111992 fin acc 2017(m) - accounting technicians ireland · syllabus: financialaccounting ... 116...

Financial Accounting

Course Text

Professional, Practical, Proven

www.AccountingTechniciansIreland.ie

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Table of Contents

FOREWORD ...............................................................................................................xi

SYLLABUS: FINANCIAL ACCOUNTING ...............................................................xvii

CHAPTER 1: INTRODUCTION TO ACCOUNTING ....................................................1

1.1 INTRODUCTION.........................................................................................................................3

1.2 ACCOUNTING ............................................................................................................................3

1.3 ACCOUNTABILITY .....................................................................................................................4

1.4 TYPES OF BUSINESS ENTITY..................................................................................................71.4.1 Sole trader ....................................................................................................................71.4.2 Partnership....................................................................................................................81.4.3 Limited Company ..........................................................................................................91.4.4 Public and Private Limited Companies ....................................................................... 11

1.5 USERS OF ACCOUNTING INFORMATION.............................................................................12

1.6 USERS OF FINANCIAL STATEMENTS....................................................................................131.6.1 Investors .....................................................................................................................131.6.2 Lenders .......................................................................................................................131.6.3 Suppliers .....................................................................................................................131.6.4 Customers...................................................................................................................141.6.5 Employees ..................................................................................................................141.6.6 Government ................................................................................................................141.6.7 Analysts ......................................................................................................................141.6.8 Public at large .............................................................................................................15

1.7 TYPES OF ACCOUNTING .......................................................................................................15

1.8 THE MAIN FINANCIAL ACCOUNTING STATEMENTS............................................................17

1.9 ACCOUNTING TERMINOLOGY...............................................................................................18

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1.10 THE ACCOUNTANT’S ROLE AND FUNCTION IN AN ORGANISATION.................................19

1.11 AUDITING .................................................................................................................................20

1.12 ACCOUNTING ETHICS............................................................................................................22

1.13 ACCOUNTING SCANDALS......................................................................................................22

1.14 RESPONSES TO SCANDALS..................................................................................................23

1.15 ETHICAL ISSUES AND THE ACCOUNTING TECHNICIAN.....................................................231.15.1 Codes of ethics ...........................................................................................................24

1.16 WHISTLE BLOWING ................................................................................................................24

CHAPTER 2: ACCOUNTING CONCEPTS & CONVENTIONS.................................27

2.1 INTRODUCTION.......................................................................................................................28

2.2 REGULATION AND STANDARDS............................................................................................28

2.3 PROFESSIONAL SELF-REGULATION ....................................................................................28

2.4 COMPANIES ACTS...................................................................................................................29

2.5 A TRUE AND FAIR VIEW..........................................................................................................29

2.6 THE BASIC PRINCIPLES OF ACCOUNTING: CONVENTIONS AND CONCEPTS ................302.6.1 Accounting conventions ..............................................................................................302.6.2 Accounting concepts...................................................................................................312.6.3 The conflict between accruals and prudence concepts ..............................................33

2.7 WHAT MAKES ACCOUNTING INFORMATION USEFUL? ......................................................33

2.8 A FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIALSTATEMENTS...........................................................................................................................35

2.9 RELEVANCE.............................................................................................................................36

2.10 RELIABILITY.............................................................................................................................36

2.11 COMPARABILITY .....................................................................................................................36

2.12 UNDERSTANDABILITY ............................................................................................................36

2.13 CONFLICTS IN THE QUALITATIVE CHARACTERISTICS OFACCOUNTING INFORMATION ................................................................................................37

2.14 ACCOUNTING POLICIES ........................................................................................................37

2.15 ESTIMATION TECHNIQUES....................................................................................................38

2.16 MEASUREMENT BASES .........................................................................................................38

2.17 SELECTING ACCOUNTING POLICIES ...................................................................................38

2.18 REVIEWING AND CHANGING ACCOUNTING POLICIES ......................................................39

2.19 FRS 102, SECTION 10: ACCOUNTING POLICIES, ESTIMATES AND ERRORS...................40

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CHAPTER 3: DOUBLE ENTRY BOOK-KEEPING....................................................43

3.1 DOUBLE ENTRY BOOK-KEEPING AND THE DUALITY CONCEPT.......................................44

3.2 THE ACCOUNTING EQUATION...............................................................................................45

3.3 LEDGER ACCOUNTS, DEBITS AND CREDITS ......................................................................46

3.4 RECORDING CASH TRANSACTIONS ....................................................................................49

3.5 RECORDING CREDIT SALES AND PURCHASES TRANSACTIONS ....................................50

3.6 RECORDING SALES AND PURCHASES RETURNS .............................................................51

3.7 ACCOUNTING FOR DISCOUNTS ...........................................................................................52

3.8 DOUBLE ENTRY CHECKLIST .................................................................................................52

3.9 BALANCING OFF LEDGER ACCOUNTS ................................................................................533.9.1 Opening and Closing balances in the ledger accounts...............................................543.9.2 Income Statement Account, ledger accounts..............................................................553.9.3 Capital account ...........................................................................................................55

3.10 EXAMPLE 8 CLOSING OFF GEORGE’S ACCOUNTS...........................................................563.10.1 Next step - trial balance ..............................................................................................593.10.2 The limitations of a trial balance .................................................................................593.10.3 The process steps in producing a trial balance from a set of ledger accounts. ..........59

3.11 EXAMPLE 9 EXTRACTING A TRIAL BALANCE FROM GEORGE’S ACCOUNTS.................60

3.12 SELF-TEST QUESTIONS.........................................................................................................61

3.13 SOLUTIONS TO SELF-TEST QUESTIONS .............................................................................63

CHAPTER 4: VAT, PAYROLL, BOOKS OF PRIME ENTRY ....................................73

4.1 ELEMENTS OF VALUE ADDED TAX (VAT) .............................................................................744.1.1 The VAT system..........................................................................................................744.1.2 Rates of VAT ...............................................................................................................744.1.3 Principles of VAT.........................................................................................................744.1.4 The Exception: Irrecoverable VAT...............................................................................754.1.5 Calculation of VAT.......................................................................................................754.1.6 Accounting entries for VAT..........................................................................................77

4.2 PAYROLL ..................................................................................................................................794.2.1 The accounting entries for Payroll ..............................................................................80

4.3 BOOKS OF PRIME ENTRY......................................................................................................814.3.1 Sales day book ...........................................................................................................824.3.2 Sales returns day book ...............................................................................................834.3.3 Purchases day book ...................................................................................................844.3.4 Purchases returns day book .......................................................................................854.3.5 The cash book ............................................................................................................864.3.6 Cash Receipts Book ...................................................................................................884.3.7 The petty cash book....................................................................................................894.3.8 The journal ..................................................................................................................90

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4.4 SELF-TEST QUESTIONS.........................................................................................................90

4.5 SOLUTIONS TO SELF-TEST QUESTIONS .............................................................................92

CHAPTER 5: INTRODUCTION TO FINANCIAL STATEMENTS ..............................97

5.1 INTRODUCTION TO FINANCIAL STATEMENTS.....................................................................98

5.2 THE INCOME STATEMENT......................................................................................................995.2.1 The trading income section.........................................................................................995.2.2 The business expenditure section ............................................................................1015.2.3 Revenue income, capital income and revenue expenditure in the Income

Statement..................................................................................................................101

5.3 THE STATEMENT OF FINANCIAL POSITION.......................................................................1035.3.1 Assets and liabilities..................................................................................................1045.3.2 Link between Statement of Financial Position and the Income Statement ...............1055.3.3 Capital Expenditure in the Statement of Financial Position ......................................105

5.4 AN INTRODUCTION TO ACCOUNTING FOR OPENING AND CLOSING INVENTORY ......1075.4.1 Closing inventory ......................................................................................................1075.4.2 Opening inventory.....................................................................................................108

5.5 GEORGE’S TRIAL BALANCE(CONTINUED FROM SECTION 3.11, CHAPTER 3) .............................................................. 110

5.6 SELF-TEST QUESTIONS.......................................................................................................114

5.7 SOLUTIONS TO SELF-TEST QUESTIONS ........................................................................... 116

CHAPTER 6: INVENTORY ......................................................................................123

6.1 ACCOUNTING FOR INVENTORY..........................................................................................1246.1.1 The accruals concept................................................................................................1246.1.2 Valuation of Inventory ...............................................................................................1256.1.3 The prudence concept ..............................................................................................1256.1.4 Cost...........................................................................................................................1266.1.5 Net Realisable value (NRV) ......................................................................................126

6.2 METHODS OF VALUING INVENTORY – SECTION 13: INVENTORIES...............................1286.2.1 First in – First out (FIFO)...........................................................................................1286.2.2 Average cost – AVCO ...............................................................................................130

6.3 THE IMPACT OF VALUATION METHODS ON THE INCOME STATEMENT AND THESTATEMENT OF FINANCIAL POSITION ...............................................................................133


6.5 SOLUTIONS TO SELF-TEST QUESTIONS ...........................................................................137

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CHAPTER 7: ACCRUALS AND PREPAYMENTS ..................................................141

7.1 THE ACCRUALS CONCEPT ..................................................................................................142

7.2 ACCRUED EXPENDITURE....................................................................................................144

7.3 PREPAID EXPENDITURE ......................................................................................................148

7.4 ACCRUED INCOME ...............................................................................................................153

7.5 PREPAID INCOME .................................................................................................................155

7.6 ACCRUALS AND PREPAYMENTS – FINANCIAL STATEMENTS EFFECT ..........................1577.6.1 The Income Statement..............................................................................................1577.6.2 The Statement of Financial Position .........................................................................158



CHAPTER 8: IRRECOVERABLE DEBTS AND ALLOWANCE FORRECEIVABLES ........................................................................................................171

8.1 ACCOUNTING CONCEPTS ...................................................................................................1728.1.1 Accruals concept.......................................................................................................1728.1.2 Prudence concept .....................................................................................................172

8.2 AGED RECEIVABLE ANALYSIS.............................................................................................1738.2.1 Advantages and Disadvantages of Selling on Credit................................................1748.2.2 Credit limits ...............................................................................................................174

8.3 IRRECOVERABLE DEBTS.....................................................................................................1748.3.1 Irrecoverable debts recovered ..................................................................................176

8.4 ALLOWANCE FOR RECEIVABLES .......................................................................................1778.4.1 Specific allowance ....................................................................................................1788.4.2 General allowance ....................................................................................................1788.4.3 Accounting for Allowance for Receivables ................................................................178

8.5 IRRECOVERABLE DEBTS AND THE ALLOWANCE FOR RECEIVABLES– TRIAL BALANCE ADJUSTMENTS. .....................................................................................184



CHAPTER 9: NON-CURRENT ASSETS AND DEPRECIATION ............................197

9.1 CURRENT AND NON-CURRENT ASSETS............................................................................198

9.2 CAPITALAND REVENUE EXPENDITURE ............................................................................1999.2.1 Capital expenditure ...................................................................................................1999.2.2 Revenue expenditure................................................................................................200

9.3 NON-CURRENT ASSET REGISTERS ...................................................................................200

9.4 ACCOUNTING FOR NON-CURRENT ASSETS.....................................................................201

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9.5 DEPRECIATION......................................................................................................................202

9.6 ESTIMATING DEPRECIATION...............................................................................................2039.6.1 Straight line depreciation ..........................................................................................2049.6.2 Reducing balance depreciation.................................................................................204

9.7 ACCOUNTING FOR DEPRECIATION....................................................................................207

9.8 DISPOSAL OF NON-CURRENT ASSETS..............................................................................210

9.9 DISPOSAL THROUGH A PART-EXCHANGE.........................................................................214

9.10 NON-CURRENT ASSETS AND THE FINANCIAL STATEMENTS..........................................217

9.11 SOME ADDITIONAL INFORMATION ON DEPRECIATION OF NON-CURRENT ASSETS...218


9.13 SOLUTIONS TO SELF- TEST QUESTIONS ..........................................................................221

CHAPTER 10: BANK RECONCILIATION STATEMENTS......................................233

10.1 NATURE AND PURPOSE OF BANK RECONCILIATION STATEMENTS..............................234

10.2 METHODOLOGY FOR PREPARING BANK RECONCILIATION STATEMENTS...................235

10.3 DETAILED DIFFERENCES BETWEEN THE BANK ACCOUNT ANDTHE BANK STATEMENT........................................................................................................237

10.4 PREPARATION OF A BANK RECONCILIATION STATEMENT..............................................24110.4.1 The Proforma for a bank reconciliation .....................................................................24210.4.2 The Proforma for a bank reconciliation with a Bank Overdraft .................................242

10.5 EXAMPLES OF BANK RECONCILIATIONS, INCLUDING AN OVERDRAFT. .......................243

10.6 BANK DEBIT AND CREDIT BALANCES IN THE STATEMENT OF FINANCIAL POSITION .250



CHAPTER 11: PREPARATION OF FINANCIAL STATEMENTS ............................259

11.1 FROM TRIAL BALANCE TO FINANCIAL STATEMENTS.......................................................260

11.2 THE INCOME STATEMENT....................................................................................................261

