Financial statements, accounting principles and accounting standards

1 Introduction

The statement of profit or loss and the statement of financial position are the key documents in the financial statements of any business.

You need to know how these are usually set out and the terminology that is used.

2 Why financial records are kept

Before looking at the statements themselves, be clear why a business keeps accounting records at all. It is not simply a legal chore. The records are the only complete history of what the business has done, and two different groups rely on them.

Internal use - by the owners and managers of the business:

• To know whether the business is making a profit, and on which products or activities.

• To know how much cash there is, who owes the business money and who the business owes.

• To control the business: to chase slow-paying customers, to check that what was ordered was received, and to spot theft and error.

• To plan: budgets, pricing and borrowing decisions all start from past figures.

External use - by people outside the business who have no other source of information:

• The tax authorities, who assess tax on the profit the records produce.

• Banks and other lenders, who want to see whether the business can repay.

• Suppliers deciding whether to grant credit, and how much.

• In a partnership, each partner, who needs the records to see that profits have been shared as the agreement says.

Because outsiders rely on them, the records have to be complete, accurate and kept up to date, and they have to be supported by documents - an invoice, a receipt, a bank statement - that an outsider could check. That is the point of the books of prime entry, the ledgers and the reconciliations you will meet in the chapters that follow.

3 Types of business transaction

An organisation can be defined as:

A social arrangement which pursues collective goals, which controls its own performance and which has a boundary separating it from its environment.

Organisations can include businesses such as companies and partnerships, clubs, charities, government departments, hospitals and schools.

Even if not strictly a ‘business’ all organisations will have business transactions. Typically these will include:

• Purchasing goods and materials. Purchases can be for cash or credit. Cash purchases are paid for immediately and are fairly rare in most businesses. Credit purchases are paid for after some time, typically a month or so
  

• Purchasing services, for example, repairs to equipment, advertising, printing costs.
  

• Sales. Cash sales, for example in shops, are paid for immediately. Credit sales are paid for after some time.
  

• Paying wages and salaries.
  

• Purchase of non-current assets.
  

• Raising finance and paying rewards to the suppliers of finance. For example, owners putting in capital or loans being raised from banks. Owners of the business expect rewards based on a share of the profit; banks usually expect interest to be paid.
  

• Accounting for and paying tax.
  

• Movements of cash and money in the bank account. These movements usually arise from the transactions above.

All of these transactions are recorded in the books of account (described in detail in a later chapter). The information is summarised at the end of accounting periods into two statements:

• Statement of profit or loss
  

• Statement of financial position

4 Statement of profit or loss

This shows the sales made and the costs incurred in a period. Sales less costs will show the profit made in the period (or if costs are greater than sales, the loss for the period). You might sometimes still hear this document referred to as the ‘Profit and loss account’, but that is no longer official terminology and you should try not to use it.

The typical layout is:

Notes

1. The name of the entity must be stated.
   

2. Statements of profit or loss are for periods. Typically they show income, expenses and profits for a period of a year. However, other periods are also possible.
   

3. Sales, or revenue, is what is sold in the period. This will exclude any sales tax that customers are charged because that is a tax passed onto the government, not a sale.
   

4. Cost of sales. The cost of sales is the direct costs of buying or making whatever is sold. Cost of sales is not generally the same as what was purchased because there can be opening and closing inventory.
   

   Cost of sales = Opening inventory + Purchases – Closing inventory
   

   The inventory adjustment ensures that sales are properly matched with the cost of the goods sold:
   

   Opening inventory + Purchases equal all the items that were available for sale.
   

   Closing inventory is what was not sold.
   

5. The gross profit is sales less cost of sales. Think of this as the main-spring of the business. If gross profit is poor, very poor profits will be made overall.
   

6. Other expenses are typically grouped and summarised as shown into selling, distribution and administration costs. This keeps the statement of profit or loss relatively uncluttered. More details can be provided as notes to the financial statements.
   

