ACCA F3 (INT) Financial Accounting - 2010 - Study text

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Paper F3 (INT)

Financial Accounting

CHAPTER

The context and purpose of

financial reporting

Contents

1 Theobjectivesoffinancialreporting

2 Theneedsofusers

3 Themainelementsoffinancialreports

4 Capitalandrevenueitems

5 Theregulatorysystemforfinancialaccounting

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The objectives of financial reporting

 The purpose of financial accounting

 Types of business entity

 Advantages and disadvantages of different types of business entity

 The nature, principles and scope of financial reporting

1 The objectives of financial reporting

1.1 The purpose of financial accounting

‘Financial accounting’ is a term that describes:

 maintaining a system of accounting records for business transactions and other

items of a financial nature, and

 reporting the financial position and the financial performance of an entity in a

set of ‘financial statements’.

Note: The term ‘entity’ is used to describe any type of organisation. ‘Business

entities’ include companies, business partnerships and the businesses of ‘sole

traders’

Many business entities operate a system of recording their business transactions in

accounting records. This system is called a book-keeping system or ledger

accounting system. All large businesses (and many small ones) have a book-

keeping system for recording the financial details of their business transactions on a

regular basis.

The information that is recorded in the book-keeping system (ledger records) of an

entity are also analysed and summarised periodically, typically each year, and the

summarised information is presented in financial statements. Financial statements

provide information about the financial position and performance of the entity.

1.2 Types of business entity

A business entity is a commercial organisation that aims to make a profit from its

operations. There are three main types of business entity;

 a sole trader

 a business partnership

 a company (a limited liability company).

Sole trader

The business of a sole trader is owned and managed by one person. Any individual

who sets up in business on his own, without creating a company, is a sole trader.

Chapter 1: The context and purpose of financial reporting

Sole trader businesses are usually small operations, but the owner might employ a

number of employees who work for the business to earn a wage or salary, but do

not have any share in the ownership of the business.

Important features of a sole trader business are as follows.

 The owner of the business is personally liable for the unpaid debts and other

obligations of the business. For example if the business owes a supplier $1,000

for goods it has purchased, but does not have the money to make the payment,

the owner of the business can be made personally liable to make the payment

out of his ‘non-business’ assets.

 The profits of a sole trader business are treated as income of the owner, for the

purpose of calculating the amount of tax payable on income.

Partnership

A business partnership is an entity in which two or more individuals (partners)

share the ownership of the business. Each partner contributes some funds (‘capital’)

to set up the business. Like a sole trader, a partnership may have employees who

work for the business, but have no share in the ownership.

Important features of a ‘normal’ partnership are as follows.

 The owners of the business are personally liable as individuals for the unpaid

debts and other obligations of the business. For example if the partnership owes

a supplier $1,000 for goods it has purchased, but does not have the money to

make the payment, the partners can be made personally liable to make the

payment out of their ‘non-business’ assets.

 The profits of a partnership are shared between the partners in an agreed way,

and each partner’s share of the profits is treated as personal income, for the

purpose of calculating the amount of tax payable on his or her income.

Company (limited liability company)

A company (a ‘corporation’ in the US) is a special form of business entity. Nearly all

companies in business are limited liability companies with liability limited by

shares.

 Ownership of the company is represented by ownership of shares. A company

might issue any number of shares, depending largely on its size. A very small

company might have just one share of $1, whereas a large stock market company

will have millions of shares in issue. If a company has issued 100 shares,

ownership of 40 shares would represent 40% of the ownership of the company.

 Unlike a sole trader or a partnership, a company has the status of a ‘legal person’

in law. This means that a company can be the legal owner of business assets, and

can sue or be sued in its own right in the law.

 A company is also taxed separately from its owners. Whereas the profits of a

sole traders and business partners are all taxed as personal income of the

business owners, the profits of a company are taxed as income of the company

itself.

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 A company has legal liability as a ‘legal person’. This means that if the company

owes a supplier $1,000 for goods it has purchased, but does not have the money

to make the payment, the company alone is liable for the debt. The owners of the

business – its ‘shareholders’ – cannot normally be made personally liable to

make the payment. The liability of shareholders is limited to the amount of

capital they have invested in the company. If the company’s shares are ‘fully

paid’ (which is normal) shareholders have no further financial liability for any

unpaid debts or other obligations of their company. This limited liability of the

company’s shareholders for the unpaid debts of their company is a major reason

why so many small businesses operate as companies.

