Financial Accounting of Contents iv Financial Accounting 1.9 ACCOUNTING TERMINOLOGY 15 1.10 THE ACCOUNTANT’S ROLE AND FUNCTION IN AN ORGANISATION 17 1.11

Financial Accounting

Course Text

Professional, Practical, Proven

www.AccountingTechniciansIreland.ie

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Table of Contents

FOREWORD ...............................................................................................................xi

SYLLABUS: FINANCIAL ACCOUNTING ................................................................xiii

CHAPTER 1: INTRODUCTION TO ACCOUNTING ....................................................1

1.1 INTRODUCTION .........................................................................................................................2

1.2 ACCOUNTING ............................................................................................................................2

1.3 ACCOUNTABILITY .....................................................................................................................3

1.4 TYPES OF BUSINESS ENTITY ..................................................................................................51.4.1 Sole trader ....................................................................................................................51.4.2 Partnership ....................................................................................................................61.4.3 Limited Company ..........................................................................................................71.4.4 Public and Private Limited Companies .........................................................................9

1.5 USERS OF ACCOUNTING INFORMATION .............................................................................10

1.6 USERS OF FINANCIAL STATEMENTS .................................................................................... 111.6.1 Investors ..................................................................................................................... 111.6.2 Lenders ....................................................................................................................... 111.6.3 Suppliers ..................................................................................................................... 111.6.4 Customers ...................................................................................................................121.6.5 Employees ..................................................................................................................121.6.6 Government ................................................................................................................121.6.7 Analysts ......................................................................................................................121.6.8 Public at large .............................................................................................................13

1.7 TYPES OF ACCOUNTING .......................................................................................................13

1.8 THE MAIN FINANCIAL ACCOUNTING STATEMENTS ............................................................15

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1.9 ACCOUNTING TERMINOLOGY ...............................................................................................15

1.10 THE ACCOUNTANT’S ROLE AND FUNCTION IN AN ORGANISATION .................................17

1.11 AUDITING .................................................................................................................................18

1.12 ACCOUNTING ETHICS ............................................................................................................19

1.13 ACCOUNTING SCANDALS ......................................................................................................20

1.14 RESPONSES TO SCANDALS ..................................................................................................21

1.15 ETHICAL ISSUES AND THE ACCOUNTING TECHNICIAN .....................................................211.15.1 Codes of ethics ...........................................................................................................21

1.16 WHISTLE BLOWING ................................................................................................................22

CHAPTER 2: ACCOUNTING CONCEPTS & CONVENTIONS .................................25

2.1 INTRODUCTION .......................................................................................................................26

2.2 REGULATION AND STANDARDS ............................................................................................26

2.3 PROFESSIONAL SELF-REGULATION ....................................................................................26

2.4 COMPANIES ACTS ...................................................................................................................27

2.5 A TRUE AND FAIR VIEW ..........................................................................................................27

2.6 THE BASIC PRINCIPLES OF ACCOUNTING: CONVENTIONS AND CONCEPTS ................282.6.1 Accounting conventions ..............................................................................................282.6.2 Accounting concepts ...................................................................................................29

2.7 WHAT MAKES ACCOUNTING INFORMATION USEFUL? ......................................................31

2.8 A FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS ...........................................................................................................................32

2.9 RELEVANCE .............................................................................................................................33

2.10 RELIABILITY .............................................................................................................................33

2.11 COMPARABILITY .....................................................................................................................33

2.12 UNDERSTANDABILITY ............................................................................................................34

2.13 CONFLICTS IN THE QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION ................................................................................................34

2.14 ACCOUNTING POLICIES ........................................................................................................35

2.15 ESTIMATION TECHNIQUES ....................................................................................................35

2.16 MEASUREMENT BASES .........................................................................................................35

2.17 SELECTING ACCOUNTING POLICIES ...................................................................................36

2.18 REVIEWING AND CHANGING ACCOUNTING POLICIES ......................................................36

2.19 IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING, ESTIMATES AND ERRORS .....................................................................................................36

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CHAPTER 3: DOUBLE ENTRY BOOK-KEEPING ....................................................39

3.1 DOUBLE ENTRY BOOK-KEEPING AND THE DUALITY CONCEPT .......................................40

3.2 THE ACCOUNTING EQUATION ...............................................................................................41

3.3 LEDGER ACCOUNTS, DEBITS AND CREDITS ......................................................................42

3.4 RECORDING CASH TRANSACTIONS ....................................................................................45

3.5 RECORDING CREDIT SALES AND PURCHASES TRANSACTIONS. ...................................46

3.6 RECORDING SALES AND PURCHASES RETURNS .............................................................47

3.7 ACCOUNTING FOR DISCOUNTS ...........................................................................................48

3.8 DOUBLE ENTRY CHECKLIST .................................................................................................49

3.9 BALANCING OFF LEDGER ACCOUNTS ................................................................................493.9.1 Opening and Closing balances in the ledger accounts ...............................................503.9.2 Statement of Profit and Loss Account, ledger accounts .............................................513.9.3 Capital account ...........................................................................................................52

3.10 EXAMPLE 8 CLOSING OFF GEORGE’S ACCOUNTS ...........................................................523.10.1 Next step - trial balance ..............................................................................................553.10.2 The limitations of a trial balance .................................................................................563.10.3 The process steps in producing a trial balance from a set of ledger accounts. ..........56

3.11 EXAMPLE 9 EXTRACTING A TRIAL BALANCE FROM GEORGE’S ACCOUNTS .................56

3.12 SELF-TEST QUESTIONS .........................................................................................................57

3.13 SOLUTIONS TO SELF-TEST QUESTIONS .............................................................................59

CHAPTER 4: VAT, PAYROLL, BOOKS OF PRIME ENTRY ....................................69

4.1 ELEMENTS OF VALUE ADDED TAX (VAT) .............................................................................704.1.1 The VAT system ..........................................................................................................704.1.2 Rates of VAT ...............................................................................................................704.1.3 Principles of VAT .........................................................................................................704.1.4 The Exception: Irrecoverable VAT ...............................................................................714.1.5 Calculation of VAT .......................................................................................................714.1.6 Accounting entries for VAT ..........................................................................................73

4.2 PAYROLL ..................................................................................................................................754.2.1 The accounting entries for Payroll ..............................................................................76

4.3 BOOKS OF PRIME ENTRY ......................................................................................................774.3.1 Sales day book ...........................................................................................................784.3.2 Sales returns day book ...............................................................................................794.3.3 Purchases day book ...................................................................................................804.3.4 Purchases returns day book .......................................................................................814.3.5 The cash book ............................................................................................................824.3.6 Cash Receipts Book ...................................................................................................844.3.7 The petty cash book ....................................................................................................854.3.8 The journal ..................................................................................................................86

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4.4 SELF-TEST QUESTIONS .........................................................................................................86

4.5 SOLUTIONS TO SELF-TEST QUESTIONS .............................................................................88

CHAPTER 5: INTRODUCTION TO FINANCIAL STATEMENTS ..............................95

5.1 INTRODUCTION TO FINANCIAL STATEMENTS.....................................................................96

5.2 THE STATEMENT OF PROFIT AND LOSS ..............................................................................975.2.1 The trading income section. ........................................................................................975.2.2 The business expenditure section ..............................................................................995.2.3 Revenue income, capital income and revenue expenditure in the Statement of

Profit and Loss ............................................................................................................99

5.3 THE STATEMENT OF FINANCIAL POSITION .......................................................................1015.3.1 Assets and liabilities ..................................................................................................1025.3.2 Link between Statement of Financial Position and the Statement of

Profit and Loss ..........................................................................................................1035.3.3 Capital Expenditure in the Statement of Financial Position ......................................1035.3.4 Loans (Capital and Revenue elements) ....................................................................104

5.4 AN INTRODUCTION TO ACCOUNTING FOR OPENING AND CLOSING INVENTORY ......1055.4.1 Closing inventory ......................................................................................................1055.4.2 Opening inventory .....................................................................................................106

5.5 GEORGE’S TRIAL BALANCE (CONTINUED FROM SECTION 3.11, CHAPTER 3) ..............................................................108

5.6 SELF-TEST QUESTIONS .......................................................................................................112

5.7 SOLUTIONS TO SELF-TEST QUESTIONS ........................................................................... 114

CHAPTER 6: INVENTORY ......................................................................................123

6.1 ACCOUNTING FOR INVENTORY ..........................................................................................1246.1.1 The accruals concept ................................................................................................1246.1.2 Valuation of Inventory ...............................................................................................1256.1.3 The prudence concept ..............................................................................................1256.1.4 Cost ...........................................................................................................................1266.1.5 Net Realisable value (NRV) ......................................................................................126

