Financial accounting and reporting 12e by BARRY ELLIOTT AND JAMIE ELLIOTT

BARRY ELLIOTT AND JAMIE ELLIOTT

FINANCIAL
ACCOUNTING
AND
REPORTING
12TH EDITION


Preface and acknowledgements

xx

Part I
I N C O M E A N D ASSET V A L U E M E A S U R E M E N T SYSTEMS
I
2
3
4

\

Accounting and reporting on a cash flow basis
Accounting and reporting on an accrual accounting basis
Income and asset value measurement: an economist's approach
Accounting for inflation

3
22
40
59

»RY F R A M E W O R K - AN A T T E M P T TO A C H I E V E
UNIFORMITY

22

5
6
7
8
9

Financial reporting -- evolution of the regulatory framework in the UK
Financial reporting - evolution of international standards
Conceptual framework
Published accounts of companies
Preparation of published accounts

99
134
158
184
231

Part 3
B A L A N C E SHEET - E Q U I T Y , LIABILITY A N D ASSET

10 Share capital, distributable profits and reduction of capital

259

11 Off balance sheet finance
12 Financial instruments
13 Employee benefits
14 Taxation in company accounts
15 Property, plant and eqiupment (PPE)
16 Leasing
17 R&D; goodwill and intangible assets; brands
18_ Inventories

284
318
342
372
399
433
453
490

19 Construction contracts

516


Contents
Part 4

123
20 Accounting for groups at date of acquisition
21 Preparation of consolidated balance sheets after the date of acquisition

22 Preparation of consolidated income statements and consolidated statements
of changes in equity
23 Accounting for associated companies
24 Accounting for the effects of changes in foreign exchange rates under IAS 21

535
552
565
580
595

Part 5
INTERPRETATION

613

25 Earnings per share
26 Cash flow statements
27 Review of financial ratio analysis
28 Trend analysis and multivariate analysis
29 An introduction to Financial Reporting on the Internet

615
642
664
706
748

Part 6

30 Corporate governance
3 I Environmental and social reporting
32 Ethics for accountants

765
81 I
84E

Appendix: Outline solutions to selected exercises

871

Index

825


Preface and acknowledgements
Part I
I N C O M E A N D ASSET V A L U E M E A S U R E M E N T SYSTEMS

xx

!

I A c c o u n t i n g and r e p o r t i n g on a cash flow basis
11

1,2
1.3

1.5
1.6
1.7
1.8
1.9
1.10
III
1.12

Introduction
Shareholders
What skills does an accountant require in respect of external reports?

1
3
4

What skills does an accountant require in respect of internal reports?
Procedural steps when reporting to internal users
Agency costs
Illustration of periodic financial statements prepared under the cash
flow concept to disclose realised operating cash flows
Illustration of preparation of balance sheet under the cash flow concept
Treatment of non-current assets in the rash flow model
What are rhe characteristics of these data that make them reliable?
Reports to external users
Summary
Review questions
Exercises

5
5
8

Rpfprpnrp^

2 A c c o u n t i n g a n d r e p o r t i n g o n a n a c c r u a l a c c o u n t i n g basis
2J
Introduction

22
2.3
2.4
2.5
2.6
2.7
2.8
2.9

Historical cost convention
Accrual basis of accounting
Mechanics of accrual accounting - adjusting cash receipts and payments
Subjective judgements required in accrual accounting - adjusting cash
receipts in accordance with IAS 18
Subjective judgements required in accrual accounting - adjusting cash
payments in accordance with the matching principle
Mechanics of accrual accounting - the balance sheet
Reformatting the statement of financial position into a balance sheet
Accounting for the sacrifice of non-current assets

8
12
14
IS
16
16
17
18
70
22
22

23
24
24
25
27
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28
28


2.10

Reconciliation of cash flow and accrual accounting data
Summary
Review questions
Exercises
References

3 I n c o m e and asset value m e a s u r e m e n t : an economist's
approach
3.1
Introduction
3.2
Role and objective of income measurement
3.3
Accountant's view of income, capital and value
3.4
Critical comment on the accountant's measure
3.5
Economist's view of income, capital and value
3.6
Critical comment on the economist's measure
3.7
Income, capital and changing price levels
Summary
Review questions
Exercises
References
Bibliography

32
34
34
35
38

40
40

40
43
46
47
53
53
55
55
56
57
58

4 A c c o u n t i n g f o r inflation
4.1
Introduction
4.2
Review of the problems of historical cost accounting (HCA)
4.3
Inflation accounting
4.4
The concepts in principle
4.5
The four models illustrated for a company with cash purchases and

59
59
59
60
60

sales
Critique of each model
Operating capital maintenance - - a comprehensive example
Critique of C C A statements
The ASB approach

61
65
68
79
81

The IASC/IASB approach
Future developments
Summary
Review questions
Exercises
References
Bibliography

