Introduction to accounting

Introduction to accounting: Objectives

• Describe the basic construction of accounts of different
types and the role and principal features of the accounts
of a company.

• Explain why companies are required to produce annual

reports and accounts.

• Explain the fundamental accounting concepts which

should be adopted in the drawing up of company
accounts
This is your introduction to the accounting part of the
course. In this chapter we consider the need for
accounts, the regulation of accounts, accounting
standards, the auditors report and accounting concepts.
Each year a company will publish four main types of
accounting statement:
• 1. an income statement (showing the income,
expenses and hence shareholders profits for the
year).
• 2. a balance sheet(showing the assets, liabilities and
shareholders funds at the end of the year).
• 3. a cashflow statement to show where the cash has
come from and how it has been spent
• 4. a statement of changes in equity to show how the
composition of equity has changed over the year.
• Companies are required to produce a set of annual
reports and accounts in an attempt to fulfil the needs
of the various users of accounting information.
 Users
of financial information
It has been suggested that financial statements have
four groups of users:

• equity investors (ieboth actual and potential

shareholders)
• loan creditors (both long-term and short-term)
• employees
• Business contacts (I e customers and suppliers)
 Users
The accounts have many other uses, and will be
used by:
• •a stock exchange to ensure that certain
requirements are met
• •the management themselves as a source of
information
• •the tax authorities as a starting point in the
calculation of the tax liability
• •stock analysts as a source of financial
information
• •credit rating agencies in order to assess the
creditworthiness of the company
 equity investors
Investment decisions require information
about profits and cashflows. Analysts are
constantly preparing and updating forecasts of
performance. The annual report provides an
opportunity to “fine tune” these forecasts.
Existing shareholders also require information
about the transactions authorised by the
directors for stewardship purposes.
 loan creditors
Lending decisions involve the measurement of
the risk of default. A lender wants to know
whether a business can generate sufficient cash
to repay any loan. The lender will also wish to
ensure that the business has an adequate asset
base to meet its obligations in the event of
failure. To this end, loan agreements often
contain restrictive covenants which are based on
accounting numbers.
Covenants specify a value for a summary statistic,
such as a gearing ratio (which measures debt as
a proportion of long-term finance).
 Employees
• Employees are interested in the enterprise’s
ability to pay salaries and also to offer job
security. Accounting information is, however,
of limited value for such decisions.
• The cashflow statement will be useful, as will
indicators of profitability.
 Business contacts

• Business contacts are interested in continuity

of sales (to customers) and of materials and
services (from the suppliers). Their interest is,
therefore, similar to that of the shareholders.
They may also use accounting information to
try to gain some insight into the company.’s
pricing and trading policies
• The annual report of a large company will,
therefore, have a wide readership. Inaddition
to the .“legitimate.” users described above,
the financial statements willalso be read by:
o •government agencies (including the tax
authorities)
o •competitors
o •potential predators.
• The relationship between the management of a company and the
various users listed above can be complex. At best there is likely to
be a degree of mistrust. For example, shareholders might be
concerned that the directors will act in their own best interests even
when this would be to the detriment of the company.
•
• At worst there will be outright hostility. For example, the directors
are unlikely to volunteer information about the company.’s
performance if that could be used by a potential competitor.
Management might, therefore, be tempted to withhold information
or to distort any figures which they do publish.

