criteria of understandability, relevance, reliability and comparability
required of financial information needed for making economic decisions and
assessing the stewardship of management.
A standard that is adopted is said to be endorsed. If a standard is awaiting endorsement,
or is rejected, it may be used as guidance if it is not inconsistent with endorsed
standards. If a rejected standard is in conflict with adopted standards, it may not
be used. When the European Commission first announced the endorsement process
there were fears expressed that this would be used to create ‘European IFRS’ by
selecting some IFRS and rejecting others. The Commission’s reply was that the EU
cannot give its powers to a body (the IASB) that is not subject to EU jurisdiction, and
it is necessary for the EU to endorse standards as part of its duty in setting laws for
Member States.
4.5.2 UK company law
Companies Act 1985
The Companies Act 1985 sets many rules for investing in and operating companies.
Parts of the Act cover the information presented in financial statements. For companies
and other organisations that do not follow the IAS Regulation, the Companies Act 1985
prescribes formats of presentation of the balance sheet and profit and loss account.
Companies must select one of the permitted formats. It also prescribes methods of
valuation of the assets and liabilities contained in the balance sheet, broadly expecting
that normally these items will be recorded at their cost at the date of acquisition,
subject to diminutions in value since that date. Some other approaches to valuation
are permitted, but these are carefully regulated and are subject to requirements for
prudence, consistency and an expectation that the business is a going concern (i.e. will
continue for some time into the future). The UK legislation places strong emphasis on
the requirement to present a true and fair view in financial statements.
Since the early 1980s company law on financial reporting has been harmonised with
that of other Member States in the EU through the Fourth and Seventh Directives of
the EU (see Chapter 7).
The directors are responsible for the preparation of company accounts. Exhibit 4.2
sets out the statement made by directors of one major public company regarding their
responsibilities in these matters. This type of statement will be found in the annual
reports of most of the large listed companies. It is regarded as an important aspect of
giving reassurance to investors and others that there is a strong system of corporate
governance within the company. It is also intended to clarify any misunderstandings
the shareholders may have about the work of directors as distinct from the work of the
auditors (see below).
The Companies (Audit, Investigations and Community Enterprise) Act, 2004 made
changes intended to improve the reliability of financial reporting, the independence of
auditors and disclosure to auditors. In particular it required a statement to be inserted
in the directors’ report confirming that there is no relevant information that has not
been disclosed to the auditors. The role of the Financial Reporting Review Panel was
strengthened by giving it new powers to require documents. HM Revenue and
Customs was authorised to pass information about companies to the FRRP.
86 Part 1 A conceptual framework: setting the scene
Company Law Reform
A major inquiry into proposals for modernising company law, starting in the late
1990s,33 led to a final report in 2001 which made recommendations to government.
The government then issued a series of consultation documents leading in March 2005
to a White Paper34 and draft legislation for further consultation. Changes in company
law are usually slow, so it takes time for recommended changes to be put into action.
Some changes are implemented ahead of others.
At the heart of the Company Law Review was the idea ‘think small first’. This
reflected a concern that company law has grown by being written for the larger company
and then ‘slimmed down’ for the smaller company. This has tended to leave
too great a burden on small companies. Focusing first on the small company should
reduce the risk of excessive burden. Disclosure by small companies is described in
outline in Chapter 7.
The government indicated that its law reform would also deal with a new EU
Directive on audit. Audit is described further in section 4.5.11.
4.5.3 The Financial Reporting Council
The Financial Reporting Council (FRC)35 describes itself as the UK’s independent
regulator for corporate reporting and governance. It is recognised in its regulatory
role by the Department of Trade and Industry. The government effectively delegates
responsibility to an independent body but maintains close interest in the strategy and
operations of the FRC.
The FRC’s aim is to promote confidence in corporate reporting and governance.
To achieve this aim it sets itself five key objectives, in promoting:
l high quality corporate reporting
l high quality auditing
l high standards of corporate governance
l the integrity, competence and transparency of the accountancy profession
l its effectiveness as a unified independent regulator.
The FRC is one regulator but it has a wide range of functions:
Exhibit 4.2
Statement of directors’ responsibilities as expressed in the annual report of a
public limited company
Statement of directors’ responsibilities
Company law requires the directors to prepare accounts for each financial year
which give a true and fair view of the state of affairs of the company and of the
group and of the profit or loss and cash flows of the group for that period. In
preparing these accounts, the directors have adopted suitable accounting policies
and then applied them consistently, made judgements and estimates that are
reasonable and prudent, followed applicable accounting standards and adopted
the going concern basis.
The directors are responsible for ensuring that the company keeps proper
accounting records which disclose with reasonable accuracy at any time the
financial position of the company and enable them to ensure that the accounts
comply with the IAS Regulation/Companies Act 1985. They are also responsible
for safeguarding the assets of the company and taking reasonable steps for the
prevention and detection of fraud and other irregularities.
Chapter 4 Ensuring the quality of financial statements 87
l setting, monitoring and enforcing accounting and auditing standards
l statutory oversight and regulation of auditors
l operating an independent investigation and discipline scheme for public interest
cases
l overseeing the regulatory activities of the professional accountancy bodies
l promoting high standards of corporate governance.
