Financial accounting ABE diplopma in business management

Business Management
Study Manuals

Diploma in
Business Management

FINANCIAL
ACCOUNTING

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Diploma in Business Management

FINANCIAL ACCOUNTING
Contents

Unit

Title

1

The Nature and Purpose of Accounting
The Scope of Accounting
Users of Accounting Information
Rules of Accounting (Accounting Standards)
Accounting Periods
The Main Characteristics of Useful Information
The Twelve Traditional Accounting Concepts
Important Accounting Terms
Different Types of Business Entity
Auditing in Business

1
3
4
6
14
14
17
20
22
25

2

Business Funding
Capital of an Enterprise
Dividends
Debentures
Types and Sources of Finance
Management of Working Capital

31
33
40
41
44
48

3

Final Accounts and Balance Sheet

53
55
55
57
59
62
67
69
71
75
75

The Trial Balance
Trading Account
Manufacturing Account
Profit and Loss Account
Allocation or Appropriation of Net Profit
The Nature of a Balance Sheet
Assets and Liabilities in the Balance Sheet
Distinction between Capital and Revenue
Preparation of Balance Sheet
4

Presentation of Financial Statements
Introduction
The UK Companies Act 1985 and Accounting Requirements
The Balance Sheet
The Income Statement
IAS 1: Statement of Changes in Equity
Summary of Statements Required by IAS 1
Narrative Statements Required in Published Financial Statements
Appendix 1: Example of Statement of Accounting Policies
Appendix 2: Example of Independent Auditors' Report
Appendix 3: Example of Directors' Report

Page

81
83
83
87
93

97
99
99
102
110
111


Unit

Title

Page

5

Profit and Cash Flow
Availability of Profits for Distribution
Cash Flow Statements
Funds Flow Statements

115
116
119
130

6

Valuation of Non-Current Assets and Inventories
Valuation of Inventories

Valuation of Long-Term Contracts
The Importance of Inventory Valuation
Depreciation
Methods of Providing for Depreciation
Borrowing Costs and IAS 23
Leased Assets and IAS 17
IAS 36: Impairment of Assets
IAS 40: Investment Properties

135
137
143
146
149
153
154
154
156
157

7

Further Accounting Standards and Concepts
Introduction
IAS 33: Earnings Per Share
IAS 20: Accounting for Government Grants
IAS 12: Income Taxes
Accounting for Research and Development Expenditure
IAS 10: Events after the Balance Sheet Date
IAS 37: Provisions, Contingent Liabilities and Contingent Assets

IAS 38: Intangible Assets
IAS 18: Revenue
IAS 24: Related Party Transactions
Accounting for Inflation

165
167
167
168
169
170
171
173
176
178
179
180

8

Assessing Financial Performance
Interpretation of Accounts
Ratio Analysis
Profitability Ratios
Liquidity Ratios
Efficiency Ratios
Capital Structure Ratios
Investment Ratios
Limitations of Accounting Ratios
Worked Examples

Issues in Interpretation

189
191
193
196
198
200
202
203
205
207
214


Unit

Title

Page

9

Sources and Costs of Finance
Introduction
Finance and the Smaller Business
Finance and the Developing Business
Finance for the Major Company
The London Money Market
The Cost of Finance

Cost of Equity
Cost of Preference Shares
Cost of Debt Capital
Weighted Average Cost of Capital (WACC)
Cost of Internally Generated Funds
Management of Factors Affecting Share Prices
Factors Determining Capital Structure
Advantages and Disadvantages of the Principal Financial Alternatives

225
227
227
230
233
239
240
241
243
243
244
245
247
249
253

10

Financial Reconstruction
Introduction
Redemption of Shares

Accounting Treatment
Example of Redemption of Preference Shares
Example of Redemption of Ordinary Shares
Redemption of Debentures

257
258
258
259
259
262
265

11

Group Accounts 1: Regulatory and Accounting Framework
Introduction
IAS 27: Consolidated and Separate Financial Statements
IFRS 3: Business Combinations
IAS 28: Investments in Associates
IFRS 3: Fair Values in Acquisition Accounting
Alternative Methods of Accounting for Group Companies
Merger Accounting

269
270
270
272
274
276

277
280

12

Group Accounts 2: The Consolidated Accounts
Introduction
The Consolidated Balance Sheet
The Consolidated Income Statement
Group Accounts – Example

283
284
284
298
306

13

Financial Accounting Examination – The Compulsory Question
The Financial Accounting Examination
December 2007 Compulsory Question
Specimen Examination Compulsory Question

323
324
325
330

1

Study Unit 1
The Nature and Purpose of Accounting
Contents

Page

A.

The Scope of Accounting
The Purpose of Accounting
Financial Accounting and Management Accounting
Money as the Common Denominator
The Business Entity

3
3
3
3
4

B.

Users of Accounting Information
Main Categories of Users
Interests of Principal Users

4

4
5

C.

Rules of Accounting (Accounting Standards)
Development of UK Accounting Standards
International Accounting Standards
Statements of Standard Accounting Practice

6
6
8
9

D.

Accounting Periods

14

E.

The Main Characteristics of Useful Information
Underlying Assumptions
Qualitative Characteristics of Financial Statements

14
15
16

F.

The Twelve Traditional Accounting Concepts
Prudence
Going Concern
Consistency
Money Measurement
Duality
Matching
Cost
Materiality
Objectivity
Realisation

17
17
18
18
18
18
19
19
19
19
19
(Continued over)

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Business Entity Concept
Separate Valuation
IAS 1: Presentation of Financial Statements

19
20
20

G.