6.2 METHODS OF VALUING INVENTORY – IAS 2 REQUIREMENTS .......................................1286.2.1 First in – First out (FIFO) ...........................................................................................1286.2.2 Average cost – AVCO ...............................................................................................129

6.3 THE IMPACT OF VALUATION METHODS ON THE STATEMENT OF PROFIT AND LOSS AND THE STATEMENT OF FINANCIAL POSITION...............................................................132


6.5 SOLUTIONS TO SELF-TEST QUESTIONS ...........................................................................136

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CHAPTER 7: ACCRUALS AND PREPAYMENTS ..................................................141

7.1 THE ACCRUALS CONCEPT ..................................................................................................142

7.2 ACCRUED EXPENDITURE ....................................................................................................143

7.3 PREPAID EXPENDITURE ......................................................................................................148

7.4 ACCRUED INCOME ...............................................................................................................153

7.5 PREPAID INCOME .................................................................................................................155

7.6 ACCRUALS AND PREPAYMENTS – FINANCIAL STATEMENTS EFFECT ..........................1577.6.1 The Statement of Profit and Loss .............................................................................1577.6.2 The Statement of Financial Position .........................................................................158



CHAPTER 8: IRRECOVERABLE DEBTS AND ALLOWANCE FOR RECEIVABLES ........................................................................................................173

8.1 ACCOUNTING CONCEPTS ...................................................................................................1748.1.1 Accruals concept .......................................................................................................1748.1.2 Prudence concept .....................................................................................................174

8.2 AGED RECEIVABLE ANALYSIS .............................................................................................1758.2.1 Advantages and Disadvantages of Selling on Credit ................................................1768.2.2 Credit limits ...............................................................................................................176

8.3 IRRECOVERABLE DEBTS .....................................................................................................1768.3.1 Irrecoverable debts recovered ..................................................................................178

8.4 ALLOWANCE FOR RECEIVABLES .......................................................................................1798.4.1 Specific allowance ....................................................................................................1808.4.2 General allowance ....................................................................................................1808.4.3 Accounting for Allowance for Receivables ................................................................180

8.5 IRRECOVERABLE DEBTS AND THE ALLOWANCE FOR RECEIVABLES – TRIAL BALANCE ADJUSTMENTS. .....................................................................................186



CHAPTER 9: NON-CURRENT ASSETS AND DEPRECIATION ............................199

9.1 CURRENT AND NON-CURRENT ASSETS ............................................................................200

9.2 CAPITAL AND REVENUE EXPENDITURE ............................................................................2019.2.1 Capital expenditure ...................................................................................................2019.2.2 Revenue expenditure ................................................................................................202

9.3 NON-CURRENT ASSET REGISTERS ...................................................................................202

9.4 ACCOUNTING FOR NON-CURRENT ASSETS .....................................................................203

9.5 DEPRECIATION ......................................................................................................................204

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9.6 ESTIMATING DEPRECIATION ...............................................................................................2059.6.1 Straight line depreciation ..........................................................................................2069.6.2 Reducing balance depreciation .................................................................................206

9.7 ACCOUNTING FOR DEPRECIATION ....................................................................................209

9.8 DISPOSAL OF NON-CURRENT ASSETS ..............................................................................212

9.9 DISPOSAL THROUGH A PART-EXCHANGE .........................................................................216

9.10 NON-CURRENT ASSETS AND THE FINANCIAL STATEMENTS ..........................................219

9.11 SOME ADDITIONAL INFORMATION ON DEPRECIATION OF NON-CURRENT ASSETS ...220


9.13 SOLUTIONS TO SELF- TEST QUESTIONS ..........................................................................223

CHAPTER 10: BANK RECONCILIATION STATEMENTS ......................................235

10.1 NATURE AND PURPOSE OF BANK RECONCILIATION STATEMENTS ..............................236

10.2 METHODOLOGY FOR PREPARING BANK RECONCILIATION STATEMENTS ...................237

10.3 DETAILED DIFFERENCES BETWEEN THE BANK ACCOUNT AND THE BANK STATEMENT ........................................................................................................239

10.4 PREPARATION OF A BANK RECONCILIATION STATEMENT ..............................................24310.4.1 The Proforma for a bank reconciliation .....................................................................24410.4.2 The Proforma for a bank reconciliation with a Bank Overdraft .................................244

10.5 EXAMPLES OF BANK RECONCILIATIONS, INCLUDING AN OVERDRAFT. .......................245

10.6 BANK DEBIT AND CREDIT BALANCES IN THE STATEMENT OF FINANCIAL POSITION .252



CHAPTER 11: PREPARATION OF FINANCIAL STATEMENTS ............................263

11.1 FROM TRIAL BALANCE TO FINANCIAL STATEMENTS .......................................................264

11.2 THE STATEMENT OF PROFIT AND LOSS ............................................................................265

11.3 THE STATEMENT OF FINANCIAL POSITION .......................................................................266

11.4 SOLE TRADER ACCOUNTS ..................................................................................................267

11.5 EXAMPLE 1: GINA O’HALLORAN ..........................................................................................268

11.6 EXAMPLE 2: RORY JAMESON’S FINANCIAL STATEMENTS ..............................................272

11.7 EXAMPLE 3: T. HIGGINS (A MORE COMPLICATED EXAMPLE) .........................................278

CHAPTER 12: ACCOUNTING FOR “NOT-FOR-PROFIT” ORGANISATIONS ......291

12.1 “NOT-FOR-PROFIT” ORGANISATIONS .................................................................................292

12.2 THE RECEIPTS AND PAYMENTS ACCOUNT .......................................................................292

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12.3 THE INCOME AND EXPENDITURE ACCOUNT ....................................................................293

12.4 ACCUMULATED FUND STATEMENT ....................................................................................295

12.5 ANNUAL SUBSCRIPTIONS ...................................................................................................29612.5.1 Entrance fees ............................................................................................................29812.5.2 Life membership subscriptions/payments .................................................................298

12.6 DIFFERENCES BETWEEN THE RECEIPTS AND PAYMENTS ACCOUNT AND THE INCOME AND EXPENDITURE ACCOUNT. ...........................................................................................301



CHAPTER 13: CONTROL ACCOUNTS & INTRODUCTION TO CONTROL ACCOUNT RECONCILIATIONS .............................................................................313

13.1 NATURE AND PURPOSE OF CONTROL ACCOUNTS .........................................................31413.1.1 Receivables ledger control account ..........................................................................31413.1.2 Payables ledger control account ...............................................................................31413.1.3 The purpose of control accounts ...............................................................................314

13.2 CONTROL ACCOUNTS AND DOUBLE ENTRY .....................................................................315

13.3 RECEIVABLES/SALES LEDGER CONTROL ACCOUNTS ....................................................31713.3.1 Explaining the Proforma Receivables Control Account .............................................31813.3.2 Applied Example of Receivables Control Account ....................................................320

13.4 PAYABLES/PURCHASES LEDGER CONTROL ACCOUNTS ................................................32113.4.1 Explaining the Proforma Payables Control Account .................................................32213.4.2 Applied Example of Payables Control Account .........................................................32313.4.3 Supplier statements ..................................................................................................324

13.5 INTRODUCTION TO CONTROL ACCOUNT RECONCILIATIONS ........................................324

13.6 CONTROL ACCOUNTS – THE STATEMENT OF FINANCIAL POSITION .............................327



CHAPTER 14: INCOMPLETE RECORDS ..............................................................337

14.1 INCOMPLETE RECORDS ......................................................................................................338

14.2 NET ASSETS APPROACH .....................................................................................................338

14.3 THE BALANCING FIGURE APPROACH ................................................................................34214.3.1 Deriving Sales – the missing figure ...........................................................................34414.3.2 Deriving Purchases – the missing figure ...................................................................34514.3.3 Deriving expenses – missing figures ........................................................................34714.3.4 Deriving Opening Capital ..........................................................................................352

14.4 MARGIN AND MARK-UP ........................................................................................................35314.4.1 Gross Profit Margin ...................................................................................................35314.4.2 Gross Profit Mark-up .................................................................................................354

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14.4.3 When Mark-up is known, what is the Margin? ..........................................................35514.4.4 When Margin is known, what is the Mark-Up? ..........................................................356