There are five operating bodies (subsidiaries of the FRC) to carry out these functions.
l Accounting Standards Board
l Auditing Practices Board
l Professional Oversight Board For Accountancy
l Financial Reporting Review Panel
l Accountancy Investigation & Discipline Board.
Each one of these is now described.
4.5.4 UK Accounting Standards Board
Traditionally, professions in the UK have been expected to regulate their own affairs
and control their members. The accounting profession satisfied this expectation
between 1970 and 1990 by forming the Accounting Standards Committee (ASC) and
requiring members of each professional body to apply accounting standards or face
disciplinary action. Over a period of years there was growing dissatisfaction with this
pure self-regulatory model because the disciplinary aspects appeared to be applied
only rarely and the existence of potential conflicts of self-interest was pointed to by
some critics as weakening the standard-setting process. Consequently, in 1990 the
purely self-regulatory approach was abandoned in favour of an independent regime
having statutory backing, but retaining some self-regulatory features. The independent
standard setting body was created as the Accounting Standards Board (ASB).
Since 1990 the ASB has published Financial Reporting Standards (FRSs) setting
standards of practice which go beyond the requirements of company law in particular
problem areas. In the period from 1970 to 1990 the standards set by the ASC were called
Statements of Standard Accounting Practice (SSAPs). Those SSAPs which remained
valid were adopted by the ASB and are gradually being replaced. SSAPs and FRSs
collectively are referred to as ‘accounting standards’. The Accounting Standards Board
(ASB) is recognised as a standard-setting body under the Companies Act 1985.
The UK ASB is gradually harmonising its standards with those of the IASB so that
eventually all companies will apply the same accounting standards, irrespective of
whether they present financial statements under the IAS Regulation or the Companies
Act. Until that happens there will continue to be some differences between ASB
standards and IASB standards but in general this need not be of concern in a first year
of study.
The ASB collaborates with accounting standard-setters from other countries and
the IASB both in order to influence the development of international standards and
in order to ensure that its standards are developed with due regard to international
developments.
The ASB has up to ten Board members, of whom two (the Chairman and the Technical
Director) are full-time, and the remainder, who represent a variety of interests, are
part-time. ASB meetings are also attended by three observers. Under the ASB’s constitution,
votes of seven Board members (six when there are fewer than ten members)
are required for any decision to adopt, revise or withdraw an accounting standard.
Board members are appointed by a Nominations Committee comprising the chairman
and fellow directors of the Financial Reporting Council (FRC).
88 Part 1 A conceptual framework: setting the scene
The Accounting Standards Board is independent in its decisions on issuing standards.
Before doing so the Board consults widely on all its proposals.
4.5.5 Auditing Practices Board
The Auditing Practices Board (APB) was established in April 2002, and replaces a previous
APB which had been in place since 1991. APB is a part of the Financial Reporting
Council. The APB is committed to leading the development of auditing practice in the
UK and the Republic of Ireland so as to establish high standards of auditing, meet the
developing needs of users of financial information and ensure public confidence in
the auditing process.
4.5.6 Professional Oversight Board for Accountancy
The Professional Oversight Board for Accountancy (POBA) contributes to the achievement
of the Financial Reporting Council’s own fundamental aim of supporting investor,
market and public confidence in the financial and governance stewardship of listed
and other entities by:
l independent oversight of the regulation of the auditing profession by the recognised
supervisory and qualifying bodies;
l monitoring the quality of the auditing function in relation to economically significant
entities;
l independent oversight of the regulation of the accountancy profession by the professional
accountancy bodies.
4.5.7 Financial Reporting Review Panel
When the Accounting Standards Board was established in 1990 it was felt to be important
that there was a mechanism for enforcing accounting standards. An effective
mechanism had been lacking in the previous process of setting standards. Accordingly
the Financial Reporting Council established a Financial Reporting Review Panel
(FRRP) which enquires into annual accounts where it appears that the requirements
of the Companies Act, including the requirement that annual accounts shall show a
true and fair view, might have been breached. The FRRP has the power to ask companies
to revise their accounts where these are found to be defective. If companies
do not voluntarily make such a revision, the FRRP may take proceedings in a court of
law to require the company to revise its accounts. These powers are contained in the
Companies Act 1985 and delegated to the FRRP by the Secretary of State for Trade and
Industry. So far the FRRP has not found it necessary to resort to legal action, having
found its powers of persuasion were sufficient.
The Financial Reporting Review Panel (FRRP), (referred to as ‘the Panel’) considers
whether the annual accounts of public companies and large private companies comply
with the requirements of the Companies Act 1985, including applicable accounting
standards. The Panel does not offer advice on the application of accounting standards
or the accounting requirements of the Companies Act 1985.
The Panel can ask directors to explain apparent departures from the requirements.
If it is not satisfied by the directors’ explanations it aims to persuade them to adopt a
more appropriate accounting treatment. The directors may then voluntarily withdraw
their accounts and replace them with revised accounts that correct the matters in error.
Depending on the circumstances, the FRRP may accept another form of remedial
action – for example, correction of the comparative figures in the next set of annual
financial statements. Failing voluntary correction, the Panel can exercise its powers to
secure the necessary revision of the original accounts through a court order. The FRRP
Chapter 4 Ensuring the quality of financial statements 89
has enjoyed a long and successful record in resolving all cases brought to its attention
without having to apply for a court order. The Panel maintains a legal costs fund of
£2m for this purpose. Also, if the case concerns accounts issued under listing rules, the
Panel may report to the Financial Services Authority.
