Introduction to accounts

The accounting framework

Each year a company will publish four main types of accounting
statement:
1. a statement of profit or loss (part of a statement of comprehensive
income), showing the income, expenses and hence shareholders’
profits for the year
2. a statement of financial position (also known as a balance sheet),
showing the assets, liabilities and shareholders’ funds at the end of
the year.
3. a cashflow statement to show where cash has come from and how it
has been spent
4. a statement of changes in equity to show how the composition of
equity has changed over the year.

USERS (NOT SO IMP)

→It has been suggested that financial statements have four groups of users: • equity investors (ie
both actual and potential shareholders) • loan creditors (both long-term and short-term) •
employees • business contacts (ie customers and suppliers).
→The accounts have many other uses, and will be used by: • a stock exchange to ensure that certain
requirements are met • the management themselves as a source of information • the tax authorities
as a starting point in the calculation of the tax liability • stock analysts as a source of financial
information • credit rating agencies in order to assess the creditworthiness of the company.

(IMPORTANT FROM BELOW)

equity investors ~
1 Investment decisions require information about profits (including dividend
policy) cashflows.
2 Analysts are constantly preparing and updating forecasts of performance.
The annual report provides an opportunity to ‘fine tune’ these forecasts.

loan creditors
1 Lending decisions involve the measurement of the risk of default.
2 A lender wants to know whether a business can generate sufficient cash to
repay any loan.
3 The lender will also wish to ensure that the business has an adequate asset
base to meet its obligations in the event of failure.
4 To this end, loan agreements often contain restrictive covenants which are
based on figures from the accounts. (Covenants specify a minimum or
maximum value for accounting ratios, such as the gearing ratio)

Employees
1 Employees are interested in the enterprise’s ability to pay salaries and offer
job security.

business contacts
1 Business contacts are interested in continuity of sales (to customers) and of
materials and services (from the suppliers). Their interest is, therefore, similar
to that of the shareholders.
2 They may also use accounting information to try to gain some insight into the
company’s pricing and trading policies.
…………………………………………………………………………………………………………………………………………………………….
In addition to the ‘legitimate’ users described above, the financial statements
will also be read by:
• government agencies (including the tax authorities)
• competitors
• potential predators.
→The relationship between the management of a company and the various
users listed above can be complex.
→ At best there is likely to be a degree of mistrust. For example, shareholders
might be concerned that the directors will act in their own best interests even
when this would be to the detriment of the company.
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→At worst there will be outright hostility. For example, the directors are
unlikely to volunteer information about the company’s performance if that
could be used by a potential competitor. Management might, therefore, be
tempted to withhold information or to distort any figures which they do
publish.
Sources of regulation
The credibility of financial statements is protected by regulations from a number of sources.

Statutory(required) requirements
In many countries, national legislation may be in place to tell what kind of
information should be published in financial statements. For example, in the
UK, the Companies Act requires companies to produce:
1 A statement of financial position showing the financial position on the last
day of the company’s financial year.
2 A statement of profit or loss for the financial year.
3 detailed disclosures which are normally presented as a series of notes to the
accounts.
4 a directors’ report.
5 an auditors’ report.

→Small companies have much less onerous requirements and do

not submit audited accounts.
→The auditors are appointed by the shareholders and report to them only, so the auditors
are completely independent of the directors.
Directors’ report
The main items that a directors’ report must contain are:
1 Certain detail about the company’s activities over the previous year, and
likely events in the coming twelve months. Opinions are expressed by the
directors.
2 A brief summary of the financial decisions that the directors have made,
including the proposed dividend, the amount of shareholders’ profits retained
by the company, charitable donations made by the company and details of any
of the company’s own shares that have been purchased during the year.
3 Details of persons who were directors during the year, their shareholdings
and their other interests in the company.
GENERAL POINTS TO REMEMBER
1-Companies Act’s accounting requirements run to dozens of pages of detailed
rules. There is, however, one overriding requirement. That is that the financial
statements must give a ‘true and fair view’.

2 Directors must consider whether, taken in the round, the financial

statements that they approve are appropriate.
3 Similarly, auditors are required to exercise professional judgement before
expressing an audit opinion. As a result, it will not be sufficient for either
directors or auditors to reach such conclusions solely because the financial
statements were prepared in accordance with applicable accounting
standards.