14.5 STEPS TO FOLLOW TO PREPARE FINANCIAL STATEMENTS FROM INCOMPLETE RECORDS. .............................................................................................................................359



CHAPTER 15: CORRECTION OF ERRORS ..........................................................379

15.1 IDENTIFICATION OF ERRORS ..............................................................................................38015.1.1 Types of errors and their impact on the Trial Balance ...............................................38015.1.2 The effect of errors on the Statement of Profit. .........................................................381

15.2 ERRORS WHICH DO NOT AFFECT THE BALANCING OF THE TRIAL BALANCE .............38115.2.1 Error of omission .......................................................................................................38115.2.2 Error of commission ..................................................................................................38615.2.3 Error of principle ........................................................................................................38815.2.4 Compensating errors ................................................................................................39115.2.5 Error of original entry ................................................................................................39515.2.6 Reversal of entries error ...........................................................................................398

15.3 CONTROL ACCOUNT RECONCILIATION AND CORRECTION OF ERRORS .....................401



CHAPTER 16: SUSPENSE ACCOUNT ..................................................................419

16.1 SUSPENSE ACCOUNT ..........................................................................................................42016.1.1 Method employed to correct errors ...........................................................................422

16.2 IDENTIFYING ERRORS CAUSING THE CREATION OF THE SUSPENSE ACCOUNT .......42316.2.1 Same sided entry error .............................................................................................42316.2.2 Single sided entry error .............................................................................................42516.2.3 Transposition error ....................................................................................................426

16.3 EXAMPLE 5: CONTROL ACCOUNT RECONCILIATION, WITH A SUSPENSE ACCOUNT ..427

16.4 EXAMPLE 6: JOHN O’CONNOR’S TRIAL BALANCE ............................................................430

16.5 ADJUSTMENT TO PROFIT ....................................................................................................437



INDEX.......................................................................................................................451

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FOREWORD

Foreword

This text has been developed by Accounting Technicians Ireland for use by students participating in our programme of study and preparing for our examinations. While every effort is made to ensure that the information outlined in this text is accurate, Accounting Technicians Ireland and

the Author cannot accept the responsibility for lack of, or perceived lack of, information contained herein.

The text is intended to be a sufficiently detailed synopsis of the current syllabus material (and knowledge level required thereof) in relation to this module.

Students should take particular note of the weighting attaching to this module, as clearly outlined in the syllabus. It is on the basis of this weighting that students should prepare their own timetable for study.

On the completion of each chapter, students should refer to the relevant questions dealing with that chapter. Ideally, students should not continue with subsequent chapters until they have completed the questions attaching to the chapter currently under review.

The solutions to the questions are provided under separate cover and although they are the suggested solutions, tutors and students should recognise and appreciate that there might very well be different approaches which would, under examination conditions, be perfectly acceptable.

We recommended that, in order to get the full benefit of the question and answer concept, students should not refer to the solution until they have made a full and genuine attempt at each question.

We also recommend that when students have attained an understanding of each chapter studied, in addition to the questions provided, they should access the Accounting Technicians Ireland website (www.accountingtechniciansireland.ie) for past papers and “sit them under exam conditions”. This will allow students to improve their time management skills and their approach to each type of question.

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Referencing

For the purposes of consistency, all references to “he” or “she” will be referred to as “he” in this publication. No other implication whatsoever is implied from this policy.

For the purposes of presentation, all references to “euro” or “sterling” will be referred to as “euro” in this publication. No other implication whatsoever is implied from this policy.

Copyright

This text is issued by Accounting Technicians Ireland to students taking its examinations. It may not be used in whole, or in part, for any course of study and/or examination of any other body whatsoever without prior permission in writing from Accounting Technicians Ireland. This publication, or any part thereof, may not be made available in any library, and it may not be reproduced, in whole or in part, stored in a retrieval system or transmitted in any form or by any means – photocopying, electronic, electrostatic, magnetic, pdf, mechanical, recording or otherwise, without prior permission in writing from Accounting Technicians Ireland, 47-49 Pearse Street, Dublin 2.

Acknowledgement

The 2013-2014 edition was edited and updated by Dr. Antoinette Flynn. Antoinette is a lecturer in Accounting and Finance with the Department of Accounting and Finance, University of Limerick. Her profile is available at www.ul.ie.

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SYLLABUS: FINANCIAL ACCOUNTING

SYLLABUS


Mandatory Module

Syllabus : Mandatory Module

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Subject Status Mandatory

Terminal Exam 100%

Module Pass Mark 50%

Learning Modes Direct Lectures, Workshops, Tutorials, Self Directed Learning

Pre-requisite Programme Entry Requirements

Key Learning Outcome

The key objective of this module is to provide learners with knowledge of accounting concepts and principles of accounting and the technical competency in the area of double entry accounting and accounts preparation for various types of business.

Key Syllabus Elements and Weightings

1. Accounting Fundamentals ......................................................................................................15%

2. Double-Entry Bookkeeping and Accounting Systems ............................................................50%

3. Accounts Preparation .............................................................................................................35%


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Learning Outcomes linked to Syllabus Elements

Accounting Fundamentals

On completion of this aspect of the module, learners will have acquired the following knowledge, competencies and know-how:

(a) An appreciation of and an ability to describe the function of and differences between financial accounting and management accounting

(b) An understanding of the different types of business entity and the accountant’s role in an organisation

(c) An ability to identify the various user groups which need accounting information and an appreciation of the characteristics of such information required to meet the objectives of each user group

(a) An understanding of accounting terminology, basic accounting concepts and principles

Double-Entry Bookkeeping and Accounting Systems

On completion of this aspect of the module, participants will have acquired the following knowledge, competencies and know-how:-

(a) A knowledge of the form and content of accounting records and the ability to record financial transactions in the books of original entry

(b) The ability to demonstrate an understanding of and use the double entry system of bookkeeping to prepare a trial balance

(c) An understanding of the distinction between capital and revenue expenditure

(d) An ability to understand, explain and use control accounts, bank reconciliation statements and suspense accounts as part of the internal control of an organisation

Accounts Preparation

On completion of this aspect of the module, learners will have acquired the following knowledge, competencies and know-how:

(a) An appreciation and understanding of the key features of financial statements;

(b) An ability to prepare financial statements for sole traders and ‘not for profit’ organisations.


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MODULE: FINANCIAL ACCOUNTING

Specific Functional Knowledge and Competencies

Understanding Application Analysis

Acounting Fundamentals (15%)

Types of business entity:

Sole traders l l

Partnerships l

Limited companies l

Function of financial accounting and management accounting

Financial Accounting l l

Management Accounting l

Purpose of accounting information l l

Nature, principles and scope of accounting l l

Accountant’s role in an organisation

Accountant’s role and function in an organisation

l l

Auditing l

Accounting terminology

Assets, liabilities, income, expenses l l

Drawings l l

Trade Receivables (debtors) and Trade payables (creditors)

l l

Introduction to financial statements l l

Basic accounting concepts and principles:

The business entity l l

The accounting equation l l

Underlying assumptions, accruals basis, going concern

l l

Users of accounting information and their information needs

The objectives of financial statements l l


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Users of accounting information and their information needs

l l

The qualitative characteristics of accounting information

l

Ethical issues and responsibilities accruing

Ethical issues for the Accounting Technician l

Ethical issues for managers, accountants and historical experience

l

Double-entry Bookkeeping & Accounting Systems (50%)

Form and content of accounting records

Business transactions and the purpose of accounting records

l l

Source documentation l l

Books of original entry

Books of original (prime) entry l l

Sales day book l l

Purchases day book l l

Sales returns day book l l

Purchases returns day book l l

Ledger accounting and double entry

Nominal ledger l l

Double entry bookkeeping l l

The journal l l

Posting from day books to nominal ledger l l

Sales and purchases ledgers l l

Accounting for VAT l l

Irrecoverable VAT l l

Accounting for wages, PAYE and PRSI l l

Salaries/wages control accounts l l


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Extraction of the trial balance l l

Distinction between capital and revenue expenditure

Explanation of capital and revenue expenditure

l l

Impact of incorrect treatment l l

Control accounts

Understanding the purpose of control accounts

l l

Receivables control accounts l

Payables control accounts l l

Contra entries l l

Debit and credit balances at the beginning and end of an accounting period

l l

Incomplete records l l

Bank reconciliation statements

Bank statements and the banking system l l

Identification of errors and omissions l l

Updating the bank account in the ledger l l

Preparation of bank reconciliation statements

l l

Accounting for errors and suspense accounts

Correction of errors l l

Types of errors and their impact on the trial balance

l l

Correction of errors and journal entries l l

Use of suspense accounts l l

Accounting for depreciation and disposal of assets

Non current assets register l

Definition of depreciation l l


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Calculation of depreciation using the straight line and reducing balance methods

l l

Ledger accounting entries for depreciation l l

Accounting for the disposal of non-current assets

l l

Accounts Preparation (35%)

Key features of financial statements

Cost of goods sold l l

Accruals l l

Prepayments l l

Discounts l l

Irrecoverable debts and allowances for receivables

l l

Non Current Assets l l

Depreciation using straight line method and reducing balance method

l l

Disposal of non current assets l l

Accounting for inventory l l

Different valuation methods and their impact on reported profits

l l

Preparation of financial statements for sole traders

From the trial balance to financial statements

l l

The Statement of Profit and Loss as part of the double entry system

l l

Layout of financial statements l l

Preparation of accounts for ‘not for profit’ organisations

Financial statements for clubs and societies l l

Receipts and payments accounts l l

Income and expenditure accounts l l


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Assessment Criteria

Assessment Techniques

100% Assessment based on the final examination.