4.5.8 Accountancy Investigation and Discipline Board
The Accountancy Investigation and Discipline Board (AIDB) is the independent, investigative
and disciplinary body for accountants in the UK. It has up to eight members.
The AIDB is responsible for operating and administering an independent disciplinary
scheme (‘the Scheme’) covering members of the major professional bodies.
The AIDB will deal with cases which raise or appear to raise important issues
affecting the public interest in the UK and which need to be investigated to determine
whether or not there has been any misconduct by an accountant or accountancy firm.
4.5.9 Committee on Corporate Governance
The Committee on Corporate Governance works to satisfy the FRC’s responsibility for
promoting high standards of corporate governance. It aims to do so by:
l maintaining an effective Combined Code on Corporate Governance and promoting
its widespread application;
l ensuring that related guidance, such as that on internal control, is current and relevant;
l influencing EU and global corporate governance developments;
l helping to promote boardroom professionalism and diversity; and
l encouraging constructive interaction between company boards and institutional
shareholders.
4.5.10 The Financial Services Authority
Under the Financial Services and Markets Act 2000, the Financial Services Authority
(FSA) is a single regulator with responsibility across a wide range of financial market
activity. It is required to maintain confidence in the UK financial system, to promote
public understanding of the financial system, to secure protection for consumers and
to reduce the scope for financial crime. The FSA is an independent, non-governmental
body and receives no funds from government. It reports annually to Parliament
through the Treasury.
The FSA regulates listing of companies’ shares on the UK stock exchange. The work
is carried out by a division called the UK Listing Authority (UKLA). When a company
first has its shares listed, it must produce a prospectus, which is normally much more
detailed than the annual report. The regulations covering the content of a prospectus
are set by the UKLA. Once a company has achieved a listing, it must keep up with
ongoing obligations under the Listing Rules, which includes providing accounting
information to the market in the annual report and press releases. Details of the Listing
Rules are not necessary for first-year study but if you are interested you can read them
on the FSA’s website: www.fsa.gov.uk.
4.5.11 Auditors
The shareholders of companies do not have a right of access to the records of the
day-to-day running of the business, and so they need someone to act on their behalf
to ensure that the directors are presenting a true and fair view of the company’s
position at a point in time and of the profits generated during a period of time. To
achieve this reassurance, the shareholders appoint a firm of auditors to investigate
90 Part 1 A conceptual framework: setting the scene
Exhibit 4.3
Sample audit report
INDEPENDENT AUDITOR’S REPORT TO THE SHAREHOLDERS OF XYZ PLC
We have audited the group financial statements of (name of entity) for the year ended . . . which comprise
the Group Income Statement, the Group Balance Sheet, the Group Cash Flow Statement, the Group
Statement of Change in Shareholders’ Equity and the related notes. These group financial statements have
been prepared under the accounting policies set out therein.
We have reported separately on the parent company financial statements of (name of entity) for the year
ended and on the information in the Directors’ Remuneration Report that is described as having been audited.
Respective responsibilities of directors and auditors
The directors’ responsibilities for preparing the Annual Report and the group financial statements in
accordance with applicable law and International Financial Reporting Standards (IFRSs) as adopted for use
in the European Union are set out in the Statement of Directors’ Responsibilities.
Our responsibility is to audit the group financial statements in accordance with relevant legal and regulatory
requirements and International Standards on Auditing (UK and Ireland). We report to you our opinion as to
whether the group financial statements give a true and fair view and whether the group financial statements
have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS
Regulation. We also report to you if, in our opinion, the Directors’ Report is not consistent with the group
financial statements, if we have not received all the information and explanations we require for our audit,
or if information specified by law regarding director’s remuneration and other transactions is not disclosed.
We review whether the Corporate Governance Statement reflects the company’s compliance with the nine
provisions of the 2003 FRC Combined Code specified for our review by the Listing Rules of the Financial
Services Authority, and we report if it does not. We are not required to consider whether the board’s
statements on internal control cover all risks and controls, or form an opinion on the effectiveness of the
group’s corporate governance procedures or its risk and control procedures.
We read other information contained in the Annual Report and consider whether it is consistent with the
audited group financial statements. The other information comprises only [the Directors’ Report, the Chairman’s
Statement, the Operating and Financial Review and the Corporate Governance Statement]. We consider the
implications for our report if we become aware of any apparent misstatements or material inconsistencies
with the group financial statements. Our responsibilities do not extend to any other information.
Basis of audit opinion
We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by
the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the
amounts and disclosures in the group financial statements. It also includes an assessment of the significant
estimates and judgments made by the directors in the preparation of the group financial statements, and of
whether the accounting policies are appropriate to the group’s circumstances, consistently applied and
adequately disclosed.
We planned and performed our audit so as to obtain all the information and explanations which we
considered necessary in order to provide us with sufficient evidence to give reasonable assurance that
the group financial statements are free from material misstatement, whether caused by fraud or other
irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of
information in the group financial statements.