83
84
85
86
87
96
96

4.6
4.7

4.8
4.9

4.10
4.11

R E G U L A T O R Y F R A M E W O R K - AN A T T E M P T T
UNIFORMITY
5

Financial r e p o r t i n g - e v o l u t i o n of t h e r e g u l a t o r y f r a m e w o r k
in t h e U K
5J
Introduction
5.2
Mandatory regulations
5.3
Arguments in support of standards
5.4
Arguments against standards
5.5
Structure of regulatory framework

91
91
99
9?
103
104
[05

Full Contents • ix
5.6
5.7
5.8
5.9
5.10
5.11
5.12

6

7

The Operating and Financial Review (OFR)
The Financial Reporting Review Panel
The Financial Services Authority
The Revised Combined Code (June 2006)
Interim reports following Cadbury
Developments for small companies
Evaluation of effectiveness of mandatory regulations
Summary
Review questions
Exercises
References

[06
114
117

117
120
122
130
131
131
132
133

Financial r e p o r t i n g - evolution of international standards
61
Introduction
6.2
National differences
6.3
Reasons for differences in financial reporting
6.4
Classification of national accounting systems
6.5
Attempts to reduce national differences
6.6
The w o r k of international bodies in harmonising and standardising
financial reporting
6.7
US GAAP
Summary
Review questions
Exercises
References

134
134
134
135
139
140

Conceptual framework
7.1
Introduction
7.2
Historical overview of the evolution of financial accounting theory
7.3
IASC Framework for the Presentation and Preparation of Financial
Statements
7.4
ASB Statement of Principles 1999
7.5
AICPA Improving Business Reporting - A Customer Focus: Meeting the
Information Needs of Investors and Creditors
7.6
ICAS Making Corporate Reports Valuable
7.7
Conceptual Framework developments
Summary
Review questions
Exercises
References

158

158
159

8 Published a c c o u n t s of c o m p a n i e s
8.1
Introduction
8.2
A public company's financial calendar
8.3
Criteria for information appearing in a published income statement
and balance sheet
8.4
The prescribed formats - the income statement
8.5
W h a t information is required to be disclosed in Format I and
Format 2?
8.6
Cost of sales

141
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155
155
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156

162
164
174
175

176
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180
182
184
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185
186
186
187
188


BJ.
8.8
8.9
8.10

8.11
8.12
8.13
8.14
8.15
8.16
8.17
8.18
8.19
8.20
8.21

8.22

Distribution costs
Administrative expenses
Other operating income or expense
What costs and income are brought into account after calculating
the trading profit in order to arrive at the profit on ordinary
activities before tax?
Does it really matter under which heading a cost is classified in the
income statement provided it is not omitted?
Discontinued operations disclosure in the income statement
Items requiring separate disclosure
The prescribed formats - the balance sheet
Statement of changes in equity
Reporting performance
Segment reporting
The fundamental accounting principles underlying the published
income statement and balance sheet
Disclosure of accounting policies
Fair view treatment
Additional information in the annual report
What information do companies provide to assist comparison
between companies reporting under different reporting regimes?
Summary
Review questions
Exercises
References

9 P r e p a r a t i o n of published accounts
9.1

Introduction
9.2
Stage I: preparation of the internal income statement from a trial
balance
9.3
Stage 2: preparation of the income statement of Illustrious SpA in
Format I style
9.4
Stage 3: preparation of the balance sheet
9.5
Preparation of accounts in Format I following IAS 8 and IFRS 5
2^
Additional information value of 1FRS 5
22
Additional information value of IAS 24
Summary
Review questions
Fxerrisps
References

L92
192
192

L22
193
193
195
196
199

200
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206
206
211
214
215
220
220
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229
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231
231
232
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236
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242
244
244
245
256

BALANCE SHEET - EQUITY. LIABILITY A N D ASSET

10 S h a r e capital, distributable profits and r e d u c t i o n of capital
UU
Introduction
10.2 Total owners' equity: an overview

10.3 Total shareholders' funds: more detailed explanation
10.4 Accounting entries on issue of shares

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260
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264


Full Contents • xi
10.5
10.6
10.7

Creditor protection: capital maintenance concept
Creditor protection: why capital maintenance rules are necessary
Creditor protection: how to quantify the amounts available to meet

265
265

creditors* Haim*

266

10.8
10.9
10.10
10.1 I

10.12

I I

Issued share capital: minimum share capital
Distributable profits: general considerations
Distributable profits: how to arrive at the amount using relevant accounts
When may capital be reduced?
Writing off part of capital which has already been lost and is not
represented by assets
10.13 Repayment of part of paid-in capital to shareholders or cancellation
of unpaid share capital
10.14 Purchase of own shares
Summary
Review questions
Exercises
References

267
267
269
269

O f f balance sheet finance
I I.I
Introduction
I 1.2 Primary financial statements: their interrelationship
I 1.3 Primary financial statements: changes in their interrelationship
11.4 Reasons that companies borrow
I 1.5 Capital gearing and its implications

