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\ CIPFA EDUCATION AND TRAINING CENTRE

CIPFA International Certificate in Public Financial Management

Financial Accounting

Fundamental accounting concepts and principles

Workbook 2

Financial Accounting June 2010

Fundamental accounting concepts 2

Contents

Topic Page

2.1 Financial accounting standards 4

2.2 IPSAS and the IPSASB conceptual framework 7

2.3 Introduction to double entry accounting and financial statements

21

Summary 42

Additional examples 43



Fundamental accounting concepts and principles

Learning objectives

2.1 Explain the purpose and role of accounting standards

2.2 Describe the content of the International Public Sector Accounting Standards Board’s (IPSASB) conceptual framework set out in IPSAS 1 Presentation of Financial Statements, including:

The need for harmonised public sector accounting standards;

The role of the IPSASB in setting standards;

Underlying assumptions and qualitative characteristics of financial statements;

Recognition and measurement of revenue, expenditure, assets, liabilities and net assets/equity in financial statements.

2.3 Explain the various concepts and principles relating to double entry accounting, including:

The accruals concept; cash accounting compared with accruals accounting;

The accounting equation, the principle of duality and the effect of transactions;

Simple financial statements.



2.1 Financial accounting standards

Learning objective 2.1 Explain the purpose and role of accounting standards

Purpose and role of accounting standards The overall purpose of accounting standards is to identify proper accounting practices for the preparation of financial statements.

Accounting standards create a common understanding between users and preparers on how particular items, for example the valuation of property, are treated. Financial statements should therefore comply with all applicable accounting standards.

The content of financial statements is often defined by national laws prescribing what, how, and when disclosures should be made. Such requirements, however, are often high-level with little, if any, detailed guidance on how the requirements should be implemented in practice. The role of accounting standards is therefore to translate high-level principles into reasoned procedures that an entity can apply in practice.

There are many different sets of accounting standards applied throughout the world. For example, in the UK the Accounting Standards Board issues Financial Reporting Standards (FRSs), in the US the Financial Accounting Standards Board (FASB) issues FASB standards and the Accounting Standards Board of Japan (ASBJ) issues ASBJ Statements. A term you may come across in your studies is GAAP, which means ‘generally accepted accounting principles’ and refers to the standard framework of guidelines for financial accounting used in any given jurisdiction.

There has been increased pressure in recent years for the adoption of a single set of global accounting standards. Much progress has been made in this mission with the creation and application of International Financial Reporting Standards (IFRSs). We will examine why a global set of accounting standards is desirable later in this workbook.

The accounting standards mentioned above are principally used by private sector entities, but are sometimes modified in order to be appropriate for use by the public services.

However, in this module you will be studying International Public Sector Accounting Standards (IPSASs) which are issued by The International Public Sector Accounting Standards Board (IPSASB).



The IPSASB focuses on the accounting and financial reporting needs of national, regional and local governments, related governmental agencies, and the constituencies they serve. A key part of the IPSASB's strategy is to converge the IPSASs with the International Financial Reporting Standards (IFRSs) issued by the IASB.

The need for harmonised public sector accounting standards

Government bodies across the world prepare financial statements with very similar objectives in mind. However the ‘user manual’ in each national jurisdiction may vary to take account of the local environment in which entities operate. Consequently the same transaction may be accounted for in a number of different ways depending on which version of the ‘user manual’ is used, for example the one for the UK, for the US, for Australia or for Japan. Such significant differences reduce the comparability and usefulness of financial statements.

While national variations in accounting practices have endured for many years, more recently there has been pressure to harmonise financial reporting practice and regulation on a global basis in order to reduce inconsistencies.

Let’s consider why there has been this drive towards a shared financial reporting framework.

Exercise 2.1

Brainstorming exercise - Why might these variations in national practice arise within the public sector?



Why harmonise public sector accounting standards?

Comparability In an increasingly globalised world it is vital that governments can compare financial information across countries. This means financial statements must be prepared using the same reporting framework to ensure comparability.

High quality reporting In some countries international standards provide a ready made high quality basis of reporting which is likely to be considered more credible than any standards which governments might develop for themselves.

Cross border cooperation With the huge importance of cross border alliances and partnerships in the world today, having standard financial practice is perceived to demonstrate cooperation and progress.

Movement of finance professionals With consistent financial reporting practices across borders finance professionals can apply their skills irrespective of the country they are in. To a lesser extent this could be said of any users of financial information, e.g. business analysts.

Consistent with private sector In some countries there is pressure to report using the same standards as business to encourage comparisons across different types of entity whether publicly or privately funded. Since IPSASs are aiming to be consistent with IFRSs, applying IPSASs can contribute to this objective.



2.2 The IPSASB

Learning objective 2.2 Describe the content of the IPSASB conceptual framework

set out in IPSAS 1 Presentation of Financial Statements The structure of the IPSASB

The governance arrangements for the International Public Sector Accounting Standards Board (IPSASB) are designed to demonstrate the legitimacy of a standard-setting organisation, including the independence of its members and the adequacy of technical expertise.

International Federation of Accountants (IFAC)

The governance of the IPSASB is overseen by its parent body the International Federation of Accountants (IFAC). IFAC is the global organisation for the accountancy profession. It works with its 157 members and associates in 123 countries and jurisdictions to protect the public interest by encouraging high quality practices by the world's accountants. IFAC members and associates are primarily national professional accountancy bodies.

International Public Sector Accounting Standards Board (IPSASB)

The IPSASB functions as an independent standard-setting body under the auspices of IFAC. It achieves its objectives by:

• Issuing International Public Sector Accounting Standards (IPSASs);

• Promoting their acceptance and the international convergence to these standards; and

• Publishing other documents which provide guidance on issues and experiences in financial reporting in the public sector.

The members of the IPSASB are appointed by the Board of IFAC. The IPSASB comprises 18 members, 15 of whom are nominated by the member bodies of IFAC and three of whom are appointed as public members. Each member has one vote.

The IFAC Nominating Committee seeks to ensure that IPSASB members possess appropriate technical expertise, knowledge of institutional arrangements encompassed by its constituency, technical proficiencies of users, preparers and auditors, and a broad geographical spread.