Opinion
In our opinion:
the group financial statements give a true and fair view, in accordance with IFRSs as adopted for use in
the European Union, of the state of the group’s affairs as at . . . and of its profit[loss] for the year then
ended; and the group financial statements have been properly prepared in accordance with the Companies
Act 1985 and Article 4 of the IAS Regulation.
Registered auditors’ Address
Date
Chapter 4 Ensuring the quality of financial statements 91
the company’s financial records and give an opinion on the truth and fairness of the
financial information presented. Exhibit 4.3 sets out the wording of a typical audit
report to the shareholders of a public company. There are some words and phrases in
this report which will become more familiar as you progress through the text. These
include ‘historical cost convention’ (Chapter 14), ‘revaluation of certain fixed assets’
(Chapter 12) and ‘accounting policies’ (introduced in Chapter 3 but mentioned again
at various points).
You will note that the auditors do not look at all the pages of the annual report.
The earlier part of the annual report is important to the companies in setting the scene
and explaining their businesses. These earlier pages are reviewed by the auditors
to ensure that anything said there is consistent with the information presented in
the audited financial statements. You will also note that the auditors have their own
code of practice, referred to as International Standards for Auditing (ISAs). The ISAs
are prepared by the International Auditing and Assurance Standards Board (IAASB)
which operates under a body called the International Financial Accounting Committee
(IFAC). The standards are then adopted by national standard setters. In the UK the
national standard setter is the Auditing Practices Board (APB) which is one of the arms
of the Financial Reporting Council.
What surprises some readers is the phrase ‘reasonable assurance that the accounts
are free from material misstatement’. The auditors are not expected to be totally
certain in their opinion and they are only looking for errors or fraud which is material.
The meaning of the word ‘material’ has proved difficult to define and it tends to be a
matter left to the judgement of the auditor. The best guidance available is that an item
is material if its misstatement or omission would cause the reader of the annual report
(shareholder or creditor) to take a different decision or view based on the financial
statements.
4.5.12 The tax system
Businesses pay tax to HM Revenue and Customs (as the tax collecting agent of the
government) based on the profits they make. Sole traders and partnerships pay income
tax on their profits while companies pay corporation tax. There are differences in
detail of the law governing these two types of taxes but broadly they both require as
a starting point a calculation of profit using commercial accounting practices. The law
governing taxation is quite separate from the law and regulations governing financial
reporting, so in principle the preparation of financial statements is not affected by tax
matters. That is very different from some other countries in the EU where the tax law
stipulates that an item must be in the financial accounting statements if it is to be
considered for tax purposes. Those countries have an approach to financial reporting
which is more closely driven by taxation matters.
In the UK the distinction may be blurred in practice in the case of sole traders
because HM Revenue and Customs is the main user of the financial statements of the
sole trader. Similarly, tax factors may influence partnership accounts, although here
the fairness of sharing among the partners is also important. The very smallest companies,
where the owners also run the business, may in practice have the same attitude
to tax matters as does the sole trader or partnership. For larger companies with a
wider spread of ownership, the needs of shareholders will take priority.
4.5.13 Is regulation necessary?
There are those who would argue that all this regulatory mechanism is unnecessary.
They take the view that in a market-based economy, competitive forces will ensure that
those providing information will meet the needs of users. It is argued that investors
92 Part 1 A conceptual framework: setting the scene
Activity 4.4
will not entrust their funds to a business which provides inadequate information. Banks
will not lend money unless they are provided with sufficient information to answer
their questions about the likelihood of receiving interest and eventual repayment of
the loan. Employee morale may be lowered if a business appears non-communicative
regarding its present position and past record of performance. Suppliers may not wish
to give credit to a business which appears secretive or has a reputation for producing
poor-quality information. Customers may be similarly doubtful.
Against that quite attractive argument for the abolition of all regulations stand
some well-documented financial scandals where businesses have failed. Employees
have lost their jobs, with little prospect of finding comparable employment elsewhere;
suppliers have not been paid and have found themselves in financial difficulties as
a result. Customers have lost a source of supply and have been unable to meet the
requirements of their own customers until a new source is found. Those who have
provided long-term finance for the business, as lenders and investors, have lost their
investment. Investigation shows that the signs and warnings had existed for those
who were sufficiently experienced to see them, but these signs and warnings did not
emerge in the published accounting information for external use.
Such financial scandals may be few in number but the large-scale examples cause
widespread misery and lead to calls for action. Governments experience pressure from
the electorate and lobby groups; professional bodies and business interest groups
decide they ought to be seen to react; and new regulations are developed which ensure
that the particular problem cannot recur. All parties are then reasonably satisfied that
they have done their best to protect those who need protection against the imbalance
of business life, and the new practices are used until the next scandal occurs and the
process starts over again.
There is no clear answer to the question ‘Is regulation necessary?’ Researchers have
not found any strong evidence that the forces of supply and demand in the market
fail to work and have suggested that the need for regulation must be justified by
showing that the benefits exceed the costs. That is quite a difficult challenge but is
worth keeping in mind as you explore some of the more intricate aspects of accounting
regulation.
Look back through this section and, for each subheading, make a note of whether you
were previously aware that such regulation existed. In each case, irrespective of your
previous state of knowledge, do you now feel a greater or a lesser sense of confidence
in accounting information? How strong is your confidence in published accounting
information? If not 100%, what further reassurance would you require?
