• The purpose of financial

reporting
PART A • Types of business entity
The content and • Users
purposes of financial • Governance
reporting • The main financial statements
Chapter 1
Introduction to https://en.my1lib.org/book/
accounting 3303771/ac443f

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 Learning objectives

1 The scope and purpose of financial statements for

external reporting
a) Define financial reporting: recording, analysing and
summarising financial data.[K]
b) Identify and define types of business entity: sole
trader, partnership, limited liability company.[K]
c) Explain the legal differences between a sole
trader, partnership and a limited liability company.
[K]
d) Identify the advantages and disadvantages of
operating as a sole trader, partnership or limited
liability company.[K]
e) Define the nature, principles and scope of financial
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 Learning objectives
2 Stakeholders needs
a) Identify the users of financial statements and state
and differentiate between their information needs.
[K]

3 The main elements of financial reports

a) Describe the purpose of each of the financial
statements:[K]
i) Statement of financial position
ii) Statement of profit or loss and other
comprehensive income
iii) Statement of changes in equity
iv) Statement of cash flows
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 Learning objectives

5 Duties and responsibilities of those charged with

governance
a) Explain what is meant by governance,
specifically in the context of the preparation of
financial statements.[K]
b) Describe the duties and responsibilities of
directors in the preparation of the financial
statements.[K]

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 Chapter overview

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 Financial reporting

• Financial reporting is a way of recording, analysing and

summarising financial data.
• Financial data is the name given to the actual transactions
carried out by a business eg sales of goods, purchases of goods,
payment of expenses.
• These transactions are recorded in books of prime entry. The
transactions are analysed in the books of prime entry and the
totals are posted to the ledger accounts.
• Finally, the transactions are summarised in the financial
statements.

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 Financial statements – Accounting
records
• In order to be able to produce a statement of profit or loss and a
statement of financial position, a business needs to keep a
record of all its transactions.
• This process is called bookkeeping.
• The process of bookkeeping involves four basic steps:
1) analyzing financial transactions and assigning them to specific accounts;
2) writing original journal entries that credit and debit the appropriate accounts;
3) posting entries to ledger accounts; and
4) adjusting entries at the end of each accounting period
• Accounting records should be complete, accurate and valid if the
information produced is to be useful for the users of financial
information.
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 Types of business entities

• Businesses of whatever size or nature exist to make a profit.

• Businesses vary from very small businesses (the local
shopkeeper or plumber) to very large ones (Vodafone, IKEA,
Corus). However, all of them want to earn profits.
• Profit is the excess of income over expenditure. When
expenditure exceeds revenue, the business is running at a loss.

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 Types of business entities

There are a number of different ways of looking at a business.

Some ideas are listed below.
• A business is a commercial or industrial concern which exists
to deal in the manufacture, resale or supply of goods and
services.
• A business is an organisation which uses economic resources
to create goods or services which customers will buy.
• A business is an organisation providing jobs for people.
• A business invests money in resources (for example buildings,
machinery, employees) in order to make even more money for its
owners.

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 Types of business entities

Businesses fall into three main types:

• Sole trader
• Partnership
• Limited liability company

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 Types of business entities

Sole trader (IT text pg 6)

• A sole trader is a business owned and run by one individual,
perhaps employing one or two assistants and controlling their
work.
• A sole trader owns and runs a business, contributes the capital
to start the enterprise, runs it with or without employees, and
earns the profits or stands the loss of the venture.
• Typical sole trading organisations include small local shops,
hairdressers, plumbers and IT repair services.

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 Types of business entities

• In law, a sole trader is not legally separate from the business

they operate. The owner is legally responsible for the business.
• A sole trader must maintain financial records and produce
financial accounts.
• However, there is no legal requirement to make these accounts
publicly available; they are usually only used to calculate the
tax due to the tax authorities on the profits of the business.
Banks and other financiers may request to see the financial
accounts of the business when considering applications for
loans and overdraft facilities.

