CIMA BA3 Study Text PDF

CIMA Subject BA3 Fundamentals of Financial Accounting Study Text  KAPLAN PUBLISHING’S STATEMENT OF PRINCIPLES LINGUISTIC DIVERSITY, EQUALITY AND INCLUSION We are committed to diversity, equality and inclusion and strive to deliver content that all users can relate to. We a...

CIMA Subject BA3 Fundamentals of Financial Accounting Study Text  KAPLAN PUBLISHING’S STATEMENT OF PRINCIPLES LINGUISTIC DIVERSITY, EQUALITY AND INCLUSION We are committed to diversity, equality and inclusion and strive to deliver content that all users can relate to. We are here to make a difference to the success of every learner. Clarity, accessibility and ease of use for our learners are key to our approach. We will use contemporary examples that are rich, engaging and representative of a diverse workplace. We will include a representative mix of race and gender at the various levels of seniority within the businesses in our examples to support all our learners in aspiring to achieve their potential within their chosen careers. Roles played by characters in our examples will demonstrate richness and diversity by the use of different names, backgrounds, ethnicity and gender, with a mix of sexuality, relationships and beliefs where these are relevant to the syllabus. 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P.4 Contents Page Chapter 1 The accounting environment 1 Chapter 2 The Regulatory Framework of Financial Reporting 53 Chapter 3 Ledger accounting and double-entry bookkeeping 87 Chapter 4 From trial balance to financial statements 121 Chapter 5 Sales tax, discounts and the books of prime entry 155 Chapter 6 Accounting for accruals and prepayments 199 Chapter 7 Accounting for payroll 217 Chapter 8 Accounting for the issue of shares 231 Chapter 9 Accounting for irrecoverable debts and allowances 257 for receivables Chapter 10 Accounting for inventory 275 Chapter 11 Non-current assets: Acquisition and depreciation 303 Chapter 12 Non-current assets: Revaluation, impairment and 335 disposal Chapter 13 Accounting reconciliations 369 Chapter 14 Incomplete records 411 Chapter 15 Accounting errors and suspense accounts 433 Chapter 16 The financial statements of single entities 453 Chapter 17 The manufacturing account 475 Chapter 18 The statement of cash flows 497 Chapter 19 The interpretation of financial statements 531 Chapter 20 Case study questions 579 Chapter 21 Mock Assessment 1 609 Chapter 22 References 651 Index I.1 P.5 P.6 Introduction This document references IFRS® Standards and IAS® Standards, which are authored by the International Accounting Standards Board (the Board), and published in the 2022 IFRS Standards Red Book. P.7  How to Use the Materials These Kaplan Publishing learning materials have been carefully designed to make your learning experience as easy as possible and to give you the best chances of success in your Cert BA Objective Test Examination. The product range contains a number of features to help you in the study process. They include: a detailed explanation of all syllabus areas extensive ‘practical’ materials generous question practice, together with full solutions. This Study Text has been designed with the needs of home-study and distance- learning candidates in mind. Such students require very full coverage of the syllabus topics, and also the facility to undertake extensive question practice. However, the Study Text is also ideal for fully taught courses. The main body of the text is divided into a number of chapters, each of which is organised on the following pattern: Detailed learning outcomes. These describe the knowledge expected after your studies of the chapter are complete. You should assimilate these before beginning detailed work on the chapter, so that you can appreciate where your studies are leading. Step-by-step topic coverage. This is the heart of each chapter, containing detailed explanatory text supported where appropriate by worked examples and exercises. You should work carefully through this section, ensuring that you understand the material being explained and can tackle the examples and exercises successfully. Remember that in many cases knowledge is cumulative: if you fail to digest earlier material thoroughly, you may struggle to understand later chapters. Activities. Some chapters are illustrated by more practical elements, such as comments and questions designed to stimulate discussion. Question practice. The text contains exam-style objective test questions (OTQs). Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an illusion to think that this provides the same benefits as you would gain from a serious attempt of your own. However, if you are struggling to get started on a question you should read the introductory guidance provided at the beginning of the solution, where provided, and then make your own attempt before referring back to the full solution. P.8 If you work conscientiously through CIMA’s Official Cert BA Study Text according to the guidelines above you will be giving yourself an excellent chance of success in your Objective Text Examination. Good luck with your studies! Quality and accuracy are of the utmost importance to us so if you spot an error in any of our products, please send an email to [email protected] with full details, or follow the link to the feedback form in MyKaplan. Our Quality Coordinator will work with our technical team to verify the error and take action to ensure it is corrected in future editions. Icon explanations Definition – These sections explain important areas of knowledge which must be understood and reproduced in an assessment environment. Key point – Identifies topics which are key to success and are often examined. Supplementary reading – These sections will help to provide a deeper understanding of core areas. The supplementary reading is NOT optional reading. It is vital to provide you with the breadth of knowledge you will need to address the wide range of topics within your syllabus that could feature in an assessment question. Reference to this text is vital when self-studying. Test your understanding – Following key points and definitions are exercises which give the opportunity to assess the understanding of these core areas. Note that not all questions are exam style, some are for understanding only. Illustration – To help develop an understanding of particular topics. The illustrative examples are useful in preparing for the Test your understanding exercises. New – Identifies topics that are brand new in subjects that build on, and therefore also contain, learning covered in earlier subjects. P.9  Study technique In this section we briefly outline some tips for effective study during the earlier stages of your approach to the Objective Test Examination. We also mention some techniques that you will find useful at the revision stage. Use of effective study and revision techniques can improve your chances of success in the Certificate in Business Accounting and in CIMA’s CGMA® Professional Qualification. Planning To begin with, formal planning is essential to get the best return from the time you spend studying. Estimate how much time in total you are going to need for each subject you are studying. Remember that you need to allow time for revision as well as for initial study of the material. With your study material before you, decide which chapters you are going to study in each week, and which weeks you will devote to revision and final question practice. Prepare a written schedule summarising the above and stick to it! It is essential to know your syllabus. As your studies progress you will become more familiar with how long it takes to cover topics in sufficient depth. Your timetable may need to be adapted to allocate enough time for the whole syllabus. Students are advised to refer to the examination blueprints (see page P.13 for further information) and the AICPA® & CIMA website, www.aicpa-cima.com, to ensure they are up-to-date. Students are advised to consult the syllabus when allocating their study time. The percentage weighting shown against each syllabus topic is intended as a guide to the proportion of study time each topic requires. Tips for effective studying (1) Aim to find a quiet and undisturbed location for your study and plan as far as possible to use the same period of time each day. Getting into a routine helps to avoid wasting time. Make sure that you have all the materials you need before you begin so as to minimise interruptions. (2) Store all your materials in one place, so that you do not waste time searching for items every time you want to begin studying. If you have to pack everything away after each study period, keep your study materials in a box, or even a suitcase, which will not be disturbed until the next time. (3) Limit distractions. To make the most effective use of your study periods you should be able to apply total concentration, so turn off all entertainment equipment, set your phones to silent mode, and put up your ‘do not disturb’ sign. (4) Your timetable