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Chapter 1
FINANCIAL STATEMENTS, ACCOUNTING
PRINCIPLES AND ACCOUNTING
STANDARDS

1. Introduction

The income statement and the statement of financial position are the key documents in the
financial statement of any business.

You need to know how these are usually set out and the terminology that is used.

2. Types of business transaction

An organization can be defined as:

A social arrangement which pursues collective goals,which controls its own performance and
which has a boundary separating it from its environment.

Organisations can include businesses such as comparies and partnerships, clubs, charities,
government departments,hospitals and schools.

Even if not strictly a ‘business’all organisations will have business transactions. Typically these will
include:

 Purchasing goods and materials.Purchases can be for cash or credit.Cash purchases are
paid for immediately and are fairly rate in most business.Credit purchases are paid for after
some time,typically a month or so
 Purchasing services, for example,repairs to equipment, advertising,printing costs.
 Sales.Cash sales,for example in shops, are paid for immediately.Credit sales are paid for
after some time.
 Paying wages and salaries.
 Purchase of non-current assets.
 Raising finance and paying rewards to the suppliers of finance.For example,owners putting
in capital or loans being raised form banks.Owners of the business expect rewards based on
a share of the profit; banks usually expect interest to be paid.
 Accounting for and paying tax.
 Movements of cash and money in the bank account.These movements usually arise from
the transactions above.
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3. Types of business documentation

Each type of business transaction has its own set of documentation . The documentation is needed
to:

 Control the progress of the transaction

 Record the transaction
 Provide a history of how the transaction proceeded.This is sometimes known as an ‘audit
trail’

Sometimes the documentation is purely internal; sometimes it arises externally or is set outside
the business. Nowadays,the term ‘documentation’ is not confined to paper documents only as
many business transactions are mostly handled using computerized records.

Typical documentation is as follows:

Purchase of goods and materials: this will usually be initiated by someone in the warehouse or
factory who can see that more material will soom be needed. Often this person raises a purchase
requisition which goes the buyers’ department.Buyers will then raise a purchase order to order
goods from the most suitable supplier.Goods , accompanied by the supplier’s delivery note,will be
received in the warehouse ,were a good received note will be raised.These must be checked back
to the order to ensure that the correct goods are being received.Invoices from suppliers will be
received and recorded by the accounting department first in a purchases day book (just a list of
invoices received)and then in the payables ledger.Usually suppliers will send statements of
account setting out the amounts still owed.Statements act as reminders and also they can be used
to check that buyers agree with suppliers’ versions of events.Later the invoices will be paid and a
remittance advice sent by the customer to indicate which invoices have been settled.

If goods are returned to suppliers (for example their quality was poor)then buyers will ask for a
credit note.This acts like a negative invoice.

Purchasing services: often, these will be recurring items such as rent,electricity ,telephone and
insurance,and an invoice will be received Sometimes they will be once-off like paying for an
advertisement in a newspaper or for the repair of a piece of equipment.These services should have
a purchase order. The invoices will be processed by the accounting department who will make
sure that the expenses look reasonable compared to previous amounts or who will ensure that the
services have been properly ordered and received.

Sales: in a retail organization sales will be intiated by customers either in a shop or through the
internet.Payment will usually take place immediately and the customer given a till(cash register)
receipt; a copy of the sales is also recorded by the cash register system.In businesses selling to
other businesses,the sales representatives (sales men and sales women)will be responsible for
encouraging customers to place sales orders.Once received ,order should result in goods dispatch
notes being raised and these act as authorization to dispatch the goods from the warehouse and
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for also sales invoices being created and sent to the customers by the accounting department.The
accounting department will also record each invoice in a sales day book (just a list of invoices)and
will then record what each customer owes in the receivables ledger.

Most businesses will send customers statements of account which set out the amounts still owed
by customers.Statements act as reminders to customers about what needs to be paid and they
also allow customers to check that they agree with the seller’s vesion of events. Payments by
credit customers should be accompanied by remittance advices which detail what is being paid.

If goods are returned by customers (for example their quality was poor)then customers will ask for
a credit note.This acts like a negative invoice.

