accounting basics

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts

CHAPTER 2Accounting and accountants


Contents

Accounting function Accounting database Recording transactions Organization of data within the general ledger Control and audit

Internal control Internal audit External audit Corporate governance

Accounting profession


Accounting function

Financial accounting system: objectives and scope

Uniform accounting procedures Functional transaction processing

systems


Financial accounting system

Objectives: Track all economic transactions of the enterprise Record and process them logically in a database Provide reporting tools and formats to

communicate information useful to decision makers

Scope Highly dependent on the size of the company


Tracking and recordingof data

Tracking and recordingof data

Processing of data

Processing of data ReportingReporting

Decision makers

Decision makers

Businesstransactions

Businesstransactions

Financial accounting system

Data Information


Uniform accounting procedures

Uniform accounting systems are central to the coordination and management of an international group

Internal accounting manuals to standardize procedures and interpretation of data

Uniform accounting rules (like IFRS) versus national accounting rules


Fig. 2.1 Group reporting flows

Group financial

statements

Uniform accounting

rules

Parent /holding

company

Subsidiaries Local tax accounts

FranceFrance

ItalyItaly

Nether-lands

Nether-lands(Germany)

(Germany)


Functional transaction processing systems

Functional systems capture different types of transactions according to their main features, like Sales Purchases Payroll Treasury Investment in long-term capacity

Transaction processing implies interactions between the accounting function and operating departments


Accounting database

General Ledger = central accounting database

Primary source of information for internal (management) and external reporting purposes


Figure 2.2 The financial accounting database

Other business expenses

Register of amounts owed to suppliers Salaries and

social charges

Finance from shareholders

and banks

Bank account cash in and

out

Register of debts owed by clients

Purchase of long-term

assets

General LedgerGeneral Ledger

Sale of goods to clients

Goods received

from suppliers

Reports to

manage-ment and

outsiders

Reports to

manage-ment and

outsiders


Recording transactions Information flows into the general

ledger through several layers of processing

Individual (daily) transactions are summarized by period and by type

Through summarization aggregates are buit up for the year’s activities


Fig. 2.3 Building aggregates

General LedgerGeneral Ledger

prepared by week (or month) and by type of transaction

(invoices, payments, receipts, expense notes, etc.)

SummariesSummaries

Daily transactions

total entered into


Recording transactions (cont.)

‘Journals’ Capture details of individual transactions Used to build up periodic summaries and feed

aggregated data into the general ledger May be organized according to functional

transaction processing systems ‘General ledger’

Collection of summarized, aggregated transaction data

Source for the preparation of periodic income statements and balance sheets


Recording transactions (cont.)

‘Audit trail’ Traces the content of aggregates back to transaction

details ‘Chart of accounts’

Used to categorize and record transactions within the accounting database according to the double-entry accounting logic

State-mandated or voluntary ‘XBRL’ (eXtensible Business Reporting Language)

Automated, flexible reporting tools Using specific tags of individual data items, defined and

linked through flexible taxonomies


Organization of data within the general ledger (G/L)

In the G/L, data are stored according to the ‘double-entry’ system

The G/L is organized into a series of ‘accounts’ (cfr. ‘chart of accounts’): data files to record transactions of a particular type

Specifics of an account: Two columns for figures: debits and credits Narrative commentary Cross-referencing details


Control and audit

Internal control Internal audit External audit Corporate governance


Internal control

Defining internal control Components of a system of

internal control Control activities

Preventive controls Detective controls Corrective controls


Defining internal control

Definition of COSO (Committee of Sponsoring Organizations)

Internal control is a process, established, operated and monitored by those charged with governance and management of a company, to provide reasonable assurance regarding the achievement of objectives in the following categories:

a) The effectiveness and efficiency of the company’s operations;b) The reliability of its financial reporting;c) Its compliance with applicable laws and regulations.


Internal control objectives (COSO)

Sustaining the company’s business operations (efficiency and effectiveness concerns)

Preparing reliable financial reporting (including financial statements)

Compliance with applicable laws and regulations


Components of a system of internal control (COSO)

A system of internal control consists of five interrelated components: Control environment Risk assessment Control activities Information and communication Monitoring

Each component is relevant for each internal control objective


Components of a system of internal control

Monitoring

Risk

assessment

Control activities

Information &

Communication

Control environment


IC system components (COSO extracts)

Control EnvironmentThe control environment sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure. Control environment factors include the integrity, ethical values and competence of the entity's people; management's philosophy and operating style; the way management assigns authority and responsibility, and organizes and develops its people; and the attention and direction provided by the board of directors.


IC system components (cont.)

Risk AssessmentEvery entity faces a variety of risks from external and internal sources that must be assessed. A precondition to risk assessment is establishment of objectives, linked at different levels and internally consistent. Risk assessment is the identification and analysis of relevant risks to achievement of the objectives, forming a basis for determining how the risks should be managed. Because economic, industry, regulatory and operating conditions will continue to change, mechanisms are needed to identify and deal with the special risks associated with change.



Control ActivitiesControl activities are the policies and procedures that help ensure management directives are carried out. They help ensure that necessary actions are taken to address risks to achievement of the entity's objectives. Control activities occur throughout the organization, at all levels and in all functions. They include a range of activities as diverse as approvals, authorizations, verifications, reconciliations, reviews of operating performance, security of assets and segregation of duties.