7. The net profit is what is left after all expenses. In an unincorporated business it belongs to the owner: it can be left in the business, where it adds to capital, or taken out as drawings.

The statement of profit or loss of an unincorporated business (a sole trader for example) could look identical, but often the expenses will be listed in greater detail.

5 The statement of financial position

As the name of this document suggests the statement of financial position (“SOFP”) shows the financial position of a business at a point in time. You might sometimes hear this document referred to as a ‘balance sheet’, but this is old terminology and you should try to avoid it.

It shows:

• Assets   (non-current assets and current assets)
  

• Liabilities   (non-current liabilities and current liabilities)
  

• Capital
  

The typical layout is:

Notes

1. The name of the entity must be stated.
   

2. Statements of financial position are drafted for a point in time.
   

3. Non-current assets are used by the business to make profits and have a life of longer than one accounting period. They are not regularly bought and sold as trading goods are.
   

4. Current assets are either cash or expected to become cash within one year. They are presented in increasing order of liquidity. So, inventory has to be first sold and then the sales proceeds have to be collected. That could all take many months. Customers (receivables) are usually expected to pay within a month or so. Cash is already cash. So, the ‘bad news’ comes first because some inventory might never sell and might never become cash.
   

5. Capital arises from capital introduced by the owners of the business and from retained profits. Any withdrawal of profits by the owners will reduce the retained profit and therefore will reduce the capital of the business.
   

Non-current liabilities are liabilities that have to be settled after more than 12 months. For example, a bank loan being repaid over five years.

Current liabilities have to be settled in less than 12 months. Note that overdrafts are repayable on demand.

The two ruled totals at the foot of each half of the statement are the same figure. That is the point of it:

Assets = Liabilities + Capital (amounts owed to the owners)

In essence, the statement of financial position sets out the accounting equation covered in more detail in a later chapter.

6 The conceptual framework of accounting

There are certain principles which underpin accounting and accounts preparation. You need to know what these are:

1. Going concern: the assumption that the business will continue functioning in the foreseeable future. This can affect the valuation of many assets because if the business closes, assets might have to be disposed of at their scrap values.
   

2. Accruals: income and expenses should be matched on a time basis, not just when cash is received or paid.
   

3. Consistency: financial statements should be drawn up using the same approaches each year. If, for example, the way an amount is measured is altered, then profits could be affected or manipulated.
   

4. Double entry: every transaction has matching Debit and Credit entries in the bookkeeping system.
   

5. Business entity: accounting records record the transactions of the business entity, not the transactions of its owners.
   

6. Materiality: an item is material if its misstatement could alter the economic decisions of users of the financial statements. Immaterial items do not have to be disclosed – indeed too much information can be confusing.
   

7. Historical cost: transactions are recorded at their historical cost.
   

8. Prudence: where there is uncertainty, do not overstate assets or income and do not understate liabilities or expenses. A profit is not recognised until it has been earned, but a loss is recognised as soon as it can be foreseen. This is why inventory is written down to net realisable value when that is lower than cost, and why an allowance is made against receivables that look doubtful before they are actually written off. Prudence does not mean deliberately understating profit: that would breach faithful representation.

Note on wording: the principle listed above as 'double entry' is called duality in the study guide. They are the same idea - every transaction has two equal and opposite effects on the accounting records.

There are also certain qualitative characteristics of accounting, which you also need to know. These are:

1. Relevance: financial information is regarded as relevant if it is capable of influencing the decisions of users. Therefore, all relevant information should be included in financial statements.
   

2. Faithful representation: financial information must be complete, neutral and free from error otherwise it will mislead users of the financial statements.
   

3. Comparability: financial information should be capable of being compared over time and with similar information about other entities. If it is not comparable, then interpretation and understanding is difficult.
   

4. Verifiability: the accounting information should be capable of being verified through auditing procedures. This allows users to place more trust in the information.
   

