Financial Accounting

Transcription

1 Financia Accounting Course Text Professiona, Practica, Proven

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3 Tabe of Contents FOREWORD...xi SYLLABUS: FINANCIAL ACCOUNTING...xvii CHAPTER 1: INTRODUCTION TO ACCOUNTING INTRODUCTION ACCOUNTING ACCOUNTABILITY TYPES OF BUSINESS ENTITY Soe trader Partnership Limited Company Pubic and Private Limited Companies USERS OF ACCOUNTING INFORMATION USERS OF FINANCIAL STATEMENTS Investors Lenders Suppiers Customers Empoyees Government Anaysts Pubic at arge TYPES OF ACCOUNTING THE MAIN FINANCIAL ACCOUNTING STATEMENTS...15 iii

4 Tabe of Contents Financia Accounting 1.9 ACCOUNTING TERMINOLOGY THE ACCOUNTANT S ROLE AND FUNCTION IN AN ORGANISATION AUDITING ACCOUNTING ETHICS ACCOUNTING SCANDALS RESPONSES TO SCANDALS ETHICAL ISSUES AND THE ACCOUNTING TECHNICIAN Codes of ethics WHISTLE BLOWING...22 CHAPTER 2: ACCOUNTING CONCEPTS & CONVENTIONS INTRODUCTION REGULATION AND STANDARDS PROFESSIONAL SELF-REGULATION COMPANIES ACTS A TRUE AND FAIR VIEW THE BASIC PRINCIPLES OF ACCOUNTING: CONVENTIONS AND CONCEPTS Accounting conventions Accounting concepts WHAT MAKES ACCOUNTING INFORMATION USEFUL? A FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS RELEVANCE RELIABILITY COMPARABILITY UNDERSTANDABILITY CONFLICTS IN THE QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION ACCOUNTING POLICIES ESTIMATION TECHNIQUES MEASUREMENT BASES SELECTING ACCOUNTING POLICIES REVIEWING AND CHANGING ACCOUNTING POLICIES IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING, ESTIMATES AND ERRORS iv

5 Financia Accounting Tabe of Contents CHAPTER 3: DOUBLE ENTRY BOOK-KEEPING DOUBLE ENTRY BOOK-KEEPING AND THE DUALITY CONCEPT THE ACCOUNTING EQUATION LEDGER ACCOUNTS, DEBITS AND CREDITS RECORDING CASH TRANSACTIONS RECORDING CREDIT SALES AND PURCHASES TRANSACTIONS RECORDING SALES AND PURCHASES RETURNS ACCOUNTING FOR DISCOUNTS DOUBLE ENTRY CHECKLIST BALANCING OFF LEDGER ACCOUNTS Opening and Cosing baances in the edger accounts Statement of Profit or Loss Account, edger accounts Capita account EXAMPLE 8 CLOSING OFF GEORGE S ACCOUNTS Next step - tria baance The imitations of a tria baance The process steps in producing a tria baance from a set of edger accounts EXAMPLE 9 EXTRACTING A TRIAL BALANCE FROM GEORGE S ACCOUNTS SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS...59 CHAPTER 4: VAT, PAYROLL, BOOKS OF PRIME ENTRY ELEMENTS OF VALUE ADDED TAX (VAT) The VAT system Rates of VAT Principes of VAT The Exception: Irrecoverabe VAT Cacuation of VAT Accounting entries for VAT PAYROLL The accounting entries for Payro BOOKS OF PRIME ENTRY Saes day book Saes returns day book Purchases day book Purchases returns day book The cash book Cash Receipts Book The petty cash book The journa...86 v

6 Tabe of Contents Financia Accounting 4.4 SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS...88 CHAPTER 5: INTRODUCTION TO FINANCIAL STATEMENTS INTRODUCTION TO FINANCIAL STATEMENTS THE STATEMENT OF PROFIT OR LOSS The trading income section The business expenditure section Revenue income, capita income and revenue expenditure in the Statement of Profit or Loss THE STATEMENT OF FINANCIAL POSITION Assets and iabiities Link between Statement of Financia Position and the Statement of Profit or Loss Capita Expenditure in the Statement of Financia Position Loans (Capita and Revenue eements) AN INTRODUCTION TO ACCOUNTING FOR OPENING AND CLOSING INVENTORY Cosing inventory Opening inventory GEORGE S TRIAL BALANCE (CONTINUED FROM SECTION 3.11, CHAPTER 3) SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS CHAPTER 6: INVENTORY ACCOUNTING FOR INVENTORY The accruas concept Vauation of Inventory The prudence concept Cost Net Reaisabe vaue (NRV) METHODS OF VALUING INVENTORY IAS 2 REQUIREMENTS First in First out (FIFO) Average cost AVCO THE IMPACT OF VALUATION METHODS ON THE STATEMENT OF PROFIT OR LOSS AND THE STATEMENT OF FINANCIAL POSITION SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS vi