Important Accounting Terms
The Accounting Equation or Basic Formula
Assets and Liabilities
Capital v. Revenue Expenditure

20
20
21
22

H.

Different Types of Business Entity

The Sole Trader
Partnerships
Limited Companies in the UK
Accounting Differences Between Companies and Unincorporated Businesses
Principle of Limited Liability
Promoters and Legal Documents

22
22
23
23
24
24
24

I.

Auditing in Business
What is an Audit?
Types of Audit
UK Law and External Audit
External Audit Report
External Audit Process
Expectations Gap

25
25
25
26
27

28
28

Answers to Questions for Practice

30

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A. THE SCOPE OF ACCOUNTING
The Purpose of Accounting
A business proprietor normally runs a business to make money. He or she needs
information to know whether the business is doing well. The following questions might be
asked by the owner of a business:


How much profit or loss has the business made?



How much money do I owe?



Will I have sufficient funds to meet my commitments?

The purpose of conventional business accounting is to provide the answers to such
questions by presenting a summary of the transactions of the business in a standard form.

Financial Accounting and Management Accounting
Accounting may be split into Financial Accounting and Management Accounting.
(a)

Financial Accounting
Financial accounting comprises two stages:

(b)



book-keeping, which is the recording of day-to-day business transactions; and



preparation of accounts, which is the preparation of statements from the bookkeeping records; these statements summarise the performance of the business –
usually over the period of one year.

Management Accounting
Management accounting is defined by the Chartered Institute of Management
Accountants (CIMA) as follows:
"The application of professional knowledge and skill in the preparation and
presentation of accounting information in such a way as to assist
management in the formulation of policies and in the planning and control

of the operations of the undertaking".
Management accounting, therefore, seeks to provide information which will be used for
decision-making purposes (e.g. pricing, investment), for planning and control.

Money as the Common Denominator
Accounting is concerned with money measurement – it is only concerned with information
which can be given a monetary value. We put money values on items such as land,
machinery and stock, and this is necessary for comparison purposes. For example, it is not
very helpful to say: "Last year we had four machines and 60 items of stock, and this year we
have five machines and 45 items of stock.". It is the money values which are useful to us.
There are, though, limitations to the use of money as the common denominator.
(a)

Human Asset and Social Responsibility Accounting
We have seen that accounting includes financial accounting and management
accounting. Both of these make use of money measurement. However, we may want
further information about a business:

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

Are industrial relations good or bad?



Is staff morale high?



Is the management team effective?

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

What is the employment policy?



Is there a responsible ecology policy?

These questions will not be answered by conventional business accounting in money
terms but by "human asset accounting" and "social responsibility accounting". These
subjects have not yet been fully developed and are outside the scope of your syllabus.
(b)

Devaluation
The value of money does not remain constant, and there is normally some degree of
inflation in the economy. We will look at the steps that have been taken to attempt to
adjust accounting statements to the changing value of money later in the course.

The Business Entity
The business as accounting entity refers to the separate identities of the business and its
owners.



The Sole Trader
There must always be a clear distinction between the owner of the business and the
business itself. For example, if Mr X owns a biscuit factory, we are concerned with
recording the transactions of the factory. We are not concerned with what Mr X
spends on food and clothes. If Mrs Y, works at home, setting aside a room in her
house, an apportionment may have to be made.



Partnership
Similarly, the partners in a business must keep the transactions of the business
separate from their own personal affairs.



Companies
In UK law, a company has a distinct "legal personality". This means that a company
may sue or be sued in its own right. The affairs of the shareholders must be
distinguished from the business of the company. The proprietor of a limited company
is therefore distinct from the company itself.

We shall return to the issue of business entities later in the unit.

B. USERS OF ACCOUNTING INFORMATION
We need to prepare accounts in order to "provide a statement that will meet the needs of the
user, subject to the requirements of statute and case law and the accounting bodies, and
aided by the experience of the reception of past reports".
So if we prepare accounts to meet the needs of the user, who is the user?

Main Categories of Users
The main users of financial accounts are:


Equity investors (shareholders, proprietors, buyers)



Loan creditors (banks and other lenders)



Employees



Analysts/advisers



Business contacts (creditors and debtors, competitors)



The government (The Inland Revenue)

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The Nature and Purpose of Accounting



The public



Management (board of directors)

5

Users can learn a lot about the running of a business entity from the examination of its
accounts, but each category of user will have its own special perspective. We need to look
at some of these in more detail.

Interests of Principal Users
What exactly do each of the users want from the accounts?


Proprietor
The perspective of the business proprietor is explained above (but see below for the
interests of shareholders).



Inland Revenue
The Inland Revenue will use the accounts to determine the liability of the business for

taxation.



Banks and other Lending Institutes
These require to know if the business is likely to be able to repay loans and to pay the
interest charged. But often the final accounts of a business do not tell the lender what
he or she wishes to know. They may be several months old and so not show the upto-date position. Under these circumstances, the lender will ask for cash flow
forecasts to show what is likely to happen in the business. This illustrates why
accounting techniques have to be flexible and adaptable to meet users' needs.



Creditors and Debtors
These will often keep a close eye on the financial information provided by companies
with which they have direct contact through buying and selling, to ensure that their own
businesses will not be adversely affected by the financial failure of another. An
indicator of trouble in this area is often information withheld at the proper time, though
required by law. Usually, the longer the silence, the worse the problem becomes.



Competitors
Competitors will compare their own results with those of other businesses. A business
would not wish to disclose information which would be harmful to its own business:
equally, it would not wish to hide anything which would put it above its competitors.