will tell you which topic to study. However, before diving in and becoming engrossed in the finer points, make sure you have an overall picture of all the areas that need to be covered by the end of that session. After an hour, allow yourself a short break and move away from your Study Text. With experience, you will learn to assess the pace you need to work at. Each study session should focus on component learning outcomes – the basis for all questions. P.10 (5) Work carefully through a chapter, making notes as you go. When you have covered a suitable amount of material, vary the pattern by attempting a practice question. When you have finished your attempt, make notes of any mistakes you made, or any areas that you failed to cover or covered more briefly. Be aware that all component learning outcomes are examinable. (6) Make notes as you study, and discover the techniques that work best for you. Your notes may be in the form of lists, bullet points, diagrams, summaries, ‘mind maps’ or the written word, but remember that you will need to refer back to them at a later date, so they must be intelligible. If you are on a taught course, make sure you highlight any issues you would like to follow up with your lecturer. (7) Organise your notes. Make sure that all your notes, calculations etc. can be effectively filed and easily retrieved later. Progression There are two elements of progression that we can measure: how quickly students move through individual topics within a subject; and how quickly they move from one course to the next. We know that there is an optimum for both, but it can vary from subject to subject and from student to student. However, using data and our experience of student performance over many years, we can make some generalisations. A fixed period of study set out at the start of a course with key milestones is important. This can be within a subject, for example ‘I will finish this topic by 30 June’, or for overall achievement, such as ‘I want to be qualified by the end of next year’. Your qualification is cumulative, as earlier papers provide a foundation for your subsequent studies, so do not allow there to be too big a gap between one subject and another. For example, E1 Managing finance in a digital world builds on your knowledge of the finance function from certificate level and lays the foundations for E2 Managing performance and all strategic papers particularly E3 Strategic management and P3 Risk management. We know that exams encourage techniques that lead to some degree of short term retention, the result being that you will simply forget much of what you have already learned unless it is refreshed (look up Ebbinghaus Forgetting Curve for more details on this). This makes it more difficult as you move from one subject to another: not only will you have to learn the new subject, you will also have to relearn all the underpinning knowledge as well. This is very inefficient and slows down your overall progression which makes it more likely you may not succeed at all. In addition, delaying your studies slows your path to qualification which can have negative impacts on your career, postponing the opportunity to apply for higher level positions and therefore higher pay. P.11  You can use the following diagram showing the whole structure of your qualification to help you keep track of your progress. Make sure you seek appropriate advice if you are unsure about your progression through the qualification. P.12 Objective Test Objective Test questions require you to choose or provide a response to a question whose correct answer is predetermined. The most common types of Objective Test question you will see are: multiple choice, where you have to choose the correct answer(s) from a list of possible answers – this could either be numbers or text multiple response with more choices and answers, for example, choosing two correct answers from a list of five available answers – this could be either numbers or text number entry, where you give your numeric answer to one or more parts of a question, for example, gross profit is $25,000 and the accrual for heat and light charges is $750 drag and drop, where you match one or more items with others from the list available, for example, matching several accounting terms with the appropriate definition drop down, where you choose the correct answer from those available in a drop down menu, for example, choosing the correct calculation of an accounting ratio, or stating whether an individual statement is true or false hot spot, where, for example, you use your computer cursor or mouse to identify the point of profit maximisation on a graph other types could be matching text with graphs and labelling/indicating areas on graphs or diagrams. CIMA has provided the following guidance relating to the format of questions and their marking: questions which require narrative responses to be typed will not be used for number entry questions, a small range of answers will be accepted. Clear guidance will usually be given about the format in which the answer is required e.g. ‘to the nearest $’ or ‘to two decimal places’ item set questions provide a scenario which then forms the basis of more than one question (usually 2–4 questions). These sets of questions would appear together in the test and are most likely to appear in BA2 and BA3 all questions are independent so that, where questions are based on a common item set scenario, each question will be distinct and the answer to a later question will not be dependent upon answering an earlier question correctly all items are equally weighted and, where a question consists of more than one element, all elements must be answered correctly for the question to be marked correct. P.13  Throughout this Study Text we have introduced these types of questions, but obviously we have had to label answers A, B, C etc. rather than using click boxes. For convenience we have retained quite a few questions where an initial scenario leads to a number of sub-questions. There will be questions of this type in the Objective Test Examination but they will rarely have more than three sub-questions. Guidance re CIMA’s CGMA on-screen calculator As part of CIMA’s Objective Test software, candidates are now provided with a calculator. This calculator is on-screen and is available for the duration of the assessment. The calculator is available in each of the Objective Tests and is accessed by clicking the calculator button in the top left hand corner of the screen at any time during the assessment. Candidates are permitted to utilise personal calculators as long as they are an approved CIMA model. Authorised CIMA models are listed on the AICPA & CIMA website. All candidates must complete a 15-minute exam tutorial before the assessment begins and will have the opportunity to familiarise themselves with the calculator and practise using it. The exam tutorial is also available online via the Pearson Vue website. Candidates may practise using the calculator by accessing the online exam tutorial. Fundamentals of Objective Tests The Objective Tests are a two-hour assessment comprising compulsory questions, each with one or more parts. There will be no choice and all questions should be attempted. The numbers of questions in each assessment are as follows: BA1 Fundamentals of Business Economics – 60 questions BA2 Fundamentals of Management Accounting – 60 questions BA3 Fundamentals of Financial Accounting – 60 questions BA4 Fundamentals of Ethics, Corporate Governance and Business Law – 85 questions All questions are equally weighted. All parts of a question must be answered correctly for the question to be marked correct. Where questions are based upon a common scenario, each question will be independent, and answers to later questions will not be dependent upon answering earlier questions correctly. P.14 CIMA’s CGMA® 2019 syllabus– Structure of subjects and learning outcomes Details regarding the content of CIMA’s new CGMA syllabus can be located within CIMA’s CGMA 2019 Certificate in Business Accounting syllabus document. Each subject within the CGMA syllabus is divided into a number of broad syllabus topics. The topics contain one or more lead learning outcomes, related component learning outcomes and indicative knowledge content. A learning outcome has two main purposes: (a) To define the skill or ability that a well prepared candidate should be able to exhibit in the examination. (b) To demonstrate the approach likely to be taken in examination questions. The learning outcomes are part of a hierarchy of learning objectives. The verbs used at the beginning of each learning outcome relate to a specific learning objective, e.g.: Calculate the break-even point, profit target, margin of safety and profit/volume ratio for a single product or service. The verb ‘calculate’ indicates a level three learning objective. The following tables list the verbs that appear in the syllabus learning outcomes and examination questions. P.15  CIMA’s CGMA VERB HIERARCHY CIMA