7 Financia Accounting Tabe of Contents CHAPTER 7: ACCRUALS AND PREPAYMENTS THE ACCRUALS CONCEPT ACCRUED EXPENDITURE PREPAID EXPENDITURE ACCRUED INCOME PREPAID INCOME ACCRUALS AND PREPAYMENTS FINANCIAL STATEMENTS EFFECT The Statement of Profit or Loss The Statement of Financia Position SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS CHAPTER 8: IRRECOVERABLE DEBTS AND ALLOWANCE FOR RECEIVABLES ACCOUNTING CONCEPTS Accruas concept Prudence concept AGED RECEIVABLE ANALYSIS Advantages and Disadvantages of Seing on Credit Credit imits IRRECOVERABLE DEBTS Irrecoverabe debts recovered ALLOWANCE FOR RECEIVABLES Specific aowance Genera aowance Accounting for Aowance for Receivabes IRRECOVERABLE DEBTS AND THE ALLOWANCE FOR RECEIVABLES TRIAL BALANCE ADJUSTMENTS SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS CHAPTER 9: NON-CURRENT ASSETS AND DEPRECIATION CURRENT AND NON-CURRENT ASSETS CAPITAL AND REVENUE EXPENDITURE Capita expenditure Revenue expenditure NON-CURRENT ASSET REGISTERS ACCOUNTING FOR NON-CURRENT ASSETS DEPRECIATION vii

8 Tabe of Contents Financia Accounting 9.6 ESTIMATING DEPRECIATION Straight ine depreciation Reducing baance depreciation ACCOUNTING FOR DEPRECIATION DISPOSAL OF NON-CURRENT ASSETS DISPOSAL THROUGH A PART-EXCHANGE NON-CURRENT ASSETS AND THE FINANCIAL STATEMENTS SOME ADDITIONAL INFORMATION ON DEPRECIATION OF NON-CURRENT ASSETS SELF-TEST QUESTIONS SOLUTIONS TO SELF- TEST QUESTIONS CHAPTER 10: BANK RECONCILIATION STATEMENTS NATURE AND PURPOSE OF BANK RECONCILIATION STATEMENTS METHODOLOGY FOR PREPARING BANK RECONCILIATION STATEMENTS DETAILED DIFFERENCES BETWEEN THE BANK ACCOUNT AND THE BANK STATEMENT PREPARATION OF A BANK RECONCILIATION STATEMENT The Proforma for a bank reconciiation The Proforma for a bank reconciiation with a Bank Overdraft EXAMPLES OF BANK RECONCILIATIONS, INCLUDING AN OVERDRAFT BANK DEBIT AND CREDIT BALANCES IN THE STATEMENT OF FINANCIAL POSITION SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS CHAPTER 11: PREPARATION OF FINANCIAL STATEMENTS FROM TRIAL BALANCE TO FINANCIAL STATEMENTS THE STATEMENT OF PROFIT OR LOSS THE STATEMENT OF FINANCIAL POSITION SOLE TRADER ACCOUNTS EXAMPLE 1: GINA O HALLORAN EXAMPLE 2: RORY JAMESON S FINANCIAL STATEMENTS EXAMPLE 3: T. HIGGINS (A MORE COMPLICATED EXAMPLE) CHAPTER 12: ACCOUNTING FOR NOT-FOR-PROFIT ORGANISATIONS NOT-FOR-PROFIT ORGANISATIONS THE RECEIPTS AND PAYMENTS ACCOUNT viii

9 Financia Accounting Tabe of Contents 12.3 THE INCOME AND EXPENDITURE ACCOUNT ACCUMULATED FUND STATEMENT ANNUAL SUBSCRIPTIONS Entrance fees Life membership subscriptions/payments DIFFERENCES BETWEEN THE RECEIPTS AND PAYMENTS ACCOUNT AND THE INCOME AND EXPENDITURE ACCOUNT SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS CHAPTER 13: CONTROL ACCOUNTS & INTRODUCTION TO CONTROL ACCOUNT RECONCILIATIONS NATURE AND PURPOSE OF CONTROL ACCOUNTS Receivabes edger contro account Payabes edger contro account The purpose of contro accounts CONTROL ACCOUNTS AND DOUBLE ENTRY RECEIVABLES/SALES LEDGER CONTROL ACCOUNTS Expaining the Proforma Receivabes Contro Account Appied Exampe of Receivabes Contro Account PAYABLES/PURCHASES LEDGER CONTROL ACCOUNTS Expaining the Proforma Payabes Contro Account Appied Exampe of Payabes Contro Account Suppier statements INTRODUCTION TO CONTROL ACCOUNT RECONCILIATIONS CONTROL ACCOUNTS THE STATEMENT OF FINANCIAL POSITION SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS CHAPTER 14: INCOMPLETE RECORDS INCOMPLETE RECORDS NET ASSETS APPROACH THE BALANCING FIGURE APPROACH Deriving Saes the missing figure Deriving Purchases the missing figure Deriving expenses missing figures Deriving Opening Capita MARGIN AND MARK-UP Gross Profit Margin Gross Profit Mark-up ix