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 Types of business entities

Advantages of being a sole trader (Int. Text pg 6)

This type of structure is ideal if the business is not complicated,
and especially if it does not require a great deal of outside
capital. Advantages include:
a) Limited paperwork and therefore cost in establishing this type
of structure
b) Owner has complete control over the business
c) Owner is entitled to profits and the ownership of assets
d) Less stringent reporting obligations compared with other
business structures – no requirement to make financial
accounts publicly available, no audit requirement
e) Can be highly flexible
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 Types of business entities

Disadvantages of being a sole trader (Int. Text pg 6)

a) Owner is personally liable for all debts (unlimited liability)
b) Personal property may be vulnerable for debts and other
business liabilities
c) Large sums of capital are less likely to be available to a sole
trader, leading to reliance on overdrafts and personal savings
d) May lead to long working hours without the normal employee
recreation leave and other benefits
e) May be issues of continuity of business in the event of death or
illness of the owner

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 Types of business entities
Partnership (Int Text pg 6)
• Partnerships occur when two or more people decide to run a
business together.
• Examples include an accountancy practice, a medical practice
and a legal practice. Partnerships are generally formed by
contract.
• Partnership agreements are legally binding and are designed to
outline the proportionate amount of capital invested, allocation
of profits between parties, the responsibilities of each of the
parties, allocation of salary and procedures for dissolving the
partnership.
• Some countries have specific legislation for partnerships. In the
UK, the provisions of the Partnership Act 1890 apply where no
partnership agreement exists.
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 Types of business entities
Partnership (Int Text pg 6)
• Partnerships are not separate legal entities from their owners.
To overcome the problematic risk factors associated with
unlimited personal liability for the debts of the business a new
form of LLP has been created in some countries.
• Partnerships must maintain financial records and produce
financial accounts.
• However, there is no legal requirement to make these accounts
publicly available, unless the partnership has LLP status.

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 Types of business entities

Advantages of partnership
a) Less stringent reporting obligations – no requirement to make
financial accounts publicly available, no audit requirement,
unless the partnership has LLP status
b) Additional capital can be raised because more people are
investing in the business
c) Division of roles and responsibilities and an increased skill set
d) Sharing of risk and losses between more people
e) No company tax on the business (profits are distributed to
partners and then subject to personal tax)

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 Types of business entities

Disadvantages of partnerships
a) Partners are jointly personally liable for all debts (unlimited
liability) unless they have formed an LLP
b) There are costs associated with setting up partnership
agreements
c) There may be issues of continuity of business in the event of
death or illness of the partners
d) Slower decision making due to the need for consensus
between partners
e) Unless a clause is written into the original agreement, when
one partner leaves, the partnership is automatically dissolved
and another agreement is required between existing partners
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 Types of business entities

Limited liability company

• Limited liability companies are incorporated to take advantage
of 'limited liability' for their owners (shareholders).
• This means that, while sole traders and partners are personally
responsible for the amounts owed by their businesses, the
shareholders of a limited liability company are only responsible
for the amount paid for their shares.
• They are not responsible for the company's debts unless they
have given personal guarantees (of a bank loan, for example).
However, they may lose the money they have invested in the
company if it fails.
• Shareholders may be individuals or other companies.

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 Types of business entities
Limited liability company
• Limited liability companies are formed under specific legislation
(eg in the UK, the Companies Act 2006).
• A limited liability company is legally a separate entity from its
owners, and can confer various rights and duties.
• There is a clear distinction between shareholders and directors
of limited companies.
a) Shareholders are the owners, but have limited rights as
shareholders over the day to day running of the company. They
provide capital and receive a return (dividend).
b) The board of directors are appointed to run the company on
behalf of shareholders. In practice, they have a great deal of
autonomy. Directors are often shareholders.
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 Types of business entities

• The reporting requirements for limited liability companies are

much more stringent than for sole traders or partnerships. In
the UK, there is a legal requirement for a company to:
 Be registered at Companies House
 Complete a Memorandum of Association and Articles of
Association to be deposited with the Registrar of Companies
 Have at least one director (two for a public limited company
(PLC)) who may also be a shareholder
 Prepare financial accounts for submission to Companies House
 Have its financial accounts audited (larger companies only)
 Distribute the financial accounts to all shareholders

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 Types of business entities

Advantages of trading as a limited liability company (Int. Text pg

8)
a) Limited liability makes investment less risky than being a sole
trader or investing in a partnership. However, lenders to a small
company may ask for a shareholder's personal guarantee to
secure any loans.
b) Limited liability makes raising finance easier (eg through the
sale of shares) and there is no limit on the number of
shareholders.
c) A limited liability company has a separate legal identity from
its shareholders. So a company continues to exist regardless of
the identity of its owners.