Paying employees: large organisations will have a wages and salaries department which is
responsible for calculating amounts owing,and dealing with employees who leave and with new
joiners. Sometimes the payments are the same every week or month;sometimes they depend on
time records (such as clock cards). In both cases employees will receive a wage or salary slip
showing their pay and any deductions for tax etc.The amounts to be paid will usually be passed to
the accounting department which will look after cash transfers to employees.

Purchase of non-current assets: The purchase of these assets will often begin with en employee
raising a purchase requisition,for example for a new printer,which is then authorized by a
manager or by the company account.When the invoice is received,someone needs to ensure that
asset has been received and that it is working properly.These paryments are handled in a similay
way to purchases of goods and raw materials.

Finance.In companies ,shares can be issued in exchange for new share capital.Loans will usually be
accompanied by a loan agreement setting out the terms of the loan.

Tax will be paid in response to an assessment by the tax authorities.

Movements in cash and bank account amouts require careful documentation.Cash payments are
usually small and usually made through the petty cash system where payments will be supported
by petty cash vouchers.Payments from bank accounts will be by cheque or credit transfer.Credit
transfers can be;

 Specially initiated by the company

 Automatic constant amount (standing orders)
 Initiated by the person receiving the money (direct debits).

In all cases there should be documentation to back up the payments.

All to these transactions are recorded in the books of account (described in detail in a later
chapter).The information is summarized at the end of accounting periods into two statements:
 Income statement
 Statement of financial position

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4. Income statement

This shows the sales made and the costs incurred in a period.Sales less costs will show the profit
made in the period(or if costs are greater than sales,the loss for the period).You might sometimes
still hear this document referred to as the ‘Profit and loss account’, but that is no longer official
terminology and you should try not to use it.

If the income statement is for a limited company its presentation is usually defined by
statute,because limited companies are closely regulated.If it is for a sole trader or a
partnership,then there can be more flexibility.

The typical layout is:

Notes
1 ABC Limited
2 Income statement for the year ended 31 December 2014
$ $
3 Sales X
4 Less: cost of sales (X)
5 Gross profit X
6 Selling costs X
6 Distribution costs X
6 Administration costs X
X
7 Net profit X

Notes
1 The name of the entity must be stated.
2 Income statements are for periods.Typically they show income,expenses and profits for a
period of a year.However,other periods are also possible.
3 Sales,or revenue,is what is sold in the period.This will exclude any sales tax that customers
are charged because that is a tax passed onto the government,not a sale.
4 Cost of sales.The cost of sales is the direct costs of buying or making whatever is sold.Cost
of sales is not generally the same as what was purchase because there can be opening and
closing inventory.
Cost of sales = Opening inventory + Purchase – Closing inventory
The inventory adjustment ensures that sales are properly matched with the cost off the
goods sold:
Opening inventory + Purchases equal all the items that were available for sale.
Closing inventory is what was not sold.
5 The gross profit is sales less cost of sales .Think of this as the main-spring of the business. If
gross profit is poor ,very poor profits will be made overall.

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6 In a company’s income statement,typically other expenses are grouped and summarized as
show into selling distribution and administration costs .This keeps the income statement
relatively uncluttered.More details can be provided as notes to the financial statements.
7 The net profit is what’s left after all expenses.Out of this ,companies will pay their
corporation tax(for example a simple percentage of the new profit).Anything left can be
kept in the business or paid out as dividends to reward shareholders)or taken as drawings in
an unincorporated business).

The income statement of an unincorporated business (a sole trader for example)could look
identical,but often the expenses will be listed in greater detail.

5. The statement of financial position

As the name of this document suggests the statement of financial position (“SOFP”)shows the
financial position of a business at a point in time .You might sometimes hear this document
referred to as a ‘balance sheet’,but this is old terminology and you should try to avoid it.
It shows:
 Assets (non-current assets and current assets)
 Liabilities (non-current liabilities and current liabilities)
 Capital
The typical layout is:
Notes
1 ABC Limited
2 statement of financial position as at 31 December 2014
$ $
3 Non current assets:
Land and buildings X
Machinery X
Vehicles X
X
4 Current assets X
Inventory X
Receivables X
Cash at bank and in hand X
X
X
5 Capital
Capital introduced X
Retained profits X
X
Non-current liabilities
Bank loan X
Current liabilities
Payables X
Overdraft X
X
X

