CIMA - C2 Fundamentals of Financial Accounting

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320 21: Manufacturing accounts ⏐ Part C Final accounts and audit

Answers to quick quiz

1 A Correct.

B Incorrect, no adjustment for work in progress has been made.

C This excludes production overheads.

D Prime cost has already been adjusted for changes in raw material inventory levels.

2 D Not part of prime cost.

Now try the questions below from the Question Bank

Question numbers Page

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321

Topic list Syllabus references

1 The regulatory framework of accounts A (6)

The regulatory

system

Introduction

This chapter looks at the regulatory framework within which accounts, particularly those of

limited liability companies, are prepared. The purpose of this section is to impress upon you

the importance of this framework, which is to be studied in much more detail in the later

stages of your qualification.

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322 22: The regulatory system ⏐ Part C Final accounts and audit

1 The regulatory framework of accounts

There is a wide range of accounting concepts in use. There are also different conventions under which accounts can be

prepared. It may seem as though almost anything goes. What rules are there?

For an unincorporated business, any form of accounting information is adequate if it gives the owner(s) of the business

a basis for planning and control, and satisfies the requirements of external users such as the tax authorities.

The activities of limited liability companies, including the way they prepare their accounts, are closely regulated.

The regulations on accounts come from four main sources.

• Company law enacted by Parliament

• Financial Reporting Standards issued by the Accounting Standards Board

• International Accounting Standards and International Financial Reporting Standards issued by the International

Accounting Standards Board

• For quoted companies, the requirements of the Stock Exchange

1.1 Company law

Limited liability companies are required by law to prepare accounts annually for distribution to their shareholders. In the

UK, a copy of these accounts must be lodged with the Registrar of Companies and is available for inspection by any

member of the public. For this reason a company's statutory annual accounts are often referred to as its published

accounts.

In 2006, all existing companies legislation was brought together in a consolidating Act, the Companies Act 2006 (CA

2006).

There are many differences between accounting systems found in the various European Union (EU) member states. For

example, in the UK a 'true and fair view' is sought, whereas in West Germany a 'legal and correct view' is observed.

Taxation and accounting principles differ and consolidation practices vary.

Since the United Kingdom became a member of the EU it has been obliged to comply with legal requirements decided on

by the EU. It does this by enacting UK laws to implement EU directives. For example, the CA 1989 was enacted in part to

implement the provisions of the seventh and eighth EU directives, which deal with consolidated accounts (for groups of

companies) and auditors.

As far as the preparation of accounts is concerned, the overriding requirement of companies legislation is that accounts

should show a 'true and fair view'. This phrase is not defined in the Companies Acts. What it certainly does not mean is

that company accounts are to be exact to the penny. For one thing, many of the figures appearing in a set of accounts

are arrived at partly by the exercise of judgement. For another, the amount of time and effort that such a requirement

would cost would be out of all proportion to the advantages derived from it (see the discussion earlier in this chapter of

the materiality concept).

The legislation also requires that the accounts of a limited liability company (except certain small companies) must be

audited. An audit, for this purpose, may be defined as an 'independent examination of, and expression of opinion on, the

financial statements of an enterprise'.

This means that a limited liability company must engage a firm of chartered or certified accountants to conduct an

examination of its accounting records and its financial statements in order to form an opinion as to whether the accounts

present a 'true and fair view'. At the conclusion of their audit, the auditors issue a report (addressed to the owners of the

company, ie its members or shareholders) which is published as part of the accounts.

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Part C Final accounts and audit ⏐ 22: The regulatory system 323

Audit is discussed in more detail in Chapter 23 of this Study Text. Note that under International Financial Reporting

Standards, a 'true and fair view' is called 'fair presentation'.

Do not neglect the role of auditors in the regulatory system.

1.2 Non-statutory regulation

Apart from company law, the main regulations affecting accounts in the UK derive from pronouncements issued by the

accounting profession. Six accountancy bodies in the UK are represented on the Consultative Committee of Accountancy

Bodies (CCAB). They are as follows.