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 Types of business entities
Advantages of trading as a limited liability company (Int. Text pg
8)
d) There are tax advantages to being a limited liability company.
The company is taxed as a separate entity from its owners and
the tax rate on companies may be lower than the tax rate for
individuals.
e) It is relatively easy to transfer shares from one owner to
another. In contrast, it may be difficult to find someone to buy a
sole trader's business or to buy a share in a partnership.

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 Types of business entities
Disadvantages of trading as a limited liability company (Int. Text
pg 8)
a) Limited liability companies have to publish annual financial
statements. This means that anyone (including competitors)
can see how well (or badly) they are doing. In contrast, sole
traders and partnerships do not have to publish their financial
statements.
b) Limited liability company financial statements have to comply
with legal and accounting requirements. In particular, the
financial statements have to comply with accounting
standards. Sole traders and partnerships may comply with
accounting standards, eg for tax purposes.

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 Types of business entities
Disadvantages of trading as a limited liability company (Int. Text
pg 8)
c) The financial statements of larger limited liability companies
have to be audited. This means that the statements are subject
to an independent review to ensure that they comply with legal
requirements and accounting standards. This can be
inconvenient, time consuming and expensive.
d) Share issues are regulated by law. For example, it is difficult to
reduce share capital. Sole traders and partnerships can
increase or decrease capital as and when the owners wish.

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 Types of business entities

• In law, sole traders and partnerships are not separate entities

from their owners. However, a limited liability company is legally
a separate entity from its owners. Contracts can therefore be
issued in the company's name.
• For accounting purposes, all three entities are treated as
separate from their owners. This is called the business entity
concept.

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 The concept of business entity

• A business is considered to be a separate entity from its owner

and so the personal transactions of the owner should never be
mixed with the business transactions.
• When considering a limited liability company, this distinction is
laid down in law – the company has a separate legal identity.
• In preparing accounts, any type of business is treated as being
a separate entity from its owner(s).

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 Nature, principles and scope of financial reporting

Financial accounting
• Financial accounting is mainly a method of reporting the
financial performance and financial position of a business. It is
not primarily concerned with providing information towards the
more efficient running of the business.
• Although financial accounts are of interest to management,
their principal function is to satisfy the information needs of
persons not involved in running the business. They provide
historical information.

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 Nature, principles and scope of financial reporting

Management accounting
• The information needs of management go far beyond those of
other account users. Managers have the responsibility of
planning and controlling the resources of the business.
Therefore they need much more detailed information. They also
need to plan for the future (eg budgets, which predict future
revenue and expenditure).
• Management (or cost) accounting is a management information
system which analyses data to provide information as a basis
for managerial action. The concern of a management
accountant is to present accounting information in the form
most helpful to management.
• You need to understand this distinction between management
accounting and financial accounting.
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 Nature, principles and scope of financial reporting

The International Accounting Standards Board (IASB) states in its

document Conceptual framework for financial reporting:
• 'The objective of financial statements is to provide information
about the financial position, performance and changes in
financial position of an entity that is useful to a wide range of
users in making economic decisions.'
• In other words, a business should produce information about its
activities because there are various groups of people who want,
or need, to know that information.
• Large businesses are of interest to a greater variety of people
and so we will consider the case of a large public company,
whose shares can be purchased and sold on a stock exchange.

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 Stakeholders' needs

The following people (users) are likely to be interested in

financial information about a large company with shares that are
listed on a stock exchange.
(a) Managers of the company are appointed by the company's
owners to supervise the day to day activities of the company.
They need information about the company's financial situation
as it is currently and as it is expected to be in the future. This
is to enable them to manage the business efficiently and to
make effective decisions.
(b) Shareholders of the company, ie the company's owners, want
to assess how well its management is performing. They want to
know how profitable the company's operations are and how
much profit they can afford to withdraw from the business for
their own use.
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 Stakeholders' needs

