Financial Accounting and Management Accounting Notes PDF

Financial accounting and management accounting\ Financial accounting\ Financial accounting is initially concerned with the recording,\ classification and summarisation of individual transactions. From this\ information, annual financial statements are produced for external\ stakeholders such as prov...

Financial accounting and management accounting\ Financial accounting\ Financial accounting is initially concerned with the recording,\ classification and summarisation of individual transactions. From this\ information, annual financial statements are produced for external\ stakeholders such as providers of finance and potential investors. These\ financial statements are a report on the directors' stewardship of the\ funds entrusted to them by the shareholders.\ Investors need to be able to choose which companies to invest in and to\ evaluate their investments. In order to facilitate evaluation and\ comparison, financial accounts are prepared using accepted accounting\ conventions and standards. 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.\ The financial statements of limited companies are public documents,\ although they do not reveal details about, for example, the profitability of\ individual products or services sold by a company. Management accounting\ Management require much more detailed and up-to-date information in\ order to control the entity and plan for the future. Management needs to\ be able to cost-out products and production methods, assess profitability\ and so on. In order to facilitate this, management accounts present\ information in any way that may be useful to management, for example\ by operating unit or product line.\ Management accounting is an integral part of management activity\ concerned with identifying, presenting and interpreting information used\ for:\ formulating strategy\ planning and controlling activities\ decision making, and\ optimising the use of resources. The main users (stakeholders) of financial statements are commonly grouped\ as follows:\ Investors and potential investors are interested in the profit and returns\ they may receive along with the security of their investment. Future profits\ may be estimated from the target entity's past performance as shown in\ the statement of profit or loss. The security of their investment will be\ indicated by the financial strength and solvency of the entity as shown in\ the statement of financial position. The largest and most sophisticated\ groups of investors are the institutional investors, such as pension funds\ and unit trusts.\ Employees and trade union representatives need to know if an employer\ can offer secure employment and possibly also pay rises. They will also\ have a keen interest in the salaries and benefits enjoyed by senior\ management. Information regarding divisional profitability will also be\ useful if a part of the entity is threatened with closure.\ Lenders need to know if they will be repaid. This will depend on the\ solvency of the entity, which should be revealed by the statement of\ financial position. Long-term loans may also be backed by 'security' given\ by the entity over specific assets. The value of these assets will be\ indicated in the statement of financial position.\ Government agencies need to know how the economy is performing in\ order to plan financial and industrial policies. The tax authorities also use\ financial statements as a basis for assessing the amount of tax payable by\ an entity.\ Suppliers need to know if they will be paid. New suppliers may also\ require reassurance about the financial health of an entity before agreeing\ to supply it with goods or services. Chapter 1\ KAPLAN PUBLISHING 5\ Customers need to know that an entity can continue to supply them into\ the future. This is particularly true if a customer is dependent on an entity\ for specialist supplies.\ The public may wish to assess the effect of the entity on the economy,\ local environment and local community. Entities may contribute to their\ local economy and community through providing employment and\ patronising local suppliers. Some entities also run corporate responsibility\ programmes through which they support the environment, economy and\ community by, for example, supporting recycling schemes.\ Management and competitors would also use the financial statements of an\ entity to make economic decisions. Management, however, predominantly use\ management accounting information as their main source of financial\ information for decision-making. Competitors may also access publicly available\ information to assist decision-making in relation to their own business activities.\ Overall, users of financial statements need information which is relevant and\ reliable to help them to assess management's stewardship of the resources\ which they control and manage. Financial information enables users to hold\ managers to account for their decisions and to enable users to make decisions\ about whether to invest in or provide additional resources to a business.\ \ 3 Types of business entity\ A business can be operated in one of several ways: Sole trader\ This is the simplest form of business entity where a business is owned and\ operated by one individual, although it may employ any number of people. With\ this form of entity, there is no legal distinction between the owner and the\ business. To this end the owner receives all of the profits of the business but The capital structure of a sole trader is also relatively simple. There is a capital\ account which represents the financial interest of the owner in the business.