11.3 THE STATEMENT OF FINANCIAL POSITION.......................................................................262

11.4 SOLE TRADER ACCOUNTS..................................................................................................263

11.5 EXAMPLE 1: GINA O’HALLORAN..........................................................................................264

11.6 EXAMPLE 2: RORY JAMESON’S FINANCIAL STATEMENTS ..............................................268

11.7 EXAMPLE 3: T. HIGGINS (A MORE COMPLICATED EXAMPLE) .........................................274

CHAPTER 12: ACCOUNTING FOR “NOT-FOR-PROFIT” ORGANISATIONS......287

12.1 “NOT-FOR-PROFIT” ORGANISATIONS.................................................................................288

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12.2 THE RECEIPTS AND PAYMENTS ACCOUNT.......................................................................288

12.3 THE INCOME AND EXPENDITURE ACCOUNT ....................................................................289

12.4 ACCUMULATED FUND STATEMENT....................................................................................291

12.5 ANNUAL SUBSCRIPTIONS ...................................................................................................29212.5.1 Entrance fees............................................................................................................29412.5.2 Life membership subscriptions/payments.................................................................294

12.6 DIFFERENCES BETWEEN THE RECEIPTS AND PAYMENTS ACCOUNT AND THE INCOMEAND EXPENDITURE ACCOUNT............................................................................................297



CHAPTER 13: CONTROL ACCOUNTS & INTRODUCTION TO CONTROLACCOUNT RECONCILIATIONS .............................................................................309

13.1 NATURE AND PURPOSE OF CONTROLACCOUNTS .........................................................31013.1.1 Receivables ledger control account ..........................................................................31013.1.2 Payables ledger control account...............................................................................31013.1.3 The purpose of control accounts...............................................................................310

13.2 CONTROLACCOUNTS AND DOUBLE ENTRY..................................................................... 311

13.3 RECEIVABLES/SALES LEDGER CONTROLACCOUNTS....................................................31313.3.1 Explaining the Proforma Receivables Control Account.............................................31413.3.2 Applied Example of Receivables Control Account ....................................................316

13.4 PAYABLES/PURCHASES LEDGER CONTROLACCOUNTS................................................31713.4.1 Explaining the Proforma Payables Control Account .................................................31813.4.2 Applied Example of Payables Control Account.........................................................31913.4.3 Supplier statements ..................................................................................................320

13.5 INTRODUCTION TO CONTROLACCOUNT RECONCILIATIONS ........................................320

13.6 CONTROLACCOUNTS – THE STATEMENT OF FINANCIAL POSITION.............................323



CHAPTER 14: INCOMPLETE RECORDS ..............................................................333

14.1 INCOMPLETE RECORDS......................................................................................................334

14.2 NET ASSETS APPROACH .....................................................................................................334

14.3 THE BALANCING FIGURE APPROACH................................................................................33814.3.1 Deriving Sales – the missing figure...........................................................................34014.3.2 Deriving Purchases – the missing figure...................................................................34114.3.3 Deriving expenses – missing figures ........................................................................34314.3.4 Deriving Opening Capital ..........................................................................................348

14.4 MARGIN AND MARK-UP........................................................................................................34914.4.1 Gross Profit Margin ...................................................................................................349

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14.4.2 Gross Profit Mark-up.................................................................................................35014.4.3 When Mark-up is known, what is the Margin? ..........................................................35014.4.4 When Margin is known, what is the Mark-Up?..........................................................351

14.5 STEPS TO FOLLOW TO PREPARE FINANCIAL STATEMENTS FROM INCOMPLETERECORDS. .............................................................................................................................355



CHAPTER 15: CORRECTION OF ERRORS ..........................................................375

15.1 IDENTIFICATION OF ERRORS..............................................................................................37615.1.1 Types of errors and their impact on the Trial Balance...............................................37615.1.2 The effect of errors on the Statement of Profit. .........................................................377

15.2 ERRORS WHICH DO NOT AFFECT THE BALANCING OF THE TRIAL BALANCE .............37715.2.1 Error of omission.......................................................................................................37715.2.2 Error of commission ..................................................................................................38215.2.3 Error of principle........................................................................................................38415.2.4 Compensating errors ................................................................................................38715.2.5 Error of original entry ................................................................................................39115.2.6 Reversal of entries error ...........................................................................................394

15.3 CONTROLACCOUNT RECONCILIATION AND CORRECTION OF ERRORS.....................397



CHAPTER 16: SUSPENSE ACCOUNT ..................................................................415

16.1 SUSPENSE ACCOUNT ..........................................................................................................41616.1.1 Method employed to correct errors ...........................................................................418

16.2 IDENTIFYING ERRORS CAUSING THE CREATION OF THE SUSPENSE ACCOUNT.......41916.2.1 Same sided entry error .............................................................................................41916.2.2 Single sided entry error.............................................................................................42116.2.3 Transposition error ....................................................................................................422

16.3 EXAMPLE 5: CONTROLACCOUNT RECONCILIATION, WITH A SUSPENSE ACCOUNT..423

16.4 EXAMPLE 6: JOHN O’CONNOR’S TRIAL BALANCE............................................................426

16.5 ADJUSTMENT TO PROFIT ....................................................................................................433



INDEX.......................................................................................................................447

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FOREWORD

Foreword

This text has been developed by Accounting Technicians Ireland for use by students participatingin our programme of study and preparing for our examinations based on the syllabus publishedfor the Academic Year 2017-2018.

While every effort is made to ensure that the information outlined in this text is accurate, AccountingTechnicians Ireland cannot accept the responsibility for lack of, or perceived lack of, informationcontained herein.

The text is intended to be a sufficiently detailed synopsis of the current syllabus material (and knowledgelevel required thereof) in relation to this module.

Students should take particular note of the weighting attaching to this module, as clearly outlined in thesyllabus. It is on the basis of this weighting that students should prepare their own timetable for study.

This text also includes questions related to the topics for this module. These questions are part of alarger database of questions that students (and also lecturers) can access online for this subject. Thesequestions (and suggested solutions) are available through your “TouchPoint” portal in the MyRevisionarea.

We recommend that students refer to MyRevision having completed each chapter or a section of thismodule. This resource allows students to study and revise online through ‘self-test’ questions. Examstandard questions are also available here.

We also recommend students refer to the past exam papers for this module. These papers are publishedon our website (www.AccountingTechniciansIreland.ie) along with suggested solutions and commentsfrom the Examiner. Attempting these “under exam conditions” will help students to prepare for theexamination and plan their study time appropriately.

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Referencing

For the purposes of consistency, all references to “he” or “she” will be referred to as “he” in thispublication. No other implication whatsoever is implied from this policy.

For the purposes of presentation, all references to “euro” or “sterling” will be referred to as “euro” inthis publication. No other implication whatsoever is implied from this policy.

Copyright

This text is issued by Accounting Technicians Ireland to students taking its examinations. It may notbe used in whole, or in part, for any course of study and/or examination of any other body whatsoeverwithout prior permission in writing from Accounting Technicians Ireland. This publication, or any partthereof, may not be made available in any library, and it may not be reproduced, in whole or in part,stored in a retrieval system or transmitted in any form or by any means – photocopying, electronic,electrostatic, magnetic, pdf, mechanical, recording or otherwise, without prior permission in writingfrom Accounting Technicians Ireland, 47-49 Pearse Street, Dublin 2.

Acknowledgement

This edition was edited and updated by Dr. Antoinette Flynn. Antoinette is a lecturer in Accountingand Finance with the Department of Accounting and Finance, University of Limerick. Her profile isavailable at www.ul.ie.

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SYLLABUS: FINANCIAL ACCOUNTING

Module:Financial Accounting

Mandatory Module

SYLLABUS 2017-2018

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Syllabus : Mandatory Module

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Subject Status Mandatory

Terminal Exam 100%

Module Pass Mark 50%

Learning Modes Direct Lectures, Workshops, Online Tutorials, Self Directed Learning

Pre-requisite: Programme Entry requirements

Key Learning Outcome

The key objective of this module is to provide learners with knowledge of accounting concepts andprinciples of accounting and the technical competency in the area of double entry accounting andaccounts preparation for various types of business.

Key Syllabus Elements and Weightings

1. Accounting Fundamentals......................................................................................................15%

2. Double-Entry Bookkeeping and Accounting Systems ............................................................50%

3. Accounts Preparation .............................................................................................................35%

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Learning Outcomes linked to Syllabus Elements

Accounting Fundamentals (15%)

On completion of this aspect of the module, learners will have acquired the following knowledge,competencies and know-how: -

(a) An appreciation of, and an ability to, describe the function of and differences between financialaccounting and management accounting;

(b) An understanding of the different types of business entity and the accountant’s role in anorganisation;

(c) An ability to identify the various user groups which need accounting information and anappreciation of the characteristics of such information required to meet the objectives of eachuser group;

(d) An understanding of accounting terminology, basic accounting concepts and principles.

Double-Entry Bookkeeping and Accounting Systems (50%)

On completion of this aspect of the module, participants will have acquired the following knowledge,competencies and know-how:-

(a) A knowledge of the form and content of accounting records and the ability to record financialtransactions in the books of original entry;

(b) The ability to demonstrate an understanding of and use the double entry system of bookkeepingto prepare a trial balance;

(c) An understanding of the distinction between capital and revenue expenditure;

(d) An ability to understand, explain and use control accounts, bank reconciliation statements andsuspense accounts as part of the internal control of an organisation.

Accounts Preparation (35%)

On completion of this aspect of the module, participants will have acquired the following knowledge,competencies and know-how:-

(a) An appreciation and understanding of the key features of financial statements

(b) An ability to prepare financial statements for sole traders and ‘not for profit’ organisations

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MODULE: FINANCIAL ACCOUNTINGSpecific Functional Knowledge andCompetencies

Understanding Application Analysis

Accounting Fundamentals (15%)

Types of business entity

The business entity l l

Sole traders l l

Partnerships l

Limited companies l

Function of financial accounting and management accounting

Financial Accounting l l

Management Accounting l

Purpose of accounting information l l

Nature, principles and scope of accounting l l

Accountant’s role in an organisation

Accountant’s role and function in anorganisation

l l

Auditing l

Accounting terminology

Assets, liabilities, income, expenses l l

Drawings l l

Trade Receivables and Trade payables l l

Introduction to financial statements l l

Basic accounting concepts and principles

The accounting equation l l

Underlying assumptions, accruals basis,going concern

l l

Users of accounting information and their information needs

The objectives of financial statements l l

Users of accounting information and theirinformation needs

l l

The qualitative characteristics of accountinginformation

l

Ethical issues and responsibilities accruing

Ethical issues for the Accounting Technician l

Ethical issues for managers, accountantsand historical experience

l

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Specific Functional Knowledge andCompetencies


Double-entry Bookkeeping & Accounting Systems (50%)

Form and content of accounting records

Business transactions and the purpose ofaccounting records

l l

Source documentation l l

Books of original entry

Sales day book l l

Purchases day book l l

Sales returns day book l l

Purchases returns day book l l

Cash Book l l

Petty Cash l l

Journal l l

Ledger accounting and double entry

Nominal ledger l l

Double entry bookkeeping l l

Posting from day books to nominal ledger l l

Sales and purchases ledgers l l

Accounting for VAT l l

Irrecoverable VAT l l

Accounting for wages, PAYE and PRSI l l

Salaries/wages control accounts l l

Extraction of the trial balance l l

Distinction between capital and revenue expenditure

Explanation of capital and revenueexpenditure

l l

Impact of incorrect treatment l l

Control accounts

Understanding the purpose of controlaccounts

l l

Receivables control accounts l l

Payables control accounts l l

Contra entries l l

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Debit and credit balances at the beginningand end of an accounting period

l l

Bank reconciliation statements

Bank statements and the banking system l l

Identification of errors and omissions l l

Updating the bank account in the ledger l l

Preparation of bank reconciliationstatements

l l

Accounting for errors and suspense accounts

Correction of errors l l

Types of errors and their impact on the trialbalance

l l

Correction of errors and journal entries l l

Use of suspense accounts l l

Incomplete records

Net Assets approach l l

Balancing Figure approach l l

Margin & Mark-up l l

Preparing Financial Statements fromIncomplete Records

l l

Accounting for depreciation and disposal of assets

Non-current assets register l

Definition of depreciation l l

Calculation of depreciation using the straightline and reducing balance methods

l l

Ledger accounting entries for depreciation l l

Accounting for the disposal of non-currentassets

l l

Accounts Preparation (35%)

Key features of financial statements

Cost of goods sold l l

Accruals l l

Prepayments l l

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Discounts l l

Irrecoverable debts and allowances forreceivables

l l

Non-Current Assets l l

Depreciation using straight line method andreducing balance method

l l

Disposal of non-current assets l l

Accounting for inventory l l

Different valuation methods and their impacton reported profits

l l

Preparation of financial statements for sole traders

From the trial balance to financialstatements

l l

The Income Statement as part of the doubleentry system

l l

Layout of financial statements l l

Preparation of accounts for ‘not for profit’ organisations

Financial statements for clubs and societies l l

Receipts and payments accounts l l

Income and expenditure accounts l l

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Assessment Criteria

AssessmentTechniques

100% Assessment based on the final exam.

