Financial Accounting

Financial Accounting _Placement test

Learning objectives

1 Overview of accounting 4
2 Financial accounting and management accounting 6
3 Users of financial statements 8
4 Types of business entity 10
5 The Framework 17
6 Qualitative characteristics 19
7 The elements of the financial statements 29

8 The components of a set of financial statements 24

9 Other important accounting concepts 28
Summary 34
Reference 35
Feedback 36

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Placement test

• Explain the context and purpose of financial reporting.

• User groups/ Users’ and stakeholders’ needs

• Types of business entity

• Financial accounts v Management accounts

• The main elements of financial reports

• Define the qualitative characteristics of financial information.

• Double-entry and accounting systems.

• Record transactions and events.
• Prepare a trial balance

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1 Overview of accounting

The accounting system of a business records and summarises the financial

performance/position of a business over/at a certain period of time.

This information is crucial to various stakeholders of the business,

who will analyse that information to make significant economic decisions.

It is of vital importance that these stakeholders have good quality information to be

able to make good quality decisions.

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1 Overview of accounting

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 2 Financial accounting and management accounting
Financial accounting
In order to facilitate comparison, financial
Financial accounting is concerned with accounts are prepared using accepted accounting
the production of financial statements for conventions and standards.
external users. • International Accounting Standards (IAS
Standards) and
These are a report on the directors’
• International Financial Reporting Standards
stewardship of the funds entrusted to
(IFRS Standards)
them by the shareholders.
help to reduce the differences in the way that
Investors need to be able to choose companies draw up their financial statements in
which companies to invest in and different countries.
compare their investments.
The financial statements are public documents,
and therefore they will not reveal details about, for
example, individual products’ profitability.
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 2 Financial accounting and management accounting

Management accounting
Management require much more detailed and up-
to-date information in order to control the
business and plan for the future. Management accounting is an integral part
of management activity concerned with
Management needs to be able to cost-out products identifying, presenting and interpreting
and production methods, assess profitability and information used for:
so on. • formulating strategy
• planning and controlling activities
In order to facilitate this, management accounts • decision making
present information in any way which may be • optimising the use of resources.
useful to management, for example by operating
unit or product line.

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3 Users of financial statements

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Test 1

Which of the following users do you think require the most detailed
financial information to be made available to them?

A Competitors
B Management of the business
C Trade unions
D Investors

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 4 Types of business entity
A business can be operated in one of several ways:
• The capital structure of a sole trader is also
Sole trader
relatively simple. There is a capital account
which represents the financial interest of the
This is the simplest form of business where a
owner in the business.
business is owned and operated by one individual,
• The capital account can be added to by the
although it might employ any number of people.
owner introducing additional capital into the
With this form of entity there is no legal distinction
business, or by the business making profits,
between the owner and the business. To this end
which the sole trader is entitled to. The capital
the owner receives all of the profits of the business
account can be reduced by the sole trader
but has unlimited liability for all the losses and
making withdrawals from the capital account
debts of the business.
during the year (often referred to a 'drawings')
or by the business making losses.

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4 Types of business entity
Partnership
• The capital structure of a partnership is
• Similar to a sole trader the owners of a similar to that of a sole trader. Each
partnership receive all the profits and have partner will have a financial interest in the
unlimited liability for the losses and debts business and this will be divided between
of the business. a capital account and current account. The
capital account is normally a fixed amount
• The key distinction is that there are at that will only change upon a partner
least two owners. The joint owners, or joining or leaving the business. The
partners, are jointly and severally liable current account includes the share of
for the losses the business makes (i.e. they profit or loss that each partner is entitled
are each fully liable in respect of all to, less any personal drawings made by
business liabilities). that partner

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 4 Types of business entity
Limited liability companies