\ The capital account can be added to by the owner introducing additional capital\ into the business, or by the business making profits, which the sole trader is\ entitled to. The capital account can be reduced by the sole trader making\ withdrawals from the capital account during the year (often referred to a\ \'drawings\') or by the business making losses.\ Partnership\ Similar to a sole trader the owners of a partnership collectively receive all the\ profits and have unlimited liability for the losses and debts of the business. The\ key distinction is that there are at least two owners. The joint owners, or\ partners, are jointly and severally liable for the losses the business makes (i.e.\ they are each fully liable in respect of all business liabilities).\ The capital structure of a partnership is similar to that of a sole trader. Each\ partner will have a financial interest in the business and this will be divided\ between a capital account and current account. The capital account is normally\ a fixed amount that will only change upon a partner joining or leaving the\ business. The current account includes the share of profit or loss that each\ partner is entitled to, less any personal drawings made by that partner.\ Limited liability companies\ Unlike sole traders and partnerships, a limited liability company is established\ as separate legal entity to their owners. This is achieved through the legal\ process of incorporation. The owners of the company (the shareholders) invest\ capital in the company in return for a shareholding that entitles them to a share\ of the residual assets of the company (i.e. what is left when the company is\ wound up or liquidated). The shareholders are not personally liable for the debts\ of the company and whilst they may lose their investment if the company\ becomes insolvent they will not have to pay the outstanding debts of the\ company if such a circumstance arises. Likewise, the company is not affected\ by the insolvency (or death) of individual shareholders. Limited liability\ companies are managed by a board of directors who are elected by the\ shareholders.\ The capital structure of a limited liability company is more formalised than that\ of a sole trader or partnership and is illustrated within this chapter. Shareholders\ cannot make withdrawals or \'drawings\' from the business in the way that a sole\ trader or partner is able to do. Instead, they receive a return on their investment\ in the company referred to as a dividend which is paid from accumulated profits. The capital structure of a sole trader is also relatively simple. There is a capital\ account which represents the financial interest of the owner in the business.\ The capital account can be added to by the owner introducing additional capital\ into the business, or by the business making profits, which the sole trader is\ entitled to. The capital account can be reduced by the sole trader making\ withdrawals from the capital account during the year (often referred to a\ \'drawings\') or by the business making losses.\ Partnership\ Similar to a sole trader the owners of a partnership collectively receive all the\ profits and have unlimited liability for the losses and debts of the business. The\ key distinction is that there are at least two owners. The joint owners, or\ partners, are jointly and severally liable for the losses the business makes (i.e.\ they are each fully liable in respect of all business liabilities).\ The capital structure of a partnership is similar to that of a sole trader. Each\ partner will have a financial interest in the business and this will be divided\ between a capital account and current account. The capital account is normally\ a fixed amount that will only change upon a partner joining or leaving the\ business. The current account includes the share of profit or loss that each\ partner is entitled to, less any personal drawings made by that partner.\ Limited liability companies\ Unlike sole traders and partnerships, a limited liability company is established\ as separate legal entity to their owners. This is achieved through the legal\ process of incorporation. The owners of the company (the shareholders) invest\ capital in the company in return for a shareholding that entitles them to a share\ of the residual assets of the company (i.e. what is left when the company is\ wound up or liquidated). The shareholders are not personally liable for the debts\ of the company and whilst they may lose their investment if the company\ becomes insolvent they will not have to pay the outstanding debts of the\ company if such a circumstance arises. Likewise, the company is not affected\ by the insolvency (or death) of individual shareholders. Limited liability\ companies are managed by a board of directors who are elected by the\ shareholders.\ The capital structure of a limited liability company is more formalised than that\ of a sole trader or partnership and is illustrated within this chapter. Shareholders\ cannot make withdrawals or \'drawings\' from the business in the way that a sole\ trader or partner is able to do. Instead, they receive a return on their investment\ in the company referred to as a dividend which is paid from accumulated profits. Comparison of companies to sole traders and partnerships\ The fact that a company is a separate legal entity means that it is very\ different from a sole trader or partnership in a number of ways.\ Property holding\ The property of a limited liability company belongs to the\ company. A change in the ownership of shares in the company\ will have no effect on the ownership of the company\'s property. (In\ a partnership the firm\'s property belongs directly to the partners\ who are entitled to their share of each asset if they leave the\ partnership.)