Format of Examination Paper

The Paper Consists of SIX Questions which will examine all key syllabus elements to ensure that learning outcomes are achieved

SECTION A

THREE Compulsory Questions

SECTION B

THREE Questions - Answer TWO

All Questions carry equal marks

Sample Paper Each of the 3 sample papers will examine appropriate parts of this syllabus.

Essential Reading Financial Accounting

Author: Accounting Technicians Ireland

Supplementary Reading

Web Resources www.AccountingTechniciansIreland.ie

www.thepost.ie

www.icai.ie

www.accaglobal.com

www.cimaglobal.com

www.cpaireland.ie

Other Resources Business and Finance

Accountancy Ireland, Chartered Accountants Ireland

Accountancy and Business, ACCA

Student Newsletter, ACCA

Irish Times Business Section (Fridays)

Sunday Business Post

Sunday Times (Business Section)

1

CHAPTER 1: INTRODUCTION TO ACCOUNTING

CHAPTER 1

Introduction to Accounting

LEARNING OUTCOMES

On completion of this chapter students should be able to:

1. Understand and define accounting

2. Explain the different types of business entity

3. List the users of the financial statements and their information needs

4. Differentiate between Financial and Management accounting

5. Understand Accounting terminology

6. Explain the accountants role in an organisation

7. Explain Auditing

8. Understand Professional Ethics and the accountant

REVISION RESOURCES

EXAM QUESTIONS: Sample and Past papers are available from the website of Accounting Technicians Ireland and are essential aids when studying Advanced Financial Accounting topics.

Chapter 1 : Introduction to Accounting

2


The objective of this module is to provide students with the knowledge to enable them to prepare a set of financial statements, for a sole trader. The purpose of financial statements is to provide information about the reporting entity’s performance and financial position in a useful manner for a wide range of users. It is important to note here that international professional accounting regulations are followed in this module.

The Financial Accounting syllabus (and this manual) has been written and will be examined under International Accounting Standards professional regulations. This is an important point to note in advance of commencing this module. The table below charts the terminology changes from UK/Irish GAAP to International Accounting Standards.

Terminology changes from UK/Irish GAAP to International Accounting Standards

UK/Irish GAAP International Accounting Standards

Trading, Profit and Loss A/C Statement of Profit and Loss

Balance Sheet Statement of Financial Position

Fixed Assets Non-Current Assets

Stock Inventory

Debtors Receivables

Provision for bad debts Allowance for Receivables

Creditors Payables

1.1 INTRODUCTION

It is not easy to provide a concise definition of accounting since the word has a broad application within business. Accountancy or accounting is the art of communicating financial information about a business entity to users such as the owners of the business and the government. The information is generally in the form of financial statements that show in money terms the economic resources under the control of management. This chapter explores the concept of accounting, the different types of business entities and the users of these financial statements, in addition to their information needs. The key accounting concepts and their importance in preparing financial statements will also be defined.

1.2 ACCOUNTING

Accounting can be defined as the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information.

This definition suggests that accounting is about providing information to others. A key concept is that accounting information is economic information – it relates to the financial or economic activities of the business or organisation. This definition implies that accounting information can be identified and measured. This is done by way of a set of accounts, based on a system of accounting known as double-


3


entry bookkeeping. The accounting system identifies and records accounting transactions (economic activity).

However, the measurement of accounting information is not a straight forward process. It involves making judgments about the value of assets owned by a business or liabilities owed by a business. It is also about accurately measuring how much profit or loss has been made by a business in a particular period. Later in this module, it will become clear that the measurement of accounting information often requires subjective judgment to come to a conclusion.

The definition identifies the need for accounting information to be communicated. The way in which this communication is achieved may vary. There are several forms of accounting communication (e.g. annual reports and accounts, management accounting reports), each of which serve a slightly different purpose. The choice of communication channel is about understanding who are the users of the information and what are their information needs.

Accounting information is communicated using financial statements. The dual purposes of financial statements are as follow:

1. To report on the financial position of an entity (e.g. a business, an organisation).

2. To show how the entity has performed (financially) over a particular period of time (an accounting period).

The most common measurement of financial performance is profit (broadly, income after paying various costs). Financial statements are explored in more detail later in the chapter.

1.3 ACCOUNTABILITY

Accountability is at the heart of accounting. Most organisations are externally accountable in some way for their actions and activities. They will produce reports on their activities that will reflect their objectives and the people to whom they are accountable. The following table provides examples of different types of organisations and how accountability is linked to their differing organisational objectives.

Organisations and Accountability

Organisation Objectives Accountable to – examples

Private/Public company (e.g. Tesco)

• Making a profit

• Creation of wealth

• Provide an adequate return on investment, given the risks

• Shareholders

• Other stakeholders (e.g. employees, suppliers)

Charities (e.g. Concern)

• Achievement of charitable aims

• Maximise spending on activities

• Charity commissioners

• Donors

Local authorities (e.g. Local County Council)

• Provision of local services • Government departments


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All of the above organisations have a significant role to play in society and have multiple stakeholders to whom they are accountable. All require systems of financial management to enable them to produce accounting information.

How does accounting information help businesses be accountable? As previously outlined in the introductory definition, accounting is essentially an information process that serves several purposes and outcomes:

1. Provides a record of assets owned, amounts owed to others and monies invested.

2. Provides reports showing the financial position of an organisation and the profitability of its operations.

3. Helps management actually manage the organisation.

4. Enables potential investors to evaluate an organisation and make decisions.

There are five overall accounting information objectives that drive this process, described below.

1. Collection: Collection in money-terms, of information relating to transactions that have resulted from business operations.

2. Recording and classifying: Recording and classifying data into a permanent and logical form. This is usually referred to as book-keeping.

3. Summarising: Summarising data to produce statements and reports that will be useful to the various users of accounting information – both external and internal.

4. Interpreting and communicating: Interpreting and communicating the performance of the business to the management and its owners.

5. Forecasting and planning: Forecasting and planning for the future operation of the business by providing management with evaluations of the viability of proposed operations. The key forecasting and planning tool is the budget.

The management process by which accounting information is collected, reported, interpreted and acted on, is called Financial Management. In preparing accounting information, care should be taken to ensure that the information presents an accurate and true reflection of the business performance and position. To impose some order on what is a subjective task, accounting has adopted certain conventions which should be applied in preparing accounts (all of which will be explored later in this module).

For financial accounting, the regulation or control of what kind of information is prepared and presented goes much further. Ireland, the UK and international companies are required to comply with a wide range of Accounting Standards that define the way in which business transactions are disclosed and reported. Accounting standards also address the calculations around transactions, which we explore in greater detail in Chapter 5. These are applied by businesses through their Accounting Policies, which will be addressed in chapter 2. The next section examines the different types of business entity and outlines their respective advantages and disadvantages.


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1.4 TYPES OF BUSINESS ENTITY

A business can be organised in one of several ways:

• Sole Trader – a business owned and operated by one person.

• Partnership – a business owned and operated by two or more people.

• Company – a business owned by its shareholders and operated by its directors, who are not necessarily the same people.

1.4.1 Sole trader

The simplest form of business is the sole trader; a sole trader is a business that is owned by one person. It may have one or more employees. It offers the least personal protection. Under law, a sole trader and the business are the same legal entity. Essentially, the sole trader and his business are one and the same thing – the sole trader is personally liable if his business is sued or owes any money, i.e. his liability is unlimited. Becoming a sole trader can be risky as the entrepreneur will be liable to repay the business’s debt from his personal wealth if necessary. Profits from the business are considered income and are taxed accordingly; essentially, the sole trader is treated as self-employed for tax purposes.