place great importance on the definition of verbs in structuring objective tests. It is therefore crucial that you understand the verbs in order to appreciate the depth and breadth of a topic and the level of skill required. The objective tests will focus on levels one, two and three of the CIMA hierarchy of verbs. However, they will also test levels four and five, especially at the management and strategic levels. Skill level Verbs used Definition Level 3 Apply Put to practical use Application Calculate Ascertain or reckon mathematically How you are expected to Conduct Organise and carry out apply your knowledge Demonstrate Prove with certainty or exhibit by practical means Prepare Make or get ready for use Reconcile Make or prove consistent/compatible Level 2 Describe Communicate the key features of Comprehension Distinguish Highlight the differences between What you are expected to Explain Make clear or intelligible/state the meaning understand or purpose of Identify Recognise, establish or select after consideration Illustrate Use an example to describe or explain something Level 1 List Make a list of Knowledge State Express, fully or clearly, the details/facts of What you are expected to Define Give the exact meaning of know Outline Give a summary of CIMA Cert BA resources Access to CIMA Cert BA resources including syllabus information is available online at www.aicpa-cima.com. Additional resources This Study Text is designed to be comprehensive and therefore sufficient to meet the needs of students studying this subject. However, CIMA recognises that many students also want to read around particular topic(s), either to extend their knowledge and understanding, or because it is particularly relevant to their work environment. P.16 CIMA has therefore produced a related reading list for those students who wish to extend their knowledge and understanding, whether for personal interest or to help support work activities as follows: BA1 – Fundamentals of Business Economics Principles of Economics 3rd ed. McDowell & Thom Applied Economics 12th ed. Griffiths & Wall Mathematics for Economists: An Introductory Textbook 4th ed. Pemberton & Rau BA2 – Fundamentals of Management Accounting Management and Cost Accounting Colin Drury Management Accounting Catherine Gowthorpe BA3 – Fundamentals of Financial Accounting Financial Accounting – An Introduction Pauline Weetman Frank Wood's Business Accounting 1 & 2 Frank Wood & Alan Sangster BA4 – Fundamentals of Ethics, Corporate Governance and Business Law Students can find out about the specific law and regulation in their jurisdiction by referring to appropriate texts and publications for their country. Managing Responsible Business CGMA Report 2015 Global Management Accounting Principles CIMA 2015 Embedded Ethical Values: A guide for CIMA Partners CIMA Report 2014 Business Ethics for SMEs: A Guide for CIMA Partners CIMA Report 2014 Ethics: Ethical Checklist CIMA 2014 Ethics Support Guide CIMA 2014 Acting under Pressure: How management accountants manage ethical issues CIMA 2012 P.17  SYLLABUS GRIDS BA3: Fundamentals of Financial Accounting Syllabus overview The main objective of this subject is to obtain a practical understanding of financial accounting and the process behind the preparation of financial statements for single entities. These statements are prepared within a conceptual and regulatory framework requiring an understanding of the role of legislation and of accounting standards. The need to understand and apply necessary controls for accounting systems, and the nature of errors is also covered. There is an introduction to measuring financial performance with the calculation of basic ratios. Note: Students are required to be aware of the format and content of published accounts but are not required to prepare them. No detailed knowledge of any specific accounting treatment contained in the International Financial Reporting Standards (IFRSs) – including the International Accounting Standards (IASs) – is necessary, except in terms IAS 2 and the treatment of inventory, IAS 16 and IAS 38 for basic non-current asset transactions. IAS 1 and IAS 7 formats will form the basis of the financial statements. The terminology used for all entities will be that of International Financial Reporting Standards. This will enable students to use a consistent set of accounting terms throughout their studies. Assessment strategy There will be a two hour computer based assessment, comprising 60 compulsory objective test questions. Short scenarios may be given to which one or more objective test questions relate. Syllabus structure The syllabus comprises the following topics and weightings: Content area Weighting A Accounting principles, concepts and regulations 10% B Recording accounting transactions 50% C Preparation of accounts for single entities 30% D Analysis of financial statements 10% 100% P.18 BA3A: Accounting principles, concepts and regulations (10%) Learning outcomes On completion of their studies, students should be able to: Lead Component Level Indicative syllabus content Study text chapter 1. Explain the a. Explain the need for 2 Accounting records to be kept and 1 principles accounting records. their uses; concept of stewardship. and b. Identify the needs of 2 Users of accounts and their concepts of different user groups. information needs. financial accounting. c. Distinguish between 2 Functions of financial and the purposes of management accounts; purpose of financial and accounting statements. management 2 Capital and revenue; cash and accounts. profit; income, expenditure, assets d. Explain capital and and liabilities. revenue, cash and 2 Underlying assumptions, policies, profit, income and accounting estimates; historical cost expenditure, assets convention; qualitative and liabilities. 2 characteristics of the Framework, e. Explain the underlying elements of financial statements. assumptions, policies The principles and elements of the and accounting 2 Framework for integrated reporting. estimates. 2 The accounting equation formula. f. Identify the need for and information to be Use of coding in record keeping. included in an integrated report. g. Describe the accounting equation. h. Explain the need for accounting codes. 2. Explain the a. Explain the influence 2 Regulatory influence of company 2 impact of of legislation and law; role of accounting standards; the accounting standards IASs and IFRSs; formats for regulatory on published published accounts. framework accounting on financial information. accounting. P.19  BA3B: Recording accounting transactions (50%) Learning outcomes On completion of their studies, students should be able to: Lead Component Level Indicative syllabus content Study text chapter 1. Prepare a. Prepare the books of 3 Record sales, purchase, income and 3, 4, 5, 11, 12, accounting prime entry. 3 expense transactions in the sales 15 records. b. Apply the principles of day book, purchase day book, cash double- entry book, returns books, and 3 sales/purchase ledger. bookkeeping. 3 The accounting equation; double- c. Prepare nominal ledger accounts. 2 entry bookkeeping rules; journal entries. d. Prepare the trial balance. 3 Record all types of business transactions in nominal ledger e. Explain the nature of accounts. accounting errors. 3 Completing the trial balance from f. Prepare accounting given ledger account balances. entries for the 3 correction of errors. Errors including those of principle, omission, and commission. g. Prepare accounting entries for non-current Journal entries and suspense assets. accounts. h. Prepare a non-current In accordance with IAS 16 – asset register. acquisition, depreciation (straight line, reducing balance), revaluation, impairment and disposal of tangibles. In accordance with IAS 38 – intangibles and amortisation. Information to be recorded in a non- current asset register. 2. Prepare a. Prepare bank 3 Reconciliation of the cashbook to the 13 accounting reconciliation bank statement. reconciliations. statements. 3 Using the imprest system for petty b. Prepare petty cash cash. statements under an 3 Reconciliation of sales and purchase imprest system. ledger control accounts to sales and c. Prepare sales and purchase ledgers. purchase ledger control account reconciliations. 3. Prepare a. Calculate sales tax. 3 Calculation of sales tax on all 5, 7, 8 accounting b. Prepare accounting 3 business transactions. entries for entries for sales tax. Accounting entries for sales tax. specific transactions. c. Prepare accounting 3 Note: No knowledge of any specific tax entries for payroll. systems/rules/rates will be required. d. Prepare accounting 3 Accounting entries for basic payroll entries for the issue of information. shares. Note: No knowledge of any specific income tax rules will be required. Issue at full market price, rights issue and bonus issue. P.20 BA3C: Preparation of accounts for single entities (30%) Learning outcomes On completion of their studies, students should be able to: Lead Component Level Indicative syllabus content Study text chapter 1. Prepare a. Prepare accounting 3 Calculations and journals for 6, 9, 10 accounting entries for accruals accruals and prepayments (income adjustments. and prepayments. 