Another feature of large companies is that they usually have a large number of

shares in issue, and a large number of shareholders. In large companies, the main

shareholders are not the managers of the business. The managers (executive

directors of the company) and owners are different persons. This is sometimes

referred to as the ‘separation of ownership from control’. This separation of

management and ownership should be familiar to you from what you will have

heard or read about large companies, but it applies to many smaller companies too.

It is not found in the businesses of sole traders or partnerships, where the owners

are usually also involved in management.

When the shareholders are not the managers of their company, it becomes essential

that information about the position and performance of the company should be

reported regularly by the management to the shareholders. This is the main purpose

of financial reporting.

However, there might be a risk that the managers of a company would make false

reports to shareholders about the financial position and performance of the

company. To reduce this risk, the laws on financial reporting and auditing are

generally much stricter for companies than for other types of business entity.

Financial reporting by sole traders, partnerships and companies

All business entities prepare some financial statements at the end of each accounting

period, normally once each year.

 The financial statements of a sole trader are private and do not have to be

disclosed, except to the tax authorities (and possibly also to a lending bank).

These must be prepared according to accepted accounting principles and

practice, but need not conform to all the requirements of accounting standards.

Similarly, the financial statements of a business partnership are private and do

not have to be disclosed.

 The financial statements of a company must be disclosed to all the shareholders

of the company, and company law might require that the statements should also

be filed with a government agency, where they can be accessed and read by any

member of the general public. Companies whose shares are traded on a major

stock market make their financial statements generally available to the public,

often on the company’s web site.

Chapter 1: The context and purpose of financial reporting

1.3 Advantages and disadvantages of different types of business entity

The advantages and disadvantages of operating as each type of business entity may

be summarised briefly as follows.

Business structure Sole trader Partnership Company

Owned by… One person Several individuals

working together

Shareholders

Liability for the

unpaid debts and

other obligations of

the business

Personal

liability of

owner

Personal liability of

partners

Limited

Management Business

managed by

its owner

Business managed

by its owners

Larger companies are

managed by

professional

managers

Raising capital Capital for

the business

is provided

by its sole

owner. Lkely

to be limited

in amount.

Capital for the

business is provided

by its owners. Often

limited in amount

Capital for the

business is provided

by its shareholders.

Public companies

can raise new capital

from investors in the

stock market.

Most very large

businesses are

companies.

Financial

accounting and

auditing

Some

financial

accounts

needed for

tax purposes

Financial accounts

needed for the

benefit of the

partners

Fairly strict

regulation of

financial reporting by

companies. Also legal

requirements for

audits (except

perhaps small

companies).

1.4 The nature, principles and scope of financial reporting

As stated earlier, financial reporting is concerned with preparing a number of

financial reports or ‘financial statements’ about the position and performance of the

entity. This information is provided for the benefit of a number of different users.

Financial statements relate to a given period of time, known as the ‘financial year’,

‘accounting period’ or ‘reporting period’. They are prepared from information held

in the financial accounting records (the ‘books or ‘ledgers’), although some

adjustments and additions are required to complete the financial statements,

especially for companies.

Financial statements should be prepared in accordance with accepted rules and

principles.

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 Some principles have been established by practice, although a framework of

principles and concepts has been issued by the International Accounting

Standards Board (IASB).

 Some rules and guidelines are provided by accounting standards. Some

countries have their own national accounting standards, but many have adopted

the international accounting standards of the IASB.

 Each country has its own laws about aspects of the preparation and content of

financial statements, especially for companies.

Accounting practice is therefore a mixture of established practice, and the

requirements of accounting standards and national laws.

Although the requirements for preparing financial statements differ between types

of business entity and different countries, there is a general system of book-keeping

or ledger accounting used by most business entities in most countries and well-

established concepts and principles for financial reporting.

Scope and objective of financial reporting

The rules on financial reporting, including the requirements of international

accounting standards, are concerned with the preparation of financial statements for

‘external’ users.

In many business entities, detailed financial reports are prepared for the benefit of

management. Providing financial information for the benefit of managers is known

as management accounting, and this is not subject to any regulatory control.

Managers can use the information in financial statements if they wish to do so, but

they ought to be able to obtain better information about the operations of their

business - and more regularly. So financial reporting is not primarily for the benefit

of management.

The IASB has issued a Framework for the Preparation and Presentation of

financial Statements, which states that 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.

So who are these users?

Chapter 1: The context and purpose of financial reporting

The needs of users

 Information for economic decisions

 Types of business entity

 Advantages and disadvantages of different types of business entity

 The nature, principles and scope of financial reporting

2 The needs of users

2.1 Information for economic decisions

The IASB states that financial statements are produced to enable users to make

economic decisions on the basis of the information that the statements provide.