The main advantages of setting up as a sole trader are:

• Total control of the business by the owner.

• Cheap and easy to start-up - there are less forms to fill in and to start trading, the sole trader does not need to employ any specialist services, other than setting up a bank account and informing the tax authorities.

• Keep all the profit – as the owner, all the profit belongs to the sole trader.

• Business affairs are private – competitors cannot see what the business is earning, so will know less about how the business works and how it succeeds.

• No obligation to produce a set of published financial statements.

The legal requirements of a sole trader are to:

• Keep proper business accounts and records for the Revenue Commissioners (who will collect the tax on profits) and if necessary VAT accounts.

• Comply with legal requirements that concern the protection of the customer (e.g. Sale of Goods and Supply of Services Act).

The main disadvantages of being a sole trader are:

• Unlimited Liability – A sole trader is liable for any debts that the business incurs. This means that any money that the owner has put into the business could be lost, but most importantly, if the business continues to incur further costs then the owner has to pay these as well. In some cases they may have to sell some of their own possessions to pay suppliers. Such a risk often puts potential sole traders off setting up businesses, and also makes them consider the other forms of business structure.


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• As a result of the sole trader and the business being the same legal form, the sole trader is taxed based on income tax not corporation tax. Corporation tax rates are more favourable than income tax rates.

• It can be difficult to raise finance. Because they are small, banks may not lend large sums of money to sole traders who may be unable to avail of other forms of long-term finance unless they change their ownership status.

• It can be difficult to enjoy economies of scale, i.e. lower costs per unit due to higher levels of production. A sole trader, for instance, may not be able to buy in bulk and enjoy the same discounts as larger businesses.

• There is a problem of continuity if the sole trader retires or dies – what happens to the business?

The reasons for being a sole trader are often a balance between business and personal costs and benefits.

1.4.2 Partnership

A partnership is a business where there are two or more owners of the enterprise. Most partnerships are between two and twenty members though there are examples, like accountancy firms and solicitors firms, where there are more partners.

A partnership is normally set up using a Deed of Partnership. This contains:

• Amount of capital each partner should provide (i.e. starting capital).

• How profits and losses should be divided.

• How many votes each partner has (usually based on the proportion of capital invested).

• Rules on how to take on new partners.

• How the partnership is brought to an end, or how a partner leaves.

In the absence of this deed of partnership, the Partnership Act of 1890 (amended in 1907) will apply to avoid any disputes in the future. The Limited Partnership Act of 1907 encompasses the UK, Scotland and Northern Ireland. It provides a legal framework for Republic of Ireland partnerships. The act states that:

• No interest is paid on capital of the partners.

• No remuneration is paid to partners for acting in the business.

• Profits and losses are to be shared equally between partners.

• Interest at the rate of 5% per annum is paid on loans made by the partners to the partnership in excess of their agreed capitals.

The main advantages of a sole trader becoming a partnership are:

• It spreads the risk across more people, so if the business gets into difficulty then there are more people to share the burden of debt.

• Partners may bring money and resources to the business (e.g. better premises to work from).

• A new partner may bring other skills and ideas to the business, complementing the work already done by the original partner.


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• Partnership increases credibility with potential customers and suppliers – who may see dealing with the business as less risky than trading with just a sole trader.

For example, a builder, working originally as a sole trader, may team up with an architect or carpenter to form a partnership. Either would bring added expertise, but also might bring added capital and/or contacts. Of course the builder could team up with another builder as well – sharing the risk, and potentially the workload.

The main disadvantages of becoming a partnership are:

• Having to share the profits.

• Less control of the business for the individual.

• Disputes over workload.

• Problems if partners disagree over the direction of the business.

The next step for a partnership is to move towards becoming a private limited company. However some partnerships do not want to move to this stage.

The advantages of remaining a partnership rather than becoming a private limited company are:

• It costs money to set-up a limited company (may need to employ a solicitor/accountant to set up the paper work).

• Company accounts are filed so the public can view them (and competitors).

• Additional cost of an auditor to check the accounts before they are filed.

When a partnership finishes, depending on how the Deed of Partnership is set up, each partner has an agreed portion of the business. Partnership accounts are not examinable in the Financial Accounting examination.

1.4.3 Limited Company

A Limited Company is a business that is owned by its shareholders, run by directors and most importantly its liability is limited. There can be one shareholder or many thousands of shareholders. Shareholders are also known as members. Each shareholder owns part of the company. As a group they select the directors who run the business. Directors often own shares in the company, but not all shareholders have to be directors.

Limited Liability means that investors can only lose the money they have invested and no more. This encourages people to finance the company, and/or set up such a business, knowing they can only lose what they have put in, if the company fails. For people or businesses who have a claim against the company, limited liability means that they can only recover money from the existing assets of the business. They cannot claim the personal assets of the shareholders to recover amounts owed by the company.

A Limited Company has to possess a separate legal entity from its shareholders, meaning that the company is seen as separate from its shareholders. To set up a limited company, a company has to


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register with the Registrar of Companies, who maintains a separate file for every company, and is issued with a Certificate of Incorporation. It also needs to have a Memorandum of Association which sets out what the company has been formed to do, and Articles of Association which are internal rules including what the directors can do and voting rights of the shareholders.

The distinguishing factor that differentiates a limited company from a sole trader and a partnership is that a limited company has to prepare annual “statutory accounts”; this is the price to be paid for the benefit of limited liability. Limited companies must produce such accounts annually and may have to appoint an independent person to audit and report on them depending on certain size criteria. Once prepared, a copy of the accounts must be sent to the Registrar of Companies which maintains a separate file for every company. The file for any company can be inspected at the Companies Registration Office for a nominal fee by a member of the general public. This is why the statutory accounts are often referred to as the published accounts.

The advantages of a limited company can be summarised as follows:

• Limited liability.

• Separate legal entity.

• The company’s trading profits are taxed at the corporation tax rate of 12.5% in Ireland, which is considerably lower that the top personal income tax rate of 41%, paid by sole traders and partnerships.

• The company’s name is protected, as two companies cannot have a similar name.

• The company continues despite the death or resignation of management and members.

• The interests and obligations of management are defined.

• Appointment, retirement or removal of directors is straightforward.

• It is easier to procure new shareholders and investors.

• A larger number of investors can own the company than, say, partners in a firm.

• The members’ rights are usually comprehensively defined in the memorandum and articles of association.

The disadvantages of a limited company can be summarised as follows:

• Initial costs of registering a company name with the Companies Registration Office.

• Additional administration costs related to the annual preparation and submission of an ‘annual return’, to the Registrar of Companies, according to statutory requirements. Fees and other penalties apply if companies don’t comply.

• Companies must hold an Annual General Meeting (AGM) within 18 months of incorporation and thereafter on an annual basis (must be an AGM in each calendar year). There are exemptions for single member companies.

• A Corporation Tax Return must be made every year and if the company is VAT Registered, VAT Returns must be made every two months.

• Every company whose turnover exceeds Euro €7.3 million must prepare and file audited financial statements with the Companies Registration Office.

• The potential separation of ownership and control which requires additional corporate governance mechanisms within the company, to monitor internal management.


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1.4.4 Public and Private Limited Companies

Limited companies are governed very tightly, namely through the Companies Acts. Limited companies can either be private limited companies or public limited companies. The difference between the two is that shares in a Public Limited Company (Plc) can be traded on the Stock Exchange and be bought by members of the general public. Shares in a Private Limited Company are not available to the general public.

A private limited company may wish to become a Plc because shares in a private limited company cannot be offered for sale to the general public, thereby restricting the availability of finance, especially if the business wants to expand. Therefore, it is attractive to change status. It is also easier to raise money through other sources of finance, e.g. from banks. It is important to note that a “Plc” does not necessarily mean that the company is quoted on the Stock Exchange. In order to have a listing on the Stock Exchange, the company must undergo a flotation or Initial Public Offering (IPO).

Flotation or Initial Public Offering (IPO)

A company may float on the stock market. This means selling all or part of the business to outside investors. This generates additional funds for the business and can be a major form of fundraising. When shares in a “Plc” are first offered for sale to the general public the company is given a “listing” on the stock exchange. This is called an Initial Public Offering (IPO).

