FINANCIAL ACCOUNTING LECTURE NOTES

BIT 223 LECTURE NOTES

LECTURE ONE (1)

Learning objectives

1. Explain the scope, nature and types of accounting

2. Explain the nature of financial statements and reporting

3. Explain the objectives, functions and types of financial statements

4. Discuss the conceptual and regulatory framework affecting the preparation of financial

statements

5. Discuss the importance of the IASB Framework

6. Apply the principles of the IASB Framework, including the qualitative characteristics

of financial information, the elements of financial statements, recognition and

measurement of the

7. elements

8. Explain and demonstrate the differences between financial statements produced using:

– The accrual basis and Going concern basis

– Cash accounting

– The break-up basis

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1.1 Scope of Accounting

Accounting has got a very wide scope and area of application. Its use is not confined to the
business world alone, but spread over in all the spheres of the society and in all professions.
Now-a-days, in any social institution or professional activity, whether that is profit earning or
not, financial transactions must take place. So there arises the need for recording and
summarizing these transactions when they occur and the necessity of finding out the net result
of the same after the expiry of a certain fixed period. Besides, there is also the need for
interpretation and communication of those information to the appropriate persons.

Only accounting use can help overcome these problems. In the modern world, accounting
system is practiced not only in all the business institutions but also in many non-trading
institutions like Schools, Colleges, Hospitals, Charitable Trust Clubs, Co-operative Society
etc., and also Government and Local Self-Government in the form of Municipality. The
professional persons like Medical practitioners, practicing Lawyers, Chartered Accountants
etc, also adopt some suitable types of accounting methods.

As a matter of fact, accounting methods are used by all who are involved in a series of
financial transactions. The scope of accounting as it was in earlier days has undergone lots of
changes in recent times. As accounting is a dynamic subject, its scope and area of operation
have been always increasing keeping pace with the changes in socio-economic changes. As a
result of continuous research in this field the new areas of application of accounting principles
and policies are emerged. National accounting, human resources accounting and social
Accounting are examples of the new areas of application of accounting systems.

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1.2 Nature of Accounting

We know Accounting is the systematic recording of financial transactions and presentation of

the related information of the appropriate persons. The basic features of accounting are as
follows:

1. Accounting is a process: A process refers to the method of performing any specific job step
by step according to the objectives, or target. Accounting is identified as a process as it
performs the specific task of collecting, processing and communicating financial information.
In doing so, it follows some definite steps like collection of data recording, classification
summarization, finalization and reporting.

2. Accounting is an art: Accounting is an art of recording, classifying, summarizing and

finalizing the financial data. The word ‘art’ refers to the way of performing something. It is a
behavioral knowledge involving certain creativity and skill that may help us to attain some
specific objectives. Accounting is a systematic method consisting of definite techniques and its
proper application requires applied skill and expertise. So, by nature accounting is an art.

3. Accounting is means and not an end: Accounting finds out the financial results and position
of an entity and the same time, it communicates this information to its users. The users then
take their own decisions on the basis of such information. So, it can be said that mere keeping
of accounts can be the primary objective of any person or entity. On the other hand, the main
objective may be identified as taking decisions on the basis of financial information supplied
by accounting. Thus, accounting itself is not an objective, it helps attaining a specific objective.
So it is said the accounting is ‘a means to an end’ and it is not ‘an end in itself.’

4. Accounting deals with financial information and transactions; Accounting records the
financial transactions and date after classifying the same and finalizes their result for a definite
period for conveying them to their users. So, from starting to the end, at every stage,
accounting deals with financial information. Only financial information is its subject matter. It
does not deal with non-monetary information of non-financial aspect.

5. Accounting is an information system: Accounting is recognized and characterized as a

storehouse of information. As a service function, it collects processes and communicates
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financial information of any entity. This discipline of knowledge has been evolved out to meet
the need of financial information required by different interested groups.