3 and expenses). b. Prepare accounting Prepare journals for irrecoverable entries for debts and allowances for irrecoverable debts 3 receivables from given information. and allowances for In accordance with IAS 2 – receivables. calculation of the figure for closing c. Prepare accounting inventory for inclusion in the entries for inventories. financial statements (FIFO, LIFO and average cost) and the journal entry to record it. 2. Prepare a. Prepare basic 3 Manufacturing accounts produced 17 manufacturing manufacturing from given information. accounts. accounts. Note: No calculation of overheads and inventory balances is required. 3. Prepare a. Prepare financial 3 In accordance with IAS 1 – 14, 16, 18 financial statements from a trial Statement of profit or loss and statements for balance. 3 other comprehensive income; a single b. Prepare financial statement of financial position; entity. statements from statement of changes in equity. 3 incomplete records. Calculate missing numbers using c. Prepare a statement the accounting equation, profit of cash flows. margins and mark-ups, receivables and payables ledgers, and cash and bank ledgers. In accordance with IAS 7 – operating, investing and financing sections. P.21  BA3D: Analysis of financial statements (10%) Learning outcomes On completion of their studies, students should be able to: Lead Component Level Indicative syllabus content 1. Identify a. Identify the information 2 Information provided by accounting 19 information provided by the ratios. provided by calculation of 2 Reasons for the changes in accounting accounting ratios. accounting ratios. ratios. b. Identify reasons for the changes in accounting ratios. 2. Calculate a. Calculation of 3 Ratios: return on capital employed; 19 basic profitability ratios. 3 gross, operating and net profit accounting b. Calculation of liquidity margins; non-current asset ratios. 3 turnover. ratios. c. Calculation of risk Trade receivables collection period ratios. and trade payables payment period; current and quick ratios; inventory turnover. Gearing and interest cover. Information concerning formulae and tables will be provided via the AICPA & CIMA website, www.aicpa-cima.com. P.22 Chapter 1 The accounting environment Chapter learning objectives When you have completed this chapter, you should be able to: explain the principles and concepts of financial accounting apply the accounting equation to record the effect of transactions. 1 The accounting environment 1 Introduction This chapter provides: an introduction to the accounting environment and an introduction to the fundamental issues associated with financial accounting. Much of the chapter relates to the first syllabus area ‘accounting principles, concepts, and regulations’. This chapter covers: the different types of business entity the need for accounting records and which accounting records are maintained the concept of stewardship the user groups of financial accounting information the definition of accounting, including use of coding in record keeping the differences between financial and management accounting the elements of the financial statements the accounting equation, including classification of transactions the qualitative characteristics of financial information the historical cost convention and other valuation bases the explanation of accounting concepts and fundamental terms, and a glossary of accounting terms. 2  Chapter 1 2 What is a business entity? A business is an entity that regularly enters into transactions that are expected to provide a reward measurable in monetary terms. It is thus obvious from everyday life that many business entities exist. What is less obvious is that their organisational (legal) structure and therefore their accounting requirements may differ. There are two main reasons for the different organisational structures that exist – the nature of their activities and their size. Note that information relating to the different types of entity organisational structure is provided for information and awareness only to provide context and understanding for your financial accounting studies. Many accounting transactions will be common to all types of business entity, such as cash receipts and payments and, therefore, the same accounting principles will apply irrespective of the nature of the business entity. However, note that you will not be examined on specialised transactions relating to partnerships, local or national government or non-profit making entities. The focus of your studies for this subject is accounting principles and transactions relating to sole traders and companies. For convenience, and to be consistent with CIMA terminology, reference will usually be made to an 'entity', rather than a 'business' or an 'organisation' or 'company'. Profit-making entities Some entities are formed with the intent of making profits from their activities for their owners: (a) Sole traders (sole proprietors) Who are they? These are entities that are owned by one person. They tend to be small because they are constrained by the limited financial resources of their owner. The sole trader will also have unlimited personal liability for debts incurred by the business. (b) Partnerships Who are they? These are entities owned by two or more persons working in common with a view to making a profit. The greater number of owners compared with a sole trader increases the availability of finance and this is often the reason for forming such a structure. As with a sole trader, each of the partners in the business has unlimited personal liability for debts incurred by the business. 3 The accounting environment (c) Limited liability companies ('companies') Who are they? These are entities recognised in law as ‘persons’ in their own right. Thus a company may own assets and incur liabilities in its own name. There is a separation in law between ownership of the company by shareholders and its management by directors. The crucial distinction between a company and either a sole trader or a partnership is that the shareholders of a company have only limited liability for debts incurred by the business, whereas sole traders and partners have unlimited personal liability for debts incurred by the business. The accounting requirements of companies must meet certain minimum obligations imposed by legislation, for example, via company law and other regulations. Some of these requirements also constitute recommended accounting practice for other types of business entity. Two types of company can be identified: private limited companies and public limited companies. Who are they? Public limited companies are ‘listed’ on a stock exchange. Listed companies may have many thousands of owners (shareholders) who are even further removed from the running of the business. In private limited companies the owners are usually also actively involved in running the business. In this way they are similar to sole traders and partnerships. This is rarely true of public companies, where the owners are unlikely to be involved in the day-to-day activities of the business. Instead, the shareholders will elect a board of directors to manage the company on a day-to-day basis on their behalf. These distinctions can be important when considering the accounting requirements, which are more onerous for public companies. The accounting requirements relating to the financial statements of companies are considered in more detail in subsequent chapters of this publication. 4  Chapter 1 Non-profit-making entities Other entities are formed with the objective of providing services, without intending to be profitable in the long term: (a) Clubs and societies Who are they? These entities exist to provide facilities and entertainments for their members. They are often sports and/or social clubs and most of their revenue is derived from the members who benefit from the club’s facilities and activities. They may carry out some activities that are regarded as ‘trading’ activities, in which profits are made, but these are not seen as the main purpose of the entity. For example, a tennis club may hold a summer barbeque to raise funds for the club. (b) Charities Who are they? These exist to provide services to particular groups, for example people with special needs and to protect the environment. Although they are regarded as non-profit-making, they often carry out trading activities, such as running shops to raise income. (c) Local and central government Who are they? Government departments are financed by members of society (including businesses). Their finances are used to provide the infrastructure in which we live, and to redistribute wealth to other members of society. The accounting requirements of local and central government are not within the syllabus and learning objectives of this subject. 