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Notes
1 The name of the entity must be stated.
Statements of financial position are drafted for a point in time.
Non-current assets are used by the business to make profits and have a life of longer than one
accounting period. They are not regularly bought and sold as trading goods are.
Current assts are either cash or expected to become cash within one year.They are presented in
increasing order of liquidity.So, inventory has to be first sold and then the sales proceeds have to
be collected.That could all take many months.Customers (receivables)are usually expected to pay
within a month or so. Cash is already cash.So,the ‘bad news’comes first because some inventory
might never sell and might never become cash.
Capital arise from capital introduced by the owners of the business and from retained profits.Any
withdrawal of profits by the owners will reduce the retained profit and therefore will reduce the
capital of the business.
Non-current liabilities are liabilities that have to be settled more than 12 months .For example , a
bank loan being repaid over five years.
Current liabilities have to be settled in less than 12 months .Note that overdrafts are repayable on
demand.
The figures maked by the arrows should be equal:
Assets = Liabilities + Capital (amount owed to the owners)
In essence,the statement of financial position sets out the accouting equation covered in more
detail in a later chapter).

6. The conceptual framework of accounting

There are certain principles which underpi accouting and accouts preparation.You need to know
what these are:
1 Going concern: the assumption that the business will continue functioning in the
foreseeable future.This can affect the valuation of many assets because if the business
closes,assets might have to be disposed of at their scrap values.
2 Accruals: income and expenses should be matched on a time basis,not just when cash is
received or paid.
3 Consistency: financial statements should be drawn up using the same approaches each
year.If for example,the way an amount is altered then profits could be affected or
manipulated.
4 Double entry: every transaction has matching Debit and Credit entries in the bookkeeping
system.

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5 Business entity: accouting records record the transactions of the business entity,not the
transactions of its owners.
6 Materiality: an item is material if its misstatement could alter the economic decisions of
user of the financial statements.Immaterial items do not have to be disclosed- indeed too
much information can be confusing.
7 Historical cost: transactions are recorded at their historical cost.

There are also certain qualitative characteristics of accounting,which you also need to know.These
are:
1 Relevance : financial information is regarded as relevant if it is capable of influencing the
decisions of users.Therefore,all relevant information should be included in financial
statements.
2 Faithful representation : financial information must be complete,neutral and free from
error otherwise it will mislead users of the financial statements.
3 Comparability: financial information should be capable of being compared over time and
with similar information about other entities.if it is not comparable ,then interpretation and
understanding is difficult.
4 Verifiability: the accounting information should be capable of being verified through
auditing procedures.This allows users to place more trust in the information.
5 Timeliness: information should be provided quickly enough to be of use in decision-making .
6 Unterstandability: information should be presented in a way that makes it understandable
to users. This can be done,for example ,by good layout,accurate descriptions and,where
necessary,notes explaining the information.

7 Accounting standards

At one time accountants had an enormous amount of discretion when it came to producing
financial statements.For example:
 There are many way in which inventory can be valued.
 There are different views on how money spent on research should be treated (is it an
expense or an investment)
 How should profits be take on large construction contracts which last several years? Spread
in some way or all taken at the very end of the contract?
Different accounting policies meant that it was hard to compare different entities because they
might use different approaches to accounting .Also it meat that some financial statements were
drawn up using approaches which might not be sufficiently prudent.
To bring consistency and prudence to the preparation of financial statements,there are now
potentially three sources of rules for many accounting issues:
National laws
 National laws
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 Local accounting standards
 International accounting standards (IAS)or international Financial Reporting Standards
IFRS).
National laws take precedence,then local standards,then international standards,though many
countries are adopting international standards.
IASs and IFRSs are developed by the international Accounting Standards Board in liaison with users
of financial statements ,academics,auditors,accounting bodies and industry.
You need to be aware of the main points covered by the following lASs:
IAS 1 Presentation of financial statements
IAS 2 Inventories
IAS 16 Property,plant and equipment
IFRS 15 Revenue
IAS 37 Provisions, contingent liabilities and contingent assets.
IAS 1 Presentation of financial statements
The objective of IAS 1 (2007) is to set out the basis for presentation of how general purpose
financial statements should be presented to ensure comparability with both the entity’s financial
statements of previous periods and with the financial statements of other entiites.IAS 1 sets out
the overall requirements for the presentation of financial statements,guidelines for their structure
and minimum requirements for their content.
IAS 2 Inventories
The fundamental principle of IAS 2 is that inventories (or stock) are must be stated at the lower of
cost and net realizable value.
Cost should include all:
 Costs of purchase (including taxes,transport,and handling )net of trade discounts received.
 Costs of conversion (including fixed and variable manufacturing overheards)
 Other costs incurred in bringing the inventories to their present location and condition.
Net realisable value is the estimated selling price in the ordinary course of business,less the
estimated cost of completion and the estimated costs necessary to make the sale.
IAS 16 Property, plant and equipment
Items of property,plant ,and equipment should be recognized as assets when:
 It is probable that the future economic benefits associated with the asset will flow to the
entity and
 The cost of the asset can be measured reliably.