The role of the IPSASB in setting standards The IPSASB are responsible for producing IPSASs and have a structured process to follow when doing so.

The principal consideration that the IPSASB must take when producing standards is to ask whether the equivalent IFRS is suitable for their needs or requires modification to be applicable in the public sector.

Key elements of the IPSASB’s development process are set out in its Terms of Reference and in Guidelines or "rules of the road" for modifying IFRSs for application by public sector entities.

In particular the Terms of Reference explains that

The IPSASB supports the convergence of international and national public sector accounting standards and the convergence of accounting and statistical bases of financial reporting where appropriate

The IPSASB follows due process in the development of all IPSASs through Exposure drafts and Consultation papers

Comments received as a result of the exposure process are considered by the IPSASB and the exposure draft is revised as appropriate

Approval of exposure drafts, re-exposure drafts and IPSASs is made by the affirmative vote of at least two-thirds of the members.

The guidelines provide more detail on current approaches, explaining that the IPSASB develops International Public Sector Accounting Standards (IPSASs) to address public sector financial reporting issues in two different ways:

By addressing public sector financial reporting issues:

that have not been comprehensively or appropriately dealt with in existing International Financial Reporting Standards (IFRSs), or

for which there is no related IFRS; and

By developing IPSASs that are converged with IFRSs by adapting them to the public sector context, in line with a 4 step process as follows:

Step 1: Are there public sector issues that warrant departure?

Step 2: Should a separate public sector project be initiated?



Step 3: Modify IASB documents

Step 4: Make IPSASB style and terminology changes to IASB documents

What is the IPSASB conceptual framework?

A financial reporting conceptual framework sets out the concepts that underlie the preparation and presentation of financial statements. Such concepts are the foundation on which financial statements are constructed and provide a platform from which standards are developed.

The IPSASB does not currently have its own framework for standards development. It is in the process of developing a Conceptual Framework for General Purpose Financial Reporting for Public Sector Entities. IPSASB members are considering consultation papers and exposure drafts on various elements of the Framework and this is still in progress as at March 2011.

The completed conceptual framework will cover the following:

Objectives of financial reporting;

Scope of financial reporting;

Qualitative characteristics of financial information;

Characteristics of the reporting entity;

Definition and recognition of the elements of financial statements;

Measurement; and

Presentation and disclosure.

At the moment we can use IPSAS 1 Presentation of Financial Statements which covers many of the above topics.

Exercise 2.2

Consultation with interested parties is a vital part of the standard setting process. Make a list of who you think may be consulted before finalising a completed IPSAS.



Objectives of financial reporting We have already covered what the objectives of financial reporting are, as stated by IPSAS 1, in workbook 1.

Qualitative characteristics of financial information The quality of information provided in financial statements determines the usefulness of the financial statements to users.

The four principal qualitative characteristics are understandability, relevance, reliability and comparability. Let’s look at each characteristic and what it means.

Understandability - Information is understandable when users might reasonably be expected to comprehend its meaning. For this purpose, users are assumed to have a reasonable knowledge of the entity’s activities and the environment in which it operates, and to be willing to study the information.

Information about complex matters should not be excluded from the financial statements merely on the grounds that it may be too difficult for certain users to understand.

Relevance - Information is relevant to users if it can be used to assist in evaluating past, present or future events or in confirming, or correcting, past evaluations. In order to be relevant, information must also be timely, as well as being relevant to the decision being taken.

[Materiality - The relevance of information is affected by its nature and materiality. Information is material if its omission or misstatement could influence the decisions of users or assessments made on the basis of the financial statements. Materiality depends on the nature or size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.]

Reliability

Reliable information is free from material error and bias, and can be

Exercise 2.3

What are the objectives of financial reporting as stated by IPSAS 1?



depended on by users to represent faithfully that which it purports to represent or could reasonably be expected to represent. To be reliable information must adhere to the following:

Faithful Representation - For information to represent faithfully transactions and other events, it should be presented in accordance with the substance of the transactions and other events, and not merely their legal form.

Substance Over Form - If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with their legal form. For example, equipment leased by an organisation but not legally owned may still need to be shown as an asset to the organisation because they take on the risks and responsibilities of ownership.

Neutrality - Information is neutral if it is free from bias. Financial statements are not neutral if the information they contain has been selected or presented in a manner designed to influence the making of a decision or judgment in order to achieve a predetermined result or outcome.

Prudence - Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty, such that assets or revenue are not overstated and liabilities or expenses are not understated.

Completeness - The information in financial statements should be complete within the bounds of materiality and cost.

Comparability - Information in financial statements is comparable when users are able to identify similarities and differences between that information and information in other reports.

Comparability applies to the:

• Comparison of financial statements of different entities; and

• Comparison of the financial statements of the same entity over periods of time.

An important implication of the characteristic of comparability is that users need to be informed of the policies employed in the preparation of financial statements, changes to those policies and the effects of those changes.

Because users wish to compare the performance of an entity over time, it is important that financial statements show corresponding



information for preceding periods.

Underlying accounting concepts Accounting practices have been developed over many years. In the course of that development, various concepts have been identified that underpin the preparation of financial statements. Before looking at the statements themselves and the processes involved in preparing them, it is important to understand some of the more important concepts. Note that these are also referred to as ‘principles’ or ‘conventions’.

Although not explicitly enforced through legislation or accounting standards, underlying accounting concepts are consistently applied by accountants involved in the preparation of financial statements.

Some of the concepts are quite difficult to grasp initially as they are quite abstract. As well as this, some of the terms used in the below descriptions may be unfamiliar to you. As you work through the materials for this module, you should spot various situations where particular concepts are being applied. Once you have seen examples of concepts being used in practice, it becomes much easier to understand the reason for this concept and its relevance to financial statements.

You should make a note that you need to come back to this part of the workbook later in your study of Financial Accounting so that you can apply the knowledge you will have gained by that stage to the descriptions and examples given below.

