Chapter 1

Entities and financial reporting statements

An
Introduction to
Financial
Accounting
9th edition

Andrew Thomas & Anne Marie Ward

© McGraw-Hill Education 2019

 Chapterobjectives
Chapter objectives

By the end of the lecture (and with private study) students should
be able to:
• Discuss the nature and functions of financial accounting.
• Outline the differences between a company, a member-governed body,
a sole trader and a partnership.
• Describe the financial statements for sole traders, partnerships and
companies.
• List the typical contents of a company’s published annual report.
• Describe the main regulatory influences on financial reporting

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 Financial statements
In its earliest form, accounting involved keeping ‘a count’ of
items (assets and liabilities) - known as stewardship
accounting. Today, this information is included in the
statement of financial position.

To help the external owners assess the performance of a

company (income less expenditure) and the performance of
management, a statement of profit or loss or the statement of
comprehensive income is required.

The two statements are published together with other related

information, in the annual report.

In some instances a third statement is required, called the

statement of cash flows (sources and uses of cash).
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 Two main types of accounting

Financial accounting is concerned with the

preparation of reports for external
stakeholders and management accounting is
concerned with the preparation of reports for
internal management purposes.

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 Financial accounting

• The process of designing and operating an

information system for collecting,
measuring and recording an enterprise’s
transactions, and;
• Summarising and communicating the
results of these transactions to users to
facilitate making financial/ economic
decisions.

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 Objectives of an appropriate
accounting system

• To record and control business transactions

• To maintain accuracy in recording

• To present final financial statements to the

owners of the business

• To present other financial reports and analyses

• To facilitate the efficient allocation of resources

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 Financial statements

Statement of profit or loss

Shows the income generated, expenditure incurred and
resultant profit or loss for a specified period of time,
typically one year, including:
• Revenue from operating activities.
• Expenses from operating activities.
• Profit or loss in the period from operating activities.
• Other income or expenses.

COMPANIES typically also include other comprehensive

income.

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 P/L - Terminology
• Revenue is income earned in the period from
normal trading activities (called operating).

• When an entity has income from activities that are

not its core business, such as receiving interest,
then this is disclosed separately, as ‘other income’.

• Expenses are yearly running costs. They are used

up in the period being reported on. E.g. electricity
used to generate heat and light, rent for the period.

• Profit or loss is the total income made by the entity

in the period less the total expenses incurred by
the entity in the period.
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 Financial statements
Statement of financial position (SOFP) - Statements
showing the assets, liabilities and capital of the entity at
a point in time.

Assets - Items of value that the business owns/has

control of, such as goods for resale (inventory), vehicles
or machinery, trade receivables cash and money at the
bank.

Capital - The amount of capital invested in the business

by its owner(s).

Liabilities - Money that has been borrowed by the

business and trade payables.

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 SOFP - Terminology

An asset is a present economic

resource controlled by the entity as a
result of past events.

Assets are categorized as either

current or non-current in nature.

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 SOFP - Terminology

Current assets - Assets that the entity expects to

turn to cash within one year (and cash itself) or
that are intended for sale or consumption as
part of the entity’s normal operating activities:
- Inventory (stock) is the name for goods that have
been purchased for resale, but are not yet sold.
- A trade receivable (debtor) is the term given to
the money that is owed from a credit customer.

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 SOFP - Terminology
Non-current assets - All other assets. Typically assets that the
entity expects to use for periods that extend beyond one year.

There are 4 types of non-current asset:

1. Tangible assets, referred to in the statement of financial
position as property, plant and equipment, can be seen and
touched (they are tangible in nature), for example a car, a
house, or a desk.
2. Intangible assets cannot be seen or touched, but have value.
3. Available-for-sale assets (financial assets) are investments that
are denominated in money, or in paper (such as shares and
bonds) which the entity holds for financial gain and which will
be sold by the entity in the future.
4. Investments in associates are also investments in paper shares;
however, the intention is to retain these investments as part of
the entity’s normal activities.

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 SOFP - Terminology

Liabilities - a present obligation of the entity to

transfer an economic resource as a result of
past events.

Like assets, liabilities are presented in the

financial statements according to the length of
time an entity expects the liability to be
outstanding.

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 SOFP - Terminology
Current liabilities - Liabilities that are due to be
settled within 12 months or that are incurred as
part of the firm’s normal operating (trading)
activities. For example:
- A trade payable (creditor) is the term given
to the money that is owed from a supplier
who provided goods on credit
- A loan from a bank is a liability because at
some point in the future the entity has to pay
this back.

Non-current liabilities - All other liabilities. Usually

payable in periods that extend beyond one year.

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 SOFP - Terminology

Equity is the residual interest in the assets

of the entity after deducting all its
liabilities.

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 Annual Report
Contents
• Financial statements (P&L/SOFP/Statement of changes in
equity/Statement of cash flows).

• Significant accounting policies (how transactions have

been accounted for).