1.3 Definition of Accounting

1. As per the American Institute of Certified Public Accountants (AICPA) – Accounting is an
art of recording, classifying and summarizing transactions and events which are in part at least
of financial character, in a significant manner and in terms of money, and interpreting the
results thereof.

2. Accounting also involves analyzing and interpreting the financial transactions and
communicating the results to the persons interested in such information.

3. Accounting is considered as an ‘Information System’, as the function of Accounting is to

provide quantitative information, primarily financial in nature about the business organisation.

1.4 Types of Accounting

The various sub–fields of Accounting are –

1. Financial Accounting: It covers the preparation and interpretation of Financial Statements

(i.e. P&L Account and the Statement of Financial Position) and communication thereof, to the
User of accounts. It is historical in nature as it records transaction which has already occurred.
It primarily helps in determination of the net result for an accounting period and the financial
position as on a given date.

2. Management Accounting: It is used for internal reporting to the Management of a business

unit. The different ways of grouping information and preparing reports as desired by the
Managers for discharging their functions are referred to as Management Accounting.

3. Cost Accounting: It is the process of accounting for cost and determination of overall cost
of the product or service. The study of the behavioral pattern of cost will enable to control cost.

4. Social Responsibility Accounting: It is concerned with accounting for social costs incurred
by the enterprise and social benefits created.

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5. Human Resource Accounting: It seeks to identify, quantify and report investments made in
human resources of an organization that are not presently accounted under any conventional
accounting practice.

1.5 Objectives and Functions of Accounting

The objectives of Accounting are –

1. To have a systematic record all business transactions which are of financial nature.

2. To know the result of business operations for a particular period of time. If Revenue /
Income exceeds the Expenses, then it is said that the business is running profitably, but if the
Expenses exceed the Revenue, then the business is operating at a loss.

3. To know the financial position of the business. This will help answer questions like how
much Assets and Liabilities that the business has on any date, whether the business is solvent,
i.e. ability to meet its liabilities in the short run and also in the long run as and when they fall
due.

4. To provide information to Users for decision making. Accounting, as the language of

business, communicates the financial result of enterprises, to various Users. Accounting aims
to meet the information needs of the decision maker and help them in rational decision making.

Functions of Accounting

The American Principles Board of the AICPA enumerated the following functions of
accounting:
1. Measurement: Accounting measures the performance of the business entity and depicts its
current financial position.

2. Forecasting: Accounting helps in forecasting future performance and financial position of

enterprise using past data.

3. Decision–making: Accounting provides relevant information to the Users of accounts to aid

rational decision–making.

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4. Comparison & Evaluation: Accounting assesses performance achieved in relation to targets

and discloses information regarding accounting policies and Contingent Liabilities, which play
an important role in predicting, comparing and evaluating the financial results.

5. Control: Accounting identifies weaknesses in the operational system and provides feedback
regarding effectiveness of measures to rectify such weaknesses.

6. Government Regulation: Accounting provides necessary information to the Government,

to exercise control on the entity as well as in collection of direct and indirect tax revenues.

1.6 Users of Financial Information

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1.7 Accounting Processes

1.8 Accounting Business Activities

1.9 Types of Financial Statements

All economic decisions are based on an evaluation of an entity’s ability to generate cash and of
the timing and certainty of its generation. Information about the entity’s financial position,
performance and changes in financial position provides the foundation on which to base such
decisions. The principal means of providing financial information to external users is the
annual financial statements. Financial statements are the accountant's summary of the
performance of an entity over a particular period and of its position at the end of that period.

A complete set of financial statements comprises:

The balance sheet (a statement of financial position)

An entity's financial position covers:
� The economic resources it controls

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� Its financial structure (ie debt and share finance)

� Its liquidity and solvency and
� Its capacity to adapt to changes in the environment in which it operates

Investors require information on financial position because it helps in assessing:

 The entity's ability to generate cash in the future

 How future cash flows will be distributed among those with an interest in, or claims on,
the entity
 Requirements for future finance and ability to raise that finance
 The ability to meet financial commitments as they fall due. Information about financial
position is primarily provided in a balance sheet.