Although not all of these concepts are included in IPSAS 1 and some are more applicable to private sector reporting, it is important you familiarise yourself with all of them as they will help you understand the fundamentals of financial accounting.

The business entity concept:

The business entity concept requires that a business and its owner are treated as separate entities. This means that personal transactions by the owner are recorded separately from business transactions. For example, any capital that the owner has invested

Exercise 2.4

Brainstorming exercise - What are the potential constraints on relevant and reliable information?



is, in effect, treated as a long term loan from the owner to the business. In this way, the owner’s personal assets and liabilities are kept separate from any business assets and liabilities.

The money measurement concept:

Financial information only takes into account those items that can be stated in monetary terms. By using a standard monetary unit, the financial records of different organisations can be compared. Unfortunately this does mean that non-quantitative items such as a highly trained and well motivated workforce, reputation of the business and brand image do not appear in the accounting records, possibly understating the market value of a business. However, any valuation attached to these items would be highly subjective and likely to fluctuate from period to period.

The duality concept:

As we shall discover in a later session on double entry bookkeeping, every transaction will impact twice upon an organisation. In this way, both sides of the accounting equation will always remain equal.

For example, if an organisation obtains a bank loan for £20,000 and uses this money to buy a new motor vehicle, the impact on the accounting equation will be as follows:

Assets will increase by £20,000, reflecting the acquisition of a new vehicle.

Liabilities will increase by £20,000, indicating that the organisation owes this money to the bank.

The historic cost concept:

It is essential that transactions are valued in a consistent manner. To ensure that this happens, transactions are normally recorded at their original (or historic) cost. This means that the market value of a business might be significantly different to that shown in the statement of financial position.

Stable monetary unit:

A monetary unit, for example, £ or €, is used in the financial statements. It is assumed that the value of the monetary unit is constant.

Accounting period (or time interval):

Financial statements are prepared on a regular basis (usually every 12 months). Notice that management accounts, which are for internal use, are usually produced on a more regular basis.



Going concern:

When preparing financial statements we assume, unless told otherwise, that the organisation will continue to operate for the foreseeable future. Thus if we were preparing financial statements for the German airline, Lufthansa, we would do so on the basis that it was to continue to operate as an airline. This is important given that, if there were plans to sell the business in the near future, the value at which assets would be shown in the statement of position might be very different. For example, if Lufthansa was to leave the airline sector it might not realise the full value of its planes and other assets.

Consistency:

It is essential that the judgements used in the preparation of financial statements are applied consistently from one accounting period to another. In this way financial statements for the current period can be compared with previous years. Hence, if Lufthansa chooses to depreciate its planes at 10% per annum, using the reducing balance method, this should not be changed without good reason - the different depreciation methods will be explained in a later session.

The accruals concept (or matching concept):

During an accounting period, income should be matched against the expenses incurred in generating it. This is regardless of whether all cash relating to these transactions has been received or paid by the end of the accounting period. As a consequence, where cash has not been paid by the end of the period, an accrual is necessary. In the same way, a prepayment is required to reflect any payments made that relate to the next accounting period. In this way, the profit reported should reflect the true value of transactions that have taken place during the period.

Returning to our earlier example, when preparing its income statement for the year ended 31 December 2010, Lufthansa should include the cost of all fuel used during the previous 12 months. This is despite the fact that at 31 December it is unlikely that Lufthansa will have paid its suppliers for all fuel received during December. This means that Lufthansa will have to accrue all amounts owing to fuel suppliers at 31 December 2010.

Prudence:

The preparation of financial statements is based upon a number of judgements and estimates. These include depreciation, allowance for debts and accruals. Prudence requires that these judgements are not over optimistic. As a consequence, when preparing financial statements, it is considered prudent to recognise in full any potential losses that might arise whilst anticipated profits are not recorded



until fully realised.

Separate determination:

An organisation cannot net off potential liabilities against potential gains. For example, if an organisation is being sued by a customer for £20,000, it is likely that the customer will win the case. The organisation should include £20,000 as a liability in its financial statements.

The same organisation might itself be suing a supplier for £15,000 and legal advice indicates that it is likely to win the case. The separate determination concept does not allow the organisation to net off these two amounts and show a liability for £5,000 in the financial statements.

Instead £20,000 will appear as a liability in the financial statements and, in accordance with the prudence concept, we will not record the income from the supplier until realised.

Objectivity:

An accountant should not include personal opinion or prejudice when preparing financial statements. The statements should be neutral or free from bias.

Realisation concept:

Profits and revenue should only be included in the financial statements when they are realised and all known expenses and losses should be provided for. One exception to this rule is where property assets are revalued and held as unrealised gains in the statements.

Substance over form:

The legal form of a transaction may sometimes differ from the commercial substance. If this is the case, the financial statements should show the commercial substance of the transaction and its impact upon an organisation.

For example, an organisation might purchase a motor vehicle costing £50,000 through a finance lease. Under the terms of the lease agreement the organisation will pay £10,000 each year for five years and legal title of the vehicle will only pass to the organisation after the final lease payment is made.

In this case, in order for the financial statements to show a fair view, commercial substance must override legal title. Although the organisation does not legally own the vehicle until the final lease payment is made, it has all the benefits and risks associated with ownership. As a result, commercial substance suggests that from



the day that the organisation first receives the vehicle, it should be treated as a non-current asset, with the corresponding lease payments recorded as a non-current liability.

Materiality:

Financial statements should be materially correct. For example, to a small business the purchase of a coffee maker costing £500 is a significant amount that may be recorded as a non-current asset. For a large multi-national corporation, with a turnover of several hundred million pounds, £500 does not represent a significant amount. An organisation of this size might only capitalise those items costing more than £5,000. Materiality suggests that the basic accounting rules should not be rigidly applied to insignificant items.



Exercise 2.5 Provide a brief explanation of each of the concepts below: (1) Going concern .......................................................... ................................................................................................. (2) Accruals or Matching Principle ................................... ................................................................................................. ................................................................................................. (3) Prudence ................................................. ................................................................................................. ................................................................................................. (4) Consistency ................................................. ................................................................................................. ................................................................................................. (5) Materiality ................................................. ................................................................................................. ................................................................................................. (6) Substance over form ................................................. ................................................................................................. ................................................................................................. (7) Separate determination .............................................. .................................................................................................



