Financial Accounting

Relevance + faithful representation are both very important 

Relevance: Ability of accounting information to influence decisions. Relevance is regarded as a fundamental characteristic of useful accounting information. 

Faithful representation: Ability of information to be relied on to represent what it says it does. Also, a fundamental quality of good accounting information. 

Relevance: Accounting information should predict future events (next year's profit) or help to confirm past events (establishing last year's profit) To be relevant, accounting information must cross a threshold of materiality (omission or misinterpretation of AI will alter decisions that users make). 

FR:Accounting information should represent what it's supposed to represent. It should therefore be complete and neutral - all information, therefore should be selected and presented without bias. It should also be free from error. This doesn't mean, however that data is always perfectly accurate as this is impossible. For example, estimates may have been made which eventually turn out inaccurate. There should, however be no errors in the way in which these estimates have been calculated. 

Claim of owners against the business

Also known as Capital or Ownership (how much does the owner invest)

Capital contributed: Share capital in a limited company

Profit: Retained earnings and reserves NOT cash. 

• Obligation - repayment of loan
• Past transaction- paying something which you purchased on credit
• Outflow of resources - cash to settle liability 

Claim: Obligation of the business to provide cash, or some othe form of benefit to an outside party.

Equity:

• Claim of the owner against the business. Claim = owner's capital. There must be a clear distinction between the business and the owner for accounting purposes. The business is seen as a separate entity with its own existence. Any funds contributed from the owner will be seen as coming from outside the business - appear as a claim against the business in terms of financial position. 

Liabilities:

• Represent the claims of all individuals and organisations, apart from the owner. They arise from past transactions or events such as supplying goods or lending money to the business. A liability will be seetled through an outflow of assets (usually cash)

Once a claim from the owners/outsiders has been incurred by a business, it will remain as an obligation until it is settled. 

All of the qualities below enhance the usefulness of AI (Accounting information)

Comparability: Helps users identify similarities and differences between items of information - enhances the usefulness of AI. Users may want to compare profit this year with that of last year. 

Verifiability: Provides assurance to users that information provided faithfully represents what it is supposedto represent. Information tends to be supported by evidence

Timeliness: Provision of accounting information in time for users to make their decision. Lack of timeliness undermines usefulness of the information. The later AI is produced, the less useful it becomes

Understandability: Allows AI to be understood by those for whom the information is primarily compiled and set out clearly + concisely. 

Finance comes from owners (shareholders) both in the form of a direct cash investment to buy shares (in the ownership of the business) and shareholders allowing past profits, which belong to them to be reinvested in the business.

Finance also comes from lenders-banks who earn interest on their loans. Further finance comes from suppliers of goods and services being prepared to supply on credit - usually interest-free. 

In larger limited companies, shareholders son't tend to get involved in the daily running of the business, a board of directors is appointed to manage the business on their behalf.  They:

1. Set the overall direction and strategy for the business

2. Monitor + control the activities of the business

3. Communicate with shareholders and others connected with the business. 

1. What is the purpose of producing accounting info?

To enable users to make more informed decisions + judgements about the organisation concerned. Unless it fulfills this purpose, there is no point in providing it. 

2. What, in economic principle, should be the determinant of what accounting information is produced? Should economics be the only issue here? 

Economic cost of providing AI should be less than the expected economic benefit from having the information available. In other words, there should be a net economic benefit from producing it; otherwise it shouldn't be produced. There are, however problems in determining the precise value of the benefit, and problems in determining the amount of the cost. Social factors may also be involved; not just economic factors, for example society has a right to certain information about a large business even though this info has no direct economic value to society. 

3. Financial accounting statements tend to reflect past events. In view of this, how can they be of any assistance to a user in making a decision, when decisions, by their very nature, can only be made about future actions? - We don't know what's going to happen in the future, so we can make judgements on the basis of past experience. Info concerning cash flows in th past can be used. 

Working capital: Current assets - Current Liabilities 

Profit: Increase in wealth attributable to the owners of a business that arises through business operations

Revenue: Measure of the inflow of assets (cash or amounts owed to a business by credit customers) or a reduction in liabilities, arising as a result of trading opeartions. 

Revenue Reserve: Part of the owner's claim (equity) of a company that arises from realised profits and gains, inlcuding after-tax trading profits and gains from disposals of non-current assets. 

Statement of Financial position: AKA Balance Sheet; Shows the assets of a business and claims on those assets. 