Format ofExamination Paper

The Paper Consists of SIX Questions which will examine all keysyllabus elements to ensure that learning outcomes are achieved

SECTION ATHREE Compulsory Questions

SECTION BTHREE Questions - Answer any TWO

All Questions carry equal marks

Sample paper Each of the 3 sample papers will examine appropriate parts of thissyllabus.

Essential Reading Financial Accounting

Author: Accounting Technicians Ireland

Web Resources www.AccountingTechniciansIreland.iewww.thepost.iewww.charteredaccountants.ie

Other Resources Business and Finance

Accountancy Ireland

Irish Times Business Section (Fridays)

Irish Independent Business Section (Thursdays)

Sunday Business Post

Financial Times

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CHAPTER 1: INTRODUCTION TO ACCOUNTING

CHAPTER 1

Introduction to Accounting

LEARNING OUTCOMES

On completion of this chapter students should be able to:

1. Understand and define accounting

2. Explain the different types of business entity

3. List the users of the financial statements and their information needs

4. Differentiate between Financial and Management accounting

5. Understand Accounting terminology

6. Explain the accountants role in an organisation

7. Explain Auditing

8. Understand Professional Ethics and the accountant

REVISION RESOURCES

EXAM QUESTIONS: Sample and Past papers are available from the website of AccountingTechnicians Ireland and are essential aids when studying Advanced Financial Accounting topics.

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Chapter 1 : Introduction to Accounting

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The objective of this module is to provide students with the knowledge to enable them to prepare a setof financial statements, for a sole trader. The purpose of financial statements is to provide informationabout the reporting entity’s performance and financial position in a useful manner for a wide range ofusers. It is important to note here that Financial Reporting Standard (FRS) 102 ‘The FRS Applicable inthe UK and Republic of Ireland’ is followed in this module.

The Financial Accounting syllabus (and this manual) has been written and will be examined underFinancial Reporting Standard (FRS) 102, the new Irish/UK generally accepted accounting practices(GAAP). This is an important point to note in advance of commencing this module. FRS 102 is largelybased on the International Accounting Standards Board’s (IASB) international financial reportingstandard for Small and Medium Enterprises (IFRS for SMEs), with modifications to address relevantcompany law and allow for extra accounting options. FRS 102 is available for use by Irish/UK unlistedgroups and listed or unlisted individual entities preparing financial statements that are intended to givea true and fair view. In other words, it may be applied by any entity that is not required to apply fullEU‑adopted IFRSs. Where an entity does not report under the Companies Act (i.e. an entity that isn’t alimited company), their financial statements are prepared in accordance with the requirements of FRS102. The presentation of financial statements in this case, cannot conflict with the statutory frameworkof the reporting entity.

As FRS 102 is within the IFRS umbrella, it is globally recognised as being fit for purpose and of highquality. This is good news for investors, shareholders and other stakeholders of Irish/UK businesses.The motivation for introducing FRS 102 is to enhance levels of transparency and consistency in financialreporting by businesses, thereby increasing overall business confidence. It is hoped that this will makeIreland/UK more attractive locations for inward investment whilst also assisting Irish/UK firms tradinginternationally. The table below charts the terminology difference between Companies Act (2014) andFRS 102.

Table 1: Terminology Differences between Companies Act (2014) and FRS 102.

Traditional terminology(Companies Act)

New UK/Irish GAAP-FRS 102

Profit and Loss Account Income Statement (under the two‑statement approach)orStatement of Comprehensive Income (under the single‑statement approach)*

Balance Sheet Statement of Financial Position

Statement of total recognisedgains and losses

Statement of Changes in Equity (can be combined with theIncome Statement)

Fixed Assets Non‑Current Assets

Stock Inventory

Debtors Trade Receivables

Creditors Trade Payables

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Traditional terminology(Companies Act)

New UK/Irish GAAP-FRS 102

Interest receivable and similarincome

Finance income/investment income

Interest payable and similarcharges

Finance costs

Allowance for doubtful debts(historically “Provision for BadDebts” or “Bad Debt Provision”)

Allowance for Receivables

Capital and reserves Equity

Tangible assets Property, Plant and Equipment as well as Investment Property

Profit and Loss Reserves Retained earnings

* The single statement approach includes the Income Statement and Statement of Changes in Equity being presented as onestatement.

1.1 INTRODUCTION

It is not easy to provide a concise definition of accounting since the word has a broad application withinbusiness. Accountancy or accounting is the art of communicating financial information about a businessentity to users such as the owners of the business and the government. The information is generally inthe form of financial statements that show in money terms the economic resources under the control ofmanagement. This chapter explores the concept of accounting, the different types of business entitiesand the users of these financial statements, in addition to their information needs. The key accountingconcepts and their importance in preparing financial statements will also be defined.

1.2 ACCOUNTING

Accounting can be defined as the process of identifying, measuring and communicating economicinformation to permit informed judgments and decisions by users of the information.

This definition suggests that accounting is about providing information to others. A key concept is thataccounting information is economic information – it relates to the financial or economic activities ofthe business or organisation. This definition implies that accounting information can be identified andmeasured. This is done by way of a set of accounts, based on a system of accounting known as double‑entry bookkeeping. The accounting system identifies and records accounting transactions (economicactivity).

However, the measurement of accounting information is not a straight forward process. It involvesmaking judgments about the value of assets owned by a business or liabilities owed by a business. It isalso about accurately measuring how much profit or loss has been made by a business in a particular

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period. Later in this module, it will become clear that the measurement of accounting information oftenrequires subjective judgment to come to a conclusion.

The definition identifies the need for accounting information to be communicated. The way in which thiscommunication is achieved may vary. There are several forms of accounting communication (e.g. annualreports and accounts, management accounting reports), each of which serve a slightly different purpose.The choice of communication channel is about understanding who are the users of the information andwhat are their information needs.

Accounting information is communicated using financial statements. The dual purposes of financialstatements are as follow:

1. To report on the financial position of an entity (e.g. a business, an organisation).

2. To show how the entity has performed (financially) over a particular period of time (an accountingperiod).

The most common measurement of financial performance is profit (broadly, income after paying variouscosts). Financial statements are explored in more detail later in the chapter.

1.3 ACCOUNTABILITY

Accountability is at the heart of accounting. Most organisations are externally accountable in some wayfor their actions and activities. They will produce reports on their activities that will reflect their objectivesand the people to whom they are accountable. The following table provides examples of different typesof organisations and how accountability is linked to their differing organisational objectives.

Organisations and Accountability

Organisation Objectives Accountable to – examples

Private/Public company(e.g. Tesco)

• Making a profit

• Creation of wealth

• Provide an adequate return oninvestment, given the risks

• Shareholders

• Other stakeholders(e.g. employees, suppliers)

Charities(e.g. Concern)

• Achievement of charitable aims

• Maximise spending on activities

• Charity commissioners

• Donors

Local authorities(e.g. Local County Council)

• Provision of local services • Government departments

All of the above organisations have a significant role to play in society and have multiple stakeholdersto whom they are accountable. All require systems of financial management to enable them to produceaccounting information.

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How does accounting information help businesses be accountable? As previously outlined in theintroductory definition, accounting is essentially an information process that serves several purposesand outcomes:

1. Provides a record of assets owned, amounts owed to others and monies invested.

2. Provides reports showing the financial position of an organisation and the profitability of itsoperations.

3. Helps management actually manage the organisation.

4. Enables potential investors to evaluate an organisation and make decisions.

There are five overall accounting information objectives that drive this process, described below.

1. Collection: Collection in money‑terms, of information relating to transactions that have resultedfrom business operations.

2. Recording and classifying: Recording and classifying data into a permanent and logical form.This is usually referred to as book-keeping.

3. Summarising: Summarising data to produce statements and reports that will be useful to thevarious users of accounting information – both external and internal.

4. Interpreting and communicating: Interpreting and communicating the performance of thebusiness to the management and its owners.

5. Forecasting and planning: Forecasting and planning for the future operation of the businessby providing management with evaluations of the viability of proposed operations. The keyforecasting and planning tool is the budget.

The management process by which accounting information is collected, reported, interpreted and actedon, is called Financial Management. In preparing accounting information, care should be taken to ensurethat the information presents an accurate and true reflection of the business performance and position.To impose some order on what is a subjective task, accounting has adopted certain conventions whichshould be applied in preparing accounts (all of which will be explored later in this module).

For financial accounting, the kind of financial information prepared and presented is governed by theInternational Financial Reporting Standards (IFRS) for publically listed companies and governed byGenerally Accepted Accounting Practices (GAAP) for other businesses.

The UK Financial Reporting Council (FRC) has changed Irish/UK GAAP by issuing new FinancialReporting Standards, FRS 100, FRS 101, FRS 102 and FRS 105.

• FRS 100 = ‘Application of Financial Reporting Requirements’, sets out rules and guidance onhow to select the appropriate accounting framework for a particular entity or group.

• FRS 101 = ‘Reduced Disclosure Framework’, introduces a new reduced disclosure frameworkenabling most subsidiaries and parents to use the recognition and measurement bases of IFRSsin their individual entity financial statements, while being exempt from a number of disclosuresrequired by full IFRSs.

• FRS 102 = ‘The FRSApplicable in the UK and Republic of Ireland’, is the main financial reportingstandard which replaces current Irish/UK GAAP. It also includes disclosure exemptions for certainqualifying entities.

• FRS 105 = ‘The Financial Reporting Standards applicable to the Micro‑entities Regime’ is afinancial reporting standard for incorporated micro entities, as defined in UK Company Law. Whileit is modelled on FRS 102, it simplifies the legal requirements for incorporated micro entities, tobetter serve their simpler nature and smaller size.

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FRS 100 sets out the new financial reporting framework as follows (Table 2):

Table 2: FRS 100 explained: Reporting options under the new Irish/UK GAAP

Reporting Entity New Irish/UK GAAP

Small Entity in Ireland(correct at time of printing)

Option of Financial Reporting Standard for Small Entities (FRSSE)or Financial Reporting Standard (FRS) 102

Micro Entity in the UK only(correct at time of printing)

Financial Reporting Standard (FRS) 102 Section 1A

Incorporated Micro Entity inthe UK only(correct at time of printing)

FRS 105 ‘The Financial Reporting Standards applicable to theMicro‑entities Regime’.

Small Entity in UK(correct at time of printing)

Financial Reporting Standard (FRS) 102

Non listed company FRS 102 (Reduced disclosure for parents and subsidiaries)

Listed company EU‑adopted International Financial Reporting Standards (Reduceddisclosure for parents and subsidiaries)

In recognition that small and very small (known asmicro) entities could be overburdened when complyingwith FRS 102, amendments were made to FRS 102 in Section 1Aand FRS 105 ‘The Financial ReportingStandards applicable to the Micro‑entities Regime’ was introduced in July 2015. The amendments toFRS 102 in Section 1A accommodate these ‘micro entities’, as a result of the EU directive 2012/6/EU of the European Parliament and of the Council (aka the Micros Directive). This new section andthe introduction of FRS 105 has made the FRSSE (Financial Reporting Standard for Smaller Entities)redundant and it is being withdrawn.

While these amendments to FRS 102 and FRS 105 are fully available to UK micro entities, there hasbeen a delay in Ireland as the Irish Companies (Accounting) Bill 2016 is still in the process of beingdebated in the Seanad, at the time of printing. Under UK legislation and the forthcoming Irish legislation,a micro entity is defined as a business that does not exceed two or more of these three criteria:

1. Turnover of £632,000 or €700,000,

2. Total Net Assets of £312,000 or €350,000,

3. Ten employees.

The new section in FRS 102 limits the burden on micro entities by requiring them to produce just twofinancial statements (the Income Statement and the Statement of Financial Position). The Statement ofRecognised Gains and Losses and the Cashflow Statement are not required for micro entities. It shouldbe noted that the terminology used in FRS 102 Section 1A is consistent with the rest of FRS 102, hencethe adoption of Income Statement and the Statement of Financial Position in this text and module.

Financial reporting standards are applied by businesses through their Accounting Policies, which will beaddressed in chapter 2. The next section examines the different types of business entity and outlinestheir respective advantages and disadvantages.

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1.4 TYPES OF BUSINESS ENTITY

A business can be organised in one of several ways:

• Sole Trader – a business owned and operated by one person.

• Partnership – a business owned and operated by two or more people.

• Company – a business owned by its shareholders and operated by its directors, who are notnecessarily the same people.

1.4.1 Sole trader

The simplest form of business is the sole trader; a sole trader is a business that is owned by one person.It may have one or more employees. It offers the least personal protection. Under law, a sole traderand the business are the same legal entity. Essentially, the sole trader and his business are one andthe same thing – the sole trader is personally liable if his business is sued or owes any money, i.e. hisliability is unlimited. Becoming a sole trader can be risky as the entrepreneur will be liable to repay thebusiness’s debt from his personal wealth if necessary. Profits from the business are considered incomeand are taxed accordingly; essentially, the sole trader is treated as self‑employed for tax purposes.