(8) Business entity ................................................. ................................................................................................. ................................................................................................. (9) Money measurement ................................................. ................................................................................................. ................................................................................................. (10) Historical cost ................................................. ................................................................................................. ................................................................................................. (11) Duality……………….………………………………….……………………………………

................................................................................................. .................................................................................................



Recognition and measurement of financial elements The elements included in the financial statements are the building blocks from which financial statements are constructed. These elements are broad classes of events or transactions that are grouped according to their economic characteristics.

The definitions of the elements can be quite complex, so before we look at the IFRS/IPSAS definitions let’s consider straight forward explanations of each element.

The five elements of financial statements are as follows:

ASSET Something that an entity owns. For example, cash, buildings or equipment.

LIABILITY Something that an entity owes. For example, a debt.

INCOME A financial gain. For example, sale of some goods.

EXPENDITURE A financial loss. For example, an electricity bill or payment for goods.

CAPITAL/EQUITY Investment in the entity by its owners. For example, shares in a Ltd Company.

Note that capital and equity are interchangeable terms at this point. We will refer to capital when dealing with sole traders.

Recognition in financial statements

An item is classed as ‘recognised’ when it is included in the financial statements.

An item should be recognised if it is probable that there will be an inflow or outflow of economic benefits associated with the asset or liability and the asset or liability can be measured reliably.

An item to be recognised in the financial statements needs to be capable of reliable measurement; however, this does not mean that the amount must be certain as the use of estimates is permitted.



Measurement in financial statements

For an item or transaction to be recognised in an entity's financial statements it needs to be measured at a monetary amount. There are several different measurement bases which can be used to recognise items in the financial statements and you will learn about these as you progress through your financial accounting studies.

Below is a table showing the more formal (and complex) definitions of the financial elements. You should return to this once you are more comfortable with the simple definitions.

Element Definition Comment Examples

Asset A resource controlled

by an entity “as a result of past events and from which future economic benefits are expected to flow” to the entity.

An asset may be utilised in a business in a number of ways, but all will lead to the generation of future economic benefits (i.e. a contribution to cash flowing to the entity).

Cash, inventories, receivables, prepayments, plant, property and equipment.

Liability A present obligation of the entity “arising from past events, the settlement of which is expected to result in an outflow” of an entity's resources.

A liability exists where an entity has a present obligation. An obligation is simply a duty or responsibility to perform in a certain way.

Trade payables, unpaid taxes and outstanding loans.

Income Increases in economic benefits not resulting from contributions made by equity holders.

Income comprises both revenue and gains. Revenue and gains arise from an entity's normal operating activities.

Revenue, revaluations, profit on the sale of a non-current asset and interest received on investments.

Expenditure Decreases in economic

benefits not resulting from distributions to equity holders.

Expenses include losses, for example write-downs of non-current assets.

Material and labour costs, depreciation, interest paid on loans and a write-down of an asset.

Equity (or Capital)

The residual interest in an entity's assets after deducting all its liabilities.

Equity = ownership interest = net assets (i.e. share capital and reserves).

Share capital, retained earnings, revaluation reserves and other reserves



2.3 Introduction to double entry accounting and financial statements

Learning objective 2.3 Explain the various concepts and principles relating to

double entry accounting and relate to simple financial statements

Financial statements In workbook 2, 3 and 4 we will focus on the financial statements of a sole trader. A sole trader is the most simple of entities, and is a business run and owned by one person. That person takes on all the financial risk of running the business.

There are two principal financial statements of an entity:

The statement of financial position

The income statement

Both the statement of financial position and the income statement are summaries of accumulated data.

The first statement that we are going to look at is the statement of financial position – we will look at the income statement later in this workbook. Initially, we will not be producing formal statements, and the examples in this workbook focus on understanding the way the main elements of the statement of financial position operate rather than worrying about the detailed presentation.

Remember that underpinning these two statements is the very important accounting concept of accruals (or matching concept). This concept says that we recognise income when it’s earned (for example when we deliver goods to a customer) and expenditure when it’s incurred (for example when we use electricity but before we’ve received a bill), regardless of when cash is received or paid.

The statement of financial position A simple definition of a statement of financial position is ‘a statement showing a summary of the financial position of an organisation on a particular date’. The two things to note here are:

It is a summary, i.e. it does not give details of all transactions;



It gives the position at a particular date, i.e. it only gives the reader financial information (e.g. the bank balance) on one day, and doesn’t necessarily indicate what balances might have been at other dates in the year.

It is important that you start to note similarities and differences between the various financial statements that are in this syllabus. When we look at the income statement, you should see that there are quite specific differences in the nature of the statement and the type of information contained in it as compared with the statement of financial position.

When using the term ‘financial position’, what we mean is that the statement of financial position tells the reader:

What the organisation owns

What the organisation owes

Where the organisation obtained its financial resources

You should now know the financial accounting terms for above.

What the organisation owns – ASSETS

What the organisation owes – LIABILITIES

Where the organisation obtained its financial resources – CAPITAL

The statement of financial position will balance, because the total of assets should always equal the total of liabilities and capital added together. The statement of financial position can be formulated into an equation called the accounting equation and can be stated in different ways, i.e.

Assets = Capital + Liabilities

Or

Capital = Assets – Liabilities

Or

Liabilities = Assets – Capital



Let’s consider some of the items that could be included within the above three elements:

ASSETS

Cash Cash in hand.

Bank Money kept in a bank.

Inventory Goods held for re-sale.

Trade receivables Money that is owed to you from customers.

Prepayments A prepayment is a payment in advance of the period to which it relates. For example, paying next year’s insurance bill.

Property, Plant and Equipment

Buildings, vehicles, IT equipment etc.

LIABILITIES

Loan An amount of money that is owed to a lender

Overdraft A negative bank balance.

Trade payables Money that you owe to suppliers.