Unlike sole traders and partnerships, limited liability companies

are established as separate legal entities to their owners. This is
achieved through the process of incorporation. The owners of • The capital structure of a limited liability
the company (the shareholders) invest capital in the business in company is more formalised than that of
return for a shareholding that entitles them to a share of the a sole trader or partnership.
residual assets of the business (i.e. what is left when the
company is wound up or liquidated). • Shareholders cannot make withdrawals
The shareholders are not personally liable for the debts of the or 'drawings' from the business in the
company and whilst they may lose their investment if the way that a sole trader or partner is able to
company becomes insolvent they will not have to pay the do. Instead, they receive a return on their
outstanding debts of the company if such a circumstance arises. investment in the company referred to as
Likewise, the company is not affected by the insolvency (or a dividend which is paid from
death) of individual shareholders. Limited liability companies accumulated profits.
are managed by a board of directors who are elected by the
shareholders.
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 3 Types of business entity
Operating as a sole trader, partnership or company
The advantages of operating as
Sole trader a sole trader include flexibility
and autonomy. A sole trader can
• Accounting conventions recognise the business as a manage the business as he or
separate entity from its owner. However, legally, the she likes and can introduce or
business and personal affairs of a sole trader are not withdraw capital at any time.
distinguished in any way. The most important consequences
of this is that a sole trader has complete personal unlimited
liability. Business debts which cannot be paid from business
assets must be met from sale of personal assets, such as a
house or a car.

• Sole trading organisations are normally small because they

have to rely on the financial resources of their owner.
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 4 Types of business entity
Operating as a sole trader, partnership or company

Partnership The advantages of trading as a partnership

stem mainly from there being many owners
Like a sole trader, a partnership is not rather than one. This means that:
legally distinguished from its members. • more resources may be available,
including capital, specialist knowledge,
skills and ideas
Personal assets of the partners may have • administrative expenses may be lower for
to be used to pay the debts of the a partnership than for the equivalent
partnership business. number of sole traders, due to economies
of scale; and
• partners can substitute for each other.
Partners can introduce or withdraw capital at
any time, provided that all the partners agree.

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 4 Types of business entity
Comparison of companies to sole traders and partnerships

Property holding The property of a limited liability company belongs to the

The fact that a company. A change in the ownership of shares in the
company is a company will have no effect on the ownership of the
separate legal entity company's property. (In a partnership the firm's property
means that it is very belongs directly to the partners who can take it with them
different from a sole if they leave the partnership.)
trader or partnership
Transferable Shares in a limited company can usually be transferred
in a number of
shares without the consent of the other shareholders. In the
ways.
absence of agreement to the contrary, a new partner
cannot be introduced into a firm without the consent of all
existing partners.
Suing and being As a separate legal person, a limited company can sue and
sued be sued in its own name. Judgements relating to
companies do not affect the members personally.
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 4 Types of business entity
Comparison of companies to sole traders and partnerships

Security for loans A company has greater scope for raising loans and may
The fact that a secure them with floating charges. A floating charge is a
company is a mortgage over the constantly fluctuating assets of a company
separate legal entity providing security for the lender of money to a company. It
means that it is very does not prevent the company dealing with the assets in the
different from a sole ordinary course of business. Such a charge is useful when a
trader or partnership company has no non-current assets such as land, but does
in a number of ways. have large and valuable inventories.
Generally, the law does not permit partnerships or individuals
to secure loans with a floating charge.

Taxation Because a company is legally separated from its shareholders,

it is taxed separately from its shareholders. Partners and sole
traders are personally liable for income tax on the profits
made by their business.
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5 The Framework
It includes discussion of:
• One of the most important documents
underpinning the preparation of financial • the purpose of the Framework
statements is the Conceptual Framework • the objectives of financial reporting
for Financial Reporting ('the Framework'), • the qualitative characteristics of useful
which was prepared by the IASB. financial information
• the definition, recognition and
• The Framework presents the main ideas, measurement of the elements from which
concepts and principles upon which all the financial statements are constructed
International Financial Reporting • the accruals and going concern concepts,
Standards, and therefore financial and
statements, are based. • the concepts of capital and capital
maintenance (not on the syllabus).

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 5 The Framework

The purpose of the Framework The objective of financial reporting

is to assist the IASB in the development of The main objective is to provide financial
financial reporting standards and to assist information about the reporting entity to
preparers of financial statements to develop users of the financial statements that is
accounting policies when reporting useful in making decisions about providing
standards do not provide sufficient economic resources to the entity, as well as
guidance, or where there is a choice of other financial decisions.
accounting policy.

It is also a useful reference document to

assist in understanding and interpreting
reporting standards.

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6 Qualitative characteristics
Qualitative characteristics are the attributes that make information provided in financial
statements useful to others.