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An item of property,plant and equipment should initially be recorded at cost.Cost includes all costs
necessary to bring the asset to working condition for its intended use.This would include not only
its original purchase price but also costs of site preparation ,delivery and handling,
installation,related professional fees for architects and engineers,and the estimated cost of
dismantling and removing the asset and restoring the site.
IAS 16 permits two accounting models:
Cost model: The asset is carried less accumulated depreciation and impairment.
Revaluation model.The asset is carried at a revalued amount,being its fair value at the date of
revaluation less subsequent depreciation and impairment,provided that fair value can be
measured reliably.
IFRS 15 Revenue
Revenue should be measured at the fair value of the consideration received or receivable .An
exchange for goods or services of a similar nature and value is not regarded as a transaction that
generates revenue.However,exchanges for dissimilar items are regarded as generating revenue.
Recognition of revenue can occur when:
 It is probable that any future economic benefit associated with the item of revenue will flow
to the entity,and
 The amount of revenue can be measured with reliability
IFRS 37 Provisions,contingent liabilities and contingent assets.
 Provision: -a liability of uncertain timing or amount.
 Liability -present obligation as a result of past events
-settlement is expected to result in an outflow of resources
(payment)
A contingent liability is a possible obligation arising from past events that depends on a future
event .For example,damages that might have to be paid are contingent on the findings of a court.
Similarly, a contingent asset arises from past events but which is dependent on future events.For
example,the amount of damages won can depend on the outcome of a court case.

Question 1

Which accounting principle says that income and expenditure should be matched on a time basis?
A Prudence
B Going concern
C Accruals

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D Business entity

Question 2

IAS 2states that inventories are must be stated at the lower of cost and net realizable value.
Which two accounting principles are in conflict if inventory is valued at net realizable value?
A Materiality and prudence
B Consistency and accruals
C Materiality and historical cost
D Prudence and accruals

Question 3

Going concern is the assumption that a business will:

A continue for the foreseeable future
B continue for the next 5 years
C be profitable in the future
D will shortly be closed down

Question 4

In its previous financial statements a business valued inventory using FIFO. In its current financial
statements it has adopted the cumulative average approach.
Which accounting principle would this violate?

A Prudence
B Consistency
C Historical cost
D Understandability

Question 5

A business bought a machine for $10,000.Delivery cost $500 and installation cost $1,000.
What is the cost of the machine according to IAS 16 ?
A $10,000
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B $10,500
C $11,000
D $11,500

Question 6

What do the following statements define according to IAS 37?

Present obligation as a result of past events
Settlement is expected to result in an outflow of resources (payment)
A A liability
B A contingent liability
C A provision
D A contingent asset.

Question 7

What is the purpose of a statement of account sent to a customer?

A It is a demand for payment
B It states to the customer what goods have been sent
C It tells the customer what is owed as a reminder and as a check
D It states the credit limit on the account.

Question 8

A remittance advice:
A Advises on what has to be paid
B Gives information about what is being paid
C Advises about goods being returned
D Gives information about wages being paid

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