\ Transferable shares\ Shares in a limited liability company can usually be transferred\ without the consent of the other shareholders. In the absence of\ agreement to the contrary, a new partner cannot be introduced\ into a firm without the consent of all existing partners.\ Suing and being sued\ As a separate legal entity, a limited company can sue and be\ sued in its own name. Judgements relating to companies do not\ affect the members personally.\ Security for loans\ A company has greater scope for raising loans and may secure\ them with floating charges. A floating charge is a mortgage over\ the constantly fluctuating assets of a company providing security\ for the lender. It does not prevent the company using the assets in\ the ordinary course of business. Such a charge is useful when a\ company does not have non-current assets such as land and\ buildings, but does have significant and valuable inventories.\ Generally, the law does not permit partnerships or individuals to\ secure loans with a floating charge.\ Taxation\ Because a company is legally separate from its shareholders, it is\ taxed separately from its shareholders. Partners and sole traders\ are personally liable for income tax on their share of the profits\ made by their business. Disadvantages of incorporation\ The disadvantages of being a limited liability company arise\ principally from restrictions imposed by relevant company law:\ -- When being formed, companies have to register and file\ formal constitution documents with the company registry,\ referred to in the UK as Registrar of Companies. Registration\ fees and legal costs must be paid. It is likely that many\ countries have a similar registration process to establish a\ company.\ -- In addition, it is normally a requirement for a company to\ produce annual financial statements that must be submitted\ to the company registry. It is also usually a requirement for\ those financial statements to be audited (in some countries\ this is only a requirement for large and medium sized\ companies). The costs associated with this can be high.\ Partnerships and sole traders are not subject to this\ requirement unless it is required by a regulatory authority,\ such as a professional body.\ -- A registered company\'s accounts and certain other\ documents are open to public inspection. The accounts of\ sole traders and partnerships are not open to public\ inspection.\ -- Limited companies are subject to strict rules in connection\ with the introduction and withdrawal of capital and profits.\ -- Members of a company may not take part in its management\ unless they are also directors, whereas all partners are\ entitled to share in management of the business, unless the\ partnership agreement provides otherwise. 4 The Framework\ One of the most important documents underpinning the preparation of financial\ statements is the Conceptual Framework for Financial Reporting 2010\ (Conceptual Framework), prepared by the International Accounting Standards\ Board (IASB) (see Chapter 2 for a discussion of the regulatory bodies).\ The Conceptual Framework presents the main ideas, concepts and principles\ upon which all International Financial Reporting Standards (normally referred to\ as 'IFRS Accounting Standards'), and therefore financial statements, are based.\ It includes discussion of\ the purpose of the Conceptual Framework\ the objectives of financial reporting\ the qualitative characteristics of useful financial information\ the definition, recognition and measurement of the elements from which\ the financial statements are constructed\ the accruals and going concern concepts, and\ the concepts of capital and capital maintenance (not in the syllabus). The purpose of the Framework\ The purpose of the Conceptual Framework is to assist the IASB in the\ development of financial reporting standards and to assist preparers of financial\ statements to develop accounting policies when reporting standards do not\ provide sufficient guidance, or where there is a choice of accounting policy.\ It is also a useful reference document to assist in understanding, interpreting\ and applying accounting standards.\ The objective of financial reporting\ The main objective is to provide financial information about the reporting entity\ to users of the financial statements that is useful in making decisions about\ providing economic resources to the entity, as well as other financial decisions.\ Prudence\ Prudence is an important concept (as referred to later in this chapter) and is the\ exercise of caution when making judgements under conditions of uncertainty.\ The helps to ensure that assets and income are not overstated in the financial\ statements, and that liabilities and expenses are not understated.\ 5 Qualitative characteristics\ Qualitative characteristics are the attributes that make the information provided\ in financial statements useful to others.\ The Conceptual Framework splits qualitative characteristics into two categories:\ (i) Fundamental qualitative characteristics\ -- Relevance\ -- Faithful representation\ (ii) Enhancing qualitative characteristics\ -- Comparability\ -- Verifiability\ -- Timeliness\ -- Understandability Fundamental qualitative characteristics\ Relevance\ Information is relevant if:\ it has the ability to influence the economic decisions of users, and\ is provided in time to influence those decisions.\ Materiality has a direct impact on the relevance of information.\ Qualities of relevance\ Information provided by financial statements needs to be relevant.\ Information that is relevant has predictive, or confirmatory, value.