Depreciation: Measure of the that portion of the cost (or fair value) of a non-current asset that has been consumed during a reporting period. 

Credit: An entry made on the right-hand side of an account in double-entry bookkeeping. 

Chapter 1

• Sole proprietorship: Individual is the sole owner of a business - small in terms of size, these businesses are common within the service sector (restaurant).
• Partnership: 2 or more individuals carry on a business together with the intention of making a profit. They are quite small in size, although some can be large - solicitors . They have unlimited liability. 
• Unlimited liability: No distinction is made between proprietor's personal wealth and that of the business, if there are business debts to be paid, the sole owner is responsible. 
• Limited companies: Business which is granted separate legal existence from that of its owners. Owners of this type of business are only liable for the amount that they have invested - limited liability. This business can become very big, as the number of individuals who subscribe capital may be unlimited. This reduces risk for individuals who invest and promotes investment. 

• Created to enhance wealth of its owner
• A business could just seek to provide good working conditions for its employees
• May seek to conserve environment for the local community
• Market economy: an economy where decisions regarding investement, production, and distribution are basedon supply and demand, and prices of goods and services are determined in a free price system. 
• In a market economy, there are strong competitive forces at work to ensure that failure to enhance an owner's wealth will not be tolerated for long. Competition for the funds provided by owners and competition for managers' jobs means that if the manager doesn't provide the expected increase in ownership walth, they will be replaced with someone more responsive to owner's needs. 

AKA Fixed assets: Heldfor long-term operations, they can be either tangible or non-tangible.

Tangible Fixed Assets: Property, plant and equipment are all assets which have a physical substance. This includes land and buildings, motor vehicles and fixtures and fittings. 

Non-Tangible assets: Patents, trademarks. 

If a business buys another brand (Kraft purchased Cadbury) this can be reflected on the financial statement, however if you just develop your own brand, you may not be able to put this onto your balance sheet.

Current assets: Assets that are held for the short term:

• Held for sale/consumption during the business' normal operating cycle
• Expected to be sold within the next year
• Held principally for trading
• Cash or near cash (easily marketable) short-term investments 

Operating cycle: Time between buying and/or creating a product/service and receiving the cash on its sale. This normally happens within a year - usually on credit; where the person can pay some time after the goods/services have been rendered.

• Inventories
• Trade receivables
• Cash

The above are interrelated: Cash is used to buy inventories which are then sold to customers on credit, when the credit customers (trade receivables) pay, the business gets back cash. 

What was accounting previously used for?

• Checking on honesty and integrity
• It was basically, management accounting - for internal use. 
• If you lend money to lots of people you have to write it down 

Double entry book-keeping was used as an early internal control: A system for recording financial transactions where each transaction is recorder twice - once as credit and once as debit. 

The East India Company issued capital for a 4 year term which was extended - this is permanenetly invested capital in the form of shares. 

Why does an enterprise need to be chopped up into artificial accounting periods: Profit needs to be calculated periodically due to the permanent investment of capital - so that investors can see whats going on. 

Accounting

External Users                                                                                                              Internal users   

Shareholders                                                                                                                  Managers

Potential Investors

Banks 

Suppliers

Customers

Financial Accounting                                                                                     Management Accounting

• Nature of the Reports produced: GENERAL-PURPOSE
• Aimed primarily at providers of finance such as owners and lenders.
• They do, however contain financial information useful for a broad range of users to allow them to make informed decisions. 
• Level of detail: BROAD OVERVIEW
• Provide broad overview of the performance and position of the business for a period + detail can be lost 
• Regulations: ACCOUNTING REGULATION
• Accounting reports are subject to accounting regulation, this means that they have to be produced with standard content and in a standard format
• The law and accounting rule makers impose these regulations
• Reporting interval: ANNUAL/BI-ANNUAL
• Some large businesses may produce reports on a 6-month basisand a few may produce quarterly ones.
• Most produce reports once a year 
• Time Orientation: HISTORICAL (PAST DATA)
• Financial accounting reports reflect the performance and position of the business for the past period
• They are backward-looking, however can still include expectations for the future - for prep of financial accounts
• Businesses may release projected info to other users in order to raise capital or fight off unwanted takeover bids
• Range & Quality of Information: FOCUS ON FINANCIAL INFO, OBJECTIVE, VERIFIABLE EVIDENCE
• Focus on info that can quantified in monetary terms