• The Chartered Institute of Management Accountants (CIMA)

• The Institute of Chartered Accountants in England and Wales (ICAEW)

• The Institute of Chartered Accountants of Scotland (ICAS)

• The Institute of Chartered Accountants in Ireland (ICAI)

• The Association of Chartered Certified Accountants (ACCA)

• The Chartered Institute of Public Finance and Accountancy (CIPFA)

The CCAB is a major influence on the way in which accounts are prepared. Our main interest will be in the accounting

standards published to lay down accounting treatments in areas where a variety of approaches might be taken. The value

of accounts would be reduced if users were not able to count on a measure of comparability between them. The aim of

accounting standards is to ensure that such comparability exists.

To understand how standards are set there are four bodies you need to know about.

• The Financial Reporting Council (FRC)

• The Accounting Standards Board (ASB)

• The Financial Reporting Review Panel (FRRP)

• The Urgent Issues Task Force (UITF)

The Financial Reporting Council. The FRC draws its membership from a wide spectrum of accounts preparers and

users. Its chairman is appointed by the Government. The FRC operates through two arms: the FRRP and the ASB.

The Accounting Standards Board. The ASB is responsible for the issue of accounting standards. Accounting standards

issued by the ASB are called Financial Reporting Standard (FRSs), of which nineteen have so far been published. Prior

to August 1990 standards were issued by the Accounting Standards Committee (ASC, now abolished. These were known

as Statements of Standard Accounting Practice (SSAPs).

Prior to publication, the ASB circulates its proposals in the form of a financial reporting exposure draft (inevitably

referred to as a FRED) and invites comments. To avoid chaos, the ASB has 'adopted' those SSAPs still extant and they

therefore remain in force.

The Financial Reporting Review Panel. The FRRP is the second operating arm of the FRC. Its task is to examine

accounts published by companies if it appears that Companies Act requirements have been breached – in particular, the

requirement that accounts should show a true and fair view. The panel has legal backing: if a public company departs

from an accounting standard, the panel may apply to the courts, which may in turn instruct the company to prepare

revised accounts.

The Urgent Issues Task Force. The UITF is an offshoot of the ASB. Its role is to assist the ASB in areas where an

accounting standard or Companies Act provision already exists, but where unsatisfactory or conflicting interpretations

have developed. As its name suggests, the UITF is designed to act quickly (more quickly than the full standard-setting

process is capable of) when an authoritative ruling is urgently needed.

Assessment

focus point

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324 22: The regulatory system ⏐ Part C Final accounts and audit

Question

Non–statutory regulation

Which body is responsible for issuing UK Financial Reporting Standards?

A FRC

B ASB

C FRRP

D UITF

Answer

B The Accounting Standards Board is responsible for issuing UK standards.

1.3 International Financial Reporting Standards

From 1 January 2005 all listed EU companies have to report under IFRS for their consolidated accounts.

The International Accounting Standards Committee (IASC) was set up in June 1973 in an attempt to co-ordinate the

development of international accounting standards (IASs). It included representatives from many countries throughout

the world, including the USA and the UK. The IASC has since been superseded by the International Accounting

Standards Board (IASB) which issues International Financial Reporting Standards (IFRSs).

From 2005 UK listed companies have to report under IFRS for the preparation of their group accounts. During 2005 and

2006 most UK companies are expected to move over to complying with International Financial Reporting Standards

rather than UK Financial Reporting Standards. There is a glossary of international terms on page (xxiii).

1.4 IFRS 1: First-time adoption of International Financial Reporting Standards

The IASB would like to make the transition to international standards as smooth as possible and has recently issued its

first entirely new standard, IFRS 1 First-time adoption of International Financial Reporting Standards, which provides

guidance on how companies should implement IFRS.

Companies reporting under IFRS for the first time in 2005 should begin by preparing an opening statement of financial

position for 1 January 2004 (if their year end is 31 December) which is correct under IFRS. This may involve adjustments

for assets and liabilities which were recognised under the previous system (eg UK FRSs) but are not recognised under

IFRS, or vice versa.

They will then be able to prepare IFRS accounts for 2004 which will provide comparatives for their first full set of IFRS

accounts in 2005.