11.6 Off balance sheet finance
11.7 Substance over form
11.8 Impact of converting to IFRS
11.9 Balance sheet as valuation document
11.10 W h y companies take steps to strengthen their balance sheets
11.11 Definitions cannot remove uncertainty: IAS 10 and IAS 37
11.12 ED IAS 37 Non-financial Liabilities
Summary
Review questions
Exercises
References

284
284
284
285
285
286
288
289
293
294
296
297
306
312
313
315
317

269
275
275
278
278
279
283

12 Financial i n s t r u m e n t s
12.1 Introduction
12.2 IAS 32 Financial Instruments: Disclosure and Presentation
12.3 IAS 39 Financial Instruments: Recognition and Measurement
12.4 IFRS 7 Financial Statement Disclosures
Summary
Review questions
Exercises
References

318
318
318
328
337
338
339
339
341

13 E m p l o y e e benefits
13.1 Introduction

13.2 Financial reporting implications
13.3 Types of scheme

342
342
343
343


13.4
13.5
13.6
13.7
13.8
13.9
13.10
13.11
13.12

Defined contribution pension schemes
Defined benefit pension schemes
IAS 19 (revised) Employee Benefits
The liability for pension and other post-retirement costs
The income statement
Comprehensive illustration
Plan curtailments and settlements
Multi-employer plans
Disclosures

345

346
348
348
351
351
353
354
354

13.13 Other long-service benefits

355

13.14
13.15
13.16
13.17
13.18
13.19
13.20
13.21
13.22
13.23

355
356
357
358
358
359

361
362
363
363
365
366
368
371

Short-term benefits
Termination benefits
IFRS 2 Share-Based Payments
Scope of IFRS 2
Recognition and measurement
Equity-settled share-based payments
Cash-settled share-based payments
Transactions which may be settled in cash or shares
Transitional provisions
IAS 26 Accounting and Reporting by Retirement Benefit Plans
Summary
Review questions
Exercises
References

14 T a x a t i o n in company accounts
14.1
14.2
14.3
14.4
14.5

14.6
14.7
14.8
14.9
14.10
14.11
14.12

372

Introduction
Corporation tax
Corporation tax systems - the theoretical background
Corporation tax systems - avoidance and evasion
Corporation tax - the system from 6 April 1999
IFRS and taxation
IAS 12 - accounting for current taxation
Deferred tax
FRS 19 (the UK standard on deferred taxation)
A critique of deferred taxation
Examples of companies following IAS 12
Value added tax (VAT)
Summary

372
372
373
374
376
378

379
381
388
389
392
392
395

Review questions
Exercises
References

395
396
397

15 Property, plant and e q u i p m e n t (PPE)

399

15.1
15.2
15.3

Introduction
WhatisPPE?
H o w is the cost of PPE determined?

399
400

401

15.4

What is depreciation?

403

15.5
15.6

W h a t are the constituents in the depreciation formula?
H o w is the useful life of an asset determined?

406
407


Full Contents * xiii
157
15.8
15.9
15.10
15.11
15.12
15.13
15.14
15.15

Residual value

Calculation of depreciation
Measurement subsequent to initial recognition
IAS
36
Impairment
of
Assets
IFRS 5 Non-Current Assets Held for Sale and Discontinued Operations
Disclosure requirements
Government grants towards the cost of PPE
Investment properties
Effect of accounting policy for PPE on the interpretation of the
financial statements
Summary
Review questions
Exercises
References

408
408
412
414
419
420
421
422
423
425
426
426

431

16 L e a s i n g
16.1 Introduction
16.2 Background to leasing
16.3 IAS 17 (and its national equivalents) - the controversy
16.4 IAS 17 - classification of a lease
16.5 IAS 17 - accounting for leases by lessees
16.6 Accounting for the lease of land and buildings
16.7 Leasing - a form of off balance sheet
financing
16.8 Accounting for leases - a new approach
16.9 Accounting for leases by lessors
Summary
Review questions
Exercises
References

433
433
433
435
437
438
444
445
446
447
448
448

450
452

1 7 R & D ; g o o d w i l l a n d i n t a n g i b l e assets; b r a n d s
17.1 Introduction
17.2 Accounting treatment for research and development
17.3 Research and development
17.4 Introduction to goodwill and intangible assets
17.5 Accounting for goodwill under IFRS 3
17.6 Is there a correct treatment for amortising goodwill?
17.7 Accounting for intangible assets under IAS 38
17.8 Disclosure of intangible assets under IAS 38
17.9 Brand accounting
17.10 Intellectual property
17.1 I Review of implementation of IFRS 3
Summary
Review questions
Exercises
References

453
453
453
455
459
459
462
467
469
471

473
478
480
480
483
488

18 Inventories
18.1 Introduction
18.2 Inventory defined

490
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490


18.3
18.4
18.5
18.6
18.7
18.8
18.9
18.10
18.11

The controversy
IAS 2 Inventories
Inventory valuation
Work-in-progress

Inventory control
Creative accounting
Audit of the year-end physical inventory count
Published accounts
Agricultural activity
Summary
Review questions
Exercises
References