The main advantages of setting up as a sole trader are:

• Total control of the business by the owner.

• Cheap and easy to start‑up ‑ there are less forms to fill in and to start trading, the sole trader doesnot need to employ any specialist services, other than setting up a bank account and informingthe tax authorities.

• Keep all the profit – as the owner, all the profit belongs to the sole trader.

• Business affairs are private – competitors cannot see what the business is earning, so will knowless about how the business works and how it succeeds.

• No obligation to produce a set of published financial statements.

The legal requirements of a sole trader are to:

• Keep proper business accounts and records for the Revenue Commissioners (who will collect thetax on profits) and if necessary VAT accounts.

• Comply with legal requirements that concern the protection of the customer (e.g. Sale of Goodsand Supply of Services Act).

The main disadvantages of being a sole trader are:

• Unlimited Liability – A sole trader is liable for any debts that the business incurs. This means thatany money that the owner has put into the business could be lost, but most importantly, if thebusiness continues to incur further costs then the owner has to pay these as well. In some casesthey may have to sell some of their own possessions to pay suppliers. Such a risk often putspotential sole traders off setting up businesses, and also makes them consider the other forms ofbusiness structure.

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• As a result of the sole trader and the business being the same legal form, the sole trader is taxedbased on income tax not corporation tax. Corporation tax rates are more favourable than incometax rates.

• It can be difficult to raise finance. Because they are small, banks may not lend large sums ofmoney to sole traders who may be unable to avail of other forms of long‑term finance unless theychange their ownership status.

• It can be difficult to enjoy economies of scale, i.e. lower costs per unit due to higher levels ofproduction.Asole trader, for instance, may not be able to buy in bulk and enjoy the same discountsas larger businesses.

• There is a problem of continuity if the sole trader retires or dies – what happens to the business?

The reasons for being a sole trader are often a balance between business and personal costs andbenefits.

1.4.2 Partnership

A partnership is a business where there are two or more owners of the enterprise. Most partnershipsare between two and twenty members though there are examples, like accountancy firms and solicitorsfirms, where there are more partners.

A partnership is normally set up using a Deed of Partnership. This contains:

• Amount of capital each partner should provide (i.e. starting capital).

• How profits and losses should be divided.

• How many votes each partner has (usually based on the proportion of capital invested).

• Rules on how to take on new partners.

• How the partnership is brought to an end, or how a partner leaves.

In the absence of this deed of partnership, the Partnership Act of 1890 (amended in 1907) will apply toavoid any disputes in the future. The Limited Partnership Act of 1907 encompasses the UK, Scotlandand Northern Ireland. It provides a legal framework for Republic of Ireland partnerships. The act statesthat:

• No interest is paid on capital of the partners.

• No remuneration is paid to partners for acting in the business.

• Profits and losses are to be shared equally between partners.

• A finance cost at the rate of 5% per annum is paid on loans made by the partners to the partnershipin excess of their agreed capitals.

The main advantages of a sole trader becoming a partnership are:

• It spreads the risk across more people, so if the business gets into difficulty then there are morepeople to share the burden of debt.

• Partners may bring money and resources to the business (e.g. better premises to work from).

• A new partner may bring other skills and ideas to the business, complementing the work alreadydone by the original partner.

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• Partnership increases credibility with potential customers and suppliers – who may see dealingwith the business as less risky than trading with just a sole trader.

For example, a builder, working originally as a sole trader, may team up with an architect or carpenterto form a partnership. Either would bring added expertise, but also might bring added capital and/or contacts. Of course the builder could team up with another builder as well – sharing the risk, andpotentially the workload.

The main disadvantages of becoming a partnership are:

• Having to share the profits.

• Less control of the business for the individual.

• Disputes over workload.

• Problems if partners disagree over the direction of the business.

The next step for a partnership is to move towards becoming a private limited company. However somepartnerships do not want to move to this stage.

The advantages of remaining a partnership rather than becoming a private limited company are:

• It costs money to set‑up a limited company (may need to employ a solicitor/accountant to set upthe paper work).

• Company accounts are filed so the public can view them (and competitors).

• Additional cost of an auditor to check the accounts before they are filed.

When a partnership finishes, depending on how the Deed of Partnership is set up, each partner has anagreed portion of the business. Partnership accounts are not examinable in the Financial Accountingexamination.

1.4.3 Limited Company

ALimited Company is a business that is owned by its shareholders, run by directors andmost importantlyits liability is limited. There can be one shareholder or many thousands of shareholders. Shareholdersare also known as members. Each shareholder owns part of the company. As a group they select thedirectors who run the business. Directors often own shares in the company, but not all shareholdershave to be directors.

Limited Liability means that investors can only lose the money they have invested and no more. Thisencourages people to finance the company, and/or set up such a business, knowing they can onlylose what they have put in, if the company fails. For people or businesses who have a claim againstthe company, limited liability means that they can only recover money from the existing assets of thebusiness. They cannot claim the personal assets of the shareholders to recover amounts owed by thecompany.

A Limited Company has to possess a separate legal entity from its shareholders, meaning that thecompany is seen as separate from its shareholders. To set up a limited company, a company has toregister with the Registrar of Companies, who maintains a separate file for every company, and is issuedwith a Certificate of Incorporation. It also needs to have a Constitution that sets out what the company

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has been formed to do, and internal rules including what the directors can do and voting rights of theshareholders.

The distinguishing factor that differentiates a limited company from a sole trader and a partnership is thata limited company has to prepare annual “statutory accounts”; this is the price to be paid for the benefitof limited liability. Limited companies must produce such accounts annually and may have to appointan independent person to audit and report on them depending on certain size criteria. Once prepared,a copy of the accounts must be sent to the Registrar of Companies which maintains a separate file forevery company. The file for any company can be inspected at the Companies Registration Office for anominal fee by a member of the general public. This is why the statutory accounts are often referred toas the published accounts.

The advantages of a limited company can be summarised as follows:

• Limited liability.

• Separate legal entity.

• The company’s trading profits are taxed at the corporation tax rate of 12.5% in Ireland, whichis considerably lower that the top personal income tax rate of 41%, paid by sole traders andpartnerships.

• The company’s name is protected, as two companies cannot have a similar name.

• The company continues despite the death or resignation of management and members.

• The interests and obligations of management are defined.

• Appointment, retirement or removal of directors is straightforward.

• It is easier to procure new shareholders and investors.

• A larger number of investors can own the company than, say, partners in a firm.

• The members’ rights are usually comprehensively defined in the memorandum and articles ofassociation.

The disadvantages of a limited company can be summarised as follows:

• Initial costs of registering a company name with the Companies Registration Office.

• Additional administration costs related to the annual preparation and submission of an ‘annualreturn’, to the Registrar of Companies, according to statutory requirements. Fees and otherpenalties apply if companies don’t comply.

• Companies must hold an Annual General Meeting (AGM) within 18 months of incorporation andthereafter on an annual basis (must be an AGM in each calendar year). There are exemptions forsingle member companies.

• A Corporation Tax Return must be made every year and if the company is VAT Registered, VATReturns must be made every two months.

• Every company whose turnover exceeds Euro €7.3 million must prepare and file audited financialstatements with the Companies Registration Office.

• The potential separation of ownership and control which requires additional corporate governancemechanisms within the company, to monitor internal management.

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1.4.4 Public and Private Limited Companies

Limited companies are governed very tightly, namely through the Companies Acts. Limited companiescan either be private limited companies1 or public limited companies. The difference between the two isthat shares in a Public Limited Company (PLC) can be traded on the Stock Exchange and be bought bymembers of the general public. Shares in a Private Limited Company are not available to the generalpublic.

A private limited company may wish to become a PLC because shares in a private limited companycannot be offered for sale to the general public, thereby restricting the availability of finance, especiallyif the business wants to expand. Therefore, it can be attractive to change status. It is also easier to raisemoney through other sources of finance, e.g. from banks. It is important to note that a “PLC” does notnecessarily mean that the company is quoted on the Stock Exchange. In order to have a listing on theStock Exchange, the company must undergo a flotation or Initial Public Offering (IPO).

Flotation or Initial Public Offering (IPO)

A company may float on the stock market. This means selling all or part of the business to outsideinvestors. This generates additional funds for the business and can be a major form of fundraising.When shares in a “PLC” are first offered for sale to the general public the company is given a “listing”on the stock exchange. This is called an Initial Public Offering (IPO).

The advantages of being a public limited company (PLC) are:

• Better access to financial resources to support growth objectives i.e. raising share capital fromexisting and new investors.

• Better liquidity – shareholders are able to buy and sell their shares (if they are quoted on a stockexchange).

• Large PLCs may find it easier to borrow from banks.

• The value of the firm is readily shown by the market capitalisation (based on the share price).

• Companies can more easily acquire other firms – e.g. by offering shares to the shareholders ofthe target firm.

• Going public gives a company a more prestigious profile.

The disadvantages of being a public limited company (PLC) are:

• Costly and complicated to set up as a PLC – The business owners need to employee specialistbankers and lawyers to help organise the converting to the PLC.

• Certain financial information must be available for all parties, competitors and customers included(this publication of financial information risks attracting further competition and arming existingcompetitors).

• Shareholders in public companies expect a steady stream of income from dividends, which mightmean that the business has to concentrate on short term objectives of creating profit, whereas itmight be better to work on longer term objectives, such as growth and investment.

1 A private company limited by shares is a “LTD”. In the Republic, the Companies Act 2014 introduced a “DAC” as a new typeof company. The distinctions between DACs and LTDs are not relevant to the Financial Accounting module and are exploredelsewhere.

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• The threat of takeover, as another company can buy up a large number of shares because sharesare traded publicly (can be sold to anyone). If they buy enough, they can then persuade othershareholders to join with them to vote in a new management team.

The reasons shareholders buy share are as follows:

• Shares sometimes pay dividends to the shareholders, which is a share of the profits at the end ofthe year. Companies on the Stock Exchange usually pay dividends twice each year.

• Over time the value of the share might increase and can be sold for a profit – this is known as a“capital gain”. Of course, the price of the shares can go down as well as up, so investing in sharescan be risky.

• If they have enough shares they can influence the management of the company. A good exampleis a “venture capitalist” that will often buy up to an average of between 10% to 50% of the sharesof a company and insist on choosing some of the directors.

Separation of Ownership and Control and the need for Corporate Governance

As a business becomes larger, the ownership and control of the business may become separated.This is because the shareholders may have the money, but not the time or management skills to runthe company. Therefore, the day‑to‑day running of the business is entrusted to the directors, who areemployed for their skills, by the shareholders. This agency relationship between the shareholders andthe directors is referred to as Corporate Governance.

The shareholders are therefore “divorced” from the running of the business for 364 days of the year.They will have their say at the Annual General Meeting (AGM) of the company, where the directorspresent the accounts and the results. In practice directors tend to have at least a modest shareholding inthe company. This provides the director with an incentive to achieve good dividends and capital growthfor the share (an increase in the share price).

NOTE: Company accounts are not examinable in the Financial Accounting examination.

In summary for all three types of entity, the money invested by the individual, the partners or theshareholders, is referred to as the business capital. In the case of a company, this capital is divided intoshares (Share Capital).

1.5 USERS OF ACCOUNTING INFORMATION

There are many potential users of accounting information, including shareholders, lenders, customers,suppliers, government departments (e.g. Revenue), employees and their organisations, and society atlarge. Anyone with an interest in the performance and activities of an organisation is traditionally calleda stakeholder.

For a business or organisation to communicate its results and position to stakeholders, it needs alanguage that is understood by all in common. Hence, accounting has come to be known as the languageof business. There are two broad types of accounting information and two broad groups of informationusers:

1. Financial Accounting: geared towards external users of accounting information.

2. Management Accounting: geared more at internal users of accounting information.

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Although there is a difference in the type of information presented in financial andmanagement accounts,the underlying objective is the same – to satisfy the information needs of the user. These needs can bedescribed in terms of the overall accounting information objectives stated in section 1.3.

1.6 USERS OF FINANCIAL STATEMENTS

It is easy to assume that the only users of accounting information are shareholders – since it is arequirement of company law that shareholders must receive financial statements. However, in reality

there are many users of accounts. The following subsections summarises the main users groups andprovides examples of their areas of interest in accounts.

1.6.1 Investors

Investors are concerned about risk and return in relation to their investments. They require informationto decide whether they should continue to invest in a business. They also need to be able to accesswhether a business will be able to pay dividends, and measure the performance of the business’management team.

The key accounting information for an investor is therefore:

• Information about growth, sales, volumes.

• Profitability (profit margins, overall level of profit).

• Investment (amounts invested, assets owned).

• Business value (share price).

• Comparative information of competitors.

1.6.2 Lenders

Banks and loan stockholders who lend money to a business require information that helps themdetermine whether loans and finance costs will be paid when due.

The key accounting information for lenders is therefore:

• Level of existing debt

• Cash flow.

• Security of assets against which the lending may be secured.

• Investment requirements in the business.