4.6 Reviewing published financial statements
If you look at the annual report of any large listed company you will find that it has
two main sections. The first part contains a variety of diagrams and photographs,
a statement by the chairman, a report by the chief executive and, in many cases, an
Operating and Financial Review which may extend to a considerable number of
pages. Other aspects of the business, such as its corporate governance and environmental
policy, may also be explained. This first part is a mixture of unregulated and
broadly regulated material. There are many sources of influence on its contents, some
of which will be explained in later chapters of this book.
The second part contains the financial statements, which are heavily regulated. As
if to emphasise this change of status, the second part of the annual report will often
have a different appearance, perhaps being printed on a different colour or grade of
Chapter 4 Ensuring the quality of financial statements 93
paper, or possibly having a smaller print size. Appendix I to this book contains extracts
from the financial statements of a fictitious company, Safe and Sure plc, which will be
used for illustration in this and subsequent chapters.
Relaxing after a hard workout at the health club, David Wilson took the opportunity
to buy Leona a drink and tell her something about Safe and Sure prior to a visit to
the company’s headquarters to meet the finance director.
DAVID: This is a major listed company, registered in the UK but operating around the world
selling its services in disposal and recycling, cleaning and security. Its name is well known
and its services command high prices because of the company’s reputation gained over
many years. Basically it is a very simple business to understand. It sells services by
making contracts with customers and collects cash when the service is performed.
In preparation for my visit I looked first at the performance of the period. This company
promises to deliver growth of at least 20% in revenue and in profit before tax so
first of all I checked that the promise had been delivered. Sure enough, at the front of
the annual report under ‘Highlights of the year’ there was a table showing revenue had
increased by 22.4% and profit before tax had increased by 20.4%. I knew I would need
to look through the profit and loss account in more detail to find out how the increases
had come about, but first of all I read the operating review (written by the chief executive)
and the financial review (written by the finance director). The chief executive gave more
details on which areas had the greatest increase in revenue and operating profit and
which areas had been disappointing. That all helps me in making my forecast of profit for
next year.
The chief executive made reference to acquisitions during the year, so I knew I would
also need to think whether the increase in revenue and profits was due to an improvement
in sales and marketing as compared with last year or whether it reflected the inclusion of
new business for the first time.
In the financial review, the finance director explained that the business tries to use as
little working capital as possible (that means they try to keep down the current assets and
match them as far as possible with current liabilities). I guessed I would need to look at
the balance sheet to confirm that, so I headed next for the financial statements at the back
of the annual report, pausing to glance at the auditors’ report to make sure there was
nothing highlighted by them as being amiss.
The financial statements are quite detailed and I wanted a broad picture so I noted down
the main items from each in a summary format which leaves out some of the detail but
which I find quite useful.
4.6.1 Income statement (profit and loss account)
Safe and Sure plc
Summary income statement (profit and loss account) with comparative figures
Notes Year 7 Year 6
£m £m
Continuing operations
Revenue 714.6 589.3
Cost of sales (491.0) (406.3)
Gross profit 223.6 183.0
Expenses and interest (26.1) (26.0)
Profit before tax 197.5 157.0
Tax on profit (62.2) (52.4)
Profit for the period from continuing operations 135.3 104.6
Discontinued operations
Loss for the period from discontinued operations (20.5) (10.0)
Profit for the period attributable to ordinary shareholders 114.8 94.6
94 Part 1 A conceptual framework: setting the scene
DAVID: It is part of my job to make forecasts of what the next reported profit of the company
is likely to be (i.e. the profit of Year 8). This is March Year 8 now so there are plenty
of current signs I can pick up, but I also want to think about how far Year 7 will be repeated
or improve during Year 8. A few years ago I would have made a rough guess and then
phoned the finance director for some guidance on whether I was in the right area. That’s
no longer allowed because the Financial Services Authority tightened up the rules on companies
giving information to some investors which is not available to others, especially
where that information could affect the share price.
One easy way out is for me to collect the reports which come in from our stockbrokers.
Their analysts have specialist knowledge of the industry and can sometimes work out what
is happening in a business faster than some of the management. However, I like to form
my own opinion using other sources, such as trade journals, and I read the annual report
to give me the background structure for my forecast. The company has helpfully separated
out the effect of continuing and discontinued operations, which helps me in making a
forecast.
When I meet the finance director next week I’ll have with me a spreadsheet analysing
revenue and profit before tax – so far as I can find the data – by product line and for each
of the countries in which the company trades. I’ll also ask the following questions:
1 Although the revenue has increased, the ratio of gross profit to revenue on continuing
operations has increased only very slightly, from 31.1% in Year 6 to 31.3% in Year 7.
That suggests that the company has increased revenue by holding price rises at a level
matching the increase in operating costs. I would like to see the company pushing
ahead with price rises but does the company expect to see a fall in demand when its
prices eventually rise?
2 The tax charge on continuing operations has decreased from approximately 33%
to 31.5%, slightly higher than the rate which would be expected of UK companies.
I know that this company is trading overseas. You say in your financial review that
the tax charge is 30% in the UK and rates on overseas profits will reduce, so am
I safe in assuming that 30% is a good working guide for the future in respect of this
company?