I 9 Construction contracts
L2J Introduction

19?
191
19.4
19.5

491
492
493
500
502
503
505
506
507
510
51 I
51 I

515
5_1_6
516

Identification of contract costs
Recognition of contract revenue and expenses
Public-private partnerships (PPPs)

516
517
518
521

Summary
Review questions
Exercises
References

526
527
527
531

PART 4
CONSOLIDATED ACCOUNTS

533

Identification of rnnrrart revenue

20 A c c o u n t i n g for groups at the d a t e of acquisition
2QJ
Introduction
20.2 The definition of a group
20.3 Consolidated accounts and some reasons for their preparation
2QA The definition of control
20.5 Alternative methods of preparing consolidated accounts
20.6 The treatment of positive goodwill
20.7 The treatment of negative goodwill
20.8 The comparison between an acquisition by cash and an exchange of
shares
20.9 Minority interests
20.10 The treatment of differences between a subsidiary's fair value and
book value
20.1 I H o w to calculate fair values
Summary
Review questions
Exercises
References
21

P r e p a r a t i o n of consolidated balance sheets after t h e d a t e of
acquisition

535
515
535
535
537
538

540
540
540
540
542
543
545
545
546
5SJ

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Full Contents • xv
21.2
21.3
21.4
21.5
21.6
21.7

Pre- and post-acquisition profits/losses
Inter-company balances
Unrealised profit on inter-company sales
Provision for unrealised profit affecting a minority
Uniform accounting policies and reporting dates
How is the investment in subsidiaries reported in the parent's own
balance sheet?
Summary

Review questions
Exercises
References

22 Preparation of consolidated income statements and
consolidated s t a t e m e n t s of changes in equity
22.1 Introduction
22.2 Preparation of a consolidated income statement - the Ante Group
22.3 The statement of changes in equity (SOCE)
22.4 Dividends or interest paid by the subsidiary out of pre-acquisition
profits
22.5 A subsidiary acquired part of the way through the year
22.6 Published format income statement
Summary
Review questions
Exercises
References
23 A c c o u n t i n g for associated companies

24

552
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556
560
560
560
561
561
561

564

565
565
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567
568
569
571
572
572
SZ3
579
580

23J

InrraHnrtinn

580

23.2
23.3
23.4
23.5
23.6
23.7

Definitions of associates and of significant influence
The treatment of associated companies in consolidated accounts

The Brill Group - the equity method illustrated
The treatment of provisions for unrealised profits
The acquisition of an associate part-way through the year
Joint ventures
Summary
Review questions
Exercises
References

580
581
58J
583
584
585
587
587
594

A c c o u n t i n g f o r t h e effects of changes in foreign e x c h a n g e
rates u n d e r IAS 21

£25

24J

Introduction

5?5

212

The difference between conversion and translation and the definition
of a foreign currency transaction
The functional currency
The presentation currency
Monetary and non-monetary items
The rules on the recording of foreign currency transactions
The treatment of exchange differences on foreign currency
transactions

24.3
24.4
24.5
24.6
24.7

595
595
596
596
597
597


24.8
24.9
24.10
24.11
24.12

24.13

Foreign exchange transactions in the individual accounts of companies
illustrated - Boil pic
The translation of the accounts of foreign operations where the
functional currency is the same as that of the parent
Granby Ltd illustration
The use of a presentation currency other than the functional currency
Granby Ltd illustration continued
Implications of IAS 21
Summary
Review questions
Exercises
References

PART 5
INTERPRETATION

597
599
599
606
607
608
609
609
609
612

613

25 Earnings p e r share
25.1 Introduction
25.2 Why is the earnings per share figure important?
25.3 How is the EPS figure calculated?
25.4 The use to shareholders of the EPS
25.5 Illustration of the basic EPS calculation
25.6 Adjusting the number of shares used in the basic EPS calculation
25.7 Rights issues
25.8 Adjusting the earnings and number of shares used in the diluted EPS
calculation
25.9 Procedure where there are several potential dilutions
25.10 Exercise of conversion rights during financial year
25.11 Disclosure requirements of IAS 33
25.12 The Improvement Project
Summary
Review questions
Exercises
References

615
615
615
6|6
617
618
619
621

2 6 Cash

26.1
26.2
26.3
26.4
26.5
26.6
26.7

flow statements
Introduction
Development of cash flow statements
Applying IAS 7 (revised) Cash Flow Statements
IAS 7 (revised) format of cash flow statements
Consolidated cash flow statements
Analysing a cash flow statement
Critique of cash flow accounting

642
642
642
643
645
649
652
654

Summary
Review questions
Exercises
References

656
657
658

27 Review of financial r a t i o analysis
27.1

Introduction

626
629
630
63J
633
634
634
636
64J

AAT

664
AM


Full Contents • xvii

27.2
27.3

27.4
27.5
27.6
27.7
27.8
27.9
27.10
27.11
27.12

Accounting ratios and ratio analysis
Six key ratios
Description of the six key ratios
Description of subsidiary ratios
Application of pyramid of ratios to JD Wetherspoon pic
Segmental analysis
Inter-firm comparisons and industry averages
Ensuring true inter-firm comparisons
World Wide Web pages for company information
Non-financial ratios
Interpretation problems when using ratios and consolidated financial
statements
Summary
Review questions
Exercises
References