10 Tabe of Contents Financia Accounting When Mark-up is known, what is the Margin? When Margin is known, what is the Mark-Up? STEPS TO FOLLOW TO PREPARE FINANCIAL STATEMENTS FROM INCOMPLETE RECORDS SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS CHAPTER 15: CORRECTION OF ERRORS IDENTIFICATION OF ERRORS Types of errors and their impact on the Tria Baance The effect of errors on the Statement of Profit ERRORS WHICH DO NOT AFFECT THE BALANCING OF THE TRIAL BALANCE Error of omission Error of commission Error of principe Compensating errors Error of origina entry Reversa of entries error CONTROL ACCOUNT RECONCILIATION AND CORRECTION OF ERRORS SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS CHAPTER 16: SUSPENSE ACCOUNT SUSPENSE ACCOUNT Method empoyed to correct errors IDENTIFYING ERRORS CAUSING THE CREATION OF THE SUSPENSE ACCOUNT Same sided entry error Singe sided entry error Transposition error EXAMPLE 5: CONTROL ACCOUNT RECONCILIATION, WITH A SUSPENSE ACCOUNT EXAMPLE 6: JOHN O CONNOR S TRIAL BALANCE ADJUSTMENT TO PROFIT SELF-TEST QUESTIONS SOLUTIONS TO SELF-TEST QUESTIONS INDEX x

11 FOREWORD Foreword This text has been deveoped by Accounting Technicians Ireand for use by students participating in our programme of study and preparing for our examinations. Whie every effort is made to ensure that the information outined in this text is accurate, Accounting Technicians Ireand and the Author cannot accept the responsibiity for ack of, or perceived ack of, information contained herein. The text is intended to be a sufficienty detaied synopsis of the current syabus materia (and knowedge eve required thereof) in reation to this modue. Students shoud take particuar note of the weighting attaching to this modue, as ceary outined in the syabus. It is on the basis of this weighting that students shoud prepare their own timetabe for study. On the competion of each chapter, students shoud refer to the reevant questions deaing with that chapter. Ideay, students shoud not continue with subsequent chapters unti they have competed the questions attaching to the chapter currenty under review. The soutions to the questions are provided under separate cover and athough they are the suggested soutions, tutors and students shoud recognise and appreciate that there might very we be different approaches which woud, under examination conditions, be perfecty acceptabe. We recommend that, in order to get the fu benefit of the question and answer concept, students shoud not refer to the soution unti they have made a fu and genuine attempt at each question. We recommend that when students have attained an understanding of each chapter studied, in addition to the questions provided, they shoud access the Accounting Technicians Ireand website ( for past papers and sit them under exam conditions. This wi aow students to improve their time management skis and their approach to each type of question. xi

12 Copyright This text is issued by Accounting Technicians Ireand to students taking its examinations. It may not be used in whoe, or in part, for any course of study and/or examination of any other body whatsoever without prior permission in writing from Accounting Technicians Ireand. This pubication, or any part thereof, may not be made avaiabe in any ibrary, and it may not be reproduced, in whoe or in part, stored in a retrieva system or transmitted in any form or by any means photocopying, eectronic, eectrostatic, magnetic, pdf, mechanica, recording or otherwise, without prior permission in writing from Accounting Technicians Ireand, Pearse Street, Dubin 2. Acknowedgement This edition was edited and updated by Dr. Antoinette Fynn. Antoinette is a ecturer in Accounting and Finance with the Department of Accounting and Finance, University of Limerick. Her profie is avaiabe at Referencing For the purposes of consistency, a references to he or she wi be referred to as he in this pubication. No other impication whatsoever is impied from this poicy. For the purposes of presentation, a references to euro or stering wi be referred to as euro in this pubication. No other impication whatsoever is impied from this poicy. xii

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17 SYLLABUS: FINANCIAL ACCOUNTING SYLLABUS Financia Accounting Mandatory Modue xvii

18 Syabus : Mandatory Modue Financia Accounting Financia Accounting Subject Status Mandatory Termina Exam 100% Modue Pass Mark 50% Learning Modes Pre-requisite Direct Lectures, Workshops, Tutorias, Sef Directed Learning Programme Entry Requirements Key Learning Outcome The key objective of this modue is to provide earners with knowedge of accounting concepts and principes of accounting and the technica competency in the area of doube entry accounting and accounts preparation for various types of business. Key Syabus Eements and Weightings 1. Accounting Fundamentas...15% 2. Doube-Entry Bookkeeping and Accounting Systems...50% 3. Accounts Preparation...35% xviii

19 Financia Accounting Syabus : Mandatory Modue Learning Outcomes inked to Syabus Eements Accounting Fundamentas On competion of this aspect of the modue, earners wi have acquired the foowing knowedge, competencies and know-how: (a) (b) (c) (a) An appreciation of and an abiity to describe the function of and differences between financia accounting and management accounting An understanding of the different types of business entity and the accountant s roe in an organisation An abiity 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 An understanding of accounting terminoogy, basic accounting concepts and principes Doube-Entry Bookkeeping and Accounting Systems On competion of this aspect of the modue, participants wi have acquired the foowing knowedge, competencies and know-how:- (a) (b) (c) (d) A knowedge of the form and content of accounting records and the abiity to record financia transactions in the books of origina entry The abiity to demonstrate an understanding of and use the doube entry system of bookkeeping to prepare a tria baance An understanding of the distinction between capita and revenue expenditure An abiity to understand, expain and use contro accounts, bank reconciiation statements and suspense accounts as part of the interna contro of an organisation Accounts Preparation On competion of this aspect of the modue, earners wi have acquired the foowing knowedge, competencies and know-how: (a) (b) An appreciation and understanding of the key features of financia statements; An abiity to prepare financia statements for soe traders and not for profit organisations. xix