The income statement (a statement of financial performance)

The profit earned in a period is used as the measure of financial performance, where
profit is calculated as income less expenses. Information about performance and
variability of performance is useful in:
 Assessing potential changes in the entity's economic resources in the future
 Predicting the entity's capacity to generate cash from its existing resource base,
and
 Forming judgements about the effectiveness with which additional resources
might be employed.

Information on financial performance is provided by:

 The income statement, and
 The statement of changes in equity (another statement of financial
performance)

The statement of changes in financial position (usually in the form of a cash flow
statement)
 Changes in financial position can be analyzed under the headings of investing,
financing and operating activities and are usually shown in a cash flow
statement.

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 Cash flow information is largely free from the more judgemental allocation and
measurement issues (ie in which period to include things and at what amount)
that arise when items are included in the balance sheet or performance
statements.

 For example, depreciation of non-current assets involves judgement and

estimation as to the period over which to charge depreciation. Cash flow
information excludes non-cash items such as depreciation.

Cash flow information is therefore seen as being factual in nature, and hence
more reliable than other sources of information.

 Information on the generation and use of cash is useful in evaluating the entity’s
ability to generate cash and its needs to use what is generated.

Notes to the financial statements: The notes and schedules attached to financial
statements can provide additional information relevant to users.

The notes to the financial statements include:

 Accounting policies, ie the specific principles, conventions, rules and practices applied
in order to reflect the effects of transactions and other events in the financial statements.

 Detailed financial and narrative information supporting the information in the primary
financial statements.

 Other information not reflected in the financial statements, but which is important to
users in making their assessments.

1.10 Bases of accounting

There are four bases of accounting which you need to be familiar with:
a. Accrual basis
b. Going concern basis
c. Cash basis
d. Break-up basis
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The accrual basis of accounting and going concern are referred to by the IASB Framework as
'underlying assumptions'.

a. Accrual basis
Under this basis of accounting, transactions are recognised when they occur, not when the
related cash flows into or out of the entity. You will be familiar with this basis from your
Accounting studies.

Examples of the importance of this basis are as follows:

 Sales are recorded in the period in which the risks and rewards of ownership pass
from seller to buyer, not when the seller receives full payment. While this basis has no
effect on the timing of the recognition of cash sales, it does mean that credit sales are
recorded earlier than if the cash basis of accounting was used. When credit sales are
recognised, a receivable is set up in the entity's books.

 Expenses are recognised in the period when the goods or services are consumed, not
when they are paid for. An amount payable will be set up in the entity's books for credit
purchases, again leading to earlier recognition than if the cash basis was used.

 The consumption of non-current assets, such as plant and machinery, is recognised

over the period during which they are used by the entity (ie the asset is
depreciated), not in the year of purchase as they would be under the cash basis of
accounting.

Financial statements prepared on this basis provide information both about past transactions
involving cash and about future resources flowing into the entity (when customers pay up) and
flowing out of it (when suppliers are paid). They are therefore more useful for the making of
economic decisions than those produced on the cash basis.

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b. Going concern basis

The accrual basis of accounting assumes that an entity is a going concern. Under this basis,
financial statements are prepared on the assumption that the entity will continue in operation
for the foreseeable future, in that management has neither the intention nor the need to
liquidate the entity by selling all its assets, paying off all its liabilities and distributing any
surplus to the owners.

Examples of the importance of this basis are as follows:

 The measurement of receivables from trade customers is made on the basis that there is
no time limit over which management will chase slow payers. If the entity were to
cease operation in, say, three months, a number of balances might have to be regarded
as bad debts

 The measurement of non-current assets is made on the basis that they can be utilised
throughout their planned life. Otherwise, they would have to be valued at what they
could immediately be sold for, which might not be very much, in the case of assets used
in markets where there is excess capacity.