Accruals An accrual is an expense which has been incurred but no invoice has yet been received. Accruals are similar to trade payables but the amount owed is an estimate.

To see why the above equation always holds true let’s consider some examples:



Now let’s consider what happens when we sell inventory and make a profit or loss. We will return to calculating profit/loss when we introduce the income statement, but for now let’s look at the impact on the accounting equation.

When we make a profit, i.e. when we sell goods for more than we bought them, this profit increases our CAPITAL. If we make a loss this would reduce our CAPITAL.

Example 1

A man decides to set up his own business selling books. He decides to invest £10,000 of his own savings in the business. There is now £10,000 in the bank (an asset) and £10,000 capital.


£10,000 (Bank) = £10,000 (Capital)

Example 2

The man decides to buy some books to sell for £500. He bought these books on credit so no money changed hands. He now has £500 of inventory (an asset) and he owes £500 to his supplier (trade payable – a liability).


£10,000 (Bank) + £500 (Inventory)

= £10,000 (Capital) + £500 (Trade payable)

Example 3

The man pays the book supplier the £500 he owes. His bank balance will reduce by £500 and the trade payable will disappear.


£9,500 (Bank) + £500 (Inventory)

= £10,000 (Capital)



As you can see, each transaction has two impacts on the financial position of the entity, meaning the accounting equation always holds true. This is the principle of duality.

Example 3

The man sells books to customers for £175, which he puts into the bank. He bought these books for £100.

Profit = £175 - £100 = £75

His bank balance has increased by £175 and his inventory has decreased by £100 (the original amount he paid for it).


£9,675 (Bank) + £400 (Inventory)

= £10,075 (Capital)



Exercise 2.6

Anne has decided to enter business selling computer hardware and software.

The following is a summary of the financial transactions for the first week of her business’s existence:

Day Transaction Items affected 1 Using her savings (a legacy from her Great-

Aunt Maud), Anne opens a separate business bank account with £400,000.

Bank Capital

2 Anne purchases suitable premises comprising retail space, storage and office for £375,000, paying by cheque.

3 Anne acquires furniture, fittings and equipment for the premises at a cost of £30,000, together with a delivery van costing £10,000. These transactions were settled by cheque payments.

4 Anne borrows £80,000 from another relative, repayable in 10 years’ time and puts it into her business bank account.

5 Anne acquires computer equipment for resale purposes from various suppliers at a cost of £60,000. She settles some suppliers by cheque payments amounting to £20,000, whereas the others will be settled in one month’s time.

6 Anne sells some of the computer equipment to various customers for £40,000. (This equipment had cost her £15,000.) £10,000 is paid to her immediately, but the remainder will be received two weeks hence.

Requirements

1. Identify the two items affected in Days 2 to 6 (Day 1 has been done for you).

2. Using the grid on the next page, evaluate the impact of each transaction by completing the ‘statement of financial position’ at the end of each day’s transactions



Please note that when presenting a Statement of financial position you must head it with the entity’s name, as well as stating it is ‘AS AT’ a particular date.

‘Statement of financial position’ as at end of Day*

1 2 3 4 5 6

Item £000s £000s £000s £000s £000s £000s

1 Premises

2 Fixtures, fittings & equipment

3 Van

4 Inventories

5 Trade receivables

6 Bank

Total assets

7 Capital

8 Profit

9 Loan

10 Trade payables

11 Overdraft

Total capital and liabilities

*Note this is not a properly formatted statement of financial position – we will look at more formally structured statement of financial positions below.



Presentation of the statement of financial position We looked earlier at the activities within financial accounting and noted that two of these were ‘classifying’ and ‘summarising’. We have done this partly in the previous exercise, i.e. we summarised all the transactions that affected the bank account and just showed a single bank balance at the end of Day 6, and we classified items into ‘assets’ and ‘liabilities’. We are now going to take this further in order to produce a Statement of financial position that is presented in a more formal manner. The format on the next page is consistent with the requirements of IPSAS 1 Presentation of Financial Statements.

The format introduces some distinctions that have not been mentioned yet that therefore require some explanation.

Assets

There are two types of assets.

A tangible asset is a physical asset, that is, it can be touched. It has a real, ‘solid’ existence. Tangible assets are often referred to as ‘property, plant and equipment’.

Intangible assets are assets which do not have a physical existence. They cannot be ‘touched’. An example is a patent, which protects an idea.

Assets are also categorised as current and non-current, depending on whether they are realisable (i.e. can be sold) in the short term or over a longer term.

Non-current assets

These are assets that are expected to be of continuing use to the organisation. As they are expected to benefit more than one accounting period, the accounting treatment is to ‘match’ their expenditure in a consistent way over their useful economic life. This is achieved through a depreciation charge, but at this stage all we will do is record the cost of the asset in the appropriate section of the Statement of financial position.

Examples of non-current assets:

Office buildings

Factory equipment

Vehicles

An investment can also be a non-current asset.



Current assets

These are, by definition, assets that are not non-current assets. The other way of looking at this is that these are items that the business consumes during an accounting period which is usually one year.

Examples of current assets:

Inventory – goods held by the business to be sold within a short time

Trade accounts receivable - represent customers who owe money for goods or services bought on credit in the course of the trading activities of the business.

Prepayments - These are amounts of money already paid by the business for benefits which have not yet been enjoyed, but will be enjoyed within the next accounting period.

Short term investments - These are stocks and shares of other businesses, currently owned, but with the intention of selling them in the near future.

Cash

Liabilities

Liabilities are also categorised as current and non-current, depending on whether they are due to be paid in the short term or over a longer term.

Non-current liabilities

These are liabilities that are not due for repayment within the next accounting period.

Examples of non-current liabilities:

Loans, which are not repayable for more than one year, such as a bank loan or a loan from an individual to a business.

A mortgage

Current liabilities

These are liabilities that are due for repayment within the next accounting period.

Examples of current liabilities:

Loans repayable within one year.

A bank overdraft which is usually repayable on demand.



Trade accounts payable - a trade payable is a person to whom a business owes money for debts incurred in the course of trading operations.

Taxation payable – amounts owed to the taxation authorities.