665
666
668

670
677
679
685
686
689
690

28 T r e n d analysis and m u l t i v a r i a t e analysis
28.1 Introduction
28.2 Horizontal analysis between two periods
28.3 Trend analysis over a series of periods
28.4 Historical summaries
28.5 Vertical analysis - common size statements
28.6 Multivariate analysis - Z-scores
28.7 H-scores
28.8 A-scores
28.9 Combining cash flow and accrual data
28.10 Accounting polices
28.11 Balanced scorecards
28.12 Valuing shares of an unquoted company - quantitative process
28.13 Valuing shares of an unquoted company - qualitative process
28.14 Shareholder value analysis (SVA)
28.15 Measuring and reporting values in the annual report
28.16 Shareholder information needs
28.17 Professional risk assessors
28.18 Aggressive earnings management
28.19 Impact of differences between IFRSs and national standards on trend
analysis
Summary

Review questions
Exercises
References

706
706
706
708
710
710
713
715
716
717
717
718
719
722
723
724
729
731
734

2 9 A n i n t r o d u c t i o n t o Financial R e p o r t i n g o n t h e I n t e r n e t
29.1 Introduction
29.2 What is XBRL?
29.3 What XBRL is not
29.4 How can it be used?
29.5 What is needed to use XBRL?

29.6 Progress of XBRL development

748
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749
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753
755
756

691
693
693
624
704

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xviii • Full Contents
29.7

Companies currently using XBRL
Summary
Review questions
Exercises

Bibliography

PART 6
ACCOUNTABILITY
30 C o r p o r a t e governance
3QJ Introduction
30.2 The need for corporate governance guidelines
30.3 Corporate governance in different countries
30.4 Corporate governance requirements
30.5 UK Voluntary Code - The Cadbury Report
30.6 The Greenbury Report
30.7 The Hampel Report
30.8 The Higgs Report
30.9 The Smith Report
30.10 The Combined Code
30.11 Directors' remuneration
30.12 Directors' remuneration - illustration from the Annual Report of
Diageoplc
30.13 Directors' remuneration - conclusion
30.14 Relations with shareholders
30. IS

Institutional investors

30.16 The Myners Report
30.17 Corporate governance - directors' remuneration summary
30.18 Auditors
Summary
Review questions
Exercises

References
31 E n v i r o n m e n t a l and social r e p o r t i n g
1LJ
Introduction
31.2 Accountants' role in a capitalist industrial society
31.3 Sustainability
31.4 Background to companies* reporting practices
31.5 European Commission recommendations for disclosures in annual
accounts
31.6 Evolution of stand-alone environmental reports
31.7 International charters and guidelines
31.8 Economic consequences of environmental reporting
31.9 Summary on environmental reporting
31.10 Environmental auditing: international initiatives
31.11 The activities involved in an environmental audit
31.12 Concept of social accounting
31.13 Background to social accounting
31.14 Corporate social responsibility

758
759
759
760
761

763
765
Z65
765
766

768
770
772
772
773
776
ZZZ
ZZZ
781
ZiJ
ZiJ
791

792
794
795
804
804
806
809
8JJ
8JJ
8J_I
812
813
814
816
8J2
821
821

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83J


Full Contents • xix
31.15 Need for comparative data
31.16 International initiatives towards triple bottom line reporting
Summary
Review questions
Exercises
References
Bibliography
32 Ethics for accountants
32.1 Introduction
32.2 The nature of business ethics
32.3 Ethical codes for businesses
32.4 The background to business ethics
32.5 The role of ethics in modern business
32.6 The role of professional accounting ethics
32.7 The role of the accountant as guardian of business ethics
32.8 Growth of voluntary standards
32.9 Conflict between Codes and Targets
Summary
Review questions
RoforpnfDC

Bibliography

A p p e n d i x : O u t l i n e solutions to selected exercises
Index

832
834
837
837
839
845
846
848
848
848
850
852
854
857
862
863
866
866
867
fi*9
869
871
879


Our objective is to provide a balanced and comprehensive framework to enable students to
acquire the requisite knowledge and skills to appraise current practice critically and to evaluate proposed changes from a theoretical base. To this end, the text contains:

• current standards,
• illustrations from published accounts,
• a range of review questions,
• exercises of varying difficulty,
• outline solutions to selected exercises in an Appendix at the end of the book,
• extensive references.
We have assumed that readers will have an understanding of financial accounting to a foundation or first-year level, although the text and exercises have been designed on the basis
that a brief revision is still helpful.
Lecturers arc using the text selectively to support a range of teaching programmes for
second-year and final-year undergraduate and postgraduate programmes. We have therefore
attempted to provide subject coverage of sufficient breadth and depth to assist selective use.
T h e text has been adopted for financial accounting, reporting and analysis modules on:
• second-year undergraduate courses for Accounting, Business Studies and Combined

Studies;
• final-year undergraduate courses for Accounting, Business Studies and Combined
Studies;
• MBA courses;
• specialist MSc courses; and
• professional courses preparing students for professional accountancy examinations.