• Seeks to meet the needs of managers
• This is for internal users (people on the inside of an organisation)
• Nature of reports produced: SPECIFIC 
• Specific-purpose reports, they're deisgned with a particular decision in mind and for a particular manager.
• Level of detail: VERY DETAILED
• Often very detailed so as to provide managers with considerable detail to help them with a particulaar operational decision.
• Regulations: UNREGULATED
• As management accounting reports are for internal use only, there are no regulations from external sources concerning the form and content of the report. They can be designed to meet the needs of particular managers. 
• Reporting interval: AS SHORT AS REQUIRED BY MANAGERS
• They may be daily, weekly or monthly as reports are provided whenever a manager needs one, this allows them to check progree frequently.
• Special-purpose reports will be prepared when needed (evaluate proposal to buy something)
• Time orientation: BASED ON PROJECTED FUTURE INFO AS WELL AS PAST INFO
• They provide info concerning future performace as well as past performance
• Range and Quality of Info: CONTAIN FINANCIAL + NON-FINANCIAL INFO
• They may contain information of a non-financial nature (physical volume of inventories, number of sales orders received, number of new products launched. 

Earliest nineteenth century partnerships were the most prevalent form of business entity:

• Unregulated 
• Unregistered - no tax 
• Fraud was rife

Joint Stock Companies Act (1844) said there is a compulsary audit required

Limited libaility had to be obtained separately (restriction of legal obligation for shareholders to have to meet all of the company's debt. 

The Joint Stock Companies Act was abandoned and not reintroduced until 1900 

• The whole point of the Companies act 1948 was to allow an auditor to give a 'true and fair view' on the balance sheet and profit and loss acount. 
• External auditors may express their opinion on whether the financial statement is fair, however the truth may be a different matter. 
• Precision, accuracy and correctness are all used in relation to accounting - good for recording of transactions, however reasonableness and consistency are better terms when used for external reporting. 

Accounting is not essentially a process of valuation, but the allocation of historical costs and revenues to current and suceeding fiscal periods - AAA (1936)

• Asset: Resource held by a business with an ability to provide future benefits. 

Future benefit: Item must be expected to have some future monetary value, either through its use in the business or its hire/sale. So an obsolete piece of equipment which can be sold for scrap is an asset, wheereas one which has no scrap value isn't an asset 

Control; belongs to us: Unless the business has control over the resource, it cannot be regarded as an asset. So for a business which offers road trips, it has no control over others accessing the road and therefore it cannot be regarded as an asset of the business unless they own it.

Past transaction; something happened which was recorded and will benefit us in the future : The transaction giving rise to a business' right to benefit must have already happened; not something which will happen at a later date. An agreement to buy a piece of equipment at some future date wouldn't mean that the item is currently an asset of the business. 

Measured in monetary terms: Unless the item can be measured in monetary terms, with a reasonable degree of reliability, it cannot be regarded as an asset on financial statement. For example, the title of a business may not be valuable to others, this is a hard value to quantify

• Management & Financial Accounting:
• Management - seeks to meet needs of business managers
• Financial - seeks to meet needs of providers of finance but also useful to other groups. 
• What kinds of business ownerships exist?
• Sole proprietorship: Easy to set up and flexible to operate but the owner has unlimited liability
• Partnership: Easy to set up and spreads the burdens of ownership, but partners usually have unlimited liability, there are also ownership risks if partners are unsuitable. 
• Limited company: Limited liability for owners, but there are obligations imposed on the way a company conducts its affairs. 
• How are businesses organised and managed?
• Most businesses of any size are set up as limited companies
• A board of directors is appointed by owners (shareholders) to oversee the running of the business

What is the financial objective of a business:

• To enhance the wealth of the owners, the needs of other groups connected with the business - such as employees cannot be ignored. The right balance between risk + return must be struck

Accounting is: Process of identifiying, measuring and communicating financial information to permit informed judgements and decisions by users of information. 

Accounting & User needs:

• For accounting to be useful, it must be clear for WHO and WHAT purpose the information will be used
• Conflicts between users may arise over the ways in which business wealth is distributed
• Accounting is used and useful in decision-making purposes

Accounting as a service:

• Involves providing financial information to various users
• In order to provide a useful service, accounting must be relevant and present faithful representation. 
• Providing a service to users can be costly, financial information should only be produced if the cost of providing the information is less than the benefits gained. 