3 The need for accounting records While recognising that many businesses will maintain their accounting records using computerised accounting packages or spreadsheets, it is important for those studying BA3 to be aware of the principles and processes that underpin these packages. Accounting records are used to record transactions entered into by an entity, whatever form it may take (e.g. sole trader, partnership, company etc.). This information can then be used to meet a range of needs or requirements as follows: they help an entity to record, summarise and classify transactions in a logical and systematic manner they help managers to easily locate information required, such as details relating to an individual sales or purchase transaction 5 The accounting environment they help managers to easily keep track of amounts owing to the entity from customers and amounts owed to suppliers they help managers and owners to meet legal obligations relating to the maintenance of accounting records they form the basis of preparation of management accounting information used by managers for control and decision-making purposes they form the basis of financial accounting information used to prepare annual accounts for business owners and other interested parties, such as tax authorities. What accounting records are maintained? In most entities, the principal transactions that take place include sales, purchases (of goods and of services) and payroll-related transactions. Other transactions include incurring costs for rent, heat and light, fuel and power and office expenses such as telephone, postage and stationery. All of these transactions (and any others entered into by an entity) must be adequately captured by the accounting system to form the basis of preparation of financial accounting and management accounting information. With most transactions a supporting document will be created to confirm that the transaction has taken place, when the transaction took place and the associated value of the transaction. This documentation is vital to the financial accountant, who uses the information on the documents as a data source to initiate the measurement and recording of the transactions. The table below summarises the main types of business documentation and sources of data for an accounting system, together with their content and purpose. In computerised systems, the information contained in these documents could be entered directly into the system. Soft copies of the documents may be exchanged between businesses without being printed – referred to as the paperless office. Contents Purpose Quotation Quantity/description/ To establish cost from details of goods various suppliers and required. cross refer to purchase order. Purchase order Details of supplier, Sent to supplier as request e.g. name, address. for supply. To check to the Quantity/description/ quotation and delivery details of goods required note. and price. Terms and conditions of delivery, payment, etc. 6  Chapter 1 Sales order Quantity/description/ Cross checked with the details of goods required order placed by customer. and price. Sent to the stores/ warehouse department for processing of the order. Despatch note Details of supplier, Provided by supplier. (goods despatched e.g. name and address. Checked with goods note – GDN) Quantity and description received and purchase of goods. order. Goods received Quantity and description Produced by the business note (GRN) of goods. receiving the goods as proof of receipt. Matched with despatch note from supplier and purchase order. Invoice Name and address of Issued by supplier of supplier and customer; goods as a request for details of goods, payment. For the supplier e.g. quantity, price, selling the goods/services value, sales tax, terms this will be treated as a of credit, etc. sales invoice. For the customer this will be treated as a purchase invoice. Statement Details of supplier, Issued by the supplier. e.g. name and address. Checked with other Includes details of date, documents to ensure that invoice numbers and the amount owing is values, payments made, correct. refunds, amount owing. Credit note Details of supplier, Issued by the supplier. e.g. name and address. Checked with documents Contains details of regarding goods returned. goods returned, e.g. quantity, price, value, sales tax, terms of credit, etc. Debit note Details of the supplier. Issued by the business Contains details of receiving the goods. Cross goods returned, referred to the credit note e.g. quantity, price, issued by the supplier. value, sales tax, terms of credit, etc. 7 The accounting environment Remittance advice Method of payment, Sent to supplier with, or as invoice number, account notification of, payment. number, date, etc. Receipt Details of payment Issued by the selling received. business indicating the payment received. 4 The concept of stewardship Stewardship is a relationship of accountability by one person or group for their management of resources and decision-making on behalf of another person or group (sometimes referred to as a principal). In a financial accounting context, employees (whether managers or directors) are ultimately accountable to the owners of that business (such as shareholders in a corporate entity) for the use of resources under their control and for the outcome of decisions they make in the use of those resources. Accountability or stewardship is therefore exercised by managers and directors periodically providing financial accounting information to their principal or business owner, normally in the form of annual financial statements. As such, the steward is placed in a position of trust to manage and account for the resources placed under their control by the principal. Accordingly, they should uphold fundamental ethical principles as follows: Integrity Objectivity Professional competence and due care Confidentiality Professional behaviour. Ethical issues are considered in more detail in BA4 Fundamentals of Ethics, Corporate Governance and Business Law. The stewardship role of management In a sole trader business or a partnership the owners of the business entity are answerable only to themselves. They own the business entity and they are responsible for its day-to-day operations. In a corporate entity this is not necessarily the case. With the exception of owner- managed companies, it is likely that shareholders do not have any involvement in the day-to-day activities of the running and decision- making of the business entity. They provide the capital and they appoint directors to manage the business entity on their behalf. 8  Chapter 1 In return the directors will receive remuneration in the form of salary and other benefits. The profit generated by the entity, however, belongs to the shareholders. It is the responsibility of the directors/management to ensure that the assets of the entity are safeguarded. This may involve ensuring that: all assets are recorded correctly, they exist, and are properly maintained and insured procedures are in place to prevent misappropriation or misuse of assets the accounting system is efficient and effective no expenditure is undertaken, or liability incurred, without proper procedures for its authorisation and control the financial statements are prepared in accordance with current legislation and accounting standards. The term often given to these responsibilities is ‘the stewardship function’. Management acts as stewards on behalf of shareholders, members and other beneficiaries, and may be answerable if they fail in this duty. That is not to say that it is their responsibility to make as much profit as possible, or even that they are to blame if losses are made, but that they must take appropriate steps to manage the risks, within the confines of the business world. 5 Who uses financial information? Accounting information is used by many discrete groups, both individuals and entities. To develop an understanding of how financial statements may be used, it is useful to classify these users into groups, and to consider the reasons why they use financial statements and what benefit or understanding they hope to gain from doing so. Any classification of this sort is somewhat arbitrary, and many users fall into more than one classification. However, the following groups are commonly recognised as having particular needs for accounting information. 