20 Syabus : Mandatory Modue Financia Accounting MODULE: FINANCIAL ACCOUNTING Specific Functiona Knowedge and Competencies Acounting Fundamentas (15%) Types of business entity: Understanding Appication Anaysis Soe traders Partnerships Limited companies Function of financia accounting and management accounting Financia Accounting Management Accounting Purpose of accounting information Nature, principes and scope of accounting Accountant s roe in an organisation Accountant s roe and function in an organisation Auditing Accounting terminoogy Assets, iabiities, income, expenses Drawings Trade Receivabes (debtors) and Trade payabes (creditors) Introduction to financia statements Basic accounting concepts and principes: The business entity The accounting equation Underying assumptions, accruas basis, going concern Users of accounting information and their information needs The objectives of financia statements xx

21 Financia Accounting Syabus : Mandatory Modue Specific Functiona Knowedge and Competencies Understanding Appication Anaysis Users of accounting information and their information needs The quaitative characteristics of accounting information Ethica issues and responsibiities accruing Ethica issues for the Accounting Technician Ethica issues for managers, accountants and historica experience Doube-entry Bookkeeping & Accounting Systems (50%) Form and content of accounting records Business transactions and the purpose of accounting records Source documentation Books of origina entry Books of origina (prime) entry Saes day book Purchases day book Saes returns day book Purchases returns day book Ledger accounting and doube entry Nomina edger Doube entry bookkeeping The journa Posting from day books to nomina edger Saes and purchases edgers Accounting for VAT Irrecoverabe VAT Accounting for wages, PAYE and PRSI Saaries/wages contro accounts xxi

22 Syabus : Mandatory Modue Financia Accounting Specific Functiona Knowedge and Competencies Understanding Appication Anaysis Extraction of the tria baance Distinction between capita and revenue expenditure Expanation of capita and revenue expenditure Impact of incorrect treatment Contro accounts Understanding the purpose of contro accounts Receivabes contro accounts Payabes contro accounts Contra entries Debit and credit baances at the beginning and end of an accounting period Incompete records Bank reconciiation statements Bank statements and the banking system Identification of errors and omissions Updating the bank account in the edger Preparation of bank reconciiation statements Accounting for errors and suspense accounts Correction of errors Types of errors and their impact on the tria baance Correction of errors and journa entries Use of suspense accounts Accounting for depreciation and disposa of assets Non current assets register Definition of depreciation xxii

23 Financia Accounting Syabus : Mandatory Modue Specific Functiona Knowedge and Competencies Understanding Appication Anaysis Cacuation of depreciation using the straight ine and reducing baance methods Ledger accounting entries for depreciation Accounting for the disposa of non-current assets Accounts Preparation (35%) Key features of financia statements Cost of goods sod Accruas Prepayments Discounts Irrecoverabe debts and aowances for receivabes Non Current Assets Depreciation using straight ine method and reducing baance method Disposa of non current assets Accounting for inventory Different vauation methods and their impact on reported profits Preparation of financia statements for soe traders From the tria baance to financia statements The Statement of Profit or Loss as part of the doube entry system Layout of financia statements Preparation of accounts for not for profit organisations Financia statements for cubs and societies Receipts and payments accounts Income and expenditure accounts xxiii

24 Syabus : Mandatory Modue Financia Accounting Assessment Criteria Assessment Techniques Format of Examination Paper 100% Assessment based on the fina examination. The Paper Consists of SIX Questions which wi examine a key syabus eements to ensure that earning outcomes are achieved SECTION A THREE Compusory Questions SECTION B THREE Questions - Answer TWO A Questions carry equa marks Sampe Paper Essentia Reading Each of the 3 sampe papers wi examine appropriate parts of this syabus. Financia Accounting Author: Accounting Technicians Ireand Suppementary Reading Web Resources Other Resources Business and Finance Accountancy Ireand, Chartered Accountants Ireand Accountancy and Business, ACCA Student Newsetter, ACCA Irish Times Business Section (Fridays) Sunday Business Post Sunday Times (Business Section) xxiv

25 CHAPTER 1: INTRODUCTION TO ACCOUNTING CHAPTER 1 Introduction to Accounting LEARNING OUTCOMES On competion of this chapter students shoud be abe to: 1. Understand and define accounting 2. Expain the different types of business entity 3. List the users of the financia statements and their information needs 4. Differentiate between Financia and Management accounting 5. Understand Accounting terminoogy 6. Expain the accountants roe in an organisation 7. Expain Auditing 8. Understand Professiona Ethics and the accountant REVISION RESOURCES EXAM QUESTIONS: Sampe and Past papers are avaiabe from the website of Accounting Technicians Ireand and are essentia aids when studying Advanced Financia Accounting topics. 1