1.5 The Stock Exchange regulations

The Stock Exchange is a market for stocks and shares, and a company whose securities are traded in this market is

known as a 'quoted' or 'listed' company.

When a share is granted a quotation on The Stock Exchange, it appears on the 'Official List' which is published in London

each business day. The Official List shows the 'official quotation' or price for the share for that day. It is drawn up by the

Quotations Department of The Stock Exchange, which derives its prices from those actually ruling in the market.

In order to receive a quotation for its securities, a company must conform with Stock Exchange Listing Rules issued by

the Council of The Stock Exchange. The company commits itself to certain procedures and standards, including matters

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Part C Final accounts and audit ⏐ 22: The regulatory system 325

concerning the disclosure of accounting information, which are more extensive than the disclosure requirements of the

Companies Acts. These include issuing the annual report within six months of the year end and publishing an interim

report giving profit and loss information.

Question

The regulatory framework

To ensure you understand which regulations apply to which type of business, fill in the table below with a 'yes' where

compliance is required and 'no' where it is not.

Type of Business

Companies Act

FRSs/SSAPs

IFRSs/IASs

Stock Exchange Listing Rules

Public Listed Company

Public Listed Company –

group accounts

Private Limited Company

Sole Proprietorship

Answer

Type Of Business

Companies Act

FRSs/SSAPs

IFRSs/IASs

Stock Exchange Listing Rules

Public Listed Company YES YES NO YES

Public Listed Company –

group accounts

YES

Private Limited Company YES YES NO NO

Sole Proprietorship

Make sure you learn the answers above

Chapter roundup

• The regulations on accounts come from four main sources.

– Company law enacted by Parliament

– Financial Reporting Standards issued by the Accounting Standards Board

– International Accounting Standards and International Financial Reporting Standards issued by the International

Accounting Standards Board

– For quoted companies, the requirements of the Stock Exchange

• From 1 January 2005 all listed EU companies have to report under IFRS for their consolidated accounts.

Assessment

focus point

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326 22: The regulatory system ⏐ Part C Final accounts and audit

Quick quiz

1 Fill in the blanks.

The main statute governing the content of limited liability company accounts in the UK is __________________

______________________________________________________.

2 What major change to UK financial reporting took place from 1 January 2005?

A All limited companies to use UK FRS in their accounts.

B All listed companies to use IFRS in their accounts.

C All listed companies to use UK FRS in their accounts.

D All listed companies to use IFRS in group accounts.

Answers to quick quiz

1 The main statute governing the content of limited liability company accounts in the UK is CA 2006.

2 D Since January 2005 listed companies have been required to prepare their group accounts to comply with IFRSs.

Now try the questions below from the Question Bank

Question numbers Page

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327

Topic list Syllabus references

1 Ownership v stewardship A (1)

2 External audit C (1)

3 Internal audit C (2)

4 Internal control C (3)

5 Controls over sales and receivables C (3)

6 Controls over purchases and payables C (3)

7 Evaluation of internal controls C (3)

8 Audit trail C (3)

9 The detection and prevention of fraud C (4)

Internal and external

audit

Introduction

So far you have been concerned with the preparation of accounts. The syllabus also includes

an appreciation of the purpose of external and internal audit.

It is a requirement of the Companies Act that all companies must appoint external auditors

who will report to the members of the company on whether in their opinion, the annual

statutory accounts give a true and fair view (or 'fair presentation'). The duties of the external

auditor are imposed by statute and cannot be limited, either by the directors or by the

members of the company. External auditors are not employees of the company.

Internal auditors are employees of the company whose duties are fixed by management, and

who report ultimately to management. In recent years it has become increasingly common

for large companies to set up internal audit departments and for the external auditors to alter

their audit approach to take account of the work done by the internal auditors.

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328 23: Internal and external audit ⏐ Part C Final accounts and audit

1 Ownership v stewardship

It is important to distinguish between ownership and stewardship.

Stewardship is the primary function of managers who are responsible for the running of the business on a day to day

basis; it means the safeguarding of the business' assets.

An audit assures proprietors that the stewardship of the organisation was effectively carried out.