C h a n g e s to t h e twelfth edition
Accounting standards
UK listed companies, together with those non-listed companies that so choose, will apply
international standards from January 2005.
For non-listed companies that choose to continue to apply UK GAAP, the ASB has
stated its commitment to progressively bringing UK GAAP into line with international


Preface and acknowlegements • xxi

standards and the ten KRSs 20-29 that have been issued since April 2004 are part of this
process.
For companies currently applying FRSSK, this will continue. The IASB launched field
tests of an SME Exposure draft in June 2007.

Accounting standards - twelfth edition updates
Chapters 5 and 6 cover the evolution of the regulatory framework in the UK and the evolution of international standards.
Topics and International Standards are covered as follows:
Chapter 4
Chapter S

Accounting for inflation
Published accounts of companies

Chapter 9 Preparation of published accounts
Chapter
11
Off
balance
sheet
finance
Chapter 12 Financial instruments
Chapter 13 Employee benefits
Chapter 14 Taxation in company accounts
Chapter 15 Property, plant and equipment (PPE)
Chapter 16 Leasing
Chapter 17 R&D; goodwill and intangible assets;
brands
Chapter 18 Inventories
Chapter 19 Construction contracts

Chapters 20 to 25 Consolidation
Chapter 25 Earnings per share
Chapter
26
C
jsh
How
Chapter 30 Corporate governance

statements

IAS 29
IAS I, IAS 14, IAS 37, IFRS I and
IFRS 5
IAS 1, IAS 8, IAS 24 and IAS 35
IAS 37
IAS 32, IAS 39 and IFRS 7
IAS 19, IAS 26 and IFRS 2
IAS 12
IAS 16, IAS 20, IAS 23, IAS 36,
IAS 40 and IFRS 5
IAS 17
IAS 38 and IFRS 3
IAS 2
IAS II
IAS 21, IAS 27, IAS 28, IAS 31 and
IFRS 3
IAS 33
IAS 7
IFRS 2

Income and asset value m e a s u r e m e n t systems
Chapters 1 to 4 continue to cover accounting and reporting on a cash flow and accrual basis,
the economic income approach and accounting for changing price levels.

The UK regulatory framework and analysis
UK listed companies will continue to be subject to national company law, and mandatory
and best practice requirements such as the Operating and Financial Review and the Combined
Code.

UK regulatory framework and analysis - twelfth edition changes
The following chapters have been retained and updated as appropriate:
Chapter
Chapter
Chapter
Chapter

10
11
27
2S

Share capital, distributable profits and reduction of capital
Oft'balance sheet finance
Review of financial ratio analysis
Trend analysis and multivariate analysis

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xxii • Preface and acknowlegements

Chapter
Chapter
Chapter
Chapter

29
30
31
32

Financial Reporting on the Internet
Corporate governance
Environmental and social reporting
Ethics for accountants

Our emphasis has been on keeping the text current and responsive to constructive comments from reviewers.

Recent developments
In addition to the steps being taken towards the development of IFRSs that will receive
broad consensus support* regulators have been active in developing further requirements
concerning corporate governance. These have been prompted by the accounting scandals in
the USA and, more recently, in Europe and by shareholder activism fuelled by the apparent
lack of any relationship between increases in directors* remuneration and company performance.
The content of financial reports continues to be subjected to discussion with a tension
between preparers, stakeholders, auditors, academic accountants and standard setters; this
is mirrored in the tension that exists between theory and practice.
• Preparers favour reporting transactions on a historical cost basis which is reliable but docs
not provide shareholders with relevant information to appraise past performance or to

predict future earnings.
• Stakeholders favour forward-looking reports relevant in estimating future dividend and
capital growth and in understanding environmental and social impacts.
• Auditors favour reports that are verifiable so that the figures can be substantiated to avoid
them being proved wrong at a later date.
• Academic accountants favour reports that reflect economic reality and are relevant in
appraising management performance and in assessing the capacity of the company to
adapt.
• Standard setters lean towards the academic view and favour reporting according to the
commercial substance of a transaction.
In order to understand the tensions that exist, students need:
• the skill to prepare financial statements in accordance with the historical cost and current
cost conventions, both of which appear in annual financial reports;
• an understanding of the main thrust of mandatory and voluntary standards;
• an understanding of the degree of flexibility available to the preparers and the impact of
this on reported earnings and the balance sheet figures;
• an understanding of the limitations of these financial reports in portraying economic
reality; and
• an exposure to source material and other published material in so far as time permits.

Instructor's Manual
A separate Instructor's Manual has been written to accompany this text. It contains fully
worked solutions to all the exercises and is of a quality that allows them to be used as over-

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Preface and acknowlegements • xxiii
head transparencies. The Manual is available at no cost to lecturers on application to the
publishers.