26 Chapter 1 : Introduction to Accounting Financia Accounting The objective of this modue is to provide students with the knowedge to enabe them to prepare a set of financia statements, for a soe trader. The purpose of financia statements is to provide information about the reporting entity s performance and financia position in a usefu manner for a wide range of users. It is important to note here that internationa professiona accounting reguations are foowed in this modue. The Financia Accounting syabus (and this manua) has been written and wi be examined under Internationa Accounting Standards professiona reguations. This is an important point to note in advance of commencing this modue. The tabe beow charts the terminoogy changes from UK/Irish GAAP to Internationa Accounting Standards. Terminoogy changes from UK/Irish GAAP to Internationa Accounting Standards UK/Irish GAAP Trading, Profit and Loss A/C Baance Sheet Fixed Assets Stock Debtors Provision for bad debts Creditors Internationa Accounting Standards Statement of Profit or Loss Statement of Financia Position Non-Current Assets Inventory Receivabes Aowance for Receivabes Payabes 1.1 INTRODUCTION It is not easy to provide a concise definition of accounting since the word has a broad appication within business. Accountancy or accounting is the art of communicating financia information about a business entity to users such as the owners of the business and the government. The information is generay in the form of financia statements that show in money terms the economic resources under the contro of management. This chapter expores the concept of accounting, the different types of business entities and the users of these financia statements, in addition to their information needs. The key accounting concepts and their importance in preparing financia statements wi aso 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 reates to the financia or economic activities of the business or organisation. This definition impies 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 doube- 2

27 Financia Accounting Chapter 1 : Introduction to Accounting 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 invoves making judgments about the vaue of assets owned by a business or iabiities owed by a business. It is aso about accuratey measuring how much profit or oss has been made by a business in a particuar period. Later in this modue, it wi become cear that the measurement of accounting information often requires subjective judgment to come to a concusion. The definition identifies the need for accounting information to be communicated. The way in which this communication is achieved may vary. There are severa forms of accounting communication (e.g. annua reports and accounts, management accounting reports), each of which serve a sighty different purpose. The choice of communication channe is about understanding who are the users of the information and what are their information needs. Accounting information is communicated using financia statements. The dua purposes of financia statements are as foow: 1. To report on the financia position of an entity (e.g. a business, an organisation). 2. To show how the entity has performed (financiay) over a particuar period of time (an accounting period). The most common measurement of financia performance is profit (broady, income after paying various costs). Financia statements are expored in more detai ater in the chapter. 1.3 ACCOUNTABILITY Accountabiity is at the heart of accounting. Most organisations are externay accountabe in some way for their actions and activities. They wi produce reports on their activities that wi refect their objectives and the peope to whom they are accountabe. The foowing tabe provides exampes of different types of organisations and how accountabiity is inked to their differing organisationa objectives. Organisations and Accountabiity Organisation Objectives Accountabe to exampes Private/Pubic company (e.g. Tesco) Making a profit Creation of weath Provide an adequate return on investment, given the risks Sharehoders Other stakehoders (e.g. empoyees, suppiers) Charities (e.g. Concern) Loca authorities (e.g. Loca County Counci) Achievement of charitabe aims Maximise spending on activities Provision of oca services Charity commissioners Donors Government departments 3

28 Chapter 1 : Introduction to Accounting Financia Accounting A of the above organisations have a significant roe to pay in society and have mutipe stakehoders to whom they are accountabe. A require systems of financia management to enabe them to produce accounting information. How does accounting information hep businesses be accountabe? As previousy outined in the introductory definition, accounting is essentiay an information process that serves severa purposes and outcomes: 1. Provides a record of assets owned, amounts owed to others and monies invested. 2. Provides reports showing the financia position of an organisation and the profitabiity of its operations. 3. Heps management actuay manage the organisation. 4. Enabes potentia investors to evauate an organisation and make decisions. There are five overa accounting information objectives that drive this process, described beow. 1. Coection: Coection in money-terms, of information reating to transactions that have resuted from business operations. 2. Recording and cassifying: Recording and cassifying data into a permanent and ogica form. This is usuay referred to as book-keeping. 3. Summarising: Summarising data to produce statements and reports that wi be usefu to the various users of accounting information both externa and interna. 4. Interpreting and communicating: Interpreting and communicating the performance of the business to the management and its owners. 5. Forecasting and panning: Forecasting and panning for the future operation of the business by providing management with evauations of the viabiity of proposed operations. The key forecasting and panning too is the budget. The management process by which accounting information is coected, reported, interpreted and acted on, is caed Financia Management. In preparing accounting information, care shoud be taken to ensure that the information presents an accurate and true refection of the business performance and position. To impose some order on what is a subjective task, accounting has adopted certain conventions which shoud be appied in preparing accounts (a of which wi be expored ater in this modue). For financia accounting, the reguation or contro of what kind of information is prepared and presented goes much further. Ireand, the UK and internationa companies are required to compy with a wide range of Accounting Standards that define the way in which business transactions are discosed and reported. Accounting standards aso address the cacuations around transactions, which we expore in greater detai in Chapter 5. These are appied by businesses through their Accounting Poicies, which wi be addressed in chapter 2. The next section examines the different types of business entity and outines their respective advantages and disadvantages. 4