Information – including financial information – has no value unless it is used.

Users of financial information usually have an interest in some aspect of what the

entity does or might do in the future. Any person or group of persons with an

interest of any kind in a business entity is sometimes referred to as a ‘stakeholder’ –

because they have some stake in what the entity does. Many users of financial

statements are therefore also stakeholders.

2.2 Users of financial statements

The International Accounting Standards Committee (IASC) has published a

document that sets out the concepts that underlie the preparation and presentation of

financial statements for users. This document is called the IASB Framework for the

preparation and presentation of financial statements. (IASB stands for the

International Accounting Standards Board, which reports to the IASC Foundation.)

The IASB Framework provides a list of users of financial statements, and an

indication of what their information needs might be.

Investors

Investors in a business entity are the providers of risk capital. Unless they are

managers as well as owners, they invest in order to obtain a financial return on their

investment. They need information that will help them to make investment

decisions. In the case of shareholders in a company, these decisions will often

involve whether to buy, hold or sell shares in the company. Their decision might be

based on an analysis of the past financial performance of the company and its

financial position, and trying to predict from the past what might happen to the

company in the future. Financial statements also give some indication of the ability

of a company to pay dividends to its shareholders out of profits.

Paper F3: Financial accounting (International)

Employees

Employees need information about the financial stability and profitability of their

employer. An assessment of profitability can help employees to reach a view on the

ability of the employer to pay higher wages, or provide more job opportunities in

the future.

Lenders

Lenders, such as banks, are interested in financial information about businesses that

borrow from them. Financial statements can help lenders to assess the continuing

ability of the borrower to pay interest, and its ability to repay the loan principal at

maturity.

Suppliers and other trade creditors

Financial information about an entity is also useful for suppliers who provide goods

on credit to a business entity, and other ‘trade creditors’ who are owed money by

the entity as a result of debts incurred in its business operations (such as money

owned for rent or electricity or telephone charges). They can use the financial

statements to assess how much credit they might safely allow to the entity.

Customers

Customers might be interested in the financial strength of an entity, especially if

they rely on that entity for the long-term supply of key goods or services.

Government

The government and government agencies are interested in the financial statements

of business entities. They might use this information for the purpose of business

regulation or deciding taxation policies.

The public

In some cases, members of the general public might have an interest in the financial

statements of a company. The IASB Framework comments: ‘For example, entities

may make a substantial contribution to the local economy in many ways including

the number of people they employ and their patronage of local suppliers.’

Managers

Managers are not included in this list of users by the IASB Framework, because

management should have access to all the financial information they need, and in

much more detail than financial statements provide. However, management is

responsible for producing the financial statement and might be interested in the

information they contain.

The International Accounting Standards Board (IASB) states in its Framework that

investors are the moist significant of the user groups in its list.

 All the information needs of user groups cannot be met by financial statements.

Chapter 1: The context and purpose of financial reporting

 However there are needs for financial information that are common to all users.

 Investors are providers of risk capital to the entity; therefore information that

meets their needs should meet most of the needs of other users, to the extent that

financial statements can meet these information needs at all.

 In producing international accounting standards, the IASB has therefore given

most consideration to the information needs of investors.

Paper F3: Financial accounting (International)

The main elements of financial reports

 Financial statements

 The statement of financial position

 Assets

 Liabilities

 Equity

 Format of a simple statement of financial position

 The income statement: income and expenses

 Format of a simple income statement

 Relationship between the income statement and the statement of financial

position

3 The main elements of financial reports

3.1 Financial statements

Financial statements present information about:

 the financial position of an entity

 its financial performance during an accounting period (‘reporting period’)

 its cash flows and

 changes in its financial position during the period.

They also show the results of how management have used and looked after the

resources of the business (‘management’s stewardship of the resources entrusted to

it’ (IAS 1 Presentation of Financial Statements)).

To do this, the financial statements provide information about an entity’s:

 assets

 liabilities

 equity

 income and expenses, including gains and losses

 contributions by the owners of the entity and distributions by the entity to its

owners, in their capacity as owners (e.g. contributions of new capital by the

owners, and payments of drawings or dividends to the owners)

 cash flows.

Information about the financial position of an entity consists of information about

its assets, liabilities and equity. This information is presented in a statement of

financial position. (In the past this has been called the balance sheet, and you will

probably come across this term during your studies.)

ACCA F3 (INT) Financial Accounting - 2010 - Study text - Emile Woolf Publishing

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