Accrued charges - expenses already built up by the business, for which no invoice has yet been received, or for which the date of payment by standing order has not yet arrived.

Capital and drawings

Capital is the funding brought into the business by the owner, along with profit generated by that business.

Drawings are the amounts (in the form of cash or other assets) that the owner has taken out of the business in the accounting period.

The owner’s capital is usually analysed into its component parts:

Capital as at the beginning of the accounting period (i.e. capital ‘brought forward’)

Add additional capital introduced during the period

Add profit earned during the period

Less drawings

Capital as at the end of the accounting period (i.e. capital ‘carried forward’)

Brought forward means ‘brought forward from the previous period’, and carried forward means ‘carried forward to the next period’. The carried forward amount at the end of one period is also the brought forward amount of the next period.



Statement of financial position as at ……………………………………

£ £ £ Non-current assets

XXXX XXXX XXXX

Current assets XXXX XXXX XXXX XXXX XXXX

Total Assets** **XXXX

Capital and liabilities:- Capital at start XXXX Add : Profit XXXX Less: Drawings XXXX = Capital at end XXXX

Non-current liabilities

XXXX XXXX XXXX

Current liabilities XXXX XXXX XXXX XXXX

Total Capital & Liabilities** **XXXX

** Note that total assets must equal capital + liabilities.

Exercise 2.7

Take the financial position of Anne’s business in ex 2.6 and present it in the above format.



Exercise 2.8

On 20 September Adam’s business statement of financial position was as follows.

£ Non-current assets 12,600 Inventory 28,900 Bank Balance 6,500 48,000 Financed by: Capital 48,000

During the week ended 25 September, the following transactions took place:

Transaction Items affected a) Inventory purchased on credit terms

£4,500.

b) Non-current assets acquired (paid by cheque) £1,500.

c) Inventory which had originally cost £9,000 was sold for £13,500 and the cash received was banked.

d) Expenses paid amounted to £1,200.

Requirement

Prepare Adam’s business ‘statement of financial position’ upon completion of the above transactions.



Revenue and capital expenditure The distinction between capital and revenue expenditure is fundamental to accounting. This is classified into two types:

Capital expenditure

Capital expenditure results in the purchase or improvement of non-current assets, which are assets that will provide benefits to the business in more than one accounting period, and which are not acquired with a view to being resold in the normal course of trade. The cost of purchased non-current assets is not charged in full to the income statement of the period in which the purchase occurs. Instead, the non-current asset is gradually depreciated over a number of accounting periods.

Capital expenditure on non-current assets results in the appearance of a non-current asset in the statement of financial position of the business. Examples of non-current assets are computers for the office, delivery vans and factory machines.

Improvement of a non-current asset means it has been enhanced, i.e. you will benefit more from the asset or the economic life has been extended. For example, replacing single glazed windows with double glazed.

Revenue expenditure

Revenue expenditure is expenditure incurred for the purpose of the trade or to maintain non-current assets.

Revenue expenditure is expenditure which is incurred for either of the following reasons:

For the purpose of the trade of the business. This includes expenditure classified as selling and distribution expenses, administration expenses and finance charges.

To maintain the existing earning capacity of non-current assets.

An important concept to grasp is that revenue expenditure is charged to the income statement of a period if it relates to the trading activity and sales of that particular period.

To fully understand this concept, look at the two examples below:

Purchasing and extending a building

A business purchases a building for £300,000. It then adds an extension to the building at a cost of £100,000. The building needs to have a few broken windows mended, its floors polished and some



missing roof tiles replaced. These cleaning and maintenance jobs cost £9,000.

Here, the original purchase (£300,000) and the cost of the extension (£100,000) are capital expenditures because they are incurred to acquire and then improve a non-current asset.

The other costs of £9,000 are revenue expenditure because these merely maintain the building and thus the ‘earning capacity’ of the building.

Income Income may also be classified as capital or revenue.

Capital income is the proceeds from the sale of non-trading assets (that is, proceeds from the sale of non-current assets, including long-term investments). The profits (or losses) from the sale of non-current assets are included in the income statement of a business for the accounting period in which the sale takes place.

Revenue income is income derived from the following sources:

The sale of trading assets, such as goods held in inventory.

The provision of services.

Interest and dividends received from investments held by the business.

Since revenue items and capital items are accounted for in different ways, the correct and consistent calculation of profit for any accounting period depends on the correct and consistent classification of items as revenue or capital.



Exercise 2.9 State whether each of the following items should be classified as ‘capital’ or ‘revenue’ expenditure or income for the purpose of preparing the income statement and the statement of financial position of the business:

1. The purchase of a property (e.g. an office building).

2. The annual depreciation of such a property.

3. Solicitors’ fees in connection with the purchase of such a property.

4. The costs of adding extra storage capacity to a mainframe computer used by the business.

5. Computer repairs and maintenance costs.

6. Profit on the sale of an office building.

7. Revenue from sales by credit card.

8. The cost of new plant.

9. Customs duty charged on the plant when imported into the country.

10. The ‘carriage’ costs of transporting the new plant from the supplier’s factory to the premises of the business purchasing the plant.

11. The cost of installing the new plant in the premises of the business.

12. The wages of the machine operators.

You may be unsure of some the scenarios above (specifically points 3, 9, 10 and 11). We will cover these points in more detail later but for now see the explanation given in the solutions.



The income statement The income statement is a statement in which revenue and expenditure are matched to arrive at a figure of profit or loss, and is the financial statement used by the private sector.

The equivalent statement as referred to in IPSAS 1 Presentation of Financial Statements is the statement of financial performance. At this stage in this module we will focus on the income statement, but we will return to the statement of financial performance and its similarities and differences to the income statement, in workbook 5.

Revenue

Revenue is the value (usually the selling price) of goods or services transferred to customers during the period.

Expenses

Expenses are the costs incurred in generating revenue during the period. Examples include electricity costs and wages.

Revenue - Expenses = Profit/Loss

If revenue exceeds expenses then a profit arises.

If expenses exceed revenue then a loss arises.