The Framework splits qualitative characteristics into two categories:

(i) Fundamental qualitative characteristics
– Relevance
– Faithful representation

(ii) Enhancing qualitative characteristics

– Comparability
– Verifiability
– Timeliness
– Understandability

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 7 The elements of the financial statements
In order to appropriately report the financial performance and position of a business the
financial statements must summarise five key elements:
# The elements Definitions Examples
1 Asset A present economic resource a building that is owned and controlled by a
controlled by the entity as a business and that is being used to house its
result of past events operations and generate revenues would be
classed as an asset.
2 Liability A present obligation of the an unpaid tax obligation or a bank loan is a
entity to transfer an economic liability
resource as a result of past
events
3 Equity This is the 'residual interest' in It is effectively what is paid back to the
the assets of the entity after owners (shareholders) when the business
deducting all liabilities. ceases to trade.
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 7 The elements of the financial statements

# The elements Definitions Examples

4 Income This consists of the increases in This can be achieved, for example, by
assets, or decreases in liabilities, that earning sales revenue or through the
result in increases in equity, other increase in the value of an asset.
than those relating to contributions
from holders of equity claims.
5 Expense This consists of the decreases in This can be achieved, for example, by
assets or increases in liabilities that purchasing goods or services off
result in decreases in equity, other another entity or through the
than those relating to distributions to reduction in value of an asset.
holders of equity claims.
Note: economic resource – A right that has the potential to produce economic benefits

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7 The elements of the financial statements

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Test 2

Classify the following items into current and non-current assets and
liabilities:
• land and buildings
• receivables
• cash
• loan repayable in two years’ time
• payables
• delivery van.

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 8 The components of a set of financial statements
$ $
Equity and liabilities
Statement of financial position at 30 June 20X7
Equity share capital @ $1 shares 40,000
Share premium 2,000
$ $
Revaluation surplus 5,000
Non-current assets
Retained earnings 43,650
Property, plant and equipment 87,500
Total equity at 30 June 20X7 90,650
Non-current liabilities
Current assets
6% bank loan (20X9) 10,000
Inventory 12,000
Current liabilities
Trade receivables 11,200
Trade payables 5,000
23,200
Bank overdraft 4,150
Total assets 110,700
Income tax liability 600
Interest accrual 300
10,050
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110,700
 8 The components of a set of financial statements
Statement of profit or loss and other comprehensive income for the year ended 30 June 20X7
$
Sales revenue 120,000
Cost of sales (72,500)
Gross profit 47,500
Distribution costs (10,700)
Administrative and selling expenses (15,650)
Operating profit 21,150
Finance costs (600)
Profit before tax 20,550
Income tax (600)
Profit for the year 19,950
Other comprehensive income:
Revaluation surplus in the year 2,000
Total comprehensive income for the year 21,950
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8 The components of a set of financial statements
Statement of changes in equity for the year ended 30 June 20X7

Equity Share Revaluati Retained Total

share premium on earnings
capital surplus

$ $ $ $ $
Balance at 1 July 20X6 34,000 1,100 3,000 25,200 63,300
Profit for the year 19,950
Dividend paid in the year (1,500)
Revaluation in the year 2,000 2,000
Issue of share capital 6,000 900 6,900

Balance at 30 June 20X7 40,000 2,000 5,000 43,650 90,650

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8 The components of a set of financial statements
The statement of cash flows The notes to the financial statements

The notes to the financial statements comprise a

This statement summarises the cash paid and
statement of accounting policies and
received throughout the reporting period.
any other disclosures required
to enable to the shareholders and other users of
Normally, it would be relevant to limited
the financial statements to make informed
liability companies only, rather than to sole
judgements about the business.
traders and partnerships. It will be explained in
greater detail later in the text.
The notes to the financial statements are usually
more detailed and extensive for limited liability
company financial statements, rather than for the
accounts of a sole trader or partnership.

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9 Other important accounting concepts
There are a number of other accounting principles that underpin the preparation of financial
statements. The most significant ones include:

Materiality
• An item is regarded as material if its omission • For example, consider if the bank balance of a
or misstatement is likely to change the large entity (such as a company listed on the
perception or understanding of the users of stock exchange) misstated by $1 in the
that information – i.e. they may make statement of financial position. This may not
inappropriate decisions based upon the be regarded as a material misstatement which
misstated information. Note that this is a would significantly distort the relevance and
subjective assessment made by those who reliability of the financial statements.
prepare the financial statements (usually • However, if the bank balance was misstated by
company directors) and it requires them to $100,000, this is more likely to be regarded as
consider the reliability of the financial a material misstatement as it significantly
statements for decision-making purposes by distorts the information included in the
users, principally the shareholders. financial statements.