Website
An electronic version of the Manual is also available for download at www.pearsoned.co.uk/
elliott-elliott.

Acknowledgements
Financial reporting is a dynamic area and we see it as extremely important that the text
should reflect this and be kept current. Assistance has been generously given by colleagues
and many others in the preparation and review of the text and assessment material. This
twelfth edition is very much a result of the authors, colleagues, re\ieuers and Pearson editorial and production staff working as a team and we are grateful to all concerned for their
assistance in achieving this.
We owe particular thanks to Ron Altshul of Leeds Metropolitan University, who has
updated 'Taxation in company accounts' (Chapter 14); Charles Batchclor formerly of F T C
Kaplan for 'Financial instruments' (Chapter 12) and "Employee benefits' (Chapter 13); Steve
Dungworth of De Montfort University, for 'Ethics for accountants' (Chapter ?>2)> which
first appeared in the third edition; O/er Krman of Kingston University, for 'Share capital,
distributable profits and reduction of share capital' (Chapter 10), which first appeared in the
second edition; Mike O'Mcara of the Regents Business School for consolidation chapters;
Paul Robins of the Financial Training Com pan) for 'Property, plant and equipment*
(Chapter 15) and 'Construction contracts' (Chapter 1°-); Professor Garry Tibbits of the
University of Western Sydney for Leasing (Chapter 16); 1 lendrika Tibbits of the University
of Western Sydney for An Introduction to Financial Reporting on the Internet (Chapter 29);
David Towers, formerly of Keele University, for R&D; Goodwill and intangible assets and
'Corporate governance* (Chapter 30); and Martin Howes for inputs to financial analysis.
The authors are grateful fur the constructive comments received from the following
reviewers which have assisted us in making improvements: Iain Fleming of the University
of Paisley, John Morley of the University of Brighton, John Forker of Queen's University,
Belfast, Breda Sweeney of Cork University, Patricia McCourt I.arres of Queen's University,
Belfast, and Dave Knight of Leeds Metropolitan University.
Thanks are owed to A.T. Benedict of the South Bank University, Keith Brown of De

Montfort University, Kenneth N. Field of the University of Leeds, Sue McDermott of
London Guildhall University, David Murphy of Manchester Metropolitan University,
Bahadur Najak of the University of Durham, Graham Sara of Coventry University, Laura
Spira of Oxford Brookes University, Ken TrunklickL formerly of the University of Derby,
and Martin TuflTy of the University of Brighton.
Thanks are also due to the following organisations: the Accounting Standards Board, the
International Accounting Standards Board, the Association of Chartered Certified
Accountants, the Association of International Accountants, the Chartered Institute of
Management Accountants, the Institute of Chartered Accountants of Scotland, Chartered
Institute of Public Finance and Accountancy, Chartered Institute of Bankers and the
Institute of Investment Management and Research.
We would also like to thank the authors of some of the end-of-chapter exercises. Some of
these exercises have been inherited from a varietv of institutions with which we have been

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xxiv * Preface and acknowlegements

associated, and we have unfortunately lost the identities of the originators of such material
with the passage of time. Wc are sorry that wc cannot acknowledge them by name and hope
that they will excuse us for using their material.
Wc arc indebted to Matthew Smith and Tim Parker of Pearson Education for active
support in keeping us largely to schedule and the attractively produced and presented
text.
Finally we thank our wives, Di and Jacklin, for their continued good humoured support
during the period of writing and revisions, and Giles Elliott for his critical comment at the
commencement of the project. We alone remain responsible for any errors and for the
thoughts and views that are expressed.
Barry and Jamie Elliott

Publisher's acknowledgements
We are grateful to the Financial Times Limited for permission to reprint the following
material:
Chapter 27, p.674 Ixx Column, O Financial Times, 17 November 2(100; Chapter 28, p.703
Earlv warning signals, V. Financial Times, 5 October 1999.


PART I

Income and asset value
measurement systems


1.1 Introduction
Accountants arc communicators. Accountancy is the art of communicating financial
information about a business entity to users such as shareholders and managers. The communication is generally in the form of financial statements that show in money terms the
economic resources under the control of the management. The art lies in selecting the information that is relevant to the user and is reliable.
Shareholders require periodic information that the managers are accounting property for
the resources under their control. This information helps the shareholders to evaluate the
performance of the managers. The performance measured by the accountant shows the extent
to which the economic resources of the business have grown or diminished during the year.
The shareholders also require information to predict future p e r f o r m a n c e . At present
companies are not required to publish forecast financial statements on a regular basis and the
shareholders use the report of past performance when making their predictions.
Managers require information in order to control the business and make investment
decisions.
In this chapter we will consider both categories of user, and the extent to which cash How
accounting would satisfy their information needs, under the following headings:
• Shareholders

• What skills does an accountant require in respect of external reports?
• Managers
• What skills does an accountant require in respect of internal reports?
• PnKX'dural steps when reporting to internal users
• Agency costs
• Illustration of operating cash Hows
• Illustration continued with statement of financial position
• Treatment of non-current assets in the cash flow model
• What are the characteristics of these data that make them reliable?
• Reports to external users.