Board of Directors

The board of directors will want up-to-date, in-depth information so that it can draw up
plans for the long term, the medium term and the short term, and compare results with
its past decisions and forecasts. The board's information will be much more detailed
than that which is published.



Shareholders
Shareholders have invested money in the business and as such are the owners of the
business. Normally, the business will be run by a team of managers and the
shareholders require the managers to account for their "stewardship" of the business,
i.e. the use they have made of the shareholders' funds.



Employees
Employees of the business look for, among other things, security of employment.

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

Prospective Buyer

A prospective buyer of a business will want to see such information as will satisfy him
or her that the asking price is a good investment.

C. RULES OF ACCOUNTING (ACCOUNTING STANDARDS)
As different businesses use different methods of recording transactions, the result might be
that financial accounts for different businesses would be very different in form and content.
However, various standards for the preparation of accounts have been developed over the
years in order that users can be assured that the information they show can be relied on.
We shall be looking at the layout of financial accounts later on in the course, but here we are
concerned with general underlying rules.
With regard to UK companies, various rules have been incorporated into legislation (through
the Companies Acts). UK Companies whose shares are listed on the Stock Exchange are
also subject to Stock Exchange rules. In addition, there are also "Statements of Standard
Accounting Practice" (SSAPs) and Financial Reporting Statements (FRSs) which are issued
by the main UK professional accounting bodies through the Accounting Standards Board
(ASB) which must be complied with.
There are also rules and regulations for the preparation of financial accounts in other
countries of the world, and an international regulatory framework is gaining in importance.
Global investment in business is becoming the norm in the 21st century and investors now
require comparable information between business entities from different countries of the
world. International regulation first began in 1973 with the establishment of the International
Accounting Standards Committee

Development of UK Accounting Standards
(a)

Historical Development
In 1942, the Institute of Chartered Accountants in England and Wales began to make
recommendations about accounting practices, and over time issued a series of 29
Recommendations, in order to codify the best practice to be used in particular

circumstances. Unfortunately, these recommendations did not reduce the diversity of
accounting methods.


The Accounting Standards Committee
In the late 1960s, there was a lot of public criticism of financial reporting methods
and the accounting profession responded to this by establishing the Accounting
Standards Committee (ASC) in 1970. The ASC comprised representatives of all
the six major accounting bodies, i.e. the Chartered Accountants of England and
Wales, of Scotland, and of Ireland, the Certified Accountants, the Cost and
Management Accountants, and the Chartered Institute of Public Finance and
Accountancy.
The Committee was set up with the object of developing definitive standards for
financial reporting.
A statement of intent produced in the 1970s identified the following objectives:
–

To narrow the areas of difference in accounting practice

–

To ensure disclosure of information on departures from definitive standards

–

To provide a wide exposure for new accounting standards

–

To maintain a continuing programme for improving accounting standards.

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There are various accounting conventions (which we'll look at later) that lay down
certain "ground rules" for accounting. However, they do still permit a variety of
alternative practices to coexist. The lack of uniformity of practices made it
difficult for users of financial reports to compare the results of different
companies. There was therefore a need for standards of accounting practice, to
try to increase the comparability of company accounts.


Statements of Standard Accounting Practice (SSAP)
The procedure for their establishment was for the ASC to produce an exposure
draft on a specific topic – e.g. accounting for stocks and depreciation – for
comment by accountants and other users of accounting information. A formal
statement was then drawn up, taking account of comments received, and issued
as a Statement of Standard Accounting Practice (SSAP). Once a statement
had been adopted by the accountancy profession, any material departures by a
company from the standard practice had to be disclosed in notes to the Annual
Financial Accounts.
These standards do not have the force of law to back them up, although all
members of the accounting profession are required by their Code of Ethics to
abide by them.



The Dearing Report
Although the ASC had much success during its period of operation and issued 25
SSAPs as well as a number of exposure drafts (EDs), Statements of Intent (SOI),
and Statements of Recommended Practice (SORP), there were many serious
criticisms of its work, leading to its eventual demise.
In July 1987, the Consultative Committee of Accountancy Bodies (CCAB) set up
a review of the standard-setting process under the chairmanship of Sir Ron
Dearing. The Dearing Report subsequently made a number of very important
recommendations. The government accepted all but one of them and in August
1990 a new Standard Setting Structure was set up.

(b)

The Accounting Standards Board
The following structure (Figure 1.1) was recommended by the Dearing Report, with the
Financial Reporting Council (FRC) acting as the policy-making body for accounting
standard-setting.
The Financial
Reporting Council
(FRC)

The Review
Panel

The Accounting
Standards Board
(ASB)

The Urgent Issues
Task Force (UITF)
Figure 1.1: Standard Setting Structure

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This gave rise to a slightly different regime for the establishment of standards and
these are now embodied in Financial Reporting Standards (FRS).


Financial Reporting Standards (FRS)
The ASB is more independent than the ASC was and can issue standards known
as Financial Reporting Standards (FRS). The ASB accepted the SSAPs then in
force and these remain effective until replaced by an FRS. The ASB develops its
own exposure drafts along similar lines to the ASC; these are known as FREDs
(Financial Reporting Exposure Drafts).