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 8 Other important accounting concepts
The going concern assumption
• Financial statements are prepared on the
Substance over form assumption that the entity is a going concern,
• If information is to be presented and will continue to operate for the foreseeable
faithfully, the economic reality must be future (i.e. it has neither the need nor the
accounted for and not just the strict legal intention to liquidate or significantly curtail its
form. operations). The normal expectation is that,
• An example of substance over form is based upon current knowledge and
the accounting treatment of redeemable
understanding of the business, it is reasonable
preference shares. Although on legal
to assume that the business will continue to
form they are shares, there is an
obligation to repay the preference operate for the next twelve months.
shareholders and so they are accounted • Note that there is no guarantee that this will
for as debt. always be the case as evidenced by business
failures and insolvencies.
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 8 Other important accounting concepts
The accruals basis of accounting

The business entity concept • This means that transactions are recorded
when revenues are earned and when expenses
• This principle means that the financial are incurred. This pays no regard to the timing
accounting information presented in the of the cash payment or receipt.
financial statements relates only to the • For example, if a business enters into a
activities of the business and not to those of contractual arrangement to sell goods to
the owner. From an accounting perspective another entity the sale is recorded when the
the business is treated as being separate contractual duty has been satisfied. That is
from its owners likely to be when the goods have been
supplied and accepted by the customer. The
payment may not be received for another
month but in accounting terms the sale has
taken place and should be recognised in the
financial statements.

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 8 Other important accounting concepts
Prudence
• Preparers of financial statements should
exercise prudence when preparing financial
statements. Assets and income should not be
overstated whilst liabilities and expenses
should not be understated.

• However, care must be exercised to ensure that

there is not deliberate misstatement of assets,
• Applying the principle of prudence helps
liabilities, income and expenses as that would to ensure that financial statements are
introduce bias into the financial statements. fairly stated and can be relied upon by
users.
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 8 Other important accounting concepts
• Consistency of accounting treatment and
Consistency presentation relates not only from one
accounting period to the next, but also
• Users of the financial statements need to be within an accounting period, so that similar
able to compare the performance of an entity transactions are accounted for in a similar
over a number of years. Therefore it is way.
important that the presentation and
classification of items in the financial
statements is retained from one period to the
next, unless there is a change in circumstances
or a requirement of a new IFRS Standard.

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 Test 3
Which of the following statements are correct?

1 Only tangible assets (i.e. those with physical substance) are recognised in the financial
statements.
2 Faithful representation means that the commercial effect of a transaction must always be
shown in the financial statements even if this differs from legal form.
3 Businesses only report transactions, events and balances that are material to users of the
financial statements.

A All of them
B 1 and 2 only
C 2 only
D 2 and 3 only

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Summary

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Reference

• ACCA. Applied Knowledge. ACCA Diploma in Accounting and Business (RQF Level 4).
Financial Accounting (FA/FFA). Study Text. Kaplan Financial Limited. (2020), Chapter 1

• Foundations in Accountancy, ACCA Paper F3 Financial Accounting Study Text, BPP

Learning Media Ltd (2016), Chapter 1

• Elliot, B. and Elliot, J. (2022) Financial Accounting and Reporting, 20th edition, Pearson.
Chapter 1

• BPP Learning Media (2022) FR Financial Reporting. Workbook, Chapter 1, 2 & 3

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Feedback
Test 1

The correct answer is B – Management

Management need detailed information in order to control their business and make
informed decisions about the future. Management information must be very up to date and
is normally produced on a monthly basis.

Other parties will need far less detail:

• Competitors will be monitoring what the competition are currently planning and working
on, but they will not be making the key decisions themselves.
• Trade unions will only require information which relates to their job role. They will only
be particularly interested in disputes.
• Investors are interested in profitability and the security of their investment.

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Feedback
Test 2

Land and buildings – non-current asset.

Receivables – current asset.
Cash – current asset.
Loan repayable in two years' time – non-current liability.
Payables – current liability.
Delivery van – non-current asset.

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Feedback
Test 3

The correct answer is C

Both tangible and intangible assets may be recognised as long as they meet the definition of
an asset as described earlier.
Faithful representation includes the concept that transactions should reflect their economic
substance, rather than the legal form of the transaction.
Businesses should report all transactions, events and balances in their financial statements.
Materiality is simply a measure for determining how significant that information is to users.

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