The International Accounting Standards Board (IASB)

→The International Accounting Standards Board (IASB) is a body that develops,

issues and withdraws accounting standards.
→The standards that are issued by the IASB are called International Financial
Reporting Standards (IFRSs).
→International standards relate to companies and other kinds of entities
which prepare accounts intended to provide a true and fair view.
→The IASB has no authority to require compliance with its accounting
standards. However, many countries require the financial statements of
publicly traded enterprises to be prepared in accordance with IFRSs

→The IASB collaborates with national accounting standard setters in many

countries in order to ensure that its standards are developed with due regard
to international and national developments.
→International accounting standards have helped both to improve and
harmonise financial reporting around the world.

The case for and against international standards

→Whatever the arguments for and against accounting standards, there is no doubt that they
have greatly improved accounting practice.
→ Before their introduction, different companies in similar circumstances were following
completely different accounting policies, leading to different and incompatible results.

→In the 1960s, there was a series of financial scandals that drew the public’s attention to the
flexibility of the accounting rules at that time.
→ In several cases where takeovers occurred, different accountants produced radically
different results for the same company. The accountancy profession was publicly criticised
and this led to the formation of the UK’s first accounting standard-setting body
 Typical contents of an annual report

The auditors’ report

→In the UK, every company above a certain size (in terms of turnover, assets
or number of employees) is required by the Companies Act 2006 to appoint
auditors to hold office from one annual general meeting to the next.
→The auditors must report to the shareholders on the published accounts.
→Auditors are elected by the shareholders and shareholders approve
the auditors’ fee.

IMPORTANT

Variations on the standard report

The wording of the standard report can be modified if the auditor wishes to
highlight areas of uncertainty or is unable to express an unqualified opinion that
the financial statements give a true and fair view.
There are various degrees of qualification:
• emphasis of matter paragraphs
• qualified opinion
• disclaimer of opinion
• adverse opinion

1) Emphasis of matter paragraphs

→If there is a significant uncertainty which has been disclosed in the
accounts, the auditor should point this out for the sake of emphasis.
→That means that it is unnecessary to issue a qualified audit report
because the financial statements give a true and fair view
→That means that it is unnecessary to issue a qualified audit report
because the financial statements give a true and fair view
→Management has disclosed the problem and the auditor has taken
care to ensure that the shareholders have read the disclosure.
2) Qualified opinion
→A qualified opinion effectively states that the financial statements
give a true and fair view ‘except for’ the problem that has been
described in the body of the audit report.
3) Disclaimer of opinion
→If the auditor is faced with such extreme uncertainty about the
financial statements that it is impossible to express an opinion then
the auditor would issue a disclaimer instead (‘we are unable to form
an opinion’).
4) Adverse opinion
→The auditor issues an adverse opinion in extreme cases of
disagreement where the financial statements have been rendered so
misleading that it must be stated that they do not give a true and fair
view.
→a company fails to comply with the Companies Act, the directors can
be required to pay for the preparation of a revised set of accounts.

Accounting concepts
→Accounting standards are based on concepts and conventions
which have gradually come together and evolved over many years
since bookkeeping and accountancy came into being.

The 11 accounting concepts we discuss in detail are:

1) The cost concept

→The cost concept has been presented as one of the
cornerstones of accounting for a very long time. Under this
concept, non-current assets generally appear in the statement of
financial position at their original cost less depreciation up to
date.
→The cost concept is being gradually phased out to provide more
scope for realism in the financial statements. For example,
tangible non-current assets such as property, plant and
equipment can be shown at their fair value rather than their
historical costs.
→The movement from cost to fair value indicates that the
accountancy profession is constantly reviewing the advantages
 and disadvantages of competing approaches. For example, cost
was favoured in the past because it is generally a defensible and
reliable measure. There is now greater reliance on fair values
because they offer a more relevant measure of the value of the
resources controlled by the company.
→ For example, it would be over-prudent to allow land to remain
at original cost in the balance sheet if it is worth ten times what
the company paid for it. That is why ‘fair values’ are permitted

2) The money measurement concept

→Accounting statements restrict themselves to matters which
can be measured objectively in money terms. Again, this simplifies
accounting enormously.
→It also means that a statement of financial position will rarely
give even a rough approximation of the value of the business
because it will exclude such items as the values of the company’s
customer base, its workforce and its brand names.