1.6.3 Suppliers

Suppliers and trade payables require information that helps them understand and assess the short‑termliquidity of a business. For example is the business able to pay short‑term debt when it falls due?

The key accounting information for suppliers is therefore:

• Cash flow.

• Management of working capital.

• Payment policy.

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1.6.4 Customers

Customers and trade receivables require information about the ability of the business to survive andprosper. As customers of the company’s products, they have a long‑term interest in the company’srange of products and services. They may even be dependent on the business for certain products andservices.

The key accounting information for customers is therefore:

• Sales growth.

• New product development.

• Investment in the business (e.g. production capacity).

1.6.5 Employees

Employees (and organisations that represent them – e.g. trade unions) require information aboutthe stability and continuing profitability of the business. They are very interested in information aboutemployment prospects and the maintenance of pension funding and retirement benefits. They are alsolikely to be interested in the pay and benefits obtained by senior management.

The key accounting information for employees is therefore:

• Revenue and profit growth.

• Levels of investment in the business.

• Overall employment data (numbers employed, wages and salary costs).

• Status and valuation of the company pension schemes/levels of company contributions.

1.6.6 Government

There are many government agencies and departments that are interested in accounting information.For example, the Revenue Commissioners need information on business profitability in order to levyand collect Corporation Tax. Customs and Excise need accounting information to verify Value AddedTax (VAT) returns; local government need similar information to levy local taxes and rates. Variousregulatory agencies (i.e. the Environment Agency) need information to support decisions about grants,for example.

1.6.7 Analysts

Investment analysts are an important user group – specifically for companies quoted on the StockExchange. They require very detailed financial and other information in order to analyse the competitiveperformance of a business and its sector. Much of this is provided by the detailed accounting disclosuresthat are required by authorities such as the London Stock Exchange. However, additional accountinginformation is usually provided to analysts via informal company briefings and media interviews.

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1.6.8 Public at large

Interest groups, formed by various individuals who have a specific interest in the activities andperformance of businesses, will also require accounting information, e.g. resident committees wherethe business is located in a residential area.

1.7 TYPES OF ACCOUNTING

As stated earlier there are two broad types of accounting information, financial and managementaccounting.

Financial Accounting is geared towards external users of accounting information. External usersare, as discussed above, investors, creditors, debtors, lenders and the government.

Such reporting is usually accomplished through the preparation and presentation of financial statements.In order to facilitate comparison, financial accounts are prepared using accepted accounting conventionsand standards. FRS 102 helps to reduce the differences in the way business entities draw up theirfinancial statements. The financial statements are public documents, and therefore they will not revealdetails about product profitability.

Management need much more detailed and up‑to‑date information in order to control the business andplan for the future.

Management accounting is geared towards internal users of accounting information. Internal usersare, as discussed above, management and employees.

Such reporting is accomplished through custom designed reports. Management accounts provideinformation to enable costing products and production methods, assessing profitability and so on. Inorder to facilitate this, management accounts present information in any way which may be useful tomanagement, for example by operating unit or by product line.

Management accounting is an integral part of management activity concernedwith identifying, presentingand interpreting information used for:

• Formulation of strategy.

• Planning and controlling activities.

• Decision making.

• Optimising the use of resources.

Students will study Management Accounting as a complete subject in Second Year. The table belowoutlines a comparison of the branches of accounting.

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Financial and Management Accounting Compared

Branches of Accounting Financial Accounting Management Accounting

Purpose Production of summaryfinancial statements forexternal users.

Production of detailed accounts, usedby management to control the businessand plan for the future.

Frequency Prepared annually. Normally prepared monthly.

Stimulus Required by law. To aid management decision making ‑not required by law

Focus of information Reflects pastperformance andcurrent position.

Includes budgets and forecasts of futureactivities, as well as reflecting pastperformance.

Framework Information is calculatedand presented inaccordance with strictlegal and accountingrequirements.

Information is computed and presentedin order to be relevant to managers.

Although there is a difference in the type of information presented in financial and managementaccounting, the underlying objective is the same – to satisfy the needs of the user. The users of financialand management accounting are summarised in diagram below.

Figure: Users of Accounting Information

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1.8 THE MAIN FINANCIAL ACCOUNTING STATEMENTS

The purpose of financial accounting statements is mainly to show the financial position of a business at aparticular point in time and to show how that business has performed over a specific period. Under FRS102, there are three financial accounting statements prepared to achieve this aim: the ComprehensiveIncome and Income Statement, the Statement of Financial Position and the Statement of Cash Flows.

UnderFRS102, three typesof other comprehensive incomeare recognisedaspart of total comprehensiveincome, outside of profit or loss, when they arise:

(i) some gains and losses arising on translating the financial statements of a foreign operation,

(ii) some actuarial gains and losses,

(iii) some changes in fair values of hedging instruments.

On balance, sole traders are less likely to report these types of comprehensive incomes, and in order tofacilitate the key objectives of this module, this manual will focus solely on the Income Statement.

For Financial Accounting purposes in this module, the two2 main financial accounting statements thathelp to achieve this aim are:

1. An Income Statement for the entire reporting period.

2. A Statement of Financial Position at the end of the reporting period.

The Income Statement provides a perspective on a longer time‑period. The detail of what financialtransactions took place in a particular period – and (most importantly) what the overall result of thosetransactions was. It provides details of the financial performance of the business within a specificaccounting period. Not surprisingly, the Income Statement measures profit or loss.

What is profit?

Profit is the amount by which sales revenue (also known as “turnover” or “income”) exceedsexpenses (“or costs”) for the period being measured.

By contrast, the Statement of Financial Position shows at a particular point in time what resources areowned by the business (assets) and what it owes to other parties (liabilities). It also shows how muchhas been invested in the business and what the sources of that investment finance were.

It is often helpful to think of a Statement of Financial Position as a snap‑shot of the business – a pictureof the financial position of the business at a specific point. Whilst this is a useful picture to have, everytime an accounting transaction takes place, the snap‑shot picture will have changed.

2 Note that preparation of the Statement of Cash Flows is outside the scope of the syllabus of this module and is included aspart of the curriculum for the next financial accounting module, ‘Advanced Financial Accounting’.

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1.9 ACCOUNTING TERMINOLOGY

Reporting to the owners and user groups is done by means of financial statements, primarily the IncomeStatement and the Statement of Financial Position. The study of these financial statements introducesthe student to a new set of vocabulary. It is important to familiarise oneself with the basic terminology, inadvance of studying the other detailed chapters on accounting in this manual.

An Income Statement will show a profit or loss earned for the accounting period for which the reportwas prepared, it is a performance statement. This report shows two forms of profit as follows:

Gross profit is the difference between revenue/sales and the cost of making the product or service.

Net profit is calculated by subtracting the total expenses of a business (including cost of sales) from itsrevenue/sales.

Sales – the exchange of goods and services for money, this includes both cash and credit sales.

Purchases – buying goods for resale or consumption, this includes both cash and credit purchases.

Income – a more general term than sales including also interest received (known as finance incomeunder FRS 102) and Rental income (previously known as rent received) from letting part of the businesspremises.

Expenses – An expense is any cost of doing business resulting from revenue‑generating activities.They are the cost of carrying on a trade or business. There are two main types of costs:

• Costs of purchases for resale, which are included in the cost of sales of the trading account.

• Other costs such as wages, rent and light and heat.

We will be exploring these concepts in detail in later chapters.

The Statement of Financial Position is a statement of position at the end of the accounting period. Itrepresents the financial position of a business at a defined point in time. It lists the assets and liabilities,including the capital invested by the owner/owners, of the business at that time.

Assets

In business and accounting, assets are economic resources owned by the business or company. Anasset is anything of value that the business owns – including cash. Assets get recorded in the Statement

of Financial Position in terms of their monetary value. There are current assets, which can be readilyturned into cash within a twelve month period (e.g. inventory, receivables, bank, cash) and non currentassets which the business owns and uses in the business for economic benefit (e.g. Land & Buildings,Motor Vehicles, Premises, Computers and Fixtures & Fittings). Thus anything that belongs to thebusiness or is due to the business is an asset of that business.

Liabilities

Anything a business owes to people or businesses other than its owners is considered a liability. There

are two types of liability, current liabilities, whichmust be paid within a year (e.g. payables, Bank overdraft)and Non‑Current Liabilities, which are debts that extend beyond one year (e.g. Long‑term loans).

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Owners’ equity

Owners’ equity, also called capital, is any debt owed to the business owners. For example, if anentrepreneur invested €50,000 to start a business, the amount recorded is recorded in a capital account,in the Statement of Financial Position.

Drawings

Drawings mean any money or goods taken out of the business for the owners own personal use (soletrader’s drawings). These are shown in the accounts but are not treated as a business expense, insteadthey are treated as a reduction to capital in the Statement of Financial Position. Drawings can be in theform of assets, stock or cash withdrawals.

Receivables

Receivables are customers who owe money to the business as a result of credit sale transactions, thegoods have been sold with payment terms being specified on the invoice. We treat these as currentassets as we anticipate getting paid for these goods within the next twelve months.

Payables

Payables are suppliers who the business owes money to as a result of credit purchase transactions, thebusiness has purchased goods on credit, only to pay for them at a later date (within the payment termson the invoice). We treat these as current liabilities as we anticipate paying for these goods within thenext twelve months.

1.10 THE ACCOUNTANT’S ROLE AND FUNCTION IN AN ORGANISATION

It is the primary role of the accountant to support financial and management accounting reporting in thebusiness. As discussed earlier in this chapter, accounting objectives can be described as the process ofcollecting, recording, presenting and analysing/interpreting financial information for the users of financialstatements. Accounting refers to the process of book‑keeping that are involved in making the financialstatements. This is a very important process in an organisation.

Book‑keeping is the process of recording the financial effect of business transactions and managingsuch records. This book‑keeping process is the primary role of the accountant, to ensure that allbusiness transactions are recorded correctly in the financial statements, in addition to ensuring thatthe transactions have been accounted for in compliance with the appropriate accounting rules andprinciples. Once the transactions have been recorded it is then the role of the accountant to interpret andcommunicate these results to the senior management structure of the organisation.

Accordingly, the accountant’s role in the organisation can be analysed as follows:

1. Preparation and presentation of timely accurate financial/management accounts to managementto help management interpret the financial information.

2. Identification of areas of inefficiency and wastages of resources in the business.

3. Treasury functions: The accountant also plays the role of the treasury functions in such a way thatthey raise finance, cash management, etc.

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4. Setting up an effective system of internal and accounting controls.

5. Preparation of feasibility reports: These reports assist management in assessing the viability/profitability or otherwise of proposed capital expenditure such as the opening of a new factory orbranch.

6. Investigation of the performance/operations of competing business organisations to assistmanagement in policy formulation.

7. Investigation of fraud within the organisation, this is a key role of the accountant in preparation ofan audit at year‑end.

8. The accountant assists the organisation to avoid rather than evade tax by using his/her knowledgeof the tax laws. (Tax evasion is illegal.)

1.11 AUDITING

What is auditing?

Auditing is the process by which something is examined with a view to an opinion being formed.

The definition most widely used within the profession is that put forward by the Auditing Practices Board– ‘independent examination and expression of opinion’. This allows others to gain assurance that someinformation, or a process, can be trusted. Prior to Limited Liability the owners of a business were fullyliable for losses or damage they caused. In the 18th century, the concept of Limited Liability was bornand as a result Legislation was needed:

• To protect interests of non‑participants

• To force stewards/directors to account for the results. The need for Auditing therefore derives fromthe need for trust/confidence in the information/process under consideration.

Owners ≠ Directors

Directors are appointed by the Shareholders to act on their behalf and have a fiduciary duty (must act inGood Faith). Directors are responsible for stewardship of assets but also are required to prepare regularreports on the effectiveness of that stewardship. Hence a conflict of interest arises and an independentexpert is employed to check the accuracy of this report. External Audits are typically required yearly bylaw.

External Audit

Company law requires the directors of a company to prepare a set of financial statements at the endof each financial year. These financial statements are primarily produced for shareholders and otherstakeholders and have the aim of informing users as to the financial health of the company. Stakeholdersrely upon the information presented to them in a set of financial statements to make economic decisionsregarding the company for example should additional funds be invested in the company. Importantdecisions are therefore made based upon the information presented in a set of financial statements.The issue then arises as to how a shareholder/user of financial statements knows that the informationcontained in the financial statements can be relied upon.

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The provision of this assurance to shareholders as a group is the fundamental role of an external auditor.An external auditor is an accountant from an independent firm of registered auditors who examines thefinancial statements and the books and records of a company in order to form an opinion. That opinionis whether the financial statements prepared by the company directors:

1. Comply with IFRSs as adopted by the European Union.

2. Have been properly prepared in accordance with the Companies Act 2014 (Republic of Ireland) andthe Companies Act 2006 (United Kingdom).

3. And overall whether the financial statements give a true and fair view of the state of the company’saffairs at the period end and of the company’s profit and cash flows for the period then ended.

But why can stakeholders not just rely on the information provided to them in a set of financial statementsby the directors?