Statements of Recommended Practice (SORP)
Although the ASB believed that Statements of Recommended Practice (SORPs)
had a role to play, it did not adopt the SORPs already issued. Not wishing to be

diverted from its central task of developing accounting standards, the Board has
left the development of SORPS to bodies recognised by the Board.
The SORPs issued by the ASC from 1986 differed from SSAPs in that SSAPs
had to be followed unless there were substantive reasons to prove otherwise,
and non-compliance had to be clearly stated in the notes to the final accounts. A
SORP simply sets out best practice on a particular topic for which a SSAP was
not appropriate. However, the later SORPs are mandatory and cover a topic of
limited application to a specific industry (e.g. local authorities, charities, housing
associations). These SORPS do not deviate from the basic principles of the
various SSAPs and FRSs currently in issue.



Urgent Issues Task Force (UITF)
This is an offshoot of the ASB which tackles urgent matters not covered by
existing standards or those which, if covered, were causing diversity of
interpretation. In these circumstances, the UITF issues a "Consensus
Pronouncement" in order to detect whether or not accounts give a true and fair
view.



Financial Reporting Review Panel
This examines contentious departures from accounting standards by large
companies. The panel has the power to apply to the court for an order requiring
a company's directors to revise their accounts.

International Accounting Standards
(a)

Historical Development
The International Standards Committee (IASC), established in 1973, was an
independent private sector body and had no formal authority. It therefore had to rely
on persuasion and the professionalism of others to encourage adoption of the
International Accounting Standards (IASs) that it issued. The IASC operated under the
umbrella of the International Federation of Accountants (IFAC), which is the worldwide
organisation of accountancy bodies and is independent of any country's government.
All members of IFAC were originally members of IASC. One of the problems facing
the IASC was that it quite often had to issue standards that accommodated two or
more alternative acceptable accounting treatments. This situation arose because
these alternative treatments were being practised in countries that were members of
the IASC.
In 1995 the IASC entered into an agreement with the International Organisation of
Securities Commission (IOSCO) (the body representing stock exchanges throughout
the world) to produce a core set of accounting standards. These standards were to be
endorsed by IOSCO as an appropriate reporting regime for business entities in the

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global marketplace for the raising of finance. This deal was to give IASC its much
needed authority. However, to gain IOSCO's backing the IASC had to agree to a
restructuring which occurred in 2000. The core standards were completed in 2000 and
adopted by IOSCO in May 2000.

The European Union, besides issuing Directives on company law (Fourth and Seventh
Directives), has also adopted the IASB standards for the preparation of financial
statements.
(b)

International Accounting Standards Board (IASB)
The IASC became known as the IASB under the required restructuring in 2000. It is
governed by a group of 19 individual trustees, known as the IASC Foundation, with
diverse geographical and functional backgrounds. The current Chair of the trustees is
Paul A. Volcker, the former chair of the US Federal Reserve Board. The trustees are
responsible for the governance, fundraising and public awareness of the IASB.
The structure under the trustees comprises the IASB as well as a Standards
Interpretation Committee (SIC) and a Standards Advisory Council, as shown below.
Trustees

Standards
Advisory
Council

IASB

SIC

Figure 1.2: International Standards Setting Structure
The IASB has 12 full-time members and 2 part-time members all of whom have
relevant technical experience and expertise. The current chair of the IASB is Sir David
Tweedie, who was previously the chair of the UK ASB.
The IASB's sole responsibility is to set International Financial Reporting Standards
(IFRSs). (Note that the standards issued by the IASC were known as International
Accounting Standards (IASs) and several of these have been adopted by the IASB –

see the list of standards later in the unit). As such it is at the forefront of harmonisation
of accounting standards across the world as it pushes for adoption of its standards with
the help of IOSCO.
Within the UK this harmonisation process with IASs has already begun. Within the EU
all stock exchange listed businesses have to comply with IASs for the publication of
their consolidated financial statements as from 1 January 2005. Businesses not listed,
which tend to form the majority, can still use the framework of standards established by
the individual country. However, within the EU, countries are converging their home
standards with the international standards and this process is occurring in other areas
of the globe.
Within this manual, we intend to use the international standards. You might, therefore,
find it useful to have a look at the IASB web site – www.iasb.co.uk.

Statements of Standard Accounting Practice
Note that, with the issuing of new accounting standards by the IASB (IFRSs), there are
currently both a number of IFRSs and IASs in force. You do not require a detailed
knowledge of all the current standards, but you should be aware of what they cover and we
briefly review them here. The standards specifically within the range of the syllabus for this

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module will be dealt with in detail in later study units under their own topic headings. (Those
not included in the syllabus for this module are indicated by ** in the following list.)

International Financial Reporting Standards


IFRS 1 First-time Adoption of International Financial Reporting Standards ** (no
UK equivalent)
The objective of this standard is to ensure that an entity's first IFRS financial
statements contain high quality information that is transparent for users and
comparable over time, provides a suitable starting point for accounting under IFRSs
and can be generated at a cost that does not exceed the benefits to users.



IFRS 2 Share-based Payment ** (UK equivalent is FRS 20)
The objective of this standard is to specify the financial reporting by an entity when it
undertakes a share-based transaction. Businesses often grant share options to
employees or other parties and until the issue of this standard there was concern over
the measurement and disclosure of such transactions.



IFRS 3 Business Combinations (FRS 6 UK similar, but not identical)
The objective of this standard is to specify the financial reporting by an entity when it
undertakes a business combination. It covers the preparation of consolidated
accounting staements using the puchase method (acquisition method) and will be dealt
with in detail in study units 11 and 12.



IFRS 4 Insurance Contracts ** (FRS 27 UK similar, but not identical)
The objective of this standard is to specify the financial reporting for insurance

contracts issued by an entity. An insurance contract ia a contract under which one
party, the insurer, accepts significant insurance risk from another party, the
policyholder, by agreeing to compensate the policyholder if a specified uncertain future
event adversely affects the policyholder.