9 The accounting environment (a) The investor group Owners are better able to make decisions regarding their investment (e.g. should they sell shares or retain shares or buy more shares?) if they have relevant information. They are also able to make decisions regarding how the business entity is managed and controlled (e.g. vote to appoint or remove directors). What do they require? This group includes both existing and potential owners of shares in corporate entities. They require information concerning the performance of the corporate entity measured in terms of its profitability and the extent to which those profits are to be distributed to shareholders. They are also interested in the social/economic policies of the corporate entity so that they may decide if they wish to be associated with such an entity. For example, does the corporate entity adhere to sound ethical principles and environmental practices? (b) The lender group What do they require? This group includes both existing and potential providers of secured or unsecured, long or short-term loan finance. They require information relating to the ability of the entity to repay the interest on such loans as they fall due. Additionally, they are also interested in the longer-term growth and stability of the entity to ensure that it is capable of repaying loans at the due date. In addition, if the loan is secured, the value of the assets used as security is important as a means of recovering the amount due if the entity defaults on repayment. (c) The employee group What do they require? This group includes current, potential and past employees. They require information relating to the ability of the entity to pay wages and pensions on a continuing basis. In addition, they are interested in the future prospects of the entity because these issues will affect job security and employment prospects within the entity. (d) The analyst/adviser group What do they require? This group includes a range of advisers to investors, employees and the general public. The needs of these users will be similar to those of their clients. The difference is, perhaps, that in some instances, the members of this group will be more technically qualified and experienced to understand and evaluate financial accounting reports. 10  Chapter 1 (e) The business contact group What do they require? This group includes customers and suppliers of the entity. Customers will be concerned to ensure that the entity has the ability to provide the goods/services requested and to continue to provide similar services in the future. Suppliers will wish to ensure that the entity will be capable of paying for the goods/services supplied when payment becomes due. (f) The government What do they require? This group includes taxation authorities, plus other local and national government agencies and departments. The taxation authorities will calculate the entity's taxation liability based upon the accounting reports and information submitted. Other government agencies will collect economic and financial data to measure and evaluate national and regional economic performance, such as employment rates and production or output levels. (g) The public What do they require? This group includes taxpayers, consumers and other community and special interest groups. They require information relating to the policies and practices of the entity and how those policies and practices affect the community. For example, the general public has become increasingly aware of, and interested in, the environmental impact a business entity has as a result of its trading activities, and what may be done to minimise any adverse impact. Similarly, the general public has also developed an interest in whether an entity takes advantage of exploitative working and employment practices to minimise operating costs. When an entity is perceived to be operating in a way which is not socially responsible, it may affect the reputation of that entity and also its profitability if, for example, there is a consumer boycott of its products. (h) Internal users What do they require? The management of the entity requires information to assist it in the performance of its duties. Three different levels of management can be identified: Strategic – this is the most senior level of management within an entity. In a commercial entity it is referred to as the board of directors. This level of management requires information to assist it with major decisions affecting the long-term future of the entity. 11 The accounting environment Tactical – this is often referred to as middle management. This level of management requires information to support it with monitoring performance and to make decisions to enable the entity to achieve its short- to medium-term targets. Operational – this is the level of management responsible for decisions which control and manage the day-to-day activities of the entity. It is common for information to be provided to this level of management in non-financial terms, such as hours worked, quantity of components produced, and so on. Having considered what a business entity is, and who the principal users of financial information are, it is now appropriate to consider what accounting is, how accounting information is recorded and how it is summarised. 6 An overview: what is accounting? What is the objective of recording and summarising accounting transactions and how is that information then used? The objective of recording and summarising transactions is to provide useful and relevant financial information to the managers, owners and other parties interested in an entity. In the context of financial accounting, this is achieved by the preparation of financial statements. A significant proportion of the syllabus for this subject deals with the recording, summarising and classifying of accounting transactions to prepare financial statements. Again, in practice this may be done by way of computerised accounting packages, but there is the requirement for you to understand the manual system which operates behind these systems. How are accounting transactions recorded and summarised? Transactions are initially recorded (i.e. listed) in books of prime entry. These books are simply a record of similar transactions recorded in sequential order (e.g. sales made on credit), which are periodically totalled, with the totals posted 12  Chapter 1 into the double-entry accounting system. This enables an individual transaction to be captured or recorded in a book of prime entry, whilst minimising the number of entries made in the double-entry accounting system. This principle will apply regardless of the method used to record accounting transactions. Small entities with relatively few transactions may maintain a manual set of accounting records. Larger entities may enter into hundreds of thousands of transactions each year and they may use computerised accounting records to manage the volume of transactions effectively. Whichever method of maintaining accounting records is used, it will be based upon the same bookkeeping principles. As each transaction is recorded in a book of prime entry, it will also have a code applied. One common feature of most accounting systems is the use of coding systems that are logical, comprehensive and also flexible enough to enable summarisation and further analysis to be made. Books of prime entry are considered in further detail later in this publication. Further detail on accounting Accounting can be described as being concerned with measurement and management. Measurement is largely concerned with the recording of past data, and management with the use of that data in order to make decisions that will benefit the entity. The measurement process is not always easy. One of the most common problems is that of when to recognise or record a transaction. For example, if we obtain goods from a supplier with payment due 60 days after the goods have been received, when should that transaction be recorded? The following possibilities may be considered: when the order was placed when the goods were received when the invoice was received from the supplier; or when the supplier was paid. Accounting, therefore, involves the exercise of judgement by the person responsible for converting data into meaningful information. It is this feature that distinguishes accounting from bookkeeping. Accounting may be defined as: the classification and recording of monetary transactions the presentation and interpretation of the results of those transactions in order to assess financial performance for an accounting period and the financial position at the end of that accounting period the monetary projection of future activities arising from the alternative planned courses of action. 13 The accounting environment Note the three aspects considered in this definition: recording, reporting and forecasting: 1 Accounting is partly a matter of record-keeping. The monetary transactions entered into by a business entity need to be controlled and monitored, and for this a permanent record is essential. For an efficient system of record-keeping, the transactions must first be classified into categories appropriate to the enterprise concerned. 2 At appropriate intervals, the individual transactions must be summarised as a basis for preparation of statements of financial performance and position of a business entity. 