Information and CommunicationPertinent information must be identified, captured and communicated in a form and timeframe that enables people to carry out their responsibilities. Information systems produce reports, containing operational, financial and compliance-related information, that make it possible to run and control the business. They deal not only with internally generated data, but also information about external events, activities and conditions necessary to informed business decision-making and external reporting. Effective communication also must occur in a broader sense, flowing down, across and up the organization. All personnel must receive a clear message from top management that control responsibilities must be taken seriously. They must understand their own role in the internal control system, as well as how individual activities relate to the work of others. They must have a means of communicating significant information upstream. There also needs to be effective communication with external parties, such as customers, suppliers, regulators and shareholders.


IC system components (cont.) Monitoring

Internal control systems need to be monitored--a process that assesses the quality of the system's performance over time. This is accomplished through ongoing monitoring activities, separate evaluations or a combination of the two. Ongoing monitoring occurs in the course of operations. It includes regular management and supervisory activities, and other actions personnel take in performing their duties. The scope and frequency of separate evaluations will depend primarily on an assessment of risks and the effectiveness of ongoing monitoring procedures. Internal control deficiencies should be reported upstream, with serious matters reported to top management and the board.


Control activities

Control activities usually involve a policy component and a procedure component Policy: establishes what should be done Procedure: actions necessary to implement a policy

Classification of control activities: Preventive controls: P&P designed to prevent an

error or fraud from occurring Detective controls: P&P designed to detect an error

or fraud as soon as posible Corrective controls: P&P to correct problems in a

timely manner


Separation of functions

Separation of functions (“segregation of duties”) as a preventive control measure

It calls for the separation of the four basic functions of transaction processing Authorizing transactions Executing transactions Recording transactions Safeguarding resources resulting from

consummating transactions The objective is mainly to provide an

environment where fraud becomes difficult


Defining internal audit

“Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organisation’s operations. It helps an organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes.”

Institute of Internal Auditors


Internal audit process

Primary task: Examine and evaluate the adequacy and

effectiveness of the internal control system Evaluate the quality of performance in

carrying out assigned responsibilities Can be considered to be part of the

monitoring component of a IC system Its scope potentially covers all activities

within the company


Independence of internal audit

Independence with regard to the acitivities they audit, is essential for the internal audit function

Independence should be assured through: Organizational position and authority

within the company Recognition of professional objectivity


Internal audit – Hierarchical position (1)

CEO

Production manager Marketing manager ... CFO

Accounting Treasury ...Internal

Audit



CEO

InternalAudit

Production manager Marketing manager ... CFO



General assembly

Board of directors

Management committee

Audit committee

CEO Internal audit


Institute of Internal Auditors (IIA)

As an international professional body, the IIA provides authoritative guidance

“Standards for the Professional Practice of Internal Auditing” establish ethical (attribute standards) and practice (performance standards) guidelines

Certification programme leading to the designation of “Certified Internal Auditor”


Standards for the Professional Practice of Auditing

Attribute standards 1000 - Purpose, Authority, and Responsibility 1100 - Independence and Objectivity 1200 - Proficiency and Due Professional Care 1300 - Quality Assurance and Improvement Program

Performance Standards 2000 Managing the Internal Audit Activity 2100 Nature of Work 2200 Engagement Planning. 2300 Performing the Engagement 2400 Communicating Results 2500 Monitoring Progress 2600 Management's Acceptance of Risks


External audit External audit = independent audit of a

company’s financial statements carried out by external auditors Also referred to as “statutory audit”

The external auditor expresses an opinion on the representational fairness of the financial statements in conformity with generally accepted accounting principles

Reassurance for outside stakeholders that the financial statements are a valid representation of the company’s financial position and performance


External auditors

Largest four international networks of external auditors: PricewaterhouseCoopers (PwC) KPMG Ernst & Young Deloitte

These “Big Four” dominate the audit market for multinational companies


Basic statutory audit tasks

The basic statutory audit consists of two tasks: To check that the accounting database

effectively picks up all the company’s activities and is correct

To check that the financial statements are a correct representation of the accounting database, use appropriate accounting policies and are a reasonable representation of the company’s real state


Report of the external auditor

The external auditor signs a public report a standard attestation regarding the

representational fairness of the financial statements

The public report may be accompanied by a ‘management letter’ Directed to company management (not

published) Comments on the audit findings, highlights

potential areas of weakness and makes recommendations


Corporate governance Corporate governance issues arise

whenever ownership of a company is separated from its management

Central concern = how management’s freedom of action may be limited by outside interests

Many countries have specific rules, regulations and guidance on corporate governance


Corporate governance recommendations

Chairman of the Board of Directors (BOD) should not be the CEO

Appointment of independent or non-executive directors

BOD committees with independent directors : Compensation committee Audit committee Nomination committee


Accounting profession Main categories of accounting professionals:

Independent auditor Independent accountant Company accountant

Independent auditor Specialists licensed to carry out the independent

audit required by company law University degree + professional examinations + at

least three years as a student in a public auditing firm

International variation in nature of scope of statutory audit and in constraints on auditor/client relationship


Accounting profession (cont.) Independent accountant

External professionals offering accounting services to (generally small) companies

May also provide tax and general consulting services, but not statutory audit services

Company accountant Internal accounting specialists, but not

necessarily governed by a professional organization

No formal educational prerequisites

accounting basics

Documents

global financial

financial

ic system

financial

accounting

accounting

accounting

internal control