\ Predictive value enables users to evaluate or assess past, present\ or future events.\ Confirmatory value helps users to confirm or correct past\ evaluations and assessments.\ Where choices have to be made between mutually exclusive options,\ the option selected should be the one that results in the relevance of the\ information being maximised -- in other words, the one that would be of\ most use in taking economic decisions.\ A threshold quality is one that needs to be studied before considering\ the other qualities of that information:\ a cut-off point -- if any information does not pass the test of the\ threshold quality, it is not material and does not need to be\ considered further.\ information is material if omitting, misstating or obscuring it could\ reasonably be expected to influence the decisions that the primary\ users of general purpose financial statements make on the basis of\ those financial statements, which provide financial information\ about a specific reporting entity.\ Faithful representation\ If information is to represent faithfully the transactions and other events\ that it purports to represent, they must be accounted for and presented\ in accordance with their substance and economic reality and not merely\ their legal form. This is known as 'substance over form'.\ To be a perfectly faithful representation, financial information should\ possess the following characteristics:\ Completeness\ To be understandable information must contain all the necessary\ descriptions and explanations. This may include estimated amounts\ where absolute precision is neither possible nor cost-effective to\ achieve. Neutrality\ Information must be neutral, i.e. free from bias. Financial statements are\ not neutral if, by the selection or presentation of information, they\ influence the making of a decision or judgement in order to achieve a\ predetermined result or outcome.\ Free from error\ Information must be free from error within the bounds of materiality. A\ material error or an omission can cause the financial statements to be\ false or misleading and thus unreliable and deficient in terms of their\ relevance.\ Free from material error does not mean perfectly accurate in all\ respects. For example, where an estimate has been used the amount\ must be described clearly and accurately as being an estimate. Enhancing qualitative characteristics\ Comparability, verifiability, timeliness and understandability are\ qualitative characteristics that enhance the usefulness of information\ that is relevant and faithfully represented.\ Comparability\ Users must be able to:\ compare the financial statements of an entity over time to identify\ trends in its financial performance and financial position\ compare the financial statements of different entities to evaluate\ their relative financial performance and financial position.\ For this to be the case there must be:\ consistency and\ disclosure.\ An important implication of comparability is that users are informed of\ the accounting policies employed in preparation of the financial\ statements, any changes in those policies and the effects of such\ changes. Compliance with accounting standards, including the\ disclosure of the accounting policies used by the entity, helps to achieve\ comparability.\ Because users wish to compare the financial position and the\ performance and changes in the financial position of an entity over time,\ it is important that the financial statements show corresponding\ information for the preceding periods. erifiability\ Verification can be direct or indirect. Direct verification means verifying\ an amount or other representation through direct observation i.e.\ counting cash. Indirect verification means checking the inputs to a\ model, formula or other technique and recalculation of the outputs using\ the same methodology.\ Timeliness\ Timeliness means having information available to decision makers in\ time to be capable of influencing their decisions. Generally, the older the\ information is, the less useful it becomes.\ Understandability\ Understandability depends on:\ the way in which information is presented\ the capabilities of users.\ It is assumed that users:\ have a reasonable knowledge of business and economic activities\ are willing to study the information provided with reasonable\ diligence.\ For information to be understandable, users need to be able to perceive\ its significance. 6 The elements of the financial statements\ In order to appropriately report the financial performance and position of a\ business the financial statements must summarise five key elements. The\ definitions are included in the Conceptual Framework and are as follows:\ 1 Asset -- A present economic resource controlled by the entity as a\ result of past events (para 4.3).\ For example, a building that is owned and controlled by a business and\ that is being used to house its operations and generate revenues would be\ classified as an asset.\ 2 Liability -- A present obligation of the entity to transfer an economic\ resource as a result of past events (para 4.26).\ For example, an unpaid tax obligation or a bank loan is a liability.\ 3 Equity -- This is the \'residual interest\' in the assets of the entity after\ deducting all liabilities. It is effectively what is returned to the owners\ (shareholders) when the business ceases to trade. 4 Income -- This consists of the increases in assets or decreases in\ liabilities that result in increases in equity, other than those relating to\ contributions from holders of equity claims. This can be achieved, for\ example, by generating revenue from sales or through the increase in the\ value of an asset.