3 Finally, accounting information can be the basis for planning and decision-making. An alternative explanation is that accounting is part of the management information system (MIS) of an entity. In this context, the accounting element is referred to as an accounting information system (AIS). Accounting can thus be said to be a method of providing information to management (and other users) relating to the activities of an entity. In order to do this it relies on the accurate collection of data from sources both internal and external to the entity. The recording of this data is often referred to as bookkeeping. 7 Use of accounting information 14  Chapter 1 The accounting system of a business entity records and summarises accounting transactions so that useful information can be prepared for managers and others. Managers need accounting information to help them to manage and control the entity (management accounting) and to prepare financial statements for external users (financial accounting). Normally financial accounting consists of preparing financial statements for external users which comprise the following: statement of profit or loss and other comprehensive income – comprises a summary of income and expenses for an accounting period statement of financial position – comprises a summary of assets and liabilities and capital at a specific date statement of changes in equity – comprises a summary of the movement in capital or equity (i.e. ownership interest) for an accounting period statement of cash flows, and notes to the financial statements. This information is crucial to various stakeholders of the business entity, who will analyse that information to make significant economic decisions. It is of vital importance that stakeholders have good quality information to be able to make their decisions. As you progress through your studies for this subject, you will learn how to record accounting transactions and how to prepare financial statements. Subject BA2 Fundamentals of Management Accounting deals with the use of accounting information for management and control purposes. 8 Financial accounting and management accounting Financial accounts are produced primarily for owners of business entities and external users. International Accounting Standards (IAS® Standards) and International Financial Reporting Standards (IFRS® Standards) help to reduce the differences in the way that companies draw up their financial statements in different countries. Management accounts are prepared for managers and others who control the business entity. The key distinctions between financial accounting and management accounting are summarised in the following diagram. 15 The accounting environment Financial accounting Financial accounting can be described as the classification and recording of monetary transactions of an entity in accordance with established concepts, principles, accounting standards and legal requirements, and their presentation, by means of various financial statements, during and at the end of an accounting period. Further detail on financial accounting Two points in particular are worth noting about this description: 1 Financial statements must comply with accounting rules published by the various regulatory bodies. In other words, an entity does not have a completely free hand as to how it prepares and presents financial statements. The reason for this is that the financial statements are primarily intended for the use of people outside of the entity. Without access to the more detailed information available to insiders, these interested parties may be misled unless financial statements are prepared based upon uniform principles and standards. 16  Chapter 1 2 Financial accounting is partly concerned with summarising the transactions of an accounting period and classifying and presenting the summary in a coherent form. This is because financial statements are intended for use by external third parties. These outsiders have a need for, and a right to receive, specified financial accounting information at defined intervals, and not be subject to the discretion and choice of management. Management accounting Management accounting can be described as the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources. Further detail on management accounting Management accounting also comprises the preparation of financial reports for non-management groups such as shareholders, lenders, regulatory agencies and tax authorities. Although the needs of external users of accounts are addressed in this definition, the emphasis of management accounting is upon providing information to help managers to control and direct the business entity. The nature and extent of information produced, and the way in which it is presented, is at the discretion of the managers concerned: they will request whatever information, in whatever format, they believe to be appropriate to meet their needs. Internal and external information Just as distinctions can be made between financial accounting and management accounting, distinctions can also be made between the nature and extent of information available within a business entity for management and control purposes, and information available to external third parties as follows: Internal information External information 1 Availability This is confidential This is available to and retained within anyone who can the entity access it – usually from a public registry 2 Frequency As and when Usually annually – as required by the entity required by law and e.g. weekly, monthly regulation etc. 17 The accounting environment 3 Content and No standard content Standard format and format or format required – content set by as required to meet legislation and business needs. It technical accounting may be very detailed standards. Typically it and may contain is highly summarised budgeted and with focus upon forecast information, historical financial along with financial information and non-financial information 4 External audit No external audit Most companies are requirement to requirement required to have an provide external audit credibility to information 5 Compliance There is no Annual financial with technical requirement for this, statements must accounting although may be comply with technical standards desirable to do so accounting standards The remainder of this publication will focus upon financial accounting, and the preparation of financial statements. As a basis for doing this, a number of important accounting terms, principles and concepts need to be defined and explained. 9 Elements of the financial statements The IASB® Conceptual Framework for Financial Reporting (’Framework’ or ‘Conceptual Framework) identifies five 'elements of the financial statements' as follows: Assets ) These elements are Liabilities ) used to form the basis of Capital ) the statement of financial position Income ) These elements are used to form the basis of Expenses ) the statement of profit or loss Each of the elements will now be defined and explained before going on to consider the accounting equation and financial statements in more detail. 18  Chapter 1 Asset The Conceptual Framework defines an asset 'a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits’ (Framework, para 4.4). This usually means that an asset has been purchased and is owned by the entity. However, be aware that it is possible to have control or use of an asset without owning it, for example, when leasing or hiring an asset. Further detail on assets Examples of assets are land, buildings, plant and machinery, motor vehicles, inventories of goods, receivables, bank balances and cash. Assets may be described as tangible or intangible. Tangible assets are those that have physical substance and can be seen or touched (e.g. land, buildings, equipment, inventories, etc.). Intangible assets do not have physical substance and cannot be seen or touched (e.g. owning a licence or a brand). Usually intangible assets have some form of legally-based rights or entitlement, such as a patent or registered trademark. You will learn more about intangible assets in Chapters 7 and 8 of this publication. Liability The Conceptual Framework defines a liability as 'a present obligation of the entity to transfer an economic resource as a result of past events’ (Framework, para 4.26). Further detail on liabilities Thus a liability can be described as an amount owed by a business entity to an individual or other business entity. Examples of liabilities are payables, loans received and bank overdrafts. 