Financial AccountingFinancial Accounting

What is accounting?What is accounting?

• Accounting is the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information

• Accounting provides the key source of information about a business to those who need it - owners/shareholders, managers, other stakeholder

AccountingAccounting

• Accounting is– a system that identifies, records and

communicates information that is relevant, reliable and comparable to help user make better decisions

– a classification and recording of monetary transactions

– presentation and interpretation of the results of those transactions in order to assess performance

Financial accountingFinancial accounting

• The classification and recording of all the monetary transactions of an entity in accordance with established concepts principles, accounting standards and legal requirements and their presentation, by means of profit and loss accounts, balance sheets and cash flow statements, during and at the end of an accounting period. (CIMA)

• The recording and presentation of business transactions in order to supply information to the owners of a business on the performance of their investment

The stewardship function The stewardship function

• Financial accounts are prepared to reassure the providers of finance that the financial resources they have provided are safe and that they are being used wisely

• Stewards (i.e. directors) have a obligation to provide relevant and reliable financial information relating to resources over which they have control but which are owned by others (i.e. shareholders)

• If the providers of finance feel that their investment is unsafe they will withdraw the finance they have provided

Reporting to stakeholdersReporting to stakeholders

• Financial accounts are prepared for shareholders- the owners of the business

• But they are of interest to other stakeholders:– potential shareholders– creditors and potential creditors– the government– employees– customers– suppliers– the community

Basic purpose of financial Basic purpose of financial accountingaccounting

• To keep a record of all financial events that have taken place in the business as and when then happen

• To record and classify information extracted from basic books of accounts

• To summarise what has happened - collecting and recording information about financial events that have taken place

• To provide a means of interpreting and analysing the information

• To present financial statements to shareholders and other stakeholders

Financial statementsFinancial statements

• The objective of financial statements is to provide information about the financial position, performance and change in financial position of an enterprise that is useful to a wide range of users in making economic decisions. (International Accounting Standards Board)

• The key statements are– profit and loss account– balance sheet– cash flow statement (not to be confused with a

cash flow budget)

Financial accounts Financial accounts

• Financial accounts– are largely based on historic information– provide an analysis for evaluation of performance– record all the financial transactions that have

taken place– classify transactions into major headings– summarise all the transactions into final accounts– ensure that the accounts show a true and fair

view

A true and fair viewA true and fair view

• Company law requires that financial statements provide a true and fair view

• This is generally taken to mean that the accounts are prepared to inform and not to mislead the user

• The accounts should provide a fair impression of the company and the results of its activities

• To provide a true and fair view accounts must conform to various accounting concepts, conventions, policies and standards

• The accounts must also be prepared in accordance with company law

Concepts, standards and Concepts, standards and policiespolicies

• Accounting concepts - principles that underpin the preparation of accounting information

• Accounting standards - rules that business must follow to give a true and fair view when drawing up accounts

• Accounting polices - the specific methods selected and followed by a company in areas (such as stock valuation, depreciation) where some flexibility is allowed.

The regulatory frameworkThe regulatory framework

• The regulatory framework provides a set of rules and regulations which govern accounting practices

• In the UK the main sources of regulation are the Companies Act and accounting standards

• Accounting standards are rules applied in accounting practice that have been recommended by the Accounting Standards Board

• They were previously known as Statements of Standard Accounting Practice (SSAP) but are now called Financial Reporting Standards (FRS)

Accounting standardsAccounting standards

• These are defined as– accounting pronouncements which must be

followed in order to give a true and fair view within the regulations

– authoritative statements of how particular types of transactions and other events should be reflected in financial statements

• Compliance with accounting standards is necessary if financial statements are to give a true and fair view.