(c) Trade contacts include suppliers who provide goods for the
company on credit and customers who purchase the goods or
services provided by the company. Suppliers want to know
about the company's ability to pay its debts; customers need to
know that the company is a secure source of supply and is in
no danger of having to close down.
(d) Providers of finance to the company might include a bank
which allows the company to operate an overdraft, or provides
longer-term finance by granting a loan. The bank wants to
ensure that the company is able to keep up interest payments,
and eventually to repay the amounts advanced.
(e) The taxation authorities want to know about business profits
in order to assess the tax payable by the company, including
sales taxes.
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 Stakeholders' needs

(f) Employees of the company should have a right to information

about the company's financial situation, because their future
careers and the size of their wages and salaries depend on it.
(g) Financial analysts and advisers need information for their
clients or audience. For example, stockbrokers need
information to advise investors. Credit agencies want
information to advise potential suppliers of goods to the
company. Journalists need information for their reading public.
(h) Government and their agencies are interested in the allocation
of resources and therefore in the activities of business entities.
They also require information in order to provide a basis for
national statistics.

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 Stakeholders' needs

(i) The public. Entities affect members of the public in a variety of

ways. For example, they may make a substantial contribution to
a local economy by providing employment and using local
suppliers. Another important factor is the effect of an entity on
the environment, for example as regards pollution.

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 Stakeholders' needs

In addition to management information, financial statements are

prepared (and perhaps published) for the benefit of other user
groups, which may demand certain information.
a) The national laws of a country may provide for the provision of
some accounting information for shareholders and the public.
b) National taxation authorities will receive the information they
need to make tax assessments.
c) A bank might demand a forecast of a company's expected
future cash flows as a precondition of granting an overdraft.

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 Stakeholders' needs

(d) The IASB is responsible for issuing International Financial

Reporting Standards (IFRSs). These require companies to
publish certain additional information. Accountants, as
members of professional bodies, are placed under a strong
obligation to ensure that company financial statements
conform to the requirements of IFRSs.
(e) Some companies voluntarily provide specially prepared
financial information for issue to their employees. These
statements are known as 'employee reports'.

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 The main elements of financial reports

• The principal financial statements of a business are the:

i. statement of financial position (SOFP)
ii. statement of profit or loss and other comprehensive income
(SOPLCI)
iii. Statement of changes in equity (SOCIE)
iv. Statement of cash flows (SOCF)

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 Financial statements – SOFP

• Statement of financial position (SOFP): The statement of

financial position is simply a list of all the assets owned and all
the liabilities owed by a business as at a particular date.
• Element in SOFP:
i. Assets
ii. Liabilities
iii. Capital or equity

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 Financial statements – Asset, liability,
equity
Assets
• An asset is something valuable which a business owns or can
use.
• The IASB's Conceptual framework for financial reporting
defines an asset as follows.
• “An asset is a present economic resource controlled by the
entity as a result of past events. An economic resource is a
right that has the potential to produce economic benefits.”
• Examples of assets are factories, office buildings, warehouses,
delivery vans, lorries, plant and machinery, computer
equipment, office furniture, cash and goods held in store
awaiting sale to customers.

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 Financial statements – Asset, liability, equity

• Some assets are held and used in operations for a long time
(Non-current assets). An office building is occupied by staff for
years. Similarly, a machine has a productive life of many years
before it wears out.
• Other assets are held for only a short time (Current-assets). The
owner of a newsagent shop, for example, has to sell their
newspapers on the same day that they get them. The more
quickly a business can sell the goods it has in store, the more
profit it is likely to make; provided, of course, that the goods are
sold at a higher price than what it cost the business to acquire
them.

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 Financial statements – Asset, liability,
equity
Liabilities
• A liability is something which is owed to somebody else.
'Liabilities' is the accounting term for the debts of a business.
The IASB's Conceptual framework for financial reporting
defines a liability as follows.
• “A liability is a present obligation of the entity to transfer
economic resource as a result of past events. An obligation is a
duty of responsibility that the entity has no practical ability to
avoid.”
• Examples of liabilities are amounts owed to a supplier for goods
bought on credit, amounts owed to a bank (or other lender), a
bank overdraft and amounts owed to tax authorities (eg in
respect of sales tax).
• Some liabilities are due to be repaid fairly quickly eg suppliers.
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 Financial statements – Asset, liability,
equity
Capital or equity
• The amounts invested in a business by the owner are amounts
that the business owes to the owner.
• This is a special kind of liability, called capital. In a limited
liability company, capital usually takes the form of shares.
Share capital is also known as equity.
• The IASB's Conceptual framework for financial reporting
defines equity as follows.
• “Equity is the residual interest in the assets of the entity after
deducting all its liabilities.”