3 With all this overseas business there must be an element of foreign exchange risk.
You say in your financial review that all material foreign currency transactions are
matched back into the currency of the group company undertaking the transaction.
You don’t hedge the translation of overseas profits back into sterling. You also say
that using Year 6 exchange rates the Year 7 profit, including the effect of the discontinued
operations, would have been £180.5m rather than the £177.0m reported.
That seems a fairly minimal effect but are these amounts hiding any swings in major
currencies where large downward movements are offset by correspondingly large
upward movements?
4 Your increase in revenue, comparing £714.6m to £589.9m, is 21.1% which is meeting
the 20% target you set yourself. However, elsewhere in the financial statements I see
that the acquisitions in Year 7 contributed £13.5m to revenue. If I strip that amount out
of the total revenue I’m left with an increase in respect of activities continuing from Year
6 which is only 19%. When the scope for acquisitions is exhausted, will you be able to
sustain the 20% target by organic growth alone?
4.6.2 Balance sheet
DAVID: Looking at the balance sheet, this is a fairly simple type of business. It is financed
almost entirely by equity capital (shareholders’ funds), so there are none of the risks associated
with high levels of borrowings which might be found in other companies.
Again, I have summarised and left out some of the details which aren’t significant in
financial terms.
Chapter 4 Ensuring the quality of financial statements 95
Safe and Sure plc
Summarised balance sheet (with comparative amounts)
Notes Year 7 Year 6
£m £m
Non-current assets
Intangible assets 260.3 237.6
Tangible assets 137.5 121.9
Investments 2.8 2.0
Taxation recoverable 5.9 4.9
406.5 366.4
Current assets
Inventories (stocks) 26.6 24.3
Amounts receivable (debtors) 146.9 134.7
Six-month deposits 2.0 –
Cash and cash equivalents 105.3 90.5
280.8 249.5
Current liabilities
Amounts payable (creditors) (159.8) (157.5)
Bank overdraft (40.1) (62.6)
(199.9) (220.1)
Net current assets 80.9 29.4
Total assets less current liabilities 487.4 395.8
Non-current liabilities
Amounts payable (creditors) 9 (2.7) (2.6)
Bank and other borrowings 10 (0.2) (0.6)
Provisions 11 (20.2) (22.2)
Net assets 464.3 370.4
Capital and reserves
Shareholders’ funds 464.3 370.4
DAVID: By far the largest non-current (fixed) asset is the intangible asset of goodwill arising
on acquisition. It reflects the fact that the group has had to pay a price for the future
prospects of companies it has acquired. Although the company reports this in the group’s
balance sheet, and I like to see whether the asset is holding its value from the group’s point
of view, I have some reservations about the quality of the asset because I know it would
vanish overnight if the group found itself in difficulties.
The other non-current assets are mainly equipment for carrying out the cleaning
operations and vehicles in which to transport the equipment. I’ve checked in the notes
to the accounts that vehicles are being depreciated over four to five years and plant
and equipment over five to ten years, all of which sounds about right. Also, they haven’t
changed the depreciation period, or the method of calculation, since last year so the
amounts are comparable. Estimated useful lives for depreciation are something I watch
closely. There is a great temptation for companies which have underperformed to cut back
on the depreciation by deciding the useful life has extended. (Depreciation is explained
more fully in Chapter 8.)
I think I might ask a few questions about working capital (the current assets minus
the current liabilities of the business). Normally I like to see current assets somewhat
greater than current liabilities – a ratio of 1.5 to 1 could be about right – as a cushion
to ensure the liabilities are met as they fall due. However, in this company the finance
director makes a point of saying that they like to utilise as little working capital as possible,
so I’m wondering why it increased from £29.4m in Year 6 to more than £80m in Year 7.
There appear to be two effects working together: current assets went up and current
liabilities went down. Amounts receivable (trade debtors) increased in Year 7 in absolute
terms but that isn’t as bad as it looks when allowance is made for the increase in revenue.
96 Part 1 A conceptual framework: setting the scene
Amounts receivable in Year 7 are 20.6% of continuing revenue, which shows some control
has been achieved when it is compared with the Year 6 amount at 22.8% of revenue.
My questions will be:
1 Mostly, the increase in the working capital (net current assets) appears to be due to the
decrease in bank borrowing. Was this a voluntary action by the company or did the bank
insist?
2 The second major cause of the increase in the working capital is the increase in the
balance held in the bank account. Is that being held for a planned purpose and, if so,
what?
3 The ratio of current assets to current liabilities has increased from last year. What target
ratio are you aiming for?
I always shudder when I see ‘provisions’ in a balance sheet. The notes to the financial
statements show that these are broadly:
£m
For treating a contaminated site 12.0
For restructuring part of the business 4.2
For tax payable some way into the future 4.0
Total 20.2
I shall want to ask whether the estimated liability in relation to the contaminated site is
adequate in the light of any changes in legislation. I know the auditors will have asked
this question in relation to existing legislation but I want to think also about forthcoming
legislation.
I am always wary of provisions for restructuring. I shall be asking more about why the
restructuring is necessary and when it will take place. I want to know that the provision is
sufficient to cover the problem, but not excessive.
The provision for tax payable some way into the future is an aspect of prudence
in accounting. I don’t pay much attention unless the amount is very large or suddenly
changes dramatically. (An explanation of deferred taxation is contained in Chapter 10.)