5. Timeliness: information should be provided quickly enough to be of use in decision-making.
   

6. Understandability: information should be presented in a way that makes it understandable to users. This can be done, for example, by good layout, accurate descriptions and, where necessary, notes explaining the information.
   

7 Accounting standards

At one time accountants had a great deal of discretion when producing financial statements: there were several acceptable ways of valuing inventory, of treating research spending, and of taking profit on long contracts. That made it hard to compare one business with another. Accounting standards exist to narrow those choices. The standards you meet in FA2 are IFRS Accounting Standards, issued by the International Accounting Standards Board; they are made up of the older International Accounting Standards (IAS) and the newer International Financial Reporting Standards (IFRS).

You need to be aware of the main points covered by the following IFRS Accounting Standards:

• IAS 1   Presentation of financial statements
  

• IAS 2   Inventories
  

• IAS 16   Property, plant and equipment
  

• IFRS 15   Revenue
  

• IAS 37   Provisions, contingent liabilities and contingent assets.
  

IAS 1     Presentation of financial statements

The objective of IAS 1 is to set out the basis for presentation of how general purpose financial statements should be presented to ensure comparability with both the entity's financial statements of previous periods and with the financial statements of other entities. IAS 1 sets out the overall requirements for the presentation of financial statements, guidelines for their structure and minimum requirements for their content.

IAS 2     Inventories

The fundamental principle of IAS 2 is that inventories must be stated at the lower of cost and net realisable value.

Cost should include all:

• Costs of purchase (including taxes, transport, and handling) net of trade discounts received.
  

• Costs of conversion (including fixed and variable manufacturing overheads)
  

• Other costs incurred in bringing the inventories to their present location and condition.
  

Net realisable value is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale.

IAS 16   Property, plant and equipment

Items of property, plant, and equipment should be recognised as assets when:

• It is probable that the future economic benefits associated with the asset will flow to the entity, and
  

• The cost of the asset can be measured reliably.
  

An item of property, plant and equipment should initially be recorded at cost. Cost includes all costs necessary to bring the asset to working condition for its intended use. This would include not only its original purchase price but also costs of site preparation, delivery and handling, installation, related professional fees for architects and engineers, and the estimated cost of dismantling and removing the asset and restoring the site.

IAS 16 permits two accounting models:

• Cost model. The asset is carried at cost less accumulated depreciation and impairment.
  

• Revaluation model. The asset is carried at a revalued amount, being its fair value at the date of revaluation less subsequent depreciation and impairment, provided that fair value can be measured reliably.
  

IFRS 15   Revenue

IFRS 15 sets out a single five-step model for recognising revenue from contracts with customers. Revenue is the amount the entity expects to be entitled to in exchange for transferring goods or services to a customer.

The five steps are:

• Identify the contract with the customer.

• Identify the separate performance obligations in the contract - the distinct goods or services the entity has promised to deliver.

• Determine the transaction price - the consideration the entity expects to be entitled to, excluding sales tax collected on behalf of the government.

• Allocate the transaction price to the performance obligations, normally in proportion to their stand-alone selling prices.

• Recognise revenue when (or as) each performance obligation is satisfied, ie when control of the goods or services passes to the customer.

IAS 37   Provisions, contingent liabilities and contingent assets.

A provision is recognised only when all three of these conditions are met:

• there is a present obligation as a result of a past event;

• it is probable that settling it will require an outflow of resources; and

• the amount can be estimated reliably.

If the first condition is met but an outflow is only possible rather than probable, or the amount cannot be estimated reliably, there is no provision - there is a contingent liability, which is disclosed in a note and not recognised in the accounts.

Telling a provision apart from the other things on the credit side of a statement of financial position is a favourite exam point:

So an electricity bill not yet received is an accrual, not a provision; a claim for damages the business will probably have to pay but whose amount it must estimate is a provision; and a claim the business is defending and will probably win is a contingent liability.