Shareholders are the owners of the company yet unless a significant shareholding is held, shareholdersare not likely to have any involvement in the day to day running of the company. Instead this is delegatedto the board of directors. The board of directors of a company is charged with running the companyon a day to day basis on behalf of shareholders and with safeguarding the assets of the company.Therefore there exists within most public limited companies a separation of ownership (shareholder)and control (directors). Further the interests of shareholders and directors may not be aligned. Theinterest of directors can tend to be more short term in nature than that of shareholders.

Shareholders elect the directors at the annual general meeting, the directors then run the companyon behalf of the shareholders. The remuneration packages of company directors tend to be linked tothe achievement of objectives, e.g., achieving a certain profit/share price level in the next three years.Accordingly, as a director’s remuneration is linked to the achievement of objectives (and these tend tobe short‑term in nature), this may lead to a situation whereby directors can become overly focused onthe short‑term performance of the company as opposed to the long term performance. Such scenariosprovide an example of how the interests of shareholders and directors can become misaligned.

Further, as directors are essentially employed by shareholders and report to shareholders through thefinancial statements, this can lead directors towards having a bias towards portraying the best financialpicture possible in the financial statements. Shareholders tend to use the information contained in thefinancial statements along with share price information to judge how effective the board of directors is.

The issues outlined above have highlighted the needs of shareholders for objective confirmation thatthe financial statements, prepared by a board of directors are reliable and present a picture of thefinancial affairs of the company that is true and fair. This assurance is obtained by shareholders throughengaging an independent audit firm. The independent audit firm will examine the books and records ofthe company and the financial statements. The external auditor will then form an opinion as to the truthand fairness of the financial statements. In forming this opinion the auditor will examine whether:

• The books are records of the company are appropriately maintained

• The provisions of company law have been followed

• Relevant financial reporting standards have been applied

• Any judgements made by the company directors and whether these judgements appearreasonable.

This is the manner in which the external audit gives reasonable assurance to shareholders and why,despite the cost of undertaking one, they are required for many companies.

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Internal Audit

The internal audit function exists normally within large public limited companies. The prime functionof the internal audit department is to act as a monitor and appraiser of the processes, tasks, policiesand actions that combined, contribute to the operational, compliance and financial internal controlenvironment within a company. The internal audit department will examine the internal controls withinan organisation to help determine if they are operating efficiently and effectively. The internal controlfunction will also usually perform spot checks upon group companies to ensure that the internal controlsthat should be in place, are actually in place, and are being adhered to. The internal audit departmenttherefore plays an important role in helping directors discharge their responsibility for the prevention anddetection of fraud and error. Thus a key difference between external and internal audit is that internalaudit cannot be thought of as independent in the same manner as external audit as internal auditors areemployees of the company they audit.

1.12 ACCOUNTING ETHICS

Accounting ethics is primarily a field of applied ethics, the study of moral values and judgements asthey apply to accountancy. It is an example of professional ethics. Ethics in accounting is of utmostimportance to the accounting profession and those who rely on their services. Accounting professionalsknow that people use their services, especially decision makers using their financial statements, andthese decision makers expect them to be highly competent, reliable and objective. Those who work inthe field of accounting must not only be well qualified but also possess a high degree of professionalintegrity.

The general ethical standards of society, apply to people in professions such as medicine and accountingas much as to anybody else. However, society places even higher expectations on accountants. Peopleneed to have confidence in the quality of the complex services provided by accountants. Because ofthese high expectations, accountants have adopted a code of ethics, also known as codes of professionalconduct. These ethical codes call for their members to maintain a level of self‑discipline that goesbeyond the requirements of laws and regulations.

Due to a diverse range of accounting services and recent corporate collapses, attention has beendrawn to ethical standards accepted within the accounting profession. These collapses have resultedin a widespread disregard for the reputation of the accounting profession. To combat the criticism andprevent fraudulent accounting, various accounting organisations and governments have developedregulations and remedies for improved ethics among the accounting profession.

1.13 ACCOUNTING SCANDALS

Accounting ethics has been deemed difficult to control as accountants and auditors must considerthe interest of the public (which relies on the information gathered in audits) while ensuring that theyremain employed by the company that they are auditing. They must consider how to best apply financialreporting standards even when faced with issues that could cause a company to face a significant lossor even be shut down. Due to several accounting scandals within the profession, critics of accountantshave stated that when asked by a client “what does two plus two equal?” the accountant would belikely to respond “what would you like it to be?”. This thought process along with other criticisms of theprofession’s issues with conflict of interest, have led to various increased standards of professionalismwhile stressing ethics in the work environment.

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From the 1980’s to the present there have been multiple accounting scandals that were widely reportedby themedia and resulted in fraud charges, bankruptcy protection requests, and the closure of companiesand accounting firms. One of the most widely reported violation of accounting ethics involved ENRON,a multinational company, which for several years had not shown a true and fair view of their financialstatements. Their Auditor Arthur Andersen, an accounting firm considered one of the “Big 5” at the time,signed off on the validity of the accounts despite the inaccuracies in the financial statements. Whenthe unethical activities were reported, not only did Enron dissolve but Arthur Anderson also went out ofbusiness. Enron’s shareholders lost US$25billion as a result of the company bankruptcy. Although onlya fraction of Arthur Anderson’s employees were involved in the scandal, the closure of the firm resultedin the loss of 85,000 jobs.

A 2007 article in Managerial Auditing Journal determined the top nine factors that contributed to ethicalfailures for accountants based on a survey of 66 members of the International Federation ofAccountants.The factors include (in order of the most significant): “self-interest, failure to maintain objectivity andindependence, inappropriate professional judgement, lack of ethical sensitivity, improper leadership andill-culture, failure to withstand advocacy threats, lack of competence, lack of organisational and peersupport, and lack of professional body support”. The main factor, self‑interest, motivates an accountantto act in his/her best interest or when facing a conflict of interest. For example, if an auditor has an issuewith an account that he or she is auditing, but is receiving financial incentives to ignore these issues, theauditor may act unethically.

1.14 RESPONSES TO SCANDALS

Since the major accounting scandals, new reforms and calls for increased higher education have beenintroduced to combat the dangers of unethical behaviour. By educating accountants on ethics beforeentering the workforce, such as through higher education or initial training at companies, it is believed itwill help to improve the credibility of the accounting profession. Companies and accounting organisationshave expanded their assistance with educators by providing education materials to assist professors ineducating students.

New US regulations such as the Sarbanes‑Oxley Act of 2002 (The UK and Ireland follow the CombinedCode of Corporate Governance), limit the level of work which can be carried out by accounting firms. Inaddition, the Act put a limit on the fee which a firm can receive from one client as a percentage of theirtotal fee. This ensures that accounting firms are not over reliant on one client for its income, in the hopethat they do not need to act unethically to keep a steady income.

1.15 ETHICAL ISSUES AND THE ACCOUNTING TECHNICIAN

Ethics in accounting is of utmost importance to accounting professionals and those who rely on theirservices. Accounting professionals know that people who use their services, especially decision makersusing financial statements, expect them to be highly competent, reliable and objective. Those whowork in the field of accounting must not only be well qualified but must also possess a high degree ofprofessional integrity.

People need to have confidence in the quality of the complex services provided by accountants andaccounting technicians. Because of these high expectations, accountants have adopted a code ofethics, also known as Codes of Professional Conduct. These ethical codes call for their members tomaintain a level of self‑discipline that exceeds the requirements of laws and regulations.

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1.15.1 Codes of ethics

By joining professional organisations, like Accounting Technicians Ireland and CIMA, accountants andaccounting technicians agree to uphold the high ethical standards of their profession.

Independence can sometimes be an issue for accountants. Maintaining integrity and objectivity callsfor avoiding both actual and apparent conflicts of interest. Being independent in fact and in appearancemeans that one not only is unbiased, impartial, and objective but also is perceived to be that way byothers. While applying to all accounting professionals, independence is especially important in the auditprofession, to ensure that he or she has no interest or ties to the company that they are auditing. Thefollowing is an example of applications of an ethical code of conduct:

• Professional and honest behaviour

• Respect for others, both clients and fellow employees

• Responsible corporate citizenship.

1.16 WHISTLE BLOWING

A whistle blower is a person who alleges misconduct in the workplace and it covers all methods ofreporting by employees of any criminal practices within their organisation. Whistle blowers make theirallegations internally (for example, to other people within the accused organisation) or externally (to lawenforcement agencies, to the media or to groups concerned with the issues). This practice may causediscontent in the work place as it involves a clash between loyalty and confidentiality.

Whistle blowing is linked to ethical behaviour because it represents a person’s understanding that anaction in his/her organisation is harmful – that it interferes with people’s rights or is unfair or detractsfrom the common good. Whistle blowing also calls upon virtues, especially courage, as standing upfor principles can be a punishing experience. Even though laws (e.g. the Protected Disclosures Act2014 in the Republic of Ireland, and the Public Interest Disclosure (Northern Ireland) Order 1998) aresupposed to protect whistle blowers from retaliation, people who feel threatened may feel forced out ofthe organisation.

Self-test questions:

1. Define accounting and discuss accounting information objectives?

2. Discuss the advantages and disadvantages of being a Limited Company?

3. Distinguish between the following items on the Statement of Financial Position:

a. Current and Non‑current Assets

b. Receivables and Payables

4. Discuss the role of the accountant in an organisation?

5. Define auditing and distinguish between an external and internal audit?

6. Comment on the importance of ethical behaviour for an accountant?

Solutions to self-test questions:

1. Refer to sections 1.2 and 1.3 of this chapter.

2. Refer to section 1.4.3 of this chapter.

3. Refer to section 1.9 of this chapter

4. Refer to section 1.10 of this chapter.


6. Refer to sections 1.12 to 1.16 of this chapter.

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PRACTICE QUESTIONS

The following questions examine the key areas the student is expected to know for this particular subject.These questions will assist the student significantly while preparing for examinations. You should alsoreview the questions available through MyRevision in your TouchPoint portal. Sample Papers for thissubject can be downloaded from www.AccountingTechniciansIreland.ie

Question 1 (ref: 1778)

Distinguish between Financial Accounting and Management Accounting. (5 marks)


‘Lenders’ are likely to be most interested in which of the following pieces of information infinancial statements?

(a) Security of assets against which the lending may be secured

(b) VAT returns for the last year

(c) Status and valuation of the company pension schemes/levels of company contributions

Question 3 (ref 2434)

With regard to the preparation of statutory financial statements, which of the followingstatements is true?

(a) They are presented in a manner that is determined by the needs of the internal users of thatinformation.

(b) They reflect past performance and current position.

(c) They are prepared on a monthly basis.

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CHAPTER 2: ACCOUNTING CONCEPTS & CONVENTIONS

CHAPTER 2

Accounting Concepts &Conventions

LEARNING OUTCOMES

On completion of this chapter students should be able to:

1. Explain the role of financial reporting standards and legislation

2. Explain and apply the basic principles of accounting

3. Discuss the need to provide a true and fair view

4. Define the term accounting policies

5. Distinguish between accounting policies, estimation techniques and measurement basis

6. Explain and discuss accounting policies and their objectives

REVISION RESOURCES

EXAM QUESTIONS: Sample and Past papers are available from the website of AccountingTechnicians Ireland and are essential aides when studying Financial Accounting topics.

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Chapter 2 : Accounting Concepts & Conventions

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2.1 INTRODUCTION

As discussed is chapter 1, there are many users of financial statements. While they may have differentareas of interest in financial statements, each group has a common requirement of that information: thatfinancial information should be relevant, reliable, comparable and understandable. Without a system toensure these common characteristics, preparers of financial statements would be able to adopt whateveraccounting approaches (policies) they chose. This means that it would be impossible for users to assessthe performance of an entity in a meaningful way. It would also be impossible to compare the financialstatements of different entities.

In addition, preparers of financial information might deliberately attempt to present an inaccurate pictureof the entity’s performance and position. Therefore, a common approach adopted by the majority ofbusiness entities would provide that basis of certainty and comparability. A common approach hasbeen developed over time through self-regulation by the accounting profession (in the form of financialreporting standards and in particular the introduction of FRS 100, FRS 101 and FRS 102) and throughnational and international laws (Companies Acts and EU Directives).

2.2 REGULATION AND STANDARDS

The most important sources of regulation are self-regulation, national and EU law. The accountingprofession, the government and the EU have produced, and continue to produce, regulations that setout how information is shown in the financial statements. Specifically, the accounting profession hasgenerated a set of financial reporting standards that stipulate how accounting information is preparedand presented; standards are continually developed and refined to retain their relevance to reality ofeconomic transactions (in particular FRS 102). These standards are based on a number of accountingconventions and concepts, explained in Section 2.6.

2.3 PROFESSIONAL SELF-REGULATION

The overall aim of professional regulation is to ensure that the financial statements are prepared inaccordance with Financial Reporting Standards (FRS), which are regulated by the Financial ReportingCouncil, FRC. According to the FRC, the key purpose of financial statements is to provide informationabout the financial position, performance and changes in the financial position of businesses that is usefulto a wide range of users. Further information (disclosure notes) accompanies the financial statements toaddress what specific financial reporting standards were followed to calculate specific figures.