IFRS 5 Non-current Assets Held for Sale and Discontinued Operations ** (no UK
equivalent)
The objective of this standard is to specify the accounting for assets held for sale, and
for the presentation and disclosure of discontinued operations.



IFRS 6 Exploration for and evaluation of Mineral Resources ** (no UK
equivalent)
This standard covers the accounting requirements for expenditure incurred in the
exploration for and evaluation of mineral resources and whether such expenditure
should be regarded as a non-current asset. It also specifies the impairment treatment
for such expenditure.



IFRS 7 Financial Instruments: Disclosures ** (FRS 29 UK)
This standard is partnered with IAS 32 Financial Instruments: Presentation. IFRS 7
deals with the disclosures that must be made by a business when it has in issue a
financial instrument defined as any contract that gives rise to a financial asset of one
entity and a financial liability or equity instrument of another entity.



IFRS 8 Operating Segments ** (SSAP 25 UK similar, but not identical)
This is basically a disclosure statement identifying when and how information should
be disclosed in the financial statements in respect of business segments.

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International Accounting Standards


IAS 1

Presentation of Financial Statements (FRS 3 UK similar, but not identical)

We will cover this is some detail in study unit 4. The standard sets out overall
requirements for the presentation of financial statements, guidelines for their structure
and minimum requirements for their content. It specifies that a complete set of
financial statements comprises:



–

a balance sheet

–

an income statement (profit and loss statement)

–

a statement of changes in equity

–

a cash flow statement

–

notes and specified disclosure requirements

IAS 2

Inventories (SSAP 9 UK similar, but not identical)

We will deal with this in study unit 6. A primary issue in the accounting for inventories
is the amount of cost to be recognised as an asset and carried forward until the related
revenues are recognised. Inventories are assets
–

held for sale

–

in the process of production for such sale

–

in the form of materials or supplies to be consumed in the production process or
the rendering of services.

The standard does not cover contruction contracts. These are dealt with under IAS 11


IAS 7

Cash Flow Statements (FRS 1 revised UK similar, but not identical)

We will cover this in study unit 5. The standard deals with the preparation of one of the
primary financial statements as specified by IAS 1. It deals with cash flows during the
period rather the matching of revenue and expenses and, therefore, provides further
information to users in terms of performance and liquidity in addition to information
provided in the income statement.


IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (FRS
18 UK similar, but not identical)
The objective of the standard is to prescribe the criteria for selecting and changing
accounting policies used in the preparation of financial statements. Its use should
enhance the relevance and reliability of the financial statements produced. This
standard is dealt with in study unit 4



IAS 10 Events After the Balance Sheet Date (FRS 21 UK)
This is dealt with in study unit 7. The standard deals with events that occur after the
balance sheet date and whether these affect the financial statements prepared and/or
whether information on these events should be provided in the notes to the accounts.



IAS 11 Construction Contracts (SSAP 9 UK similar, but not identical)
Dealt with in study unit 6. The primary issue in dealing with construction contracts that
cover more than one accounting period is the allocation of contract revenue and
contract costs to the appropriate acconting period.

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

IAS 12 Income Taxes (FRS 16 and 19 UK similar, but not identical)
Dealt with in study unit 7. Income taxes are all domestic and foreign taxes which are
based on taxable profits. The standard deals with the accounting of both current taxes
and deferred taxes.



IAS 16 Property, Plant and Equipment (FRS 15 UK similar, but not identical)
Dealt with in study unit 6. The principal issues in accounting for property, plant and
equipment (tangible fixed assets) are the recognition of the assets, the determination
of their carrying amounts and the depreciation charges and impairment losses to be
recognised in relation to them.



IAS 17 Leases (SSAP 21 UK similar, but not identical)
This forms part of study unit 6. Businesses do not always purchase the fixed assets
they require but, rather,; quite often lease them from another party. These leased
assets in substance can be used by the business as if they had purchased them and,
therefore, the standard details the recognition and accounting for such leased assets.
This is an example of accounting for substance over form.



IAS 18 Revenue ( FRS 5 UK similar, but not identical)
Dealt with in study unit 7. Income, as defined in the Framework for the Preparation
and Presentation of Financial Statements (see study unit 4), is increases in economic
benefits during the accounting period. It further states that income encompasses both
revenues and gains. So what is revenue? This standard answers that question and
explains how it should be measured.



IAS 19 Employee Benefits ** (FRS 17 UK similar, but not identical)
Many businesses, in addition to wages/salaries, provide further benefits to their
employees. Such benefits include:

–

retirement plans

–

insurance plans such as hospital, dental, life and disability insurance

–

stock options

–

profit sharing plans

–

recreational programmes

–

vacation schemes, etc.

This standard deals with the accounting for all employee benefits except those dealt
with under a specific standard. The standard requires the recognition of a liability
when an employee has provided service in exchange for employee benefits to be paid
in the future and the recognition of an expense when the entity consumes the
economic benefit arising from service by an employee in exchange for employee
benefit.



IAS 20 Accounting for Government Grants and Disclosure of Government
Assistance (SSAP 4 UK similar, but not identical)
Dealt with in study unit 7. Government grants should be recognised in the income
statement so as to match the expenditure to which they relate. Capital grants relating
to capital expenditure should be credited to revenue over the expected useful
economic life of the asset.



IAS 21 The Effects of Changes in Foreign Exchange Rates ** (SSAP 20 UK
similar, but not identical)

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A business may carry on foreign activities in two ways – it may have transactions in
foreign currencies or it may have foreign operations. The objective of this standard is
to presribe how to deal with such activities in the financial statements.