The advantages of being a public limited company (Plc) are:

• Better access to financial resources to support growth objectives i.e. raising share capital from existing and new investors.

• Better liquidity – shareholders are able to buy and sell their shares (if they are quoted on a stock exchange).

• Large Plc’s may find it easier to borrow from banks.

• The value of the firm is readily shown by the market capitalisation (based on the share price).

• Companies can more easily acquire other firms – e.g. by offering shares to the shareholders of the target firm.

• Going public gives a company a more prestigious profile.

The disadvantages of being a public limited company (Plc) are:

• Costly and complicated to set up as a Plc – The business owners need to employee specialist bankers and lawyers to help organise the converting to the Plc.

• Certain financial information must be available for all parties, competitors and customers included (this publication of financial information risks attracting further competition and arming existing competitors).

• Shareholders in public companies expect a steady stream of income from dividends, which might mean that the business has to concentrate on short term objectives of creating profit, whereas it might be better to work on longer term objectives, such as growth and investment.

• The threat of takeover, as another company can buy up a large number of shares because shares are traded publicly (can be sold to anyone). If they buy enough, they can then persuade other shareholders to join with them to vote in a new management team.


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The reasons shareholders buy share are as follows:

• Shares sometimes pay dividends to the shareholders, which is a share of the profits at the end of the year. Companies on the Stock Exchange usually pay dividends twice each year.

• Over time the value of the share might increase and can be sold for a profit – this is known as a “capital gain”. Of course, the price of the shares can go down as well as up, so investing in shares can be risky.

• If they have enough shares they can influence the management of the company. A good example is a “venture capitalist” that will often buy up to an average of between 10% to 50% of the shares of a company and insist on choosing some of the directors.

Separation of Ownership and Control and the need for Corporate Governance

As a business becomes larger, the ownership and control of the business may become separated. This is because the shareholders may have the money, but not the time or management skills to run the company. Therefore, the day-to-day running of the business is entrusted to the directors, who are employed for their skills, by the shareholders. This agency relationship between the shareholders and the directors is referred to as Corporate Governance.

The shareholders are therefore “divorced” from the running of the business for 364 days of the year. They will have their say at the Annual General Meeting (AGM) of the company, where the directors present the accounts and the results. In practice directors tend to have at least a modest shareholding in the company. This provides the director with an incentive to achieve good dividends and capital growth for the share (an increase in the share price).

NOTE: Company accounts are not examinable in the Financial Accounting examination.

In summary for all three types of entity, the money invested by the individual, the partners or the shareholders, is referred to as the business capital. In the case of a company, this capital is divided into shares (Share Capital).

1.5 USERS OF ACCOUNTING INFORMATION

There are many potential users of accounting information, including shareholders, lenders, customers, suppliers, government departments (e.g. Revenue), employees and their organisations, and society at large. Anyone with an interest in the performance and activities of an organisation is traditionally called a stakeholder.

For a business or organisation to communicate its results and position to stakeholders, it needs a language that is understood by all in common. Hence, accounting has come to be known as the language of business. There are two broad types of accounting information and two broad groups of information users:

1. Financial Accounting: geared towards external users of accounting information.

2. Management Accounting: geared more at internal users of accounting information.


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Although there is a difference in the type of information presented in financial and management accounts, the underlying objective is the same – to satisfy the information needs of the user. These needs can be described in terms of the overall accounting information objectives stated in section 1.3.

1.6 USERS OF FINANCIAL STATEMENTS

It is easy to assume that the only users of accounting information are shareholders – since it is a requirement of company law that shareholders must receive financial statements. However, in reality there are many users of accounts. The following subsections summarises the main users groups and provides examples of their areas of interest in accounts.

1.6.1 Investors

Investors are concerned about risk and return in relation to their investments. They require information to decide whether they should continue to invest in a business. They also need to be able to access whether a business will be able to pay dividends, and measure the performance of the business’ management team.

The key accounting information for an investor is therefore:

• Information about growth, sales, volumes.

• Profitability (profit margins, overall level of profit).

• Investment (amounts invested, assets owned).

• Business value (share price).

• Comparative information of competitors.

1.6.2 Lenders

Banks and loan stockholders who lend money to a business require information that helps them determine whether loans and interest will be paid when due.

The key accounting information for lenders is therefore:

• Level of existing debt

• Cash flow.

• Security of assets against which the lending may be secured.

• Investment requirements in the business.

1.6.3 Suppliers

Suppliers and trade payables require information that helps them understand and assess the short-term liquidity of a business. For example is the business able to pay short-term debt when it falls due?

The key accounting information for suppliers is therefore:

• Cash flow.

• Management of working capital.

• Payment policy.


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1.6.4 Customers

Customers and trade receivables require information about the ability of the business to survive and prosper. As customers of the company’s products, they have a long-term interest in the company’s range of products and services. They may even be dependent on the business for certain products and services.

The key accounting information for customers is therefore:

• Sales growth.

• New product development.

• Investment in the business (e.g. production capacity).

1.6.5 Employees

Employees (and organisations that represent them – e.g. trade unions) require information about the stability and continuing profitability of the business. They are very interested in information about employment prospects and the maintenance of pension funding and retirement benefits. They are also likely to be interested in the pay and benefits obtained by senior management.

The key accounting information for employees is therefore:

• Revenue and profit growth.

• Levels of investment in the business.

• Overall employment data (numbers employed, wages and salary costs).

• Status and valuation of the company pension schemes/levels of company contributions.

1.6.6 Government

There are many government agencies and departments that are interested in accounting information. For example, the Revenue Commissioners need information on business profitability in order to levy and collect Corporation Tax. Customs and Excise need accounting information to verify Value Added Tax (VAT) returns; local government need similar information to levy local taxes and rates. Various regulatory agencies (i.e. the Environment Agency) need information to support decisions about grants, for example.

1.6.7 Analysts

Investment analysts are an important user group – specifically for companies quoted on the Stock Exchange. They require very detailed financial and other information in order to analyse the competitive performance of a business and its sector. Much of this is provided by the detailed accounting disclosures that are required by authorities such as the London Stock Exchange. However, additional accounting information is usually provided to analysts via informal company briefings and media interviews.


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1.6.8 Public at large

Interest groups, formed by various individuals who have a specific interest in the activities and performance of businesses, will also require accounting information, e.g. resident committees where the business is located in a residential area.

1.7 TYPES OF ACCOUNTING

As stated earlier there are two broad types of accounting information, financial and management accounting.

Financial Accounting is geared towards external users of accounting information. External users are, as discussed above, investors, creditors, debtors, lenders and the government.

Such reporting is usually accomplished through the preparation and presentation of financial statements. In order to facilitate comparison, financial accounts are prepared using accepted accounting conventions and standards. International Accounting Standards (IAS) help to reduce the differences in the way companies draw up their financial statements. The financial statements are public documents, and therefore they will not reveal details about product profitability.

Management need much more detailed and up-to-date information in order to control the business and plan for the future.

Management accounting is geared towards internal users of accounting information. Internal users are, as discussed above, management and employees.

Such reporting is accomplished through custom designed reports. Management accounts provide information to enable costing products and production methods, assessing profitability and so on. In order to facilitate this, management accounts present information in any way which may be useful to management, for example by operating unit or by product line.

Management accounting is an integral part of management activity concerned with identifying, presenting and interpreting information used for:

• Formulation of strategy.

• Planning and controlling activities.

• Decision making.

• Optimising the use of resources.

Students will study Management Accounting as a complete subject in Second Year. The table below outlines a comparison of the branches of accounting.


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Financial and Management Accounting Compared

Branches of Accounting Financial Accounting Management Accounting

Purpose

Production of summary financial statements for external users.

Production of detailed accounts, used by management to control the business and plan for the future.

Frequency Prepared annually. Normally prepared monthly.

Stimulus Required by law. Not mandatory.

Focus of informationReflects past performance and current position.

Includes budgets and forecasts of future activities, as well as reflecting past performance.

Framework

Information is calculated and presented in accordance with strict legal and accounting requirements.

Information is computed and presented in order to be relevant to managers.

Although there is a difference in the type of information presented in financial and management accounting, the underlying objective is the same – to satisfy the needs of the user. The users of financial and management accounting are summarised in diagram below.