What are financial reporting standards?

Financial reporting standards are a set of rules and guidelines, issued by a body formed within theaccounting profession, governing the preparation and presentation of all financial statements thatpurport to show a “true and fair view”.

The single coherent standard FRS 102 has replaced the patchwork of Irish/British GAAP accountingstandards, for accounting periods commencing on or after January 1, 2015. FRS 102 is largely based

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on the International Accounting Standards Board’s (IASB)1 IFRS for SMEs, with modifications to addresscompany law and allow for extra accounting options. However, unlike the IFRS for SMEs, FRS 102can be used by financial institutions (as defined in FRS 102) and includes a number of disclosurerequirements for financial institutions in relation to their use of financial instruments. FRS 102 has manyadvantages including a substantial reduction in disclosure requirements (approximately 80% whencompared to full IFRSs); simpler recognition and measurement rules; and the removal of irrelevanttopics, such as earnings per share and options.

However, while financial reporting standards may refer to company law, they themselves are not law.The Companies Act(s), does require large companies to state that their financial statements havebeen prepared in accordance with applicable financial reporting standards. Importantly, non-corporatebusinesses such as sole traders and partnerships do not have the same constraints, but tend to followstandards (in particular FRS 102) anyway as the owners of the business still require reliable information.

2.4 COMPANIES ACTS

The Companies Acts require that every company produces financial statements to the shareholders atregular intervals. They lay down detailed requirements concerning the presentation of company accountsand the disclosure of financial information. The legislation also requires that financial statements show a“true and fair view”. Although students are required to have an awareness of the role of the CompaniesActs in financial accounting, it is not necessary to account for limited companies in this FinancialAccounting module. Both financial reporting standards and the Companies Acts refer to the notion of a“true and fair view” of the economic transactions of firms. This core notion deserves further exploration.

2.5 A TRUE AND FAIR VIEW

In drawing up financial statements, whether they are external (financial accounts) or internally focused(management accounts), a clear objective is that the accounts fairly reflect the true substance of thebusiness and the results of its operation. The theory of accounting has, therefore, developed the conceptof a “true and fair view”. The “true and fair view” is applied to the financial statements to assess whetheraccounts do indeed portray accurately the business’ activities.

What is the ‘true and fair’ view?

“True and fair” is a legal concept and ultimately its meaning may be decided by the courts. However,there is no legal definition of “true and fair”.

The meaning of “true and fair” may change over time. What was true and fair twenty years ago mightnot be true and fair today. This is because generally accepted accounting practice (GAAP) changes inresponse to changes in the business environment. The recent introduction of FRS 102 and its treatmentof financial instruments is a case in point (i.e. financial derivatives are now required to be fair valued and

1 The International Accounting Standards Board (IASB) is the independent standard-setting body of the International FinancialReporting Standards (IFRS) Foundation. IFRS, developed by the IASB, are high quality, understandable, enforceable andglobally accepted reporting standards based upon clearly articulated principles.

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shown on the Statement of Financial Position). Ultimately, financial statements prepared in accordancewith all applicable accounting principles and regulations will normally give a “true and fair” view.

Businesses often state that their accounts show a “true and fair view” of their financial performance(profit or loss) during the accounting period and their financial position (assets and liabilities) at theperiod end. As stated above, a limited company’s financial statements are required by law to show a“true and fair view”. Sole traders and partnerships will normally wish their financial statements to showa “true and fair view”, although this is not a legal requirement. This is because financial information isnot useful otherwise.

To support the application of the “true and fair view” of business transactions, the accounting professionhas adopted certain concepts and conventions which help to ensure that financial information ispresented accurately and consistently. These conventions and concepts are the foundation upon whichfinancial reporting standards are built. Significantly, accounting conventions and concepts provideguidance to businesses when there are a number of alternative accounting options available. The nextsection explains these accounting concepts and conventions in detail.

2.6 THE BASIC PRINCIPLES OF ACCOUNTING: CONVENTIONS ANDCONCEPTS

Accounting principles are conventions or accepted practice which apply generally to transactions. Theseaccounting principles have been developed by accountants over time. They can be used to determinethe following:

• which assets and liabilities are recorded on a Statement of Financial Position,

• how assets and liabilities are valued,

• what income and expenditure is recorded in the Income Statement,

• the value of income and expenditure recorded.

Next, the accounting conventions and accounting concepts are explored in greater detail.

2.6.1 Accounting conventions

Historical cost

The historical cost accounting system is a system of accounting in which all values are based on thehistorical costs incurred. The figure shown in the financial statements for an item is the value of theitem when the transaction occurred, not a current market value. For example, a property is shown inthe financial statements at its original cost, not at a value that the property could be currently sold for.Although this may not show a true value of the business, it is at least objective, in that the original costof the property is fact. Any current market valuations would be based on opinions of the various valuersand thus would be subjective. In practice, although most assets and liabilities are held at historic cost,some businesses might “revalue” certain non-current assets, especially land and buildings, to a currentvalue.

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The other conventions (monetary measurement, business entity and materiality) in a set of accountscan be summarised as follows:

Monetary measurement

Accountants do not account for items unless they can be quantified in monetary terms, every recordedevent or transaction is measured in terms of money. Items that are not accounted for (unless someoneis prepared to pay something for them) include things like workforce skill, morale, market leadership,brand recognition and quality of management.

Business Entity

Financial Accounting information relates only to the activities of the business entity and not to thepersonal activities of its owners. The business accounts are prepared as though the business is anentity that is separate from its owner. Sole traders and partnerships are not legally separate from itsowners. For example, a sole trader is liable for the debts of the business and his or her own personalassets must be sold to meet them if the business does not have sufficient resources. Even so, foraccounting purposes, the business is regarded as being a separate entity and accounts are drawn upfor the business separately from the trader’s own personal financial dealings.

In contrast, a limited company is a separate legal entity distinct from its owners. A company can enterinto legal contracts in its own right. If it becomes insolvent, the owners are only liable for the sum thatthey have invested. Note: The preparation of the accounts for a limited company is not part of thismodule (Financial Accounting), although the principles discussed throughout the chapter are the samefor any type of business.

Materiality

Materiality is a threshold quality that is demanded of all information in the financial statements. Financialstatements should separately disclose items that are significant (material) enough to affect decisionsmade by the users. The understandability (clarity) of the financial statements is improved if onlysignificant (material) items are included. If immaterial information is included in the financial statements,users may not be able to interpret the picture given by the accounts as a whole or may miss genuinelyimportant items.

What is and what is not significant will differ from organisation to organisation. For example, supposethat a sale of €200 has been recorded in error as a sale of €2,000.

• If the total sales are €20m, the error will not affect a user’s overall view of the business’sperformance given by the Income Statement (as it is not material).

• If total sales are only €20,000, the error is material. If it is not corrected the Income Statement willbe misleading.

2.6.2 Accounting concepts

Five important accounting concepts underpin the preparation of any set of accounts:

Dual aspect

Dual aspect may be stated as “for every debit, there is a credit”. Every transaction should have a twosided effect to the extent of the same amount. This concept has resulted in the Accounting Equation

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which we will fully explore in Chapter 3, it states that at any point of time the assets of any entity mustbe equal (in monetary terms) to the total of the owner’s capital and outsider’s liabilities. This may beexpressed as:

Assets = Capital + Liabilities

The duality concept underpins double entry and the Statement of Financial Position and this will beexamined in detail in Chapter 3.

Going Concern

Financial transactions are usually prepared on the assumptions that the business will continue inoperational existence for the foreseeable future (usually 12 months). This means that the financialstatements are drawn up on the assumption that there is no intention or necessity to close down thebusiness.

If the financial statements are not prepared on the going concern basis then they must be prepared onwhat is known as the break-up basis. The break-up basis reflects the following:

• Some non-current assets may be sold at less than their value on the Statement of FinancialPosition, whilst a machine may have a use for a specific business, it may be scrap or no use toother businesses.

• In contrast, property may be sold for a value in excess of that shown in the Statement of FinancialPosition based on original cost.

• If the entire inventory is sold at once then it will not be sold for as much money as if it were soldin the normal way.

• Some receivables may decide not to pay the business if it is known the business is about to gointo liquidation.

In most cases financial statements are prepared on a going concern basis.

Consistency

A business should be consistent in its accounting treatment of similar items, both within a particularaccounting period and between one accounting period and the next. For example, similar items ofexpenditure should not be treated as capital items and included as non-current assets one year, thenas revenue items deducted from profit another year. Users of accounts can, therefore, make moremeaningful comparisons of financial performance from year to year. Where accounting policies arechanged, companies are required to disclose the fact and explain the impact of the change.

Prudence

In conditions of uncertainty, a cautious approach should be taken, so that gains and assets are notoverstated and losses and liabilities are not understated. This means that:

• Sales and profit should not be included in the Income Statement until the cash has been receivedor that there is reasonable certainty that the cash will be received.

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• In contrast, losses should be recognised in the Income Statement as soon as they are foreseenand considered reasonably certain.

For example, inventory should always be valued at the lower of cost or net realisable value. Net realisablevalue (NRV) is the estimated selling price less costs to complete and sell. This normally results ininventory being valued at cost. If NRV is greater than cost and the goods were valued at NRV, then thebusiness would be recognising profit on the sale before it has been earned. But if NRV is less than cost,the goods are valued at NRV, i.e. the expected loss on the eventual sale of the goods is recognisedimmediately.

Matching or “Accruals”

Income is recognised in the financial statements as it is earned, not when the cash is received.Expenditure is recognised as it is incurred, not when it is paid for. When income is incurred over time(e.g. rental/finance income) or expenditures are time-based (e.g. rent payments), the income andexpenditure recognised in the Income Statement should relate to the time period, not to the receipts andpayments of cash.

Offsetting

Assets and liabilities are not permitted to be offset nor income and expenses, unless permitted by FRS102. However, allowances for bad debts and inventory are not regarded as offsetting. Similarly thenetting off of book values against the proceeds on selling an asset in order to calculate a profit or losson disposal is not regarded as offsetting.

2.6.3 The conflict between accruals and prudence concepts

There are instances where the accruals concept and the prudence concept conflict. For example, theprudence concept says that a sale should only be recognised when the cash is received or its receiptis reasonably certain. Accruals, on the other hand, states that a sale is recognised as earned when thetransaction takes place, which is before the cash is received.

The argument is resolved by the words, “reasonably certain”. These allow the operation of the accrualsconcept within the boundaries of prudence because a sale on credit is legally enforceable and thereforethe cash receipt is reasonably certain. Preparers should aim for a “neutral” or “objective” view of events,which is neither too optimistic nor too pessimistic.

2.7 WHAT MAKES ACCOUNTING INFORMATION USEFUL?

Useful accounting information is information that is relevant, reliable, comparable and understandablefrom the perspective of the users of that accounting information. That perspective is taken intoconsideration when business entities have to decide which of two or more accounting policies oraccounting estimation techniques to adopt. Business entities judge the appropriateness of accountingpolicies to their particular circumstances, by considering whether the resultant information is useful tousers. In addition to applying the guiding principles of accounting conventions and concepts in suchscenarios, business entities also consider six key qualitative characteristics of accounting information,which have been identified as markers of usefulness. There is general agreement that, in order to satisfy

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the needs of various user groups, accounting information should demonstrate these characteristics, aslisted in table below.

Key Characteristics of Financial Accounting Information

Characteristic Brief Explanation

RelevanceAccounting information must assist a user to form, confirm or maybe revise aview.

ReliabilityAccounting information should be truthful, accurate, complete (nothingsignificant missed out) and capable of being verified (e.g. by a potentialinvestor).

ComparabilityUsers of accounting information should be able to make performancecomparisons over time and also compare similar companies in the sameindustry group.

UnderstandabilityAccounting information is expressed with clarity, in such a way that it will beunderstandable to users.

ObjectivityAccounting information should be prepared and reported in a “neutral” way. Inshort, it is not biased towards a particular user group or vested interest.

TimelinessInformation should be provided within the decision time frame, as unduedelays may cause the information to lose its value. This requires managementto achieve a balance between relevance and reliability of financial information.

Balance betweenbenefit and cost

The benefits derived from financial information should exceed the cost ofproviding it.

Substance overform

Transactions and other events should be reported in accordance to theirsubstance and not merely their legal form (enhancing reliability).

CompletenessInformation in the financial statements should be complete within the boundsof materiality and cost.

The FRC developed these qualitative characteristics of information in financial statements to serveas a guide to resolving accounting issues not addressed directly in a financial reporting standard.Most of these qualitative characteristics of accounting information are enshrined in the FRS 102. It isa conceptual framework that sets out the concepts that underlie the preparation and presentation offinancial statements for external users. Secondly, it is intended to be relevant to the financial statementsof profit-oriented entities, including public sector profit-oriented entities, regardless of their size. Finally,this conceptual framework is not itself a financial reporting standard nor can it override the requirementsof any existing financial reporting standard.

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What is a conceptual framework?