IAS 23 Borrowing Costs (no UK equivalent)
Dealt with in study unit 6. Businesses often borrow acquire loans, to purchase assets.

Normally the interest costs on such assets should be expensed to the income
statement in accordance with the matching principle. However, it is possible to put
forward an alternative argument that such borrowing costs, the interest, should be
capitalised as part of the cost of the asset. This standard deals with the accounting for
borrowing costs and whether the alternative treatment can be permitted.



IAS 24 Related Party Disclosures (FRS 8 UK similar, but not identical)
Dealt with in study unit 7. The objective of this standard is to ensure that a business's
financial statements contain the disclsoures necessary to draw attention to the
possibility that its financial position and profit or loss may have been affected by the
existence of related parties and by transactions and outstanding balances with such
parties. This disclsoure is necessary because quite often such transactions would not
be entered into with unrelated parties.



IAS 26 Accounting and Reporting by Retirement Benefit Plans ** (FRS 17 UK,
similar but not identical)
This standard deals with the preparation of financial statements by retirement benefit
plan (pension schemes) entities.



IAS 27 Consolidated and Separate Financial Statements (FRS 2 UK similar, but
not identical)
This forms the basis of study units 11 and 12 where we deal with the preparation of
financial statements for holding and subsidiary businesses.



IAS 28 Investments in Associates (FRS 9 UK similar, but not identical)
Again this is dealt with in study units 11 and 12.



IAS 29 Financial Reporting in Hyperinflationary Economies ** (FRS 24 UK)
In an hyperinflationary economy, financial statements are only useful if they are
expressed in terms of the measuring unit current at the balance sheet date. Thus, the
standard requires restatement of financial statements of businesses operating in an
hyperinflationary economy.



IAS 31 Interests in Joint Ventures** (FRS 9 UK similar, but not identical)



IAS 32 Financial Instruments: Presentation ** (FRS 25 UK)



IAS 33 Earnings per Share (FRS 22UK)
Dealt with in study unit 7. This statement specifies the determination and presentation
of the earnings per share figure/s in the financial statements.



IAS 34 Interim Financial Reporting ** (ASB statement interim reports



IAS 36 Impairment of Assets (FRS 11 UK similar, but not identical)
Dealt with in study unit 6. The objective of this standard is to prescribe the procedures
that a business applies to ensure that its assets are carried at no more than their
recoverable amount. An asset is carried at more than its recoverable amount if its
carrying value exceeds the amount to be recovered through the use or sale of the
asset. If this is the case, the asset is described as impaired and the standard requires
the business to recognise an impairmemt loss.

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

IAS 37 Provisions, Contingent Liabilities and Contingent Assets (FRS 12 UK,
similar but not identical)
See study unit 7. The standard deals with the appropriate recognition and
measurement of provisions and contingencies. It defines a provision as a liability of
uncertain timing or amount.



IAS 38 Intangible Assets (FRS 10 UK similar, but not identical)
See study unit 7. The standard only permits the recognition of intangible assets if
certain criteria are met. An intangible asset is defined as an identifiable non-monetary
asset without physical substance, such as research and development costs,
broadcasting licences, airline route authority, patents, copyrights, etc.



IAS 39 Financial Instruments: Recognition and Measurement ** (FRS 26 UK)



IAS 40 Investment Property (SSAP 19 UK similar, but not idemtical)
See study unit 6. An investment property is property held by a business to earn rentals
or for capital appreciation or both, rather than for use in the production or supply of
goods or services. The standard deals with the accounting treatment of such
investment properties.



IAS 41 Agriculture **

D. ACCOUNTING PERIODS
An owner of a business will require financial information at regular intervals. As we have
noted, he or she will want to be able to check periodically how well or badly the business is
doing. Financial accounts are normally prepared on an annual basis, e.g. twelve months to
the 31 March. Preparing accounts on an annual basis facilitates comparisons between one
year and previous years and assists forecasting the next year. For example, there may be
seasonal factors affecting the business, which will even out over the year. An ice-cream
vendor will expect to make more sales in the summer months than in the winter months. He

would not be able to tell if business is improving by looking at accounts for six months ended
31 March 20XX and comparing them with accounts for the six months ended 30 September
20XX. True comparison of profit/loss can be gained only when he examines his accounts for
the years (say) 31 March 20X1 and 31 March 20X2.
Accounts normally have to be prepared annually for tax purposes as tax is assessed on
profits of a 12-month accounting period. In the case of limited companies, accounts are
prepared annually to the "accounting reference date". It is necessary to calculate annually
the amount of profit available for distribution to shareholders by way of dividend.

E. THE MAIN CHARACTERISTICS OF USEFUL
INFORMATION
A number of attempts have been made since the 1970s to create some form of conceptual
framework for financial accounting. The IASBs version, the Framework for the Preparation
and Presentation of Financial Statements, was issued in 1989. This document is separate
from the IASs and IFRSs and basically assembles the body of accounting theory so that
standards are formulated on a consistent basis and not in an ad hoc manner. The
framework has several sections, but the two we will discuss here are the underlying
assumptions in the preparation of financial statements and the qualitative characteristics of
such statements.