• Examples of accounting standards: Goodwill and intangible assets (FRS 10), Accounting policies (FRS 18), the impact of foreign exchange rates on accounts (FRS 23)

Accounting policiesAccounting policies

• These are the accounting bases that managers of a business have selected to use because – they consider them appropriate to their particular business– they are best suited to present results and financial position

fairly

• The definition reveals that managers are able, within certain constraints, to select a particular policy

• Accounting standards allow some flexibility in treatment of items e.g. depreciation, stock valuations

• Accounting policies have to be declared in the annual report

• But there is a danger that flexibility opens the door to “windowing dressing” of accounts

Accounting conventions and Accounting conventions and conceptsconcepts

Boundary rulesEntityPeriodicityGoing concern Qualitative

Measurement rulesMoney measurementHistorical costRealizationMatchingDual aspectMateriality

Ethical rules

PrudenceConsistency ObjectivityRelevance

Boundary rules (1)Boundary rules (1)

• Business entity – as far as accounting is concerned, the

business is distinct from all other units, including the owner's)

– the firm is a separate entity - separate from owners and managers

• Going concern – accounts are prepared on the assumption

that the firm will continue into the foreseeable future

Boundary rules (2)Boundary rules (2)

• Periodicity – the requirement to produce financial statements

at set time intervals– accounts are prepared for a set period of time– this requirement is embodied in Company Law

• Qualitative– accountant restrict the data that are collected to

those that are easily quantifiable– items that are impossible to put into numbers are

not included in a conventional accounting system

Measurement rules (1)Measurement rules (1)

• Monetary measurement– only transactions that can be given a

monetary value are recorded in the books of account

– money measurement is used for all assets and liabilities

– accounting only deals with those items capable of being translated into monetary terms

Measurement rules (2)Measurement rules (2)

• Historic cost– valuations based on original cost rather

than current worth– all values are based on historical costs

incurred– assets are valued with reference to the

cost of acquisition

Measurement rules (3)Measurement rules (3)

• Realisation – a sale is recognised when the product or

service has been delivered and the buyer has accepted the invoice

– at this point ownership is transferred and the transaction is recognised as sales revenue

– in the books of account, goods have been replaced by either cash or by a debtor

Measurement rules (4)Measurement rules (4)

• Revenues and costs are recorded when they are incurred - not when cash is received or paid

• This point needs to be appreciated especially in relation to the profit and loss account:

• A sale made in one accounting period is classed as revenue even though the inflow of cash occurs in the next accounting period. A sale is realised when a good is delivered

• The costs associated with the sales are matched in the same accounting period whether or not there hade been a cash outflow to settle the payment of the costs

Measurement rules (5)Measurement rules (5)

• Accruals or matching– this is a fundamental principle in accounting

- it involves matching of sales and expenses so that all the expenses incurred in making a sale are deducted from it

– costs and revenues are matched so that financial records refer to the same goods and services in the same time period

– match this revenue against the cost incurred in generating the revenue

Measurement rules (6)Measurement rules (6)

• Dual aspect– all transactions involve two sides and so all

transactions are recorded twice– there must always be a debit entry and a

credit entry when recording financial transactions which affect the business

– the system of accounting works on the principle that whenever value is given, value must also be received

Measurement rules (7)Measurement rules (7)

• Materiality – accountants should not spend time trying

to record accurately items that are trivial and immaterial

– information is material if its omission or misstatement could influence the economic decisions of users on the basis of the financial statement

Ethical rules (1)Ethical rules (1)

• Prudence– accountants should be conservative when

producing accounts– if there is any doubt about the value of any

transaction then a conservative approach should be adopted

– always consider the worse case scenario and avoid over-optimism

– if in doubt underestimate revenue but overestimate costs

– the accountant recognises revenue only when it is realised in an acceptable form but provides for all expenses and losses as soon as they are known

– provision is made for all known liabilities

Ethical rules (2)Ethical rules (2)

• Consistency– accounts are prepared following the same

principles that were used in the previous set of accounts

– adopt the same procedure every time for recording and measuring items

– use the same accounting policies over time for fair comparison

Ethical rules (3)Ethical rules (3)

• Objectivity– accounts are based on measurable and

verifiable facts– accounts should be prepared with the

minimum amount of bias– adopt standard practices

• Relevance – include all information that is relevant

Financial information Financial information should be… should be…

• Accurate - free from error of content or principle• Material - useful not trivial• Timely - available in time to support decision

making• Relevant - to the issue. Applicable to the

purpose required• Reliable - a complete and faithful

representation• Comparable - consistent approach to provide

meaningful comparisons• Clear and understandable - capable of being

understood by those for whom the information has been prepared