3) The business entity concept

→The affairs of the business are kept separate from those of the
owners. This is perfectly valid in the case of a limited company,
which has its own legal identity. It would, however, also apply to
sole traders and partnerships where the business does not have a
separate legal form.

4) The realisation concept

→Income is recognised as and when it is ‘earned’.
→It is not, therefore, necessary to wait until the customer settles
his or her bill. This avoids the fluctuations in reported income
which might arise if everything was accounted for on a cash basis.
→A business might report income long before the related cash
inflows which may be a problem for a growing business.
→ (not important) This concept runs alongside the accruals
concept by emphasising the fact that profit should be recognised
in the period it is earned, rather than when the financial
settlement takes place. If a company has sold its products or
services, then the sales should be recognised in the accounts. The
 fact that the company might not have received payment is an
entirely separate concern. The profitability of the business is
measured through the statement of profit or loss and the
cashflow is dealt with through the cashflow statement and the
provision for bad debts.
5) The accruals concept
→Expenses are recognised as and when they are incurred,
regardless of whether the amount has been paid.
→Suppose for example, that on 1 February, a drug company pays
the quarterly rental on its development laboratories for the period
February, March and April, then completes its accounts for the
year to March. The company would be justified in allocating only
two thirds of the rental payment in the period to the end of
March.
6) The matching concept
→income and expenses which relate to each other should be
matched together and dealt with in the same statement of profit
or loss.
→Expenditure incurred in generating the income for a period
should be recorded as incurred over the same period, ie the
expenditure is matched to the income.
7) The Dual aspect concept
→The dual aspect concept recognises that every transaction or
adjustment will affect two figures. For example, the purchase of
inventory for cash will increase the asset of inventory and reduce
the asset of cash. This concept forms the basis for the double
entry bookkeeping system.
8) Materiality
→There is little point in providing information which is so detailed
as to be unintelligible. The statements can, therefore, be made
clearer by showing totals such as ‘administrative expenses’
instead of listing every item which makes this heading up.
→Similarly, there is very little point in making minute adjustments
which have no real effect on the overall picture portrayed by the
financial statements.
→. Accountants might report rough approximations for certain
costs rather than waste time calculating more precise figures.
9) Prudence
→The preparers of the financial statements should avoid presenting
an unduly optimistic set of results.
→The lowest reasonable figure should be stated for profit or for any
of the assets. The highest reasonable figure should be stated for any
liabilities. This means that there is very little danger of the figures
lulling anybody into a false sense of security by overstating the
company’s strengths.
→However, it is not permitted to include deliberate margins in the
financial statements by understating assets or revenues or by
overstating expenses or liabilities. Prudence should only be applied in
situations where there is uncertainty.

10) The going concern concept

→It is usually assumed that a business will continue indefinitely
in its present form.
→The going concern concept means that the enterprise ‘will
continue in operational existence for the foreseeable future’.

11) Consistency
→The figures published by the company should be comparable
from one year to the next. Accounting policies should not,
therefore, be changed from one year to the next unless there is a
very good reason for doing so
→Any changes should be highlighted and their impact explained,
which may involve restating prior year figures in the accounts.

Bringing the concepts together

Most are designed to make the statements easier to prepare (eg

the money measurement concept) while other are designed to
make the statements more useful (eg accruals produces more
meaningful profit figures). When taken together, however, the
concepts often conflict with one another and this makes their
application confusing for accountants and readers of financial
statements alike.
The most obvious conflicts are between the concept of prudence
and the going concern and realisation concepts.

There can sometimes be a conflict between relevance and

reliability. For example, valuing assets at cost is very reliable
because the cost is a historical fact. Unfortunately, cost is unlikely
to be very relevant to most decisions. Valuations tend to be more
useful, but they can be unreliable unless they can be based on
clear and observable market prices which are rarely available in
the real world.