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Underlying Assumptions

These are twofold – accruals and going concern
(a)

Accruals
Accruals is taking into account or matching income and expenditure occurring within
an accounting period, whether actual cash is received or paid during the time or not.
The reasoning behind the assumption is that profit for the period should represent fairly
the earnings of the time covered and, in view of the dynamic nature of any business, it
is unlikely that all invoices will have been paid. However, they should be accounted for
to give a true picture.
A distinction is made between the receipt of cash and the right to receive cash, and
between the payment of cash and the legal obligation to pay cash. The accruals
assumption requires the accountant to include as expenses or income those sums
which are due and payable.
You need to remember what the following terms mean:


Receipt – the receipt of cash or cheques by the business, normally in return for
goods or services rendered. The receipt may relate to another financial period,
e.g. it may be for goods sold at the end of the previous period.



Payment – the payment of cash or cheques by the business in return for goods
or services received. Again, a payment may be in respect of goods purchased in
the previous financial year or a service to be rendered in the future, e.g. rates
payable in advance.

Additionally, the term "capital receipt" is used to describe amounts received from the
sale of fixed assets or investments, and similarly "capital payment" might relate to an

amount paid for the purchase of a fixed (i.e. long-term) asset.


Revenue income – the income which a business earns when it sells its goods.
Revenue is recognised when the goods pass to the customer, NOT when the
customer pays.



Expenses – these include all resources used up or incurred by a business
during a financial year irrespective of when they are paid for. They include
salaries, wages, rates, rent, telephone, stationery, etc.

To help you understand the significance of these terms, here are a few examples
(financial year ending 31 December):


Telephone bill £200 paid January Year 2 relating to previous quarter = Payment
Year 2; Expense Year 1.



Debtors pay £500 in January Year 2 for goods supplied (sales) in Year 1 =
Receipt Year 2; Revenue Income Year 1.



Rent paid £1,000 July Year 1 for the period 1 July Year 1 to 30 June Year 2 =
Payment £1,000 Year 1; Expense Year 1 £500, Expense Year 2 £500.

In a later study unit we will see how these matters are dealt with in the final accounts.
(b)

Going Concern
This assumption infers that the business is going on steadily trading from year to year
without reducing its operations.
You can often see if an organisation is in financial trouble, for example if it lacks
working capital, and in these circumstances it would not be correct to follow this
concept. It would probably be better to draw up a statement of affairs, valuing assets
on a break-up basis rather than reflecting the business as a going concern (i.e. on the

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basis of a sudden sale of all the assets, where the sale prices of the assets would be
less than on ordinary sale).
Inclusion of other potential liabilities might be necessary to reflect the situation properly
– for example, payments on redundancy, pensions accrued, liabilities arising because
of non-completion of contracts.
Thus, the going concern concept directly influences values, on whatever basis they are
measured

Qualitative Characteristics of Financial Statements
These characteristics are the attributes that make the information provided useful to users.

The IASB state that there are four principal characteristics – understandability, relevance,
reliability and comparability. We will deal with each of these in turn.
(a)

Understandability
Information provided to users must not be so complex that a user with a reasonable
knowledge of business and economic activities and accounting, and a willingness to
study the information with reasonable diligence, would not be able to understand it.
There is a fine balancing act needed here by preparers of financial statements to
ensure that all information relevant to users is given to them even though it may be
complex.

(b)

Relevance
To be useful, information must be relevant to the decision-making needs of users.
Relevance is closely related to its predictive role – that is the extent to which the
information helps users to predict the organisation's future and so make decisions
about it. For example, the attempt by a potential investor to predict future profitability
and dividend levels will be at least partly based on the financial statements. A sub
characteristic to relevance is materiality – Information is material and therefore relevant
if its omission or mis-statement could influence the economic decisions of users.
Materiality depends of the size of the item or error judged in the particular
circumstances.

(c)

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 that which it either purports to

represent or could reasonably be expected to represent.
There is quite often a conflict between relevant and reliable information. Information
may be relevant, but so unreliable in nature or representation that its recognition may
be potentially misleading. For example, if the validity and amount of a claim for
damages under a legal action are disputed, it may be inappropriate for the business to
recognise the full amount of the claim in the balance sheet as this would provide
unreliable information. However, to ensure relevance, it would be appropriate to
disclose the amount and circumstances of the claim in a note to the accounts.
Reliable information also requires several sub-characteristics to be present as follows:


Faithful representation – information provided must represent faithfully those
transactions and other events it purports to represent.



Substance over form – transactions need to be accounted for in accordance with
their substance not merely their legal form. Substance is not always consistent
with legal form. For example, a business may dispose of an asset to another
party in such a way that documentation purports to pass legal ownership to that
party; nevertheless, though, agreements may exist that ensure that the business

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continues to enjoy the future economic benefits within the asset. In such
circumstances a sale would not represent faithfully the transaction entered into.
Such agreements are generally referred to as "sale and buy back". Another
example of substance over form is a finance lease which we will refer to later.

(d)



Neutrality – information must be neutral, that is free from bias and provided in an
objective manner. This also ensures that the characteristic of prudence must not
override all other characteristics



Prudence – as preparers have to contend with the uncertainties that inevitably
surround many events and transactions, then a degree of caution must be
brought to bear when making judgements on such events and transactions. This
degree of caution is required such that assets or income are not overstated and
liabilities or expenses are not understated. For example, when assessing the
useful life of plant and equipment, preparers must be cautious in their estimate
but not deliberately pessimistic. The exercise of prudence does not allow the
creation of hidden reserves or excessive provisions as this would result in the
accounts not being neutral.



Completeness – for information to be reliable it must be complete within the
bounds of materiality and cost. An omission can cause information to be false or

misleading and thus unreliable and deficient in terms of its relevance.