4.6.3 Cash flow statement
DAVID: Cash is an important factor for any business. It is only one of the resources available
but it is the key to survival. I’ve summarised the totals of the various main sections of
the cash flow statement. ‘Net cash’ means the cash less the bank borrowings.
Safe and Sure plc
Summary cash flow statement (with comparative amounts)
Consolidated cash flow statement for the years ended 31 December
Notes Year 7 Year 6
£m £m
Net cash from operating activities 143.0 116.3
Net cash used in investing activities (98.3) (85.3)
Net cash used in financing activities (10.2) (46.4)
Net increase/(decrease) in cash and cash equivalents* 34.5 (15.4)
What I’m basically looking for in the cash flow statement is how well the company is
balancing various sources of finance. It generated £143m from operating activities and that
was more than sufficient to cover its investing activities in new fixed assets and acquisitions.
There was also enough to cover the dividend of £29.5m, which is a financing activity but
that was partly covered by raising new loan finance. This is why the cash used in financing
activities is only £10.2m. I come back to my earlier question of why they are holding so
much cash.
Chapter 4 Ensuring the quality of financial statements 97
Activity 4.5 Read David’s explanation again and compare it carefully with the financial statements. It is
quite likely that you will not understand everything immediately because the purpose of
this book as a whole is to help you understand published financial statements and we are,
as yet, only at the end of Chapter 4. Make a note of the items you don’t fully understand
and keep that note safe in a file. As you progress through the rest of the book, look back
to that note and tick off the points which subsequently become clear. The aim is to have
a page full of ticks by the end of the book.
4.7 Summary
The objective of financial statements is to provide information about the financial
position, performance and changes in financial position of an entity that is useful to a
wide range of users in making economic decisions.
The four principal qualitative characteristics, as described by the IASB Framework, are:
l understandability
l relevance
l reliability
l comparability.
Relevance and reliability are twin targets which may cause some tension in deciding
the most appropriate way to report accounting information.
The accounting measurement principles that are most widely known in the UK are
found within the Companies Act 1985:
l going concern
l accruals
l consistency
l prudence.
Prudence in accounting means exercising a degree of caution when reporting assets,
liabilities and profits. Overstatement of assets causes the overstatement of profit.
Understatement of liabilities causes the overstatement of profit. Prudence requires
avoiding overstating profit but also avoiding deliberate understatement of profit.
Regulation of financial reporting in the UK comes from several sources.
l The IAS Regulation requires all listed groups of companies to prepare financial
statements using the system of the International Accounting Standards Board
(IASB system). Other companies may choose to follow the IASB system.
l Companies that do not follow the IASB system must comply with UK company law.
l The Financial Reporting Council regulates accounting and auditing matters under
the authority of UK company law.
l The Financial Reporting Council oversees the UK Accounting Standards Board which
sets accounting standards for companies that are complying with UK company law.
l The Financial Reporting Review Panel takes action against companies whose
annual reports do not comply with the relevant accounting system (IASB or UK
company law).
l The Financial Services Authority regulates a wide range of financial service activities
including the London Stock Exchange. It sets Listing Rules for companies listed on
the Stock Exchange.
l Auditors give an opinion on whether financial statements present a true and fair
view of the profit or loss of the period and the state of affairs at the end of the
period. They are professionally qualified accountants with auditing experience who
are members of a recognised professional body.
98 Part 1 A conceptual framework: setting the scene
l The UK tax system charges corporation tax on company profits. Her Majesty’s Revenue
and Customs (HMRC) start with the accounting profit in calculating the amount of
tax payable but there are some special rules of accounting for tax purposes.
Further reading
IASB (1989), Framework for the Preparation and Presentation of Financial Statements, International
Accounting Standards Board.
Paterson, R. (2002), ‘Whatever happened to Prudence?’, Accountancy, January, p. 105.
The website of the Financial Reporting Council explains the methods and nature of regulation
of financial reporting and the accountancy profession: www.frc.org.uk
The Questions section of each chapter has three types of question. ‘Test your understanding’
questions to help you review your reading are in the ‘A’ series of questions. You will find the
answers to these by reading and thinking about the material in the book. ‘Application’ questions
to test your ability to apply technical skills are in the ‘B’ series of questions. Questions requiring
you to show skills in problem solving and evaluation are in the ‘C’ series of questions. A letter
[S] indicates that there is a solution at the end of the book.
A Test your understanding
A4.1 Explain what is meant by each of the following: (section 4.2)
(a) relevance;
(b) reliability;
(c) faithful representation;
(d) neutrality;
(e) prudence;
(f ) completeness;
(g) comparability;
(h) understandability; and
(i) materiality.
A4.2 Explain the accounting measurement principles of each of the following: (section 4.3)
(a) going concern;
(b) accruals;
(c) consistency;
(d) the concept of prudence.
A4.3 Explain why companies should avoid overstatement of assets or understatement of
liabilities. (section 4.4)
A4.4 Explain the responsibilities of directors of a company towards shareholders in relation
to the financial statements of a company. (section 4.5.2)
A4.5 Explain the impact on financial statements of each of the following: (section 4.5)
(a) company law;
(b) the International Accounting Standards Board; and
(c) the UK tax law.