\ 5 Expense -- This consists of the decreases in assets or increases in\ liabilities that result in decreases in equity, other than those relating to\ distributions to holders of equity claims. This can be achieved, for\ example, by purchasing goods or services from another entity or through\ the reduction in value of an asset.\ Note: economic resource -- A right that has the potential to produce economic\ benefits (para 4.4). It may be thought of as anything which a business makes\ use of in order to produce and supply goods and services to its customers. For\ example, a business makes use of plant and equipment, which could be\ purchased or hired, to help produce goods and services 7 The components of a set of financial statements\ A set of financial statements comprises:\ the statement of financial position\ This statement summarises the assets, liabilities and equity balances of\ the business at the end of a reporting period.\ The classification or grouping of assets, liabilities and equity in a\ consistent manner helps users of financial statements to understand that\ information and enable identification of information that is of particular\ relevance to them. Consistent presentation of information also helps users\ to make comparison and undertake analysis of financial information.\ A specimen statement of financial position, including hypothetical\ monetary amounts, is presented below Note that there is a standard format to the statement of financial position.\ Assets and liabilities have each been classified into either \'non-current\' or\ \'current\' items. Current assets are those which are expected to be\ converted into cash within twelve months of the reporting date. Non-\ current assets are those which are used in the business over a number of\ years to generate sales revenues and profits.\ Non-current liabilities are those which will be settled more than twelve\ months from the reporting date. Current liabilities are those which will be\ settled within twelve months of the reporting date.\ The capital structure of a limited liability company will be explained in more\ detail in the chapter 'Capital structure and finance costs'. In the case of a\ sole trader, the items classified within the \'Equity\' section of the statement\ would be replaced by a simple capital account.\ the statement of profit or loss and other comprehensive income\ This statement summarises the revenues earned and expenses incurred\ by the business throughout the reporting period. This used to be referred\ to as a \'profit and loss account.\' A specimen statement of profit or loss and\ other comprehensive income, including hypothetical monetary amounts, is\ presented below. Note that there is a standard format to the statement of financial position.\ Assets and liabilities have each been classified into either \'non-current\' or\ \'current\' items. Current assets are those which are expected to be\ converted into cash within twelve months of the reporting date. Non-\ current assets are those which are used in the business over a number of\ years to generate sales revenues and profits.\ Non-current liabilities are those which will be settled more than twelve\ months from the reporting date. Current liabilities are those which will be\ settled within twelve months of the reporting date.\ The capital structure of a limited liability company will be explained in more\ detail in the chapter 'Capital structure and finance costs'. In the case of a\ sole trader, the items classified within the \'Equity\' section of the statement\ would be replaced by a simple capital account.\ the statement of profit or loss and other comprehensive income\ This statement summarises the revenues earned and expenses incurred\ by the business throughout the reporting period. This used to be referred\ to as a \'profit and loss account.\' A specimen statement of profit or loss and\ other comprehensive income, including hypothetical monetary amounts, is\ presented below. the statement of changes in equity\ This statement summarises the movement in equity balances (share\ capital, share premium, revaluation surplus and retained earnings -- all\ explained in greater detail later in the text) from the beginning to the end of\ the reporting period. It applies only to limited liability companies and would\ not be required for a sole trader or partnership 8 Important accounting principles and concepts\ There are a number of other accounting principles and concepts that underpin\ the preparation of financial statements. The most significant ones include:\ Materiality\ An item is regarded as material if its omission or misstatement is likely to\ change the perception or understanding of the users of that information -- i.e.\ they may make inappropriate decisions based upon the misstated information.\ Note that this is a subjective assessment made by those who prepare the\ financial statements (usually company directors) and it requires them to\ consider the reliability of the financial statements for decision-making purposes\ by users, principally the shareholders. For example, consider if the bank balance of a large entity (such as a company\ listed on the stock exchange) was misstated by \$1 in the statement of financial\ position. This may not be regarded as a material misstatement which would\ significantly distort the relevance and reliability of the financial statements.\ However, if the bank balance was misstated by \$100,000, this is more likely to\ be regarded as a material misstatement as it significantly distorts the\ information presented in the financial statements.\ Aggregation of similar items is permitted as this presents summarised\ information of items with similar characteristics in the financial statements. For\ example, the total amount due from trade receivables is disclosed rather than\ specific amounts due from each credit customer.