Format of income statement for period ended X

£

Revenue (sales) x

Less:

Cost of sales

Opening inventory x

Purchases x

x

Closing inventory (x) (x)

Gross Profit x

Add: Other income x

Less: Expenses (x)

Net Profit x



Many businesses try to distinguish between a gross profit earned on trading and a net profit after other income and expenses. In the first part of the statement, revenue from selling goods is compared with direct costs of acquiring or producing the goods sold to arrive at a gross profit figure. Additions for non-trading income are added to the gross profit and deductions are made in respect of indirect costs (overheads).

Gross profit

The gross profit (or loss) is the difference between revenue and cost of sales.

Cost of sales

The cost of sales is the cost of inventory ‘used up’ or ‘consumed’ in the accounting period. It is calculate by taking the opening inventory (at the beginning of the accounting period), plus purchases during the period less closing inventory. In other words, what we had at the beginning, plus what we have bought, less what we still have at the end must equal what we have used up during the period. This may also be referred to as ‘cost of goods sold’.

Net profit

Net profit = gross profit plus non-trading income less expenses.

Net profit can be calculated as the difference between gross profit and all other relevant expenses (e.g. the cost of renting premises or running a vehicle). This is effectively what an income statement does.

Alternatively, net profit can be regarded as the increase in the net assets or capital of the business – this is in effect what we were doing in the earlier examples where we focused in the effects of transactions on the statement of financial position.

The income statement shows in detail how the profit (or loss) of a period has arisen. The owners and managers of a business need to know how much profit or loss has been made, but there is only limited information value in the profit figure alone. In order to exercise financial control effectively, managers must know how much income has been earned, what costs have been and whether the performance of sales or the control of costs appears to be satisfactory. This is the basic reason for preparing the income statement.

Receipts and payments

Note that the terms ‘receipts’ and ‘payments’ are used in a different way to ‘revenue’ and ‘expenses’. Receipts and payments are cash flow items, whereas revenue and expenses refer to accruals-based figures.

The exercise below provides a simple example of how an income



statement is compiled. The exercises that follow thereafter combine this with compiling a statement of financial position.

Exercise 2.10 At the beginning of September Brian's business had only one asset - £3,000 in the business bank account; there were no liabilities. During September the business sold goods on cash terms to the value of £3,300. In addition, goods to the value of £5,700 were sold on credit terms. Of this amount £1,800 was still owing to the business on 30 September. During September the business bought goods on credit terms amounting to £8,400. Brian had paid all but £1,200 of this amount by the end of the month. On 30 September he still held goods which had cost him £1,500. Other expenses incurred by the business amounting to £600 were paid during the month. NB. All receipts and payments pass through the business bank account. Requirement: (a) Calculate the profit for September. (b) Determine the bank balance at 30 September. (c) Prepare the statement of financial position as at 30 September. (d) Assess the performance of Brian's business for the month.

This exercise highlights the difference between cash and accruals accounting. If cash accounting was being applied we would show the receipts and payments only, i.e. the cash received and paid within the accounting period. However, since we are applying accruals accounting when calculating profit and producing the statement of financial position, we must consider when income is earned and expenditure incurred, regardless of cash movement, and the subsequent balances at the period end.



Exercise 2.11

On 1 January Carol left employment repairing electrical equipment to start her own business. She had saved £20,000 and paid this into a business bank account as her capital. Her transactions for the year are summarised as follows:

Testing equipment purchased during the year amounted to £14,000. All this had been paid except £2,000 still outstanding at 31 December. Carol expects the equipment to be of use for several years.

Charges to customers for work done during the year, and received in cash totalled £117,000. In addition, charges to customers for work completed on repairs but still to be collected at 31 December were £6,000.

Purchases of electrical materials during the year amounted to £21,000. Of this £3,000 was still owing to the suppliers at 31 December. There was an inventory of materials in the shop, value £2,000, at the year end.

Rent paid for the shop was £11,000.

Carol withdrew £40,000 from the business for her own use.

Requirements

a) Calculate Carol’s profit or loss for the year ended 31 December.

b) Calculate Carol’s bank balance as at 31 December

c) Prepare Carol’s statement of financial position as at 31 December



Exercise 2.12

David started a business as a wholesale fruiterer on 1 October 2010. He opened a business bank account and paid in £14,000. He already had a van, and was to treat this as one of the business assets. The value of the van at 1 October was £6,000.

The following is a summary of what happened during the first year of business:

Supplies paid for during the year amounted to £190,400

£25,200 was owing to suppliers at 30 September 2002

The value of inventory at 30 September 2002 was estimated to be £12,500

The value of goods sold during year was £315,700

A debt of £840 owed by a customer was written off as irrecoverable

The remaining balance of debts owed by customers at 30 September 2002 was £19,600

Van expenses of £3,900 were paid for

Stationery, advertising and miscellaneous expenses of £11,900 were paid for

David withdrew £35,000 from the business for his own use.

Requirements

a) Calculate the profit or loss for the year ended 30 September 2011.

b) Calculate the bank balance as at 30 September 2011.

c) Prepare the statement of financial position as at 30 September 2011.

Note that irrecoverable debts should be treated as an expense in the income statement, as well as being deducted from trade receivables on the statement of financial position.



Exercise 2.13

Emma’s Statement of financial position at 1 January 2010 contained the following assets: shop premises £60,000, fixtures £15,000, van £10,000, inventory £8,000 and cash at bank £7,000. Emma had no liabilities.

On 1 January, Emma acquired an additional shop for £50,000 and paid £10,000 for new fixtures. To assist her in paying for this expansion she borrowed £50,000 from her bank, repayable in ten years, paying interest half-yearly (on 30 June and 31 December) at 10% per annum.

During 2001 Emma made cash sales of £150,000 and credit sales of £90,000 of which £10,000 was outstanding at the date of the statement of financial position. Of this, it is estimated that £400 will not be received from a customer who has become bankrupt.

Emma paid £146,000 to her suppliers during the year and at the end of the year she still owed them £14,000. She estimated the balance of inventory at 31 December 2001 to be £12,000.