A conceptual framework is a coherent system of interrelated objectives and fundamental principles;it is a framework which prescribes the nature, function and limits of financial accounting and financialstatements.

There are a variety of arguments for having a conceptual framework. It enables financial reportingstandards to be developed in accordance with agreed principles. As transactions become more complexand businesses become more sophisticated, it helps preparers and auditors of accounts to deal withtransactions which are not the subject of an accounting standard. Finally, it strengthens the credibilityof financial reporting and the accounting profession. Ultimately, the conceptual framework sets out theconcepts that underlie the preparation and presentation of financial statements. It identifies principlesfor the IASB to use when it develops and revises IFRSs. The UK Financial Reporting Council is one ofthe contributing bodies to the development of the conceptual framework.

[Note: This is the approach taken in the UK and Ireland (FRC), and by the IASB.]

The following is examinable under the Financial Accounting syllabus in relation to theFramework for the Preparation and Presentation of Financial Statements.

2.8 A FRAMEWORK FOR THE PREPARATION AND PRESENTATION OFFINANCIAL STATEMENTS

Following on from chapter 1, the objective of financial statements is to provide information about thereporting entity’s financial performance (Income Statement), financial position (Statement of FinancialPosition) and cash flows of an entity that is useful to a wide range of users in making economicdecisions. Financial statements do not provide all the information needed by users (the users of financialstatements have been discussed in detail in chapter 1). Financial statements do however provide aframe of reference against which users can evaluate the more specific information they obtain from othersources. How then does the ‘Framework for the Preparation and Presentation of Financial Statements’[referred to as the Framework, hereafter], affect the financial statements? Initially, the Framework setsout the underlying assumptions of financial statements:

• Accruals basis, an accounting concept previously discussed in section 2.6.2.

• Going concern basis, another accounting concept previously discussed in section 2.6.2.

In deciding what should be included in financial statements, when it should be included and how it shouldbe presented, the aim of the Framework is to ensure that financial statements yield useful information.According to the Framework, financial information is useful, as discussed earlier in the chapter, if it is:

• Relevant,

• Reliable,

• Comparable,

• Understandable.

These qualitative characteristics are explained below, in the context of their application in the Framework.

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2.9 RELEVANCE

Information is relevant if it has the ability to influence the economic decisions of users and is providedin time to influence those decisions. Materiality is a component of relevance. Information is material ifits omission or misstatement could influence the economic decisions of users. Timeliness is anothercomponent of relevance. To be useful, information must be provided to users within the time period inwhich it is most likely to bear on their decisions.

2.10 RELIABILITY

Information is reliable when:

• It can be depended upon to present a true and fair view,

• It is free from bias,

• It is free from material error,

• It is complete,

• In conditions of uncertainty, a degree of caution (i.e. prudence) has been applied in exercisingjudgement and making the necessary estimates.

2.11 COMPARABILITY

Users must be able to compare financial statements of an entity over time to identify trends in financialperformance and position. Users must also be able to compare the financial statements of differententities to evaluate their relative financial performance and financial position.

Preparers of accounts must also observe the consistency concept (discussed earlier). They must alsodisclose the accounting policies adopted in the financial statements.

2.12 UNDERSTANDABILITY

Information is understandable if users are able to appreciate its significance. Understandability dependson:

• The way in which the effects of transactions and other events are classified,

• The way in which information is presented,

• The capabilities of users.

It is assumed that users have a reasonable knowledge of business and economic activities and arewilling to study the information provided with reasonable diligence.

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2.13 CONFLICTS IN THE QUALITATIVE CHARACTERISTICS OFACCOUNTING INFORMATION

These characteristics sometimes run counter to each other. Examples of where conflicts exist betweenthese qualities are shown below.

Relevance versus Reliability

Information that is relevant may not be reliable and vice versa. For example, we have already seen thatan asset can be valued either at its original (historic) cost or at its current value. Current value probablyprovides more relevant information, but historic cost is more reliable, because it is less subjective.

Suppose that an entity has a significant amount owing from a customer and it is not certain that it will bepaid. The entity could delay preparing its financial statements until the customer either pays the amountowing or refuses to pay. By that time the accounts would be more reliable, but less relevant becausethey would be out of date.

Neutrality versus Prudence

Reliable information should possess both these qualities. Neutrality means freedom from bias, butprudence may result in bias. Prudence seeks to ensure that, where there is uncertainty, profits andassets are not overstated while losses and liabilities are not understated.

Relevance versus Understandability

Information that is relevant and reliable may be difficult for some users to understand. In these situations,the entity must find a trade-off, or compromise, that maximises the usefulness of the information in thefinancial statements by:

• Where there is a conflict between relevance and reliability it is usually appropriate to use theinformation that is most relevant of whichever information is reliable.

• There is also a need to balance the cost of providing information with the likely benefits to usersof providing it.

To summarise, the Framework provides the guiding principles for firms to produce useful accountinginformation, which accurately reflects the economic reality for that firm (a true and fair view) within theregulatory boundaries. The accounting choices that the individual firm makes in order to demonstrate atrue and fair view of its businesses activities, are known as its accounting policies.

2.14 ACCOUNTING POLICIES

Accounting policies are those principles, bases, conventions, rules and practices applied by an entitythat specify how the effects of transactions and other events are to be reflected in its financial statementsthrough:

(i) Recognising,

(ii) Selecting measurement basis for, and

(iii) Presenting,

assets, liabilities, gains, losses and changes to capital. Accounting policies do not include estimationtechniques.

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For example, an accounting policy for a particular type of expenditure may specify whether an asset ora loss is to be recognised; the basis on which it is to be measured; and where in the Income Statementor Statement of Financial Position it is to be recognised.

2.15 ESTIMATION TECHNIQUES

Estimation techniques are the methods adopted by an entity to arrive at estimated monetary amountsfor assets, liabilities, gains, losses and changes in capital. An accounting policy specifies the basis onwhich an item is to be measured, and where there is uncertainty over the money value corresponding tothat basis, an estimation technique is used to arrive at that money value.

For example, a company’s accounting policy is to set up an allowance for receivables. The method usedto estimate the amount of the allowance is the estimation technique applied. Another example is that ofdepreciation; the accounting policy is that a business depreciates its non current assets.

The accounting estimate is the method and rate of depreciation used, e.g. 15% straight line.

2.16 MEASUREMENT BASES

All of the elements of financial statements – assets, liabilities, revenues, expenses and change in capitalstructure have to be measured.

Possible measurement bases for assets could include:

• Cost,

• Net realisable value (the estimated selling price less costs to complete and sell),

• Replacement cost,

The measurement bases an entity adopts are part of its accounting policies. Any material change in ameasurement bases is thus a change in an accounting policy.

2.17 SELECTING ACCOUNTING POLICIES

The principles of selection are as follows:

• Accounting policies should be selected in such a way as to ensure the financial statements showa ‘true and fair view’.

• Accounting policies should be consistent with the requirements of financial reporting standardsand companies legislation (if applicable).

• Accounting policies should be selected so as to provide users of the financial statements withuseful information.

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2.18 REVIEWING AND CHANGING ACCOUNTING POLICIES

An entity should review its accounting policies regularly to ensure that they remain the most appropriate.However, frequent changes to accounting policies would impair the comparability of the financialstatements and this should not occur unless this is completely necessary. At this point, it is useful todiscuss in a little more detail the relevant financial reporting standard for this module, FRS 102. FRS102 is one of 4 financial reporting standards introduced by the Financial Reporting Council (FRC), theUK’s independent regulator responsible for promoting high quality corporate governance and financialreporting. This introduction changed the Irish and British Generally Accepted Accounting Practices(GAAP) by simplifying the disclosure requirements of all non-listed entities.

• FRS 100 = Application of Financial Reporting Requirements,

• FRS 101 = Reduced Disclosure Framework,

• FRS 102 = The FRS Applicable in the UK and Republic of Ireland.

• FRS 105 = The FRS for incorporated micro entities, currently applicable in the UK only.

In short, FRS 102 simply permits all non-listed companies to adopt the new standard. This marksa transition to an international framework for financial reporting intended to be cost-effective andproportionate to the needs of smaller entities.

To summarise FRS 102, this financial reporting standard:

• Identifies the qualitative characteristics underlying the financial statements.

• Requires financial statements, excluding cash flow information, to be prepared using the accrualbasis of accounting.

• Describes financial position as the relationship between assets, liabilities and equity.

• Describes performance as the relationship between income and expenses. Income encompassesboth revenue and gains, whereas expenses include both expenses and losses.

• Defines basic elements of financial statements as well as the concepts for recognition andmeasurement.

• Identifies the limited circumstances in which assets and liabilities, or income and expenses, canbe offset.

Financial statements that comply with FRS 102 should include an explicit and unreserved statement ofcompliance. In extremely rare circumstances when departure is required to maintain fair presentation,additional disclosures have to be provided.

There are three sections of FRS 102 that relate to the Financial Accounting syllabus: Section 10:Accounting Policies, Estimates and Errors, Section 13: Inventories, and Section 17: Property, Plantand Equipment. Thus far, this chapter has reviewed the regulatory influences on accounting, developedthe accounting conventions, concepts and characteristics and discussed accounting policies withoutreference to individual sections in FRS 102. FRS 102, Section 10: Accounting Policies, Estimates andErrors warrants further discussion as a lot of this chapter directly relates to this section.

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2.19 FRS 102, SECTION 10: ACCOUNTING POLICIES, ESTIMATES ANDERRORS

FRS 102, section 10 explains the criteria required for selecting and changing accounting policies; andsets out the accounting treatment and disclosures required for changes and corrections to estimates orerrors. Essentially, it sets out the principles to be followed by an entity in selecting its accounting policies.In particular, this section identifies a number of accounting concepts as important in the selection ofaccounting policies. These are selectively discussed here.

In section 10, the financial reporting standard requires that an entity’s management shall use itsjudgement in developing and applying an accounting policy that results in information that is:

(a) relevant to the economic decision-making needs of users; and

(b) reliable, in that the financial statements:

• represent faithfully the financial position, financial performance and cash flows of the entity;

• reflect the economic substance of transactions, other events and conditions, and not merelythe legal form;

• are neutral (objective), i.e. free from bias;

• are prudent; and

are complete in all material respects

This section also discusses the consistency of accounting policies chosen. It advises managers toselect and apply its accounting policies consistently for similar transactions, other events and conditions,unless an FRS or FRCAbstract specifically requires or permits categorisation of items for which differentpolicies may be appropriate. When an entity makes changes to accounting policies, it is advised only todo so when the change is:

(a) is required by an FRS or FRC Abstract; or

(b) it results in the financial statements providing reliable and more relevant information about theeffects of transactions, other events or conditions on the entity’s financial position, financialperformance or cash flows.

The section also outlines situations which are not changes in accounting policies:

(a) the application of an accounting policy for transactions, other events or conditions that differ insubstance from those previously occurring;

(b) the application of a new accounting policy for transactions, other events or conditions that didnot occur previously or were not material; and

(c) a change to the cost model when a reliable measure of fair value is no longer available (orvice versa) for an asset that an FRS or FRC Abstract would otherwise require or permit to bemeasured at fair value.

Finally, the overarching objective of this section is to enhance the relevance and reliability of financialstatements; and to enhance the comparability of financial statements with the financial statements of

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other entities. Given this objective, it is reasonable to assert that that section 10 of FRS 102 is a clearexpression of the Framework for the Preparation and Presentation of Financial Statements.

Self-test questions:

1. Discuss the concept of a ‘true and fair view’?

2. Explain the historical cost convention in accounting?

3. Explore the potential conflicts between the Accruals concept and the Prudence concept?

4. Discuss the characteristics of useful accounting information?

5. In relation to accounting policies, what are estimation techniques?

Solutions to self-test questions:

1. Refer to sections 2.5 of this chapter.

2. Refer to section 2.6.1 of this chapter.

3. Refer to sections 2.6.2 and 2.6.3 of this chapter



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PRACTICE QUESTIONS

The following questions examine the key areas the student is expected to know for this particular subject.These questions will assist the student significantly while preparing for examinations. You should alsoreview the questions available through MyRevision in your TouchPoint portal. Sample Papers for thissubject can be downloaded from www.AccountingTechniciansIreland.ie


Comment on the regulatory influences on accounting information. (5 marks)

Question 2 (ref: 1713) Based on a recent exam question

(a) Accounting concepts and conventions are of fundamental importance in thepreparation of financial statements.

Outline your understanding of the following concepts/conventions:

• Accruals;

• Going concern;

• Historical cost;

• Materiality;

• Prudence. (9 marks)

(b) Outline your understanding of the term ‘accounting policy’.

The consistent application of accounting policies year on year is important toallow users of accounting information compare the financial information of anentity year on year. (3 marks)

There are however two scenarios where an entity can change an accountingpolicy. State the two scenarios. (2 marks)

(c) List the users of accounting information. Outline the main information that eachuser is interested in andstate why. (6 marks)

Total 20 Marks

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111992 fin acc 2017(m) - accounting technicians ireland · syllabus: financialaccounting ... 116...

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