29 Financia Accounting Chapter 1 : Introduction to Accounting 1.4 TYPES OF BUSINESS ENTITY A business can be organised in one of severa ways: Soe Trader a business owned and operated by one person. Partnership a business owned and operated by two or more peope. Company a business owned by its sharehoders and operated by its directors, who are not necessariy the same peope Soe trader The simpest form of business is the soe trader; a soe trader is a business that is owned by one person. It may have one or more empoyees. It offers the east persona protection. Under aw, a soe trader and the business are the same ega entity. Essentiay, the soe trader and his business are one and the same thing the soe trader is personay iabe if his business is sued or owes any money, i.e. his iabiity is unimited. Becoming a soe trader can be risky as the entrepreneur wi be iabe to repay the business s debt from his persona weath if necessary. Profits from the business are considered income and are taxed accordingy; essentiay, the soe trader is treated as sef-empoyed for tax purposes. The main advantages of setting up as a soe trader are: Tota contro of the business by the owner. Cheap and easy to start-up - there are ess forms to fi in and to start trading, the soe trader does not need to empoy any speciaist services, other than setting up a bank account and informing the tax authorities. Keep a the profit as the owner, a the profit beongs to the soe trader. Business affairs are private competitors cannot see what the business is earning, so wi know ess about how the business works and how it succeeds. No obigation to produce a set of pubished financia statements. The ega requirements of a soe trader are to: Keep proper business accounts and records for the Revenue Commissioners (who wi coect the tax on profits) and if necessary VAT accounts. Compy with ega requirements that concern the protection of the customer (e.g. Sae of Goods and Suppy of Services Act). The main disadvantages of being a soe trader are: Unimited Liabiity A soe trader is iabe for any debts that the business incurs. This means that any money that the owner has put into the business coud be ost, but most importanty, if the business continues to incur further costs then the owner has to pay these as we. In some cases they may have to se some of their own possessions to pay suppiers. Such a risk often puts potentia soe traders off setting up businesses, and aso makes them consider the other forms of business structure. 5

30 Chapter 1 : Introduction to Accounting Financia Accounting As a resut of the soe trader and the business being the same ega form, the soe trader is taxed based on income tax not corporation tax. Corporation tax rates are more favourabe than income tax rates. It can be difficut to raise finance. Because they are sma, banks may not end arge sums of money to soe traders who may be unabe to avai of other forms of ong-term finance uness they change their ownership status. It can be difficut to enjoy economies of scae, i.e. ower costs per unit due to higher eves of production. A soe trader, for instance, may not be abe to buy in buk and enjoy the same discounts as arger businesses. There is a probem of continuity if the soe trader retires or dies what happens to the business? The reasons for being a soe trader are often a baance between business and persona costs and benefits 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 exampes, ike accountancy firms and soicitors firms, where there are more partners. A partnership is normay set up using a Deed of Partnership. This contains: Amount of capita each partner shoud provide (i.e. starting capita). How profits and osses shoud be divided. How many votes each partner has (usuay based on the proportion of capita invested). Rues on how to take on new partners. How the partnership is brought to an end, or how a partner eaves. In the absence of this deed of partnership, the Partnership Act of 1890 (amended in 1907) wi appy to avoid any disputes in the future. The Limited Partnership Act of 1907 encompasses the UK, Scotand and Northern Ireand. It provides a ega framework for Repubic of Ireand partnerships. The act states that: No interest is paid on capita of the partners. No remuneration is paid to partners for acting in the business. Profits and osses are to be shared equay between partners. Interest at the rate of 5% per annum is paid on oans made by the partners to the partnership in excess of their agreed capitas. The main advantages of a soe trader becoming a partnership are: It spreads the risk across more peope, so if the business gets into difficuty then there are more peope 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 skis and ideas to the business, compementing the work aready done by the origina partner. 6