19 The accounting environment Capital (also known as equity) The Framework defines equity as 'the residual interest in the assets of the entity after deducting all its liabilities' (Framework, para 4.63). In this context, capital or equity is not easy to define, but it can be regarded as a special kind of liability that exists between a business entity and its owner(s). In effect, it shows the net amount invested in the business entity by the owner(s) and would be due to them if business activities were terminated. The above elements can then be arranged into the accounting equation as follows: Assets = Liabilities + Capital, or Capital = Assets – Liabilities, or Liabilities = Assets – Capital The accounting equation will be studied in more depth towards the end of this chapter. Further detail on capital To return to the accounting equation, you can perhaps see that the assets of an entity have been provided, or ‘financed’, by liabilities due to either outsiders or to the owners. This emphasises the importance of the separate entity concept described previously. As we regard the owners as being separate from the business entity itself, we can regard the amount owed by the business entity to its owners as a kind of liability. Effectively, we can restate the accounting equation in an even simpler form: Assets of the business entity = Liabilities of the business entity This statement is always true no matter what transactions the business entity undertakes. Any transaction that increases or decreases the assets of the business entity must increase or decrease its liabilities by an identical amount. You may be wondering exactly what is meant by saying that capital is an amount ‘owed’ by the business entity to its owners. How can the business entity ‘owe’ anything in this way? How has it incurred a debt? The answer is that when a business entity commences, it is common for the owners to ‘invest’ some of their private or personal resources into the business. As the business entity operates it generates its own resources in the form of profits, which technically belongs to the owners. Some of the profit may remain in the business entity, whilst some profit may be withdrawn by the owners in the form of goods or cash. This withdrawal of profits in simple entity structures such as sole traders is known as ‘drawings’. 20  Chapter 1 Income The Framework defines income as 'increases in assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from holders of equity claims' (Framework, para 4.68). In simple terms, for most business entities this will be sales revenue earned on the sale of goods or provision of services to customers. It could also include other items such as bank interest received. Expense The Framework defines expenses as 'decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims'(Framework, para 4.69). This may occur, for example, when purchasing goods for resale or by incurring operating and other costs such as wages, heat and light charges or repairs to factory machinery. Capital and revenue transactions Since the accounting equation makes use of three of the elements of the financial statements as follows: Assets – Liabilities = Capital or, it can be re-stated as: Assets = Capital + Liabilities It therefore demonstrates the relationships that exist within any business entity. The equation is the basis of one of the most common accounting statements prepared – the statement of financial position. This equation will form the basis of much of your studies for this subject to record accounting transactions. It will be considered in further detail later in this publication. Consequently, it is important that you understand the following distinctions: between capital and revenue transactions, and between cash and profit. 21 The accounting environment Capital transactions Capital transactions relate to costs incurred that will affect the entity in the long term, i.e. more than a year. For the purpose of your studies for this subject we will assume this relates to purchases of non-current assets such as buildings, plant and machinery etc. Capital costs or capital expenses will NOT be included as an expense in the statement of profit or loss but as a non-current asset in the statement of financial position. Revenue transactions Revenue transactions relate to expenses that will only affect the entity in the current accounting period, for example wages, rent payable and vehicle running costs. Revenue expenses will be included as expenses in the statement of profit or loss and NOT in the statement of financial position. Capital transactions = statement of financial position Revenue transactions = statement of profit or loss Capital and revenue transactions – further information Capital transactions The word ‘capital’ means different things in different contexts. You have already seen how the word is used to identify the investment by an owner in the business entity. Capital transactions are those that affect the business entity in the long term, as well as in the current period. Capital expenditure is expenditure on non-current assets, and capital receipts would result from the disposal of those assets. Other transactions that are regarded as capital transactions are the obtaining of, and repayment of, non-current finance. Capital transactions initially affect the statement of financial position. Of course, non-current assets are used up over a number of years, and so eventually they will be consumed. We account for this by including depreciation in the statement of profit or loss. You will consider this is more detail as you progress through your studies for this subject. Revenue transactions Revenue transactions are those that affect the entity in the current accounting period. Revenue receipts come from sales, and sometimes in the form of income from investments. Revenue expenditure is expenditure on items that are consumed in the current accounting period, for example the running expenses of the entity, cost of sales and so on. Revenue transactions affect the figures in the statement of profit or loss. 22  Chapter 1 Cash and profit A key point to understand is the difference between cash and profit. Cash may be regarded as the value of notes and coins (including bank balances) an entity has access to at any point in time. Consequently, cash transactions are accounted for based upon the date of receipt and payment of cash. Profit is the difference between sales revenue less expenses incurred during an accounting period, which is accounted for on an accruals basis. In effect, this means that transactions are accounted for on the date that they are entered into, which may not be the same as the date of receipt or payment of cash. It is explained further elsewhere in this chapter. The profit or loss for an accounting period will not be matched by an equal increase or decrease in the cash and bank balances of an entity for several reasons. This may be demonstrated by two relatively simple examples as follows: consider the situation of a business entity that sells goods on credit for $100. When the sale is made, sales revenue of $100 can be recorded in the accounting records. However, there will not be an equivalent increase in the cash and bank balances until the customer actually pays for the goods at some later date. consider the situation of a business entity that purchases new office equipment at a cost of $500, paying cash immediately. This represents the purchase of a non-current asset, and the reduction in the value of another asset (cash and bank balances) by $500. Therefore, this transaction affects only the statement of financial position and does not immediately affect the profit or loss for that accounting period. As you progress through your studies for this subject, you will come across further examples of transactions which do not have an equal impact upon profit and cash. Some of those transactions are noted below for reference: some accounting transactions do not affect the profit or loss for an accounting period, but do affect cash and bank balances, such as: – capital introduced into the business entity by the proprietor – cash drawings from the business entity by the proprietor – purchase of non-current assets, such as property plant and equipment. some accounting transactions do affect the profit or loss for an accounting period, but do not affect cash and bank balances, such as: – accounting for accruals and prepayments – accounting for depreciation – accounting for irrecoverable debts and allowances for receivables. 23 The accounting environment 10 The qualitative characteristics of financial information So far, we have considered who the users of financial information are, and for what purpose they may require financial information. All of the user groups identified, both internal and external to the entity, require that financial information provided should be useful. In this context, information should: enable its recipient to make effective decisions be adequate for taking effective action to control the entity or provide valuable details relating to its environment be compatible with the responsibilities and needs of its recipient be produced at optimum cost be easily understood by its recipient be timely, and be sufficiently accurate and precise for the purpose of its provision. The Framework requires that financial information should have certain qualitative characteristics to ensure that it meets the needs of users. The Framework identifies two fundamental qualitative characteristics and four enhancing qualitative characteristics as follows: (i) Fundamental qualitative characteristics – Relevance – Faithful representation. (ii) Enhancing qualitative characteristics – Comparability – Verifiability – Timeliness – Understandability. Note that the content relating to th