\ Substance over form\ As noted earlier, if information is to be presented faithfully, the economic reality\ must be accounted for and not just the strict legal form.\ An example of substance over form that you will encounter later in the text is\ the accounting treatment of redeemable preference shares. Although in legal\ form they are shares, there is an obligation to repay the preference\ shareholders and so they are accounted for as liability.\ Going concern\ Financial statements are prepared on the assumption that the entity is a going\ concern, and will continue to operate for the foreseeable future (i.e. it has\ neither the need nor the intention to liquidate or significantly curtail its\ operations). The normal expectation is that, based upon current knowledge and\ understanding of the business, it is reasonable to assume that the business will\ continue to operate for the next twelve months. Note that there is no guarantee\ that this will always be the case as evidenced by business failures and\ insolvencies.\ The business entity\ This principle means that the financial accounting information presented in the\ financial statements relates only to the activities of the business and not to\ those of the owner. From an accounting perspective the business is treated as\ being separate from its owners.\ Accrual accounting\ This means that transactions are recorded when revenues are earned and\ when expenses are incurred. This pays no regard to the timing of any\ associated cash payment or receipt.\ For example, if a business enters into a contractual arrangement to sell goods\ to another entity the sale is recorded when the contractual duty has been\ satisfied. That is likely to be when the goods have been supplied and accepted\ by the customer. The payment may not be received for another month but in\ accounting terms the sale has taken place and should be recognised in the\ financial statements. Prudence\ Preparers of financial statements should exercise prudence when preparing\ financial statements. Assets and income should not be overstated whilst\ liabilities and expenses should not be understated. However, care must be\ exercised to ensure that there is not deliberate misstatement of assets,\ liabilities, income and expenses as that would introduce bias into the financial\ statements. Applying the principle of prudence helps to ensure that financial\ statements are fairly stated and can be relied upon by users.\ Consistency\ Consistency of accounting treatment and presentation relates not only from one\ accounting period to the next, but also within an accounting period, so that\ similar transactions are accounted for in the same way. Application of IFRS\ Accounting Standards also help to promote consistency of accounting treatment\ between entities as identical items are subject to the same accounting\ requirements. Users of the financial statements need to be able to compare the\ performance of an entity over a number of years and to be able to compare the\ financial performance and position of different entities. Therefore it is important\ that the presentation and classification of items in the financial statements is\ retained from one accounting period to the next, unless there is a change in\ circumstances or a requirement of a new IFRS Accounting Standard as this\ facilitates comparability of information in the financial statements.\ Offsetting\ Offsetting is netting-off transactions and balances, which results in recording or\ presenting only the net effect of those transactions and balances. This reduces\ the information available to users of financial information and is not permitted\ (subject to a few limited exceptions). The gross or full effect of transactions and\ balances should be recorded and presented in financial statements.\ For example, many entities have both cash in the bank and a bank loan. They\ are presented separately in the financial statements (one as an asset and the\ other as a liability), rather than just the net balance. Similarly, if an entity both\ sells to, and buys from, another entity on credit terms, it may have both a\ receivable (amount due to it) and a payable (amount due from it) outstanding at\ the accounting year end. The two amounts are presented separately in the\ financial statements, rather than simply the net amount due to or from the entity. Duality\ This principle recognises that every transaction has two effects and therefore\ must be recorded twice in the accounting records. It is the fundamental principle\ upon which double-entry bookkeeping is based and is covered in detail in the\ following chapters of this publication.\ For example, if an entity uses a business debit card to purchase a laptop for\ use in the office, what is the dual effect? The entity now has new asset (a\ laptop) and a reduced bank balance. Both effects, the dual effect, must be\ recorded in the accounting records.\ Historical cost and current value\ Historical cost is the original monetary value of a transaction at the date that\ transaction was entered into. For example, an entity may have purchased a\ factory thirty years ago at a historical cost of, say, \$100,000. It bears no relation\ to the current value of the factory that may now have a current value\ significantly in excess of its original cost due to the cumulative effect of inflation\ and other economic factors. Similarly, the historical cost of an item of plant and\ equipment may be significantly more than its current value due to factors such\ as wear and tear from usage and changes in technology