Emma made the following additional payments in 2010:

£ Wages 24,000 Van expenses 2,000 Shop expenses 3,000 Rates 1,800 Miscellaneous expenses 2,000

During the year, Emma’s drawings amounted to £50,000.

Requirements

a) Prepare Emma’s income statement for the year ended 31.12.10

b) Determine Emma’s bank balance on 31.12.10.

c) Prepare Emma’s statement of financial position as at 31.12.10.



Summary

This workbook has introduced many fundamental principles which underpin financial accounting and therefore it is very important that you understand the content before progressing onto more complex areas.

You should now have a good understanding of what accounting standards are, why they are important and be able to explain the reasons behind the drive for international harmonisation.

Although the IPSASB conceptual framework is still under development we have taken many of the important learning points from IPSAS 1. Ensure you understand and can explain the qualitative characteristics of financial information, the fundamental accounting concepts and the financial elements. Pay particular close attention to the accounting concepts of accruals, going concern, prudence and duality, as you will see these concepts used frequently throughout the rest of the module.

Financial accounting could not exist without the accounting equation. It forms the basis of double entry bookkeeping and financial statements, so it is crucial you understand and can apply it to various financial transactions.

Ensure you know, understand and can prepare the basic formats of the statement of financial position and income statement.

This workbook should give you a good grounding in financial accounting, preparing you for the topics ahead.



Additional exercises

Exercise 2.14 – Statement of financial position 1. From the following information, prepare the statement of financial position for Alan's business as at 30 June: £ Inventory 5,460 Trade payables 1,660 Cash in hand 100 Premises 39,400 Bank overdraft 380 Alan's capital 58,000 Motor Vans 12,680 Trade receivables 2,400 2. From the following information, prepare the statement of financial position for Alice's business as at 31 July: £ Trade payables 2,740 Machinery 2,800 Alice's capital 12,800 Inventory 6,240 Loan 2,400 Trade receivables 960 Motor vehicles 5,400 Bank ??? 3. How do you think the following items should be accounted for in the

accounts of Adrian's business in respect of the year ended 31 August? Give reasons for your answer.

(a) An amount owing for a computer that is used in the business's

office and which was paid for in September. (b) An amount owing for electricity consumed in Adrian's home. (c) An invoice in respect of goods which were not received until

September. (d) Fixtures which had been installed during August but which were not

paid for until October. (e) An amount owing from a customer who has been declared

bankrupt. (f) A personal CD player purchased by Adrian for his partner using the

business bank account.



4. Determine the missing figures in the following (note ‘working

capital’ is a term referring to the difference between current assets and current liabilities):

(a) Capital £7,080, liabilities £1,920, assets ? (b) Assets £8,120, liabilities £1,120, capital? (c) Capital £20,000, non-current liabilities £0, non-current assets

£14,000, working capital? (d) Current liabilities £3,600, current assets £5,200, non-current assets

£9,600, non-current liabilities £0, capital? (e) Current assets £18,000, capital £32,000, current liabilities £10,000,

non-current liabilities £5,000, non-current assets?

5. In the following statements which item in [ ] is correct? (a) Capital will be reduced if the business makes a [profit/loss]. (b) If the business has any liabilities, capital must be [more/less] than

the total assets. (c) The difference between all the assets and liabilities is [capital/profit]. (d) The business owes money in respect of [trade receivables/trade

payables]. (e) After paying £500 for new equipment, the value of total assets

[will/will not] change. (f) A delivery van owned by a retail business is a [non-current/ current]

asset. (g) If the business hires machinery, it [will/will not] be shown in the

statement of financial position.



6. Angus owns a garage where he sells and repairs vehicles. Should he

classify the following as non-current assets, current assets, non-current liabilities, or current liabilities?

Cash register Amount due to suppliers for parts Second hand vehicle for resale Breakdown truck Spare parts Amount owed by a customer for repairs Petrol inventory Bank overdraft Loan repayable in 5 years Electronic engine tuner 7. Describe what has happened in order to cause the following statement of financial position to be produced: (a) (b) (c) (d) (e) (f) £ £ £ £ £ £ Vehicle - 400 400 400 400 400 Inventories - - 200 360 360 160 Trade receivables

- - - - - 320

Cash 1,000 600 400 400 280 280 1,000 1,000 1,000 1,160 1,040 1,160

Capital 1,000 1,000 1,000 1,000 1,000 1,120 Trade payables

-

-

-

160

40

40

1,000 1,000 1,000 1,160 1,040 1,160



Exercise 2.15 – Income statement

Edwin is in business selling audio and video equipment. On 1.1.10 his assets and liabilities were:

Furniture and fittings £11,000, vehicle £6,000, inventory £38,000, trade receivables £12,000, cash at bank £3,600, trade payables (for purchases) £30,000.

On 1.4.10 Edwin purchased his shop premises from his landlord at a price of £60,000. To help pay for this he borrowed £40,000 from his bank, the loan being repayable in five years time and bearing interest at a rate of 9% p.a.. Interest charges are deducted automatically from Edwin’s bank account each month.

Cash sales and credit sales for the year were £168,000 and £300,000, respectively. £295,000 cash was received from trade receivables during the year; of the remaining trade receivables one customer owing £1,000 has recently been declared bankrupt.

Edwin has paid £375,000 to his suppliers during the year, and at 31.12.10 he still owed his suppliers £45,000. Inventory in hand at 31.12.10 amounted to £75,000.

In addition to his supplies, Edwin made the following payments during the year.

salary of sales manager £19,000 clerical assistant’s salary £8,000 cleaner’s wages £4,000 general office expenses £1,800 vehicle expenses £1,200 heating and lighting £1,800 rates to 31.12.01 £3,600 rent paid for the period 1.1.01 - 31.12.01 £1,400 personal drawings £30,000.

Required:

a) Prepare Edwin’s income statement for the year ended 31.12.10.

b) Determine Edwin’s bank balance as at 31.12.10.

c) Prepare Edwin’s statement of financial position as at 31.12.10



Exercise 2.16

State four accounting concepts, and explain how each one contributes to fair presentation in the financial statements. (10)

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