The stewardship concept is wider than ensuring that the assets of an organisation are properly recorded, valued and

insured. It also includes the control of costs, the improvement of efficiency and the optimisation of profits. Additionally

whilst management

's stewardship responsibilities extend primarily to the owners of the business it also includes all

other users of the accounts.

2 External audit

External auditors report to the members of the company on whether, in their opinion, the annual statutory accounts give

a true and fair view. Their duties are imposed by statute and they are not employees of the company. Under International

Financial Reporting Standards, auditors report on 'fair presentation'.

An external audit is an independent examination of, and expression of opinion on the financial statements of an

enterprise.

2.1 The audit

If the 'enterprise' is a limited company, 'external audit' means statutory audit, that is, under the Companies Act 2006.

The statutory audit requirement, arose as discussed in Section 1, because of the separation of owners (shareholders)

and managers (directors).

External auditors are generally firms of chartered or certified accountants. They summarise their conclusions on the

company

's financial statements by issuing an audit report, addressed to the shareholders. The report must state whether

in the auditors opinion.

(a) The statement of financial position gives a true and fair view of the state of affairs of the company at the

end of the financial year.

(b) The income statement gives a true and fair view of the profit or loss of the company for the financial year.

'True and fair' is not defined in company law or accounting standards. The words are used together rather than

separately and the term is generally taken to mean 'reasonably accurate and free from bias or distortion'. Under IFRS, the

term is 'fair presentation'.

Although there is no official definition of 'true and fair', the Companies Act states that the directors may depart from any

provisions of company law or accounting standards if these are inconsistent with the requirement to give a true and fair

view. This

'true and fair override' has been treated as an important loophole in the law and has been the cause of much

argument and dissatisfaction within the accounting profession.

Key terms

Key term

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Part C Final accounts and audit ⏐ 23: Internal and external audit 329

Remember that a statutory audit is limited to the above aims. Auditors may also be asked to do other work.

2.2 Non-statutory audits

Non-statutory audits are performed by independent auditors because the owners, members, trustees, governing bodies

or other interested parties desire them, not because the law requires them. Auditing may therefore extend to any kind of

undertaking which produces accounts (eg clubs, sole traders, charities, partnerships), and may extend to forms of

financial statements other than the annual report and accounts. Examples include an audit of a statement of expenditure

in support of an application for a regional development grant, and a value for money audit to ensure that managers are

spending money wisely.

3 Internal audit

Internal auditors are employees of the company whose duties are fixed by management and who report to management.

'Internal auditing is an independent appraisal function established within an organisation to examine and evaluate its

activities as a service to the organisation. The objective of internal auditing is to assist members of the organisation in

the effective discharge of their responsibilities. To this end internal auditing furnishes them with analysis, appraisals,

recommendations, counsel and information concerning the activities reviewed.' (Institute of Internal Auditors)

3.1 Scope of internal audit

The scope of an internal audit varies widely and may range from systems review to implementation of corporate policies,

plans and processes.

The CIMA's Official Terminology defines an audit as a systematic examination of the activities and status of an entity

based primarily on investigation and analysis of its systems, controls and records. Internal audit is now defined as per

the Institute of Internal Auditors, and the CIMA

's own definition is currently:

'an independent appraisal function established within a organisation to examine and evaluate its activities as a service to

the organisation'.

Internal audit has a much wider scope than external audit. External auditors need only consider whether a company

accounts give a true and fair view of its financial position. They need not comment in their audit reports on ways in

which the company

's results or controls could be improved.

From the definitions of the internal audit the two main features of internal audit emerge.

(a) Independence. Although an internal audit department is part of an organisation, it should be independent

of the line management whose sphere of authority it may audit. The department should therefore report to

the board or to a special internal audit committee and not to the finance director. The reason for this is

best seen by thinking about what could happen if the internal audit department reported some kind of

irregularity to a finance director without realising that the finance director was actually involved. The

director would take the report and decide that it was all very interesting, but not worth pursuing. A very

different line might be taken by another, independent director!

It is also important that internal auditors should have appropriate scope in carrying out their

responsibilities, and unrestricted access to records, assets and personnel.

Key term

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Assessment

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