 The accrual basis and going concern are referred to by the IASB Framework as
'underlying assumptions'.

c. Cash basis

The cash basis of accounting is not used in the preparation of a company balance sheet and
income statement as it is not allowed by IFRS or UK GAAP, although the cash effect of

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transactions is presented in the form of a cash flow statement. The cash basis may be used
however, for small unincorporated entities, for example clubs and societies.

In many ways the cash basis of accounting is very simple. Only the cash impact of a
transaction is recorded.

Examples of the impact of this are as follows:

 Sales are recorded in the period in which the seller receives full payment. For credit
sales this will delay the recognition of the transaction.

 Purchases are recorded in the period in which goods are paid for rather than the period
in which the goods are purchased. For credit purchases this will delay the recognition of
the purchase.

 The purchase of a capital asset is treated as a cash outflow at the point that the cash
consideration is paid. No subsequent adjustment is made for depreciation as this has no
impact on the cash balance of the business.

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Worked example: Comparison of accrual basis and cash basis

d. Break-up basis
The key assumptions made in accrual based accounting are that the business will continue as a
going concern. However, this will not necessarily always be the case. There may be an
intention or need to sell off the assets of the business.

Such a sale typically arises where the business is in financial difficulties and needs the cash to
pay its creditors. Where this is the case an alternative method of accounting must be used (in
accordance with IAS 1 Presentation of Financial Statements).
In these circumstances the financial statements will be prepared on a break-up basis. The
effect of this is seen primarily in the balance sheet as follows:

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Classification of assets
All assets and liabilities would be classified as current rather than non-current.

Valuation of assets
Assets would be valued on the basis of the recoverable amount on sale. This is likely to be
substantially lower than the carrying amount of assets held under historical cost accounting.

1.11 The IASB Framework

The IASB Framework for the Preparation and Presentation of Financial Statements
(Framework) is the conceptual framework upon which all IASs and IFRSs are based. It
determines:
 How financial statements are prepared, and
 The information they contain

Conceptual Framework
The Framework consists of the fundamental (preface) issues discussed followed by
introductory discussions on:
 The objective of financial statements
 Underlying assumptions
 Qualitative characteristics of financial statements
 The elements of financial statements
 Recognition of the elements of financial statements
 Measurement of the elements of financial statements
 Concepts of capital and capital maintenance

Preface
The Preface to the Framework points out the fundamental reason why financial statements are
produced worldwide, ie to satisfy the requirements of external users, but that practice varies
due to the individual pressures in each country. These pressures may be social, political,
economic or legal, but they result in variations in practice from country to country including:
 The form of the statements
 The definition of their component parts (assets, liabilities, etc)

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 The criteria for recognition of items

 Scope and disclosure of financial statements
It is these differences which the IASB wishes to narrow by harmonizing all aspects of financial
statements, including the regulations governing accounting standards and their preparation and
presentation. The Preface also emphasises the way the financial statements are used to make
economic decisions.

Introductory concepts
The Introduction provides a list of the purposes of the Framework:

a. Provide those who are interested in the work of the IASB with information about its
approach to the formulation of IASs (now IFRSs).

b. Assist the Board of the IASB in the development of future IASs and in its review of
existing IASs.

c. Assist the Board of the IASB in promoting harmonisation of regulations, accounting

standards and procedures relating to the presentation of financial statements by
providing a basis for reducing the number of alternative accounting treatments
permitted by IASs.

d. Assist national standard-setting bodies in developing national standards.

e. Assist preparers of financial statements in applying IASs and in dealing with topics
that have yet to form the subject of an IAS. Assist auditors in forming an opinion as to
whether financial statements conform with IASs.

f. Assist users of financial statements in interpreting the information contained in

financial statements prepared in conformity with IASs.
The Framework is not an IFRS and so does not overrule any individual IFRS. In the (rare) case
of conflict between an IFRS and the Framework, the IFRS will prevail. These cases will
diminish over time as the Framework will be used as a guide in the production of future IFRSs.
The Framework itself will be revised occasionally depending on the experience of the IASB in
using it.