Figure: Users of Accounting Information


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1.8 THE MAIN FINANCIAL ACCOUNTING STATEMENTS

The purpose of financial accounting statements is mainly to show the financial position of a business at a particular point in time and to show how that business has performed over a specific period. For Financial Accounting purposes the two main financial accounting statements that help to achieve this aim are:

1. Statement of Profit and Loss for the entire reporting period.

2. A Statement of Financial Position at the end of the reporting period.

The Statement of Profit and Loss provides a perspective on a longer time-period. The detail of what financial transactions took place in a particular period – and (most importantly) what the overall result of those transactions was. It provides details of the financial performance of the business within a specific accounting period. Not surprisingly, the Statement of Profit and Loss measures profit.

What is profit?

Profit is the amount by which sales revenue (also known as “turnover” or “income”) exceeds expenses (“or costs”) for the period being measured.

By contrast, the Statement of Financial Position shows at a particular point in time what resources are owned by the business (assets) and what it owes to other parties (liabilities). It also shows how much has been invested in the business and what the sources of that investment finance were.

It is often helpful to think of a Statement of Financial Position as a snap-shot of the business – a picture of the financial position of the business at a specific point. Whilst this is a useful picture to have, every time an accounting transaction takes place, the snap-shot picture will have changed.

1.9 ACCOUNTING TERMINOLOGY

Reporting to the owners and user groups is done by means of financial statements, primarily the Statement of Profit and Loss and the Statement of Financial Position. The study of these financial statements introduces the student to a new set of vocabulary. It is important to familiarise oneself with the basic terminology, in advance of studying the other detailed chapters on accounting in this manual.

A Statement of Profit and Loss will show a profit or loss earned for the accounting period for which the report was prepared, it is a performance statement. This report shows two forms of profit as follows:

Gross profit is the difference between revenue/sales and the cost of making the product or service.

Net profit is calculated by subtracting the total expenses of a business (including cost of sales) from its revenue/sales.

Sales – the exchange of goods and services for money, this includes both cash and credit sales.

Purchases – buying goods for resale or consumption, this includes both cash and credit purchases.

Income – a more general term than sales including also interest received and rent received from letting part of the business premises.


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Expenses - An expense is any cost of doing business resulting from revenue-generating activities. They are the cost of carrying on a trade or business. There are two main types of costs:

• Costs of purchases for resale, which are included in the cost of sales of the trading account.

• Other costs such as wages, rent and light and heat.

We will be exploring these concepts in detail in later chapters.

The Statement of Financial Position is a statement of position at the end of the accounting period. It represents the financial position of a business at a defined point in time. It lists the assets and liabilities, including the capital invested by the owner/owners, of the business at that time.

Assets

In business and accounting, assets are economic resources owned by the business or company. An asset is anything of value that the business owns – including cash. Assets get recorded in the Statement of Financial Position in terms of their monetary value. There are current assets, which can be readily turned into cash within a twelve month period (e.g. inventory, receivables, bank, cash) and non current assets which the business owns and uses in the business for economic benefit (e.g. Land & Buildings, Motor Vehicles, Premises, Computers and Fixtures & Fittings). Thus anything that belongs to the business or is due to the business is an asset of that business.

Liabilities

Anything a business owes to people or businesses other than its owners is considered a liability. There are two types of liability, current liabilities, which must be paid within a year (e.g. payables, Bank overdraft) and Non-Current Liabilities, which are debts that extend beyond one year (e.g. Long-term loans).

Owners’ equity

Owners’ equity, also called capital, is any debt owed to the business owners. For example, if an entrepreneur invested €50,000 to start a business, the amount recorded is recorded in a capital account, in the Statement of Financial Position.

Drawings

Drawings mean any money or goods taken out of the business for the owners own personal use (sole trader’s drawings). These are shown in the accounts but are not treated as a business expense, instead they are treated as a reduction to capital in the Statement of Financial Position. Drawings can be in the form of assets, stock or cash withdrawals.

Receivables

Receivables are customers who owe money to the business as a result of credit sale transactions, the goods have been sold with payment terms being specified on the invoice. We treat these as current assets as we anticipate getting paid for these goods within the next twelve months.


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Payables

Payables are suppliers who the business owes money to as a result of credit purchase transactions, the business has purchased goods on credit, only to pay for them at a later date (within the payment terms on the invoice). We treat these as current liabilities as we anticipate paying for these goods within the next twelve months.

1.10 THE ACCOUNTANT’S ROLE AND FUNCTION IN AN ORGANISATION

It is the primary role of the accountant to support financial and management accounting reporting in the business. As discussed earlier in this chapter, accounting objectives can be described as the process of collecting, recording, presenting and analysing/interpreting financial information for the users of financial statements. Accounting refers to the process of book-keeping that are involved in making the financial statements. This is a very important process in an organisation.

Book-keeping is the process of recording the financial effect of business transactions and managing such records. This book-keeping process is the primary role of the accountant, to ensure that all business transactions are recorded correctly in the financial statements, in addition to ensuring that the transactions have been accounted for in compliance with the appropriate accounting rules and principles. Once the transactions have been recorded it is then the role of the accountant to interpret and communicate these results to the senior management structure of the organisation.

Accordingly, the accountant’s role in the organisation can be analysed as follows:

1. Preparation and presentation of timely accurate financial/management accounts to management to help management interpret the financial information.

2. Identification of areas of inefficiency and wastages of resources in the business.

3. Treasury functions: The accountant also plays the role of the treasury functions in such a way that they raise finance, cash management, etc.

4. Setting up an effective system of internal and accounting controls.

5. Preparation of feasibility reports: These reports assist management in assessing the viability/profitability or otherwise of proposed capital expenditure such as the opening of a new factory or branch.

6. Investigation of the performance/operations of competing business organisations to assist management in policy formulation.

7. Investigation of fraud within the organisation, this is a key role of the accountant in preparation of an audit at year-end.

8. The accountant assists the organisation to avoid rather than evade tax by using his/her knowledge of the tax laws. (Tax evasion is illegal.)


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1.11 AUDITING

What is auditing?

Auditing is the process by which something is examined with a view to an opinion being formed.

The definition most widely used within the profession is that put forward by the Auditing Practices Board – ‘independent examination and expression of opinion’. This allows others to gain assurance that some information, or a process, can be trusted. Prior to Limited Liability the owners of a business were fully liable for losses or damage they caused. In the 18th century, the concept of Limited Liability was born and as a result Legislation was needed:

• To protect interests of non-participants

• To force stewards/directors to account for the results. The need for Auditing therefore derives from the need for trust/confidence in the information/process under consideration.

Owners ≠ Directors

Directors are appointed by the Shareholders to act on their behalf and have a fiduciary duty (must act in Good Faith). Directors are responsible for stewardship of assets but also are required to prepare regular reports on the effectiveness of that stewardship. Hence a conflict of interest arises and an independent expert is employed to check the accuracy of this report. External Audits are typically required yearly by law.

External Audit

In most developed countries, companies are required to produce annual Financial Statements and have them audited by an external auditor.

The statutory audit is going through a period of criticism and change. Part of this is due to the perceived failure of auditors to notice companies about to collapse, often due to massive frauds and accounting irregularities (e.g. Anglo, Quinn Insurance). Linked to this is the growing belief that many firms of auditors are unable to make objective judgements because they are too close to the companies they audit. In addition to the above, the value of an audit to smaller companies has been in question for some time.

Internal Audit

In order to run a company effectively, and meet their legal responsibilities, directors need assurance in a number of areas in addition to the accuracy of their published financial statements. Much of this work involves financial matters and is therefore likely to be carried out by accountants and/or auditors.

With company collapses an increasing trend, often due to fraud or a failure to adequately appreciate the risks facing the business, the role of internal audit has been growing for some time. Internal audit is now seen as an almost essential element of good “corporate governance” (how companies are governed or run), and most large companies have at least an element of internal audit activity.


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Auditors are bound by an ethical and technical framework to ensure they remain independent and to ensure that they carry out their work with due skill and care. In Ireland, the regulatory framework governing auditors is essentially comprised of:

• Ethical standards: These are intended to ensure the objectivity, integrity and independence of the auditor.

• International Standards on Auditing (ISA’s): These are intended to ensure that the work of the auditor is conducted in accordance with international standards of best practice.

Once the audit is completed, the financial statements are signed off by the auditors with an audit report on their findings. This must then be presented by the directors at the annual general meeting of the shareholders of the company.

Not all companies are required to carry out a “statutory audit”. Under the European Union (Accounts) Regulations 2012, Statutory Instrument (No 304), small Irish companies who wish to be exempt must satisfy the following criteria:

• The company must be a company to which the Companies Acts 1963-2009 applies i.e. a Private Limited Company;

• Turnover must not exceed €8.8 million.

• Gross assets must not exceed €4.4 million.