Comparability
Users need to be able to compare financial statements of a business through time in
order to identify trends in its financial position and performance. Users also need to be
able to compare one business with another and, therefore, the measurement and
display of the financial effect of transactions and other events must be carried out in a
consistent way for different entities. Thus, we have the need for accounting standards
from this characteristic.

In can be quite difficult to ensure that all four main characteristics and their
subcharacteristics are applied when preparing financial statements. In practice, a balancing
or trade-off between the characteristics is often necessary. Generally, the aim is to achieve
an appropriate balance among the characteristics in order to meet the objectives of financial
statements which is to provide useful information to users.

F.

THE TWELVE TRADITIONAL ACCOUNTING CONCEPTS

Over a period of time a number of conventions/concepts have been postulated by various
bodies interested in financial statements. Many of these are incorporated in the above
characteristics, but for completeness of your study we provide them here. These concepts
are incorporated by preparers in current financial statements.

Prudence
Prudence is proper caution in measuring profit and income.
Where sales are made for cash, profit and income can be accounted for in full. Where sales
are made on a credit basis, however, the question of the certainty of profits or incomes
arises. If there is not a good chance of receiving money in full, no sales are made on credit

anyway; but if, in the interval between the sale and the receipt of cash, it becomes doubtful
that the cash will be received, prudence dictates that a full provision for the sum outstanding
should be made. A provision being an amount which is set aside via the profit and loss
account.

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The two main aspects of this concept are that:


Income should not be anticipated and all possible losses should be provided for.



The method of valuation of an asset which gives the lesser value should always be
chosen.

Prudence is often exercised subjectively on grounds of experience and is likely, in general, to
lead to an understatement of profit. The subjectivity involved can lead to variation between
accountants in the amount of provision for bad debts, etc. and is bound to create differences
between results obtained by the same general method of measurement. Users are therefore
provided with pictures of various businesses which although apparently comparable, in fact
conceal individual distortions.

In long-term credit arrangements, such as hire-purchase agreements, difficulties arise in the
actual realisation of income and profit. The date of the sale, whether on a cash or credit
basis, is usually regarded as the date of realisation; but if you have money coming in over
two or three years, measurement of the actual sum realised is subject to controversy.

Going Concern
As noted above, this concept assumes that the business is going on steadily trading from
year to year without reducing its operations.

Consistency
This is one of the most useful concepts from the point of view of users who need to follow
accounting statements through from year to year. Put simply, it involves using unvarying
accounting treatments from one accounting period to the next – for example, in respect of
stock valuation, etc.
You can only identify a trend with certainty if accounts are consistent over long periods;
otherwise, the graph of a supposed trend may only reflect a lack of precision or a change of
accounting policies. However, there will usually be changes or inconsistencies in accounting
policies over the years and in public accounts it is essential to stress these changes so that
users can make proper allowance for differences.

Money Measurement
Whether in historic or current terms, money is used as the unit of account to express
information on a business and, from analysis of the figures, assumptions can be made by
the users.
As we have seen, though, this concept of a common unit goes only some way towards
meeting user needs, though, and further explanation is often needed on non-monetary
requirements – such as the experience of the management team, labour turnover, social
policy.

Duality

Each item in a business has two accountancy aspects, reflected in its accounting treatment
as follows:


Double-entry book-keeping requires each transaction to be entered twice – once as a
debit and once as a credit. The debit represents an increase in the assets of the
company or an expense, and the credit entry represents a reduction in the cash
balance to pay for the item, or an increase in the level of credit taken.



The assets of a business are shown in one section of a balance sheet and the liabilities
in another.

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There is little to criticise in this duality, but we are looking behind the framework at the
efficiency of the system and judging it by its success in meeting user needs. Duality falls
short in the same sphere as money measurement, because there are areas in which it is not
relevant.

Matching
Often considered the same as the accruals concept, matching calls for the revenue earned

in a period to be linked with related costs. This gives rise to accruals and prepayments
which account for the difference between cash flow and profit and loss information. This
distinction will be clarified when you look at examples later.

Cost
As money is used to record items in the business accounts, each item has a cost.
Accountants determine the value of an asset by reference to its purchase price, not to the
value of the returns which are expected to be realised. Many problems are raised by this
convention, particularly in respect of the effect of inflation upon asset values.
This can also be considered as the historic cost concept.

Materiality
Accounting for every single item individually in the accounts of a multi-million pound concern
would not be cost-effective.
A user would gain no benefit from learning that a stock figure of £200,000 included £140
work-in-progress as distinct from raw materials. Neither would it make much difference that
property cost £429,872 rather than £430,000. Indeed, rounded figures give clarity to
published statements. So, when they are preparing financial statements, accountants do not
concern themselves with minor items. They attempt rather to prepare clear and sensible
accounts.
The concept of materiality leaves accounts open to the charge that they are not strictly
accurate, but generally the advantages outweigh this shortcoming.

Objectivity
Financial statements should be produced free from bias (not a rosy picture to a potential
lender and a poor result for the taxman, for instance). Reports should be capable of
verification – a difficult problem with cash forecasts.

Realisation
Any change in the value of an asset may not be recognised until the moment the firm

realises or disposes of that asset. For example, even if a sale is on credit, we recognise
the revenue as soon as the goods are passed to the customer.
However, unrealised gains, such as increases in the value of stock prior to resale, are now
widely recognised by non-accountants (e.g. bankers) and this can lead to problems with this
concept.

Business Entity Concept
The affairs of the business are distinguished from the personal affairs of the owner(s). Thus
a separate capital account is maintained in the business books, which records the business's
indebtedness to the owner(s).

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