31 Financia Accounting Chapter 1 : Introduction to Accounting Partnership increases credibiity with potentia customers and suppiers who may see deaing with the business as ess risky than trading with just a soe trader. For exampe, a buider, working originay as a soe trader, may team up with an architect or carpenter to form a partnership. Either woud bring added expertise, but aso might bring added capita and/ or contacts. Of course the buider coud team up with another buider as we sharing the risk, and potentiay the workoad. The main disadvantages of becoming a partnership are: Having to share the profits. Less contro of the business for the individua. Disputes over workoad. Probems if partners disagree over the direction of the business. The next step for a partnership is to move towards becoming a private imited company. However some partnerships do not want to move to this stage. The advantages of remaining a partnership rather than becoming a private imited company are: It costs money to set-up a imited company (may need to empoy a soicitor/accountant to set up the paper work). Company accounts are fied so the pubic can view them (and competitors). Additiona cost of an auditor to check the accounts before they are fied. 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 examinabe in the Financia Accounting examination Limited Company A Limited Company is a business that is owned by its sharehoders, run by directors and most importanty its iabiity is imited. There can be one sharehoder or many thousands of sharehoders. Sharehoders are aso known as members. Each sharehoder owns part of the company. As a group they seect the directors who run the business. Directors often own shares in the company, but not a sharehoders have to be directors. Limited Liabiity means that investors can ony ose the money they have invested and no more. This encourages peope to finance the company, and/or set up such a business, knowing they can ony ose what they have put in, if the company fais. For peope or businesses who have a caim against the company, imited iabiity means that they can ony recover money from the existing assets of the business. They cannot caim the persona assets of the sharehoders to recover amounts owed by the company. A Limited Company has to possess a separate ega entity from its sharehoders, meaning that the company is seen as separate from its sharehoders. To set up a imited company, a company has to 7

32 Chapter 1 : Introduction to Accounting Financia Accounting register with the Registrar of Companies, who maintains a separate fie for every company, and is issued with a Certificate of Incorporation. It aso needs to have a Memorandum of Association which sets out what the company has been formed to do, and Artices of Association which are interna rues incuding what the directors can do and voting rights of the sharehoders. The distinguishing factor that differentiates a imited company from a soe trader and a partnership is that a imited company has to prepare annua statutory accounts ; this is the price to be paid for the benefit of imited iabiity. Limited companies must produce such accounts annuay 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 fie for every company. The fie for any company can be inspected at the Companies Registration Office for a nomina fee by a member of the genera pubic. This is why the statutory accounts are often referred to as the pubished accounts. The advantages of a imited company can be summarised as foows: Limited iabiity. Separate ega entity. The company s trading profits are taxed at the corporation tax rate of 12.5% in Ireand, which is consideraby ower that the top persona income tax rate of 41%, paid by soe traders and partnerships. The company s name is protected, as two companies cannot have a simiar name. The company continues despite the death or resignation of management and members. The interests and obigations of management are defined. Appointment, retirement or remova of directors is straightforward. It is easier to procure new sharehoders and investors. A arger number of investors can own the company than, say, partners in a firm. The members rights are usuay comprehensivey defined in the memorandum and artices of association. The disadvantages of a imited company can be summarised as foows: Initia costs of registering a company name with the Companies Registration Office. Additiona administration costs reated to the annua preparation and submission of an annua return, to the Registrar of Companies, according to statutory requirements. Fees and other penaties appy if companies don t compy. Companies must hod an Annua Genera Meeting (AGM) within 18 months of incorporation and thereafter on an annua basis (must be an AGM in each caendar year). There are exemptions for singe 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 miion must prepare and fie audited financia statements with the Companies Registration Office. The potentia separation of ownership and contro which requires additiona corporate governance mechanisms within the company, to monitor interna management. 8

33 Financia Accounting Chapter 1 : Introduction to Accounting Pubic and Private Limited Companies Limited companies are governed very tighty, namey through the Companies Acts. Limited companies can either be private imited companies or pubic imited companies. The difference between the two is that shares in a Pubic Limited Company (Pc) can be traded on the Stock Exchange and be bought by members of the genera pubic. Shares in a Private Limited Company are not avaiabe to the genera pubic. A private imited company may wish to become a Pc because shares in a private imited company cannot be offered for sae to the genera pubic, thereby restricting the avaiabiity of finance, especiay if the business wants to expand. Therefore, it is attractive to change status. It is aso easier to raise money through other sources of finance, e.g. from banks. It is important to note that a Pc does not necessariy mean that the company is quoted on the Stock Exchange. In order to have a isting on the Stock Exchange, the company must undergo a fotation or Initia Pubic Offering (IPO). Fotation or Initia Pubic Offering (IPO) A company may foat on the stock market. This means seing a or part of the business to outside investors. This generates additiona funds for the business and can be a major form of fundraising. When shares in a Pc are first offered for sae to the genera pubic the company is given a isting on the stock exchange. This is caed an Initia Pubic Offering (IPO). The advantages of being a pubic imited company (Pc) are: Better access to financia resources to support growth objectives i.e. raising share capita from existing and new investors. Better iquidity sharehoders are abe to buy and se their shares (if they are quoted on a stock exchange). Large Pc s may find it easier to borrow from banks. The vaue of the firm is readiy shown by the market capitaisation (based on the share price). Companies can more easiy acquire other firms e.g. by offering shares to the sharehoders of the target firm. Going pubic gives a company a more prestigious profie. The disadvantages of being a pubic imited company (Pc) are: Costy and compicated to set up as a Pc The business owners need to empoyee speciaist bankers and awyers to hep organise the converting to the Pc. Certain financia information must be avaiabe for a parties, competitors and customers incuded (this pubication of financia information risks attracting further competition and arming existing competitors). Sharehoders in pubic 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 onger term objectives, such as growth and investment. The threat of takeover, as another company can buy up a arge number of shares because shares are traded pubicy (can be sod to anyone). If they buy enough, they can then persuade other sharehoders to join with them to vote in a new management team. 9