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1.12 Qualitative characteristics of financial statements

Overview
The Framework states that qualitative characteristics are the attributes that make the
information provided in financial statements useful to users. The four principal qualitative
characteristics are understandability, relevance, reliability and comparability.

The key issues can be summarized as follows:

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Understandability

Users must be able to understand financial statements. They are assumed to have some
business, economic and accounting knowledge and to be able to apply themselves to study the
information properly. Complex matters should not be left out of financial statements simply
due to its difficulty if it is relevant information.

Relevance
Relevant information is both predictive and confirmatory. These roles are interrelated.

Definition

Relevance: Information has the quality of relevance when it influences the economic decisions
of users by helping them evaluate past, present or future events or confirming, or correcting,
their past evaluations. Information on financial position and performance is often used to
predict future position and performance and other things of interest to the user, eg likely
dividend, wage rises. The manner of presentation will enhance the ability to make
predictions, eg by highlighting unusual items.

Materiality
The relevance of information is affected by its nature and its materiality.

Definition

Materiality: Information is material if its omission or misstatement could influence the

economic decisions of users taken on the basis of the financial statements. Information may be
judged relevant simply because of its nature (eg remuneration of management). In other cases,
both the nature and materiality of the information are important. Materiality is not a primary
qualitative characteristic itself (like reliability or relevance), because it is merely a threshold or
cut-off point.

Reliability
Information must also be reliable to be useful. The user must be able to depend on it being a
faithful representation.

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Definition: Reliability: Information has the quality of reliability when it is free from material
error and bias and can be depended upon by users to represent faithfully that which it either
purports to represent or could reasonably be expected to represent. Even if information is
relevant, if it is very unreliable it may be misleading to recognise it, eg a disputed claim for
damages in a legal action.
Faithful representation

Information must represent faithfully the transactions it purports to represent in order to be

reliable. There is a risk that this may not be the case, not due to bias, but due to inherent
difficulties in identifying the transactions or finding an appropriate method of
measurement or presentation.

Where measurement of the financial effects of an item is so uncertain, entities should not
recognise such an item. For example, although there is usually no doubt as to the existence of
internally generated goodwill, there is considerable doubt as to its true value, ie it cannot be
measured reliably.

Substance over form

Faithful representation of a transaction is only possible if it is accounted for according to its
substance and economic reality, not with its legal form.

Definition
Substance over form: The principle that transactions and other events are accounted for and
presented in accordance with their substance and economic reality and not merely their legal
form.
Most transactions are reasonably straightforward and their substance, ie commercial effect, is
the same as their strict legal form. However, in some instances this is not the case as can be
seen in the following worked example.

Worked example: Sale and repurchase agreement

A Ltd sells goods to B Ltd for £10,000, but undertakes to repurchase the goods from B Ltd in
12 months’ time for £11,000. The legal form of the transaction is that A has sold goods to B as
it has transferred legal title. To reflect the legal form, A Ltd would record a sale and show the
resulting profit, if any, in its income statement. In 12 months’ time when legal title is regained,
A Ltd would record a purchase.

There would be no liability to B Ltd in A Ltd’s balance sheet until the goods are repurchased.
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The above treatment does not provide a faithful representation because it does not reflect the
economic substance of the transaction. After all, A Ltd is under an obligation from the outset to
repurchase the goods and A Ltd bears the risk that those goods will be obsolete and unsalable
in a year’s time.

The substance is that B Ltd has made a secured loan to A Ltd of £10,000 plus interest of
£1,000. To reflect substance, A Ltd should continue to show the goods as an asset in
inventories (at cost or net realizable value, if lower) and should include a liability to B Ltd of
£10,000 in payables. A Ltd should accrue for the interest over the duration of the loan. When A
Ltd pays £11,000 to regain legal title, this should be treated as a repayment of the loan plus
accrued interest.

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