1.2 Shareholders
Shareholders are external users. As such, they are unable to obtain access to the same
amount of detailed historical information as the managers, e.g. total administration costs are


4

" I n c o m e and asset value m e a s u r e m e n t systems

disclosed in the published profit and loss account, but not an analysis lo show how the figure
is made up. Shareholders are also unable to obtain associated information, e.g. budgeted
sales and costs. Even though the shareholders own a company, their entitlement to information is restricted.
The information to which shareholders arc entitled is restricted to that specified by
statute, e.g. the Companies Acts, or by professional regulation, e.g. Financial Reporting
Standards, or by market regulations, e.g. Listing requirements. This means that there may
be a tension between the a m o u n t of information that a shareholder would like to receive and
the amount that the directors are prepared to provide. For example, shareholders might consider that forecasts of future cash flows would be helpful in predicting future dividends, but
the directors might be concerned that such forecasts could help competitors or make directors open to criticism if forecasts are not met. As a result, this information is not disclosed.
There may also be a tension between the q u a l i t y of information that shareholders would

like to receive and that which directors are prepared to provide. For example, the shareholders might consider that judgements made by the directors in the valuation of long-term
contracts should be fully explained, whereas the directors might prefer not to reveal this
information given the high risk of error that often attaches to such estimates. In practice,
companies tend to compromise: they do not reveal the judgements to the shareholders, but
maintain confidence by relying on the auditor to give a clean audit report.
The financial reports presented to the shareholders are also used by other parties such as
lenders and trade creditors, and they have come to be regarded as general -pur pose reports.
However, it may be difficult or impossible to satisfy the needs of all users. For example,
users may have different time-scales - shareholders may be interested in the long-term trend
of earnings over three years, whereas creditors may be interested in the likelihood of
receiving cash within the next three months.
The information needs of the shareholders are regarded as the primary concern. The government perceives shareholders to be important because they provide companies with their
economic resources. It is shareholders* needs that take priority in deciding on the nature and
detailed content of the general-purpose reports. 1

1.3 W h a t skills does an accountant require in respect of e x t e r n a l reports?
For external reporting purposes the accountant has a two-fold obligation:
• an obligation to ensure that the financial statements comph with statutory, professional
and Listing requirements; this requires the accountant to possess technical expertise;
• an obligation to ensure that the financial statements present the substance of the commercial transactions the company has entered into; this requires the accountant to have
c o m m e r c i a l awareness. 2

1.4

Managers
Managers are internal users. As such, they have access to detailed financial statements
showing the current results, the extent to which these vary from the budgeted results and
the future budgeted results. Examples of internal users are sole traders, partners and, in a
company context, directors and managers.
There is no statutory restriction on the amount of information that an internal user may

receive; the only restriction would be that imposed by the company's own policy.

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Accounting and reporting on a cash flow basis * 5

Frequently, companies operate a 'need to know' policy and only the directors sec all the
financial statements; employees, for example, would be most unlikely to receive information
that would assist them in claiming a salary increase - unless, of course, it happened to be a
time of recession, when information would be more freely provided by management as a
means of containing claims for an increase.

1.5 W h a t skills does an accountant require in respect of internal reports?
For the internal user, the accountant is able to tailor his or her reports. The accountant is
required to produce financial statements that are specifically relevant to the user requesting
them.
The accountant needs to be skilled in identifying the information that is needed and conveying its implication and meaning to the user. The user needs to be confident thai the
accountant understands the user's information needs and will satisfy them in a language that
is understandable. The accountant must be a skilled communicator who is able to instil confidence in the user that the information is:
• relevant to the user's needs;
• measured objectively;
• presented within a time-scale that permits decisions to be made with appropriate information;
• verifiable, in that it can be confirmed that the report represents the transactions that have
taken place;
• reliable, in that it is as free from bias as is possible;
• a complete picture of material items;
• a fair representation of the business transactions and events that have occurred or are
being planned.
The accountant is a trained reporter of financial information. Just as for external reporting,

the accountant needs commercial awareness. It is important, therefore, that he or she should
not operate in isolation.

1.5.1 Accountant's reporting role
The accountant's role is to ensure that the information provided is useful for making
decisions. For external users, the accountant achieves this by providing a general-purpose
financial statement that complies with statute and is reliable. For internal users, this is done
by interfacing with the user and establishing exactly what financial information is relevant
to the decision that is to be made.
We now consider the steps required to provide relevant information for internal users.

1.6 Procedural steps w h e n r e p o r t i n g to internal users
A number of user steps and accounting action steps can be identified within a financial
decision model. These are shown in Figure 1.1.
Note that, although we refer to an accountant/user interface, this is not a single occurrence because the user and accountant interface at each of the user decision steps.

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