Information Identification (First 2 stages are concerned with preparation)

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Information Recording

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Information Analysis (Last 2 stages are concerned with using the info collected) 

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Information reporting 

Balance sheet = statement of financial position 

What does a balance sheet show?

WHERE finance CAME from AND WHERE it was put INTO the business

Reserves: Part of the owners claim (equity) of an incorporated business (private and public) limited company that has arisen from profits and gains, to the extent that these haven't been distributed to shareholders or reduced by losses. 

Limited company: Business unit which is granted separate legal existence from that of its owner - owners of this type of business are liable for debts up to the amount that they've agreed to invest. 

• Profit is NOT the same as cash 
• Reserves are NOT pots of cash; they'reprofits reinvested in the busines. 

Assets = Equity + Liabilities

OR

Assets - Liabilities = Equity 

Three statements are produced on a regular, recurring basis and they aim to answer 3 questions:

1. What cash movements took place?

2. How much wealth was generated?

3. What is the accumulated wealth of the business at the end of the period and what form is it?

Separate financial statements to answer the above questions:

1. Statement of cash inflows: Statement which shows a business' sources and uses of cash for a period. 

2. Income statement (profit and loss account): measures and reports profit/loss the business has generated during a period. It's derived by deducting from total revenue for a period, the total expenses associated with that revenue, 

3. Statement of financial position (balance sheet) 

Accounting Conventions: Their role; Attempt to deal with practical problems experienced by preparers and users of financial statements, rather than to reflect some theoretical ideal. 

1. Business Entity                   MOP DAH BGC

2. Historical Cost

3. Prudence

4. Going Concern

5. Dual Aspect

6. Money Measurement

7. Accruals (Matching)

8. Consistency 

9. Objectivity

1. Business entity: Business and its owners are separate entities. 

For accounting purposes, the business and its owner(s) are treated as separate and distinct. This is why owners are treated as being claimants against their own business in repsect of their investement. 

For sole proprietors and partnerships, the law doesn't make any distinction between the business and its owners. 

For limited companies, on the other hand the business' finances are separate to your own finances 

Value of assets shown on the statement of financial position should be based on their acquisition cost (historic cost). 

Many argues, however that historic costs soon become outdated and so are unlikely to help in the assessment of current financial position. 

Recording assets at their current value would provide a more realsitic view of financial position and would be relevant for a wide range of decisions. However a system of measurement based on current value can be a problem. 

The term 'current value' can be defined in different ways. It can be defined broadly as either the current replacement cost or thr current realisable value (selling price) of an asset. The 2 types of valuation may result in quite different figures being produced to represent the current value of an item. 

Furthermore, replacement cost and realisable value can be defined in different ways. Figures based on current values may be heavily dependant on the opinions of managers, therefore some form of independent verification is required to ensure financial statements retain credibility among users.  

Caution should be exercised when making accounting judgements. It involves reporting actual + expected losses immediately but reporting profits when they arise; not before they're realised. 

If we expect a loss, we write a new valuation for our machinery (due to water damage)

There is a greater emphasis placed on expected losses than on expected profits.

For example: The prudence convention requires that the expected loss from future sales be recognised immediately rather than when the goods are eventually sold. 

If, however these inventories could have been sold above their original cost, profit would only be recognised at the time of sale (when its been realised) 

The pridence convention evolved to counteract the excessive optimism of some managers and is designed to prevent an overstatement of financial position and performance.

Where excessive prudence is applied, it will lead to an understatement of profits and financial statement; leading to a consistent bias in the reporting of both financial performance + position. 

Financial statments should be prepared on the assumption that a business will continue operations for the forseeable future, unless there is evidence to the contrary. It is assumed that there is no intention, or need, to sell off the non-current assets of the business. 

Where a business is in financial difficulties, however non-current assets may have to be sold to repay those with claims against the business. (equity in the business). 

The reaslisable (sale) value of many assets us often much lower than the values reported in the statement of financial position. This is because the value to the business of the assets, were it to continue operating,is higher than the immediate realisable value.

In the event of a forced sale of assets, therefore, significant losses would arise. These losses must be anticipated and fully reported  when a business' going concern status is called into question. 

Each transaction has two aspects; both of which will affect the statement of financial position

For example, the purchase of a motot car for cash results in an increase in one asset (car) and a decrease in another (cash). The repayment of borrowings results in the decrease in a liability (borrowings) and the decrease in an asset (cash).