• Reports from management (outlining how they have

discharged their stewardship duties and what they plan to
do in the future)
– Directors’ report
– Chairman’s report/Chief executives report
– Operating and financial review
– Corporate social responsibility report (CSR)
– Corporate governance report
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 Types of entity
Information provided by financial statements, though
standardised, is adapted to meet the needs of the main
users of that information.

Different examples are referred to in the textbook:

• Sole traders
• Partnerships
• Clubs (online chapter)
• Manufacturing entities
• Companies

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 Sole trader
• Sole traders are individuals who have started a
business on their own.

• Sole trader businesses are unincorporated

businesses - they are not separate legal
entities, not companies.

• The sole trader is responsible for the debts of

the business (they have unlimited liability).

• Profits made in sole trader businesses are

regarded as their owners’ by the tax authorities
and are subject to income tax. Therefore, the
financial statements do not include income tax.

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 Sole trader
• Sole traders have to get financial statements
prepared for the purposes of completing their self-
assessment tax return which has to be filed annually.

• This return requires quite a bit of expense detail,

therefore sole-trader statements of profit or loss are
more detailed (have less aggregation of expenses)
than occurs in company financial statements.

• The statement of financial position disclosures are

similar to those required for companies, however,
more detail is provided in this statement on non-
current assets and changes in the owner’s capital.

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 Partnerships
Partnerships occur when two or more individuals
get together to form a business together.
A partnership can be incorporated as a limited
liability partnership or as an unincorporated
business.
If it is unincorporated, then the same principles as
outlined above for sole traders apply, except that
the partners will be jointly liable for partnership
debts.
In many instances, the partnership will have a
partnership agreement which may alter the profit
sharing ratios between the partners.
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 Partnerships
• The partners have to get financial statements
prepared for the partnership for the purposes of
completing a partnership return for the tax
authorities and for completing their personal
self-assessment tax return, which has to be filed
annually.

• The partnership return requires quite a bit of

expense detail; therefore partnership
statements of profit or loss are more detailed
(have less aggregation of expenses) than
company statements of profit or loss.

• If the partnership is incorporated, then the

disclosures for companies are relevant.
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 Member-governed bodies

• Run by members, for the benefit of members

• Many are unincorporated (not established under law

as a company). Some of these entities are large,
formal and subject to their own legislation (not
company legislation).

• Examples of this type of organisation include mutual

building societies, sports clubs and life assurance
companies.

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 Companies
• Incorporated by law as separate legal entities.
• Can own assets and can take action in their own right.
• Are regulated by legislation (Companies Act 2006), the accounting
profession and the stock exchanges (if listed).
• Have to pay corporation tax.
• The two most common forms of company are Public Limited
Companies (PLCs) and Private Limited Companies (Ltd.s).
• PLCs offer shares to the public on recognized share exchanges
(these are called listed companies).
• Ltd. companies are privately owned, usually by a family or a small
group of investors.
• These shares may be sold privately but are not publicly sold on
exchanges.
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 Companies (cont.)
• In both public and private limited companies, owners’
private wealth is protected from creditors by legislation.
• They have what is referred to as limited liability - owners
will only lose their investment (represented by monies
paid for shares held) in the company if it fails.

• A company should prepare a statement of

comprehensive income showing profit or loss for the
period (revenue less expenses) in the first part of the
statement and other comprehensive income in the
second part of the statement, with the final line showing
the total comprehensive income for the period.

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Companies – Statement of
comprehensive income

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 IAS - presentation of financial
statements
Financial statements should contain 4 statements:
1. A statement of comprehensive income - two options
are available:
• A single statement called a statement of comprehensive
income.
• Two statements: a statement of profit or loss and a separate
statement dealing with all non-owner changes in equity (the
comprehensive income statement).
2. To report the net worth of the business, a statement
of financial position has to be prepared at the
reporting date
3. A statement of changes in equity is required to show
all owner changes in equity, such as dividends paid to
owners, or new share issues
4. Finally a statement of cash flows is also required

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 IAS - presentation of financial
Regulatory framework of accounting
statements
• Regulatory framework of accounting is a general term used
to describe the legislation and other rules that govern the
content and format of company financial statements.

Sources:

• Legislation: The Companies Act 2006 (as amended)

• Accounting profession: Accounting standards and guidance

• Stock Exchanges: The listing rule book

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 Summary
• Financial accounting emerged from demand for quality financial
information about an entity’s financial performance and
financial position by stakeholders who are external to the entity.
• Information on performance is included in a statement of profit
or loss (sole traders/partnerships).
• Information on the state of a company’s affairs is included in the
statement of financial position.
• Five types of business entity are covered in this book: sole
traders, manufacturing entities, clubs (online chapter),
partnerships and companies.
• The financial statements of each type of entity are adapted to
suit the information needs of their main stakeholders.
• Regulation provides rules and guidance on content. Regulatory
sources are legislation, the profession and stock exchanges.

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 Student – study action

• Read chapter 1
• Try to explain the key terms and concepts (check your
answer with the chapter and the online glossary)
• Try the review questions (check your answers against
the chapter)
• Try the learning activities on the student online learning
centre (www.mcgraw-hill.co.uk/textbooks/thomas)

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