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 Financial statements – Pro-forma

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 Financial statements – SOPL

• Statement of profit or loss: A statement of profit or loss is a

record of income generated and expenditure incurred over a
given period. The statement shows whether the business has
had more revenue (sales) than expenditure (profit) or vice versa
(loss).
• Element in SOPL:
i. Revenue / Income
ii. Expenses

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 Financial statements – SOPL
Revenue
• Revenue is the income generated by the operations of a
business for a period.
• Revenue is the gross inflow of economic benefits (cash,
receivables, other assets) arising from the ordinary operating
activities of an enterprise (such as sales of goods, sales of
services, interest, royalties and dividends).
• The IASB's Conceptual framework defines income, revenue and
expenses as follows.
“Income is increases in assets or decreases in liabilities that
result in increases in equity, other than those relating to
contributions from holders of equity claims.”

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 Financial statements – SOPL

Expenses
• Expenses are the costs of running the business for the same
period.
• The IASB's Conceptual framework defines income, revenue and
expenses as follows.
“Expenses are decreases in assets or increases in liabilities that
result in decreases in equity, other than those relating to
distributions to holders of equity claims.”

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 Financial statements – SOPL – Pro-forma

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 Statement of profit or loss

Statement of profit or loss

RON KNUCKLE
STATEMENT OF PROFIT OR LOSS
FOR THE YEAR ENDED ………………..

$ $
Sales 12,500
Cost of sales (5,000)
Gross profit 7,500
Expenses
Rent 3,500
Bank loan interest 100
Other expense 1,900
(5,500)
Profit for the year 2,000

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 IAS 1 Presentation of financial statements
a) One single statement

ABC CO
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31 DECEMBER 20X2
Ilustrating the classification of expenses by function
20X2 20X1
$ $
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expense (X) (X)
Other expenses (X) (X)
Finance cost (X) (X)
Profit before tax X X
Income tax expense (X) (X)
Profit for the year X X
Other comprehensive income:
Gains on property revaluation X X

Total comprehensive income for the year X X

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 IAS 1 Presentation of financial statements

Statement of changes in equity (SOCIE)

• AS 1 requires an entity to provide a statement of changes in equity. The statement of changes in
equity shows the movements in the entity's equity for the period.
• The statement of profit or loss and other comprehensive income is a straightforward
measure of the financial performance of the entity, in that it shows all items of income and
expense recognised in a period. It is then necessary to link this result with the results of
transactions with owners of the business, such as share issues and dividends. The statement
making the link is the statement of changes in equity.
• The statement of changes in equity simply takes the equity section of the statement of
financial position and shows the movements during the year. The bottom line shows the
amounts for the current statement of financial position. As we saw above, the total
comprehensive income for the year is split between the gains on revaluation of property,
which is credited to the revaluation surplus, and the profit for the year, which is credited to
retained earnings.
 IAS 1 Presentation of financial statements

Statement of changes in equity

• An example statement of changes in equity is shown below.

• Dividends paid during the year are not shown on the statement of profit or loss; they are
shown in the statement of changes in equity.
 Statement of Cash flow (SOCF)

• Statements of cash flows are a useful addition to the financial

statements of a company because accounting profit is not the
only indicator of performance. They concentrate on the sources
and uses of cash and are a useful indicator of a company's
liquidity and solvency.