34 Chapter 1 : Introduction to Accounting Financia Accounting The reasons sharehoders buy share are as foows: Shares sometimes pay dividends to the sharehoders, which is a share of the profits at the end of the year. Companies on the Stock Exchange usuay pay dividends twice each year. Over time the vaue of the share might increase and can be sod for a profit this is known as a capita gain. Of course, the price of the shares can go down as we as up, so investing in shares can be risky. If they have enough shares they can infuence the management of the company. A good exampe is a venture capitaist that wi 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 Contro and the need for Corporate Governance As a business becomes arger, the ownership and contro of the business may become separated. This is because the sharehoders may have the money, but not the time or management skis to run the company. Therefore, the day-to-day running of the business is entrusted to the directors, who are empoyed for their skis, by the sharehoders. This agency reationship between the sharehoders and the directors is referred to as Corporate Governance. The sharehoders are therefore divorced from the running of the business for 364 days of the year. They wi have their say at the Annua Genera Meeting (AGM) of the company, where the directors present the accounts and the resuts. In practice directors tend to have at east a modest sharehoding in the company. This provides the director with an incentive to achieve good dividends and capita growth for the share (an increase in the share price). NOTE: Company accounts are not examinabe in the Financia Accounting examination. In summary for a three types of entity, the money invested by the individua, the partners or the sharehoders, is referred to as the business capita. In the case of a company, this capita is divided into shares (Share Capita). 1.5 USERS OF ACCOUNTING INFORMATION There are many potentia users of accounting information, incuding sharehoders, enders, customers, suppiers, government departments (e.g. Revenue), empoyees and their organisations, and society at arge. Anyone with an interest in the performance and activities of an organisation is traditionay caed a stakehoder. For a business or organisation to communicate its resuts and position to stakehoders, it needs a anguage that is understood by a in common. Hence, accounting has come to be known as the anguage of business. There are two broad types of accounting information and two broad groups of information users: 1. Financia Accounting: geared towards externa users of accounting information. 2. Management Accounting: geared more at interna users of accounting information. 10

35 Financia Accounting Chapter 1 : Introduction to Accounting Athough there is a difference in the type of information presented in financia and management accounts, the underying objective is the same to satisfy the information needs of the user. These needs can be described in terms of the overa accounting information objectives stated in section USERS OF FINANCIAL STATEMENTS It is easy to assume that the ony users of accounting information are sharehoders since it is a requirement of company aw that sharehoders must receive financia statements. However, in reaity there are many users of accounts. The foowing subsections summarises the main users groups and provides exampes of their areas of interest in accounts Investors Investors are concerned about risk and return in reation to their investments. They require information to decide whether they shoud continue to invest in a business. They aso need to be abe to access whether a business wi be abe to pay dividends, and measure the performance of the business management team. The key accounting information for an investor is therefore: Information about growth, saes, voumes. Profitabiity (profit margins, overa eve of profit). Investment (amounts invested, assets owned). Business vaue (share price). Comparative information of competitors Lenders Banks and oan stockhoders who end money to a business require information that heps them determine whether oans and interest wi be paid when due. The key accounting information for enders is therefore: Leve of existing debt Cash fow. Security of assets against which the ending may be secured. Investment requirements in the business Suppiers Suppiers and trade payabes require information that heps them understand and assess the short-term iquidity of a business. For exampe is the business abe to pay short-term debt when it fas due? The key accounting information for suppiers is therefore: Cash fow. Management of working capita. Payment poicy. 11

36 Chapter 1 : Introduction to Accounting Financia Accounting Customers Customers and trade receivabes require information about the abiity of the business to survive and prosper. As customers of the company s products, they have a ong-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: Saes growth. New product deveopment. Investment in the business (e.g. production capacity) Empoyees Empoyees (and organisations that represent them e.g. trade unions) require information about the stabiity and continuing profitabiity of the business. They are very interested in information about empoyment prospects and the maintenance of pension funding and retirement benefits. They are aso ikey to be interested in the pay and benefits obtained by senior management. The key accounting information for empoyees is therefore: Revenue and profit growth. Leves of investment in the business. Overa empoyment data (numbers empoyed, wages and saary costs). Status and vauation of the company pension schemes/eves of company contributions Government There are many government agencies and departments that are interested in accounting information. For exampe, the Revenue Commissioners need information on business profitabiity in order to evy and coect Corporation Tax. Customs and Excise need accounting information to verify Vaue Added Tax (VAT) returns; oca government need simiar information to evy oca taxes and rates. Various reguatory agencies (i.e. the Environment Agency) need information to support decisions about grants, for exampe Anaysts Investment anaysts are an important user group specificay for companies quoted on the Stock Exchange. They require very detaied financia and other information in order to anayse the competitive performance of a business and its sector. Much of this is provided by the detaied accounting discosures that are required by authorities such as the London Stock Exchange. However, additiona accounting information is usuay provided to anaysts via informa company briefings and media interviews. 12