• 90% of the shareholders of the company must approve the removal of the annual audit requirement.

• An average employee level of a maximum of 50 people.

• Filing requirements up to date.

• Additionally the company must:

• Be a private limited company.

• Not be part of a group of companies.

• Not be a bank or insurance company.

[Note: A small UK limited company will normally be one that meets two or more of the following criteria for the current and previous year:

• Turnover not more than £6.5 million

• Statement of Financial Position total not more than £3.26 million

• Not more than 50 employees

A medium-sized limited company will be one that meets two or more of the following criteria:

• Turnover not more than £25.9 million

• Statement of Financial Position total not more than £12.9 million

• Not more than 250 company employees].

1.12 ACCOUNTING ETHICS

Accounting ethics is primarily a field of applied ethics, the study of moral values and judgements as they apply to accountancy. It is an example of professional ethics. Ethics in accounting is of utmost


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importance to the accounting profession and those who rely on their services. Accounting professionals know that people use their services, especially decision makers using their financial statements, and these decision makers expect them to be highly competent, reliable and objective. Those who work in the field of accounting must not only be well qualified but also possess a high degree of professional integrity.

The general ethical standards of society, apply to people in professions such as medicine and accounting as much as to anybody else. However, society places even higher expectations on accountants. People need to have confidence in the quality of the complex services provided by accountants. Because of these high expectations, accountants have adopted a code of ethics, also known as codes of professional conduct. These ethical codes call for their members to maintain a level of self-discipline that goes beyond the requirements of laws and regulations.

Due to a diverse range of accounting services and recent corporate collapses, attention has been drawn to ethical standards accepted within the accounting profession. These collapses have resulted in a widespread disregard for the reputation of the accounting profession. To combat the criticism and prevent fraudulent accounting, various accounting organisations and governments have developed regulations and remedies for improved ethics among the accounting profession.

1.13 ACCOUNTING SCANDALS

Accounting ethics has been deemed difficult to control as accountants and auditors must consider the interest of the public (which relies on the information gathered in audits) while ensuring that they remain employed by the company that they are auditing. They must consider how to best apply accounting standards even when faced with issues that could cause a company to face a significant loss or even be shut down. Due to several accounting scandals within the profession, critics of accountants have stated that when asked by a client “what does two plus two equal?” the accountant would be likely to respond “what would you like it to be?”. This thought process along with other criticisms of the profession’s issues with conflict of interest, have led to various increased standards of professionalism while stressing ethics in the work environment.

From the 1980’s to the present there have been multiple accounting scandals that were widely reported by the media and resulted in fraud charges, bankruptcy protection requests, and the closure of companies and accounting firms. One of the most widely reported violation of accounting ethics involved ENRON, a multinational company, which for several years had not shown a true and fair view of their financial statements. Their Auditor Arthur Andersen, an accounting firm considered one of the “Big 5” at the time, signed off on the validity of the accounts despite the inaccuracies in the financial statements. When the unethical activities were reported, not only did Enron dissolve but Arthur Anderson also went out of business. Enron’s shareholders lost US$25billion as a result of the company bankruptcy. Although only a fraction of Arthur Anderson’s employees were involved in the scandal, the closure of the firm resulted in the loss of 85,000 jobs.

A 2007 article in Managerial Auditing Journal determined the top nine factors that contributed to ethical failures for accountants based on a survey of 66 members of the International Federation of Accountants. The factors include (in order of the most significant): “self-interest, failure to maintain objectivity and independence, inappropriate professional judgement, lack of ethical sensitivity, improper leadership and ill-culture, failure to withstand advocacy threats, lack of competence, lack of organisational and peer support, and lack of professional body support”. The main factor, self-interest, motivates an accountant


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to act in his/her best interest or when facing a conflict of interest. For example, if an auditor has an issue with an account that he or she is auditing, but is receiving financial incentives to ignore these issues, the auditor may act unethically.

1.14 RESPONSES TO SCANDALS

Since the major accounting scandals, new reforms and calls for increased higher education have been introduced to combat the dangers of unethical behaviour. By educating accountants on ethics before entering the workforce, such as through higher education or initial training at companies, it is believed it will help to improve the credibility of the accounting profession. Companies and accounting organisations have expanded their assistance with educators by providing education materials to assist professors in educating students.

New US regulations such as the Sarbanes-Oxley Act of 2002 (The UK and Ireland follow the Combined Code of Corporate Governance), limit the level of work which can be carried out by accounting firms. In addition, the Act put a limit on the fee which a firm can receive from one client as a percentage of their total fee. This ensures that accounting firms are not over reliant on one client for its income, in the hope that they do not need to act unethically to keep a steady income.

1.15 ETHICAL ISSUES AND THE ACCOUNTING TECHNICIAN

Ethics in accounting is of utmost importance to accounting professionals and those who rely on their services. Accounting professionals know that people who use their services, especially decision makers using financial statements, expect them to be highly competent, reliable and objective. Those who work in the field of accounting must not only be well qualified but must also possess a high degree of professional integrity.

People need to have confidence in the quality of the complex services provided by accountants and accounting technicians. Because of these high expectations, accountants have adopted a code of ethics, also known as Codes of Professional Conduct. These ethical codes call for their members to maintain a level of self-discipline that exceeds the requirements of laws and regulations.

1.15.1 Codes of ethics

By joining professional organisations, like Accounting Technicians Ireland and CIMA, accountants and accounting technicians agree to uphold the high ethical standards of their profession.

Independence can sometimes be an issue for accountants. Maintaining integrity and objectivity calls for avoiding both actual and apparent conflicts of interest. Being independent in fact and in appearance means that one not only is unbiased, impartial, and objective but also is perceived to be that way by others. While applying to all accounting professionals, independence is especially important in the audit profession, to ensure that he or she has no interest or ties to the company that they are auditing. The following is an example of applications of an ethical code of conduct:

• Professional and honest behaviour

• Respect for others, both clients and fellow employees

• Responsible corporate citizenship.


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1.16 WHISTLE BLOWING

A whistle blower is a person who alleges misconduct in the workplace and it covers all methods of reporting by employees of any criminal practices within their organisation. Whistle blowers make their allegations internally (for example, to other people within the accused organisation) or externally (to law enforcement agencies, to the media or to groups concerned with the issues). This practice may cause discontent in the work place as it involves a clash between loyalty and confidentiality.

Whistle blowing is linked to ethical behaviour because it represents a person’s understanding that an action in his/her organisation is harmful – that it interferes with people’s rights or is unfair or detracts from the common good. Whistle blowing also calls upon virtues, especially courage, as standing up for principles can be a punishing experience. Even though laws are supposed to protect whistle blowers from retaliation, people who feel threatened may feel forced out of the organisation.

Self-test questions:

1. Define accounting and discuss accounting information objectives?

2. Discuss the advantages and disadvantages of being a Limited Company?

3. Distinguish between the following items on the Statement of Financial Position:

a. Current and Non-current Assets

b. Receivables and Payables

4. Discuss the role of the accountant in an organisation?

5. Define auditing and distinguish between an external and internal audit?

6. Comment on the importance of ethical behaviour for an accountant?

Solutions to self-test questions:

1. Refer to sections 1.2 and 1.3 of this chapter.

2. Refer to section 1.4.3 of this chapter.

3. Refer to section 1.9 of this chapter

4. Refer to section 1.10 of this chapter.

5. Refer to section 1.11 of this chapter.

6. Refer to sections 1.12 to 1.16 of this chapter.


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PRACTICE QUESTIONS

The following questions examine the key areas the student is expected to know for this particular subject. These questions will assist the student significantly while preparing for examinations in May/August. Sample Papers for this subject can be downloaded from www.AccountingTechniciansIreland.ie

Question 1

When an individual decides to start business, that business can be organised in one of three ways. Provide a definition of each of these business types. (5 marks)

Question 2

Outline your understanding of “Limited Liability”. (5 marks)

Question 3

Each business type in Question 1 above has associated advantages and disadvantages. For each of these business types provide two advantages and two disadvantages. (5 marks)

Question 4

Distinguish between Financial and Management Accounting. (5 marks)

Question 5

Identify four users of financial information, and include the type their information needs. (5 marks)

Question 6

Discuss ethical behaviour in accounting. (5 marks)

Documents

Financial Accounting of Contents iv Financial Accounting 1.9 ACCOUNTING TERMINOLOGY 15 1.10 THE ACCOUNTANT’S ROLE AND FUNCTION IN AN ORGANISATION 17 1.11