A4.6 Explain how the monitoring of financial statements is carried out by each of the following:
(section 4.5)
(a) the auditors; and
(b) the Financial Reporting Review Panel.
QUESTIONS
Chapter 4 Ensuring the quality of financial statements 99
B Application
B4.1 [S]
Explain each of the following:
(a) The IAS Regulation
(b) The Financial Reporting Council
(c) The Auditing Practices Board
B4.2 [S]
Explain any two accounting measurement principles, explaining how each affects current
accounting practice.
B4.3 [S]
Discuss the extent to which the regulatory bodies explained in this chapter have, or ought to
have, a particular concern for the needs of the following groups of users of financial statements:
(a) shareholders;
(b) employees;
(c) customers; and
(d) suppliers.
C Problem solving and evaluation
C4.1
Choose one or more characteristics from the following box that you could use to discuss the
accounting aspects of each of the statements 1 to 5 and explain your ideas:
l relevance l understandability l completeness
l reliability l materiality l prudence
l comparability l neutrality l faithful representation
1 Director: ‘We do not need to tell shareholders about a loss of £2,000 on damaged stock
when our operating profit for the year is £60m.’
2 Shareholder: ‘I would prefer the balance sheet to tell me the current market value of land is
£20m than to tell me that the historical cost is £5m, although I know that market values
fluctuate.’
3 Analyst: ‘If the company changes its stock valuation from average cost to FIFO, I want to
hear a good reason and I want to know what last year’s profit would have been on the
same basis.’
4 Regulator: ‘If the company reports that it has paid “commission on overseas sales”, I don’t
expect to discover later that it really meant bribes to local officials.’
5 Director: ‘We have made a profit on our drinks sales but a loss on food sales. In the Notes
to the Accounts on segmental results I suggest we combine them as “food and drink”. It will
mean the annual report is less detailed for our shareholders but it will keep competitors in
the dark for a while.’
C4.2
Choose one or more accounting measurement principles from the following box that you could
use to discuss the accounting aspects of each of the problems 1–5 and explain your ideas.
l going concern l accruals l consistency l prudence.
1 Director: ‘The fixed assets of the business are reported at depreciated historical cost
because we expect the company to continue in existence for the foreseeable future. The
market value is much higher but that is not relevant because we don’t intend to sell them.’
2 Auditor: ‘We are insisting that the company raises the provision for doubtful debts from 2%
to 2.5% of debtor amount. There has been recession among the customer base and the
financial statements should reflect that.’
100 Part 1 A conceptual framework: setting the scene
3 Analyst: ‘I have great problems in tracking the depreciation policy of this company. It owns
several airports. Over the past three years the expected useful life of runways has risen from
30 years to 50 years and now it is 100 years. I find it hard to believe that the technology of
tarmacadam has improved so much in three years.’
4 Auditor: ‘We have serious doubts about the ability of this company to renew its bank overdraft
at next month’s review meeting with the bank. The company ought to put shareholders
on warning about the implications for the financial statements.’
5 Shareholder: ‘I don’t understand why the company gives a profit and loss account and a cash
flow statement in the annual report. Is there any difference between profit and cash flow?’
Activities for study groups
Continuing to use the annual reports of a company that you obtained for Chapter 1, look for the
evidence in each report of the existence of the directors, the auditors and the various regulatory
bodies.
In your group, draw up a list of the evidence presented by companies to show that the annual
report has been the subject of regulation. Discuss whether the annual report gives sufficient
reassurance of its relevance and reliability to the non-expert reader.
Notes and references
1. IASB (1989), Framework, para. 12.
2. Ibid., para. 20.
3. Ibid., para. 21.
4. Ibid., para. 24.
5. Ibid., para. 25.
6. Ibid., para. 26.
7. Ibid., paras. 27–8.
8. Ibid., paras. 29–30.
9. Ibid., para. 31.
10. Ibid., paras. 33–4.
11. Ibid., para. 35.
12. Ibid., para. 36.
13. Ibid., para. 37.
14. Ibid., para. 38.
15. Ibid., para. 39.
16. Ibid., para. 42.
17. Ibid., para. 39.
18. Ibid., para. 41.
19. Ibid., para. 40.
20. Ibid., para. 43.
21. Ibid., para. 44.
22. ASB (1999), Statement of Principles, p. 34.
23. Companies Act 1985, sch. 4, paras. 10–14.
24. IASB (1989), Framework, para. 23.
25. IASB (1989), Framework, para. 23.
26. ASB (1999), Appendix III, paras. 21–3.
27. ASB (2000), Financial Reporting Standard 18 (FRS 18) Accounting Policies, Accounting Standards
Board, para. 28.
28. IASB (1989), Framework, para. 37.
29. ASB (2000), Appendix IV, paras. 12 to 20.
30. IASB (1989), Framework, para. 27.
31. http://europa.eu.int/comm/internal_market/accounting/index_en.htm
32. www.efrag.org/
33. Details can be found on the website of the Department of Trade and Industry, www.dti.gov.uk/
cld/review.htm
34. Company Law Reform, March 2005, Cm. 6456, DTI.
35. www.frc.org.uk/
Part 2
Reporting the transactions
of a business
5 Accounting information for service businesses
6 Accounting information for trading