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EXAMPLE OF A STATEMENT OF CASH FLOWS
STATEMENT OF CASH FLOWS (DIRECT METHOD)
YEAR ENDED 20X7
$m $m
Cash flows from operating activities
Cash receipts from customers 30,330
Cash paid to suppliers and employees (27,600)
Cash generated from operations 2,730
Interest paid (270)
Income taxes paid (900)
Net cash from operating activities 1,560
Cash flows from investing activities
Purchase of property, plant and equipment (900)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 200
Net cash used in investing activities (480)
Cash flows from financing activities
Proceeds from issuance of share capital 250
Proceeds from long-term borrowings 250
Dividends paid* (1,290)
Net cash used in financing activities (790)
Net increase in cash and cash equivalents 290
Cash and cash equivalents at beginning of period 120
Cash and cash equivalents at end of period 410
* This could also be shown as an operating cash flow.
 Governance
• Governance: Those charged with governance of a company are
responsible for the preparation of the financial statements.
• Corporate governance is the system by which companies and
other entities are directed and controlled.
• Good corporate governance is important because the owners of
a company and the people who manage the company are not
always the same, which can lead to conflicts of interest.

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 Governance
• The UK Corporate Governance Code (formerly known as the
Combined Code) sets out standards of good practice for listed
companies on board composition and development,
remuneration, shareholder relations, accountability and audit.
The code is published by the Financial Reporting Council (FRC).
On this page you can trace the evolution of the code through
past versions and consultations.
(https://www.icaew.com/technical/corporate-governance/codes-
and-reports/uk-corporate-governance-code)

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 Legal responsibilities of directors

• Directors have a duty of care to show reasonable competence

and may have to indemnify the company against loss caused by
their negligence.
• Directors are also said to be in a fiduciary position in relation to
the company, which means that they must act honestly in what
they consider to be the best interest of the company and in
good faith.
• A fiduciary is someone who manages money or property for
someone else. When you're named a fiduciary and accept the
role, you must – by law – manage the person's money and
property for their benefit, not yours.
(https://www.consumerfinance.gov/ask-cfpb/what-is-a-fiduciary-
en-1769/#:~:text=A%20fiduciary%20is%20someone%20who,for
%20their%20benefit%2C%20not%20yours.)
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 Legal responsibilities of directors

In the UK, the Companies Act 2006 sets out seven statutory
duties of directors. Directors should:
• Act within their powers
• Promote the success of the company
• Exercise independent judgement
• Exercise reasonable skill, care and diligence
• Avoid conflicts of interest
• Not accept benefits from third parties
• Declare an interest in a proposed transaction or arrangement

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 Legal responsibilities of directors

• Companies Act 2006 is the principle that the purpose of the

legal framework surrounding companies should be to help
companies do business. A director's main aim should be to
create wealth for the shareholders.
• Principle means that the law should encourage long-termism
and regard for all stakeholders by directors and that stakeholder
interests should be pursued in an enlightened and inclusive
way.

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 Legal responsibilities of directors

When exercising this duty directors should consider:

 The consequences of decisions in the long term
 The interests of their employees
 The need to develop good relationships with customers and
suppliers
 The impact of the company on the local community and the
environment
 The desirability of maintaining high standards of business
conduct and a good reputation
 The need to act fairly as between all members of the company

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 Responsibility for the financial statements

• Directors are responsible for the preparation of the financial

statements of the company.
• Specifically, directors are responsible for:
• The preparation of the financial statements of the company
in accordance with the applicable financial reporting
framework (eg IFRSs)
• The internal controls necessary to enable the preparation of
financial statements that are free from material
misstatement, whether due to error or fraud
• The prevention and detection of fraud.

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 Chapter Summary

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 Chapter Summary

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 Chapter Summary

1 Accounting
 Accounting is a way of recording, analysing and summarising a
business's transactions.

2 Accounting records
 All businesses must keep sufficient accounting records in order
to be able to produce accurate information about the entity's
activities.

3 The concept of business entity

 The business entity concept states that a business is a
separate entity from its owners.
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 Chapter Summary

4 Types of business entities

 There are three main types of businesses. For sole traders and
partnerships the owners have unlimited liability and bear all the
risks and reap all the rewards of being in business. For a limited
liability company the shareholders' liability is limited to the
extent of their investment.

5 Users of financial information

 Financial statements are used by a wide variety of users, each
with different information needs. Satisfying the investors' needs
will mean that the majority of other users' needs are also met.

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 Chapter Summary 6

6 Proforma financial statements

 Companies must follow a prescribed format when producing
their financial statements. There is, however, no set format for a
sole trader's statement of profit or loss and statement of
financial position.

7 Governance
 Corporate governance is the process by which businesses are
directed and controlled by those responsible for running the
business.

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