• The credibility of published financial statements is protected by the

imposition of regulations from a diverse range of sources.
• The following regulation body affect listed companies
 Statutory requirements
In many countries, national legislation may be in
place to dictate what kind of information should be
published in financial statements. For example, in
the UK, the Companies Act requires a number of
documents
• a balance sheet showing the financial position on
the last day of the company’s financial year
• an income statement for the financial year
• detailed disclosures which are normally presented
as a series of notes to the accounts
• a directors’ report
• an auditors’ report.
Directors’ Report
The main items that a directors.’ report must contain are:
• certain detail about the company.’s activities over the
previous year, and likely events in the coming twelve
months. Opinions are expressed by the directors.
• a brief summary of the financial decisions that the
directors have made, including the proposed dividend,
the amount of shareholders.’ profits retained by the
company, charitable donations made by the company
and details of any of the company’s own shares that
have been purchased during the year.
• details of persons who were directors during the year,
their shareholdings and their other interests in the
company.
Annual report
The main items that a directors’ report must contain are:
• certain detail about the company’s activities over the
previous year, and likely events in the coming twelve
months. Opinions are expressed by the directors.
• a brief summary of the financial decisions that the
directors have made, including the proposed dividend, the
amount of shareholders.’ profits retained by the company,
charitable donations made by the company and details of
any of the company’s own shares that have been purchased
during the year.
• details of persons who were directors during the year, their
shareholdings and their other interests in the company
• listed companies also have to include in their directors.’
report additional information required by the Stock
Exchange such as a geographical analysis of turnover and
average time to pay creditors.
• The Companies Act.’s accounting requirements run to dozens
of pages of detailed rules. There is, however, one overriding
requirement. That is that the financial statements must give
a “true and fair view.” The Act does not define truth and
fairness and so the phrase must be interpreted in terms of
normal English usage. There is, however, a growing body of
evidence that this is a term of art and that it has a technical
meaning for accountants.
• To a large extent, the truth and fairness of the statements
can be determined by whether they comply with all of the
rules and regulations which were outlined above. It is,
however, necessary to exceed the formal disclosure
requirements or to deviate from the rules governing
calculation if doing so would enable the company to give a
true and fair view. This requirement to look beyond the
codified rules appears to give the concept of truth and
fairness an independent existence.
• In the United States, following successive
accounting scandals in 2001-2 involving Enron,
WorldCom and others, a tough new statute has
been introduced. The Sarbanes-Oxley statute
(known as Sarb-Ox or SOX) aims to improve the
accountability of managers to shareholders and to
restore faith in the accounting system.
• Some companies will be subject to other legislation
specific to their type of industry. For example, in
many countries there are specific rules relating to
specialised businesses such as insurance companies,
banks, pension funds and charities.
 The International Accounting
Standards Board (IASB)
• The International Accounting Standards Board (IASB) is
the body that develops, issues and withdraws
accounting standards. The standards that are issued by
the IASB are called International Financial Reporting
Standards (IFRSs)
• The IASB has no authority to require compliance with
its accounting standards.
• However, many countries require the financial
statements of publicly traded enterprises to be
prepared in accordance with IFRSs, and (where
necessary) to give particulars of any material departure
from those standards and the reasons for it.
 The International Accounting
Standards Board (IASB)
• The IASB collaborates with national
accounting standard-setters in many
countries in order to ensure that its
standards are developed with due regard to
international and national developments.
International accounting standards have
helped both to improve and harmonise
financial reporting around the world
 The auditors’ report
• Every company is required by the Companies Act
1989 to appoint auditors to hold office from one
annual general meeting to the next. The
auditors must report to the shareholders on the
published accounts.
• The auditors must comment on whether, in their
opinion, the balance sheet and income tatement
have been properly prepared in accordance with
the Companies Acts and relevant accounting
standards, and whether, in their opinion, the
accounts give a true and fair view.
• The fundamental purpose of the audit report is
to add credibility to the financial statements
 The auditors’ report
The contents of an auditors’ report
The auditors.’ report must contain:
1. a title, identifying the person or persons to whom the
report is addressed
2. an introductory paragraph identifying the financial
statements audited
3. separate sections, appropriately headed, dealing with:
(a) respective responsibilities of directors and auditors
(b) the basis of the auditors.’ opinion
(c) the auditors.’ opinion on the financial statements
4. the manuscript or printed signature of the auditors,
with the address
5. the date of the auditors.’ report.
 The auditors’ report
• Variations on the standard report
The wording of the standard report can be
modified if the auditor wishes to highlight
areas of uncertainty or is unable to express
an unqualified opinion that the financial
statements give a true and fair view. There
are various degrees of qualification:
• emphasis of matter paragraphs
• qualified opinion
• disclaimer of opinion
• adverse opinion
 Emphasis of matter paragraphs
• If there is a significant uncertainty which has
been disclosed in the accounts, the auditor
should point this out. However, if the
financial statements give a true and fair view,
then the auditor would issue an unqualified
opinion.
 Qualified opinion
• This may be issued where there is a limitation
on the information which the auditor has
obtained, or the auditor disagrees with the
treatment of a matter, but the auditor is still
able to express an opinion of the financial
statements.
 Disclaimer of opinion
• If the auditor cannot obtain sufficient
information to express an opinion, a disclaimer
of opinion may be issued.
 Adverse opinion
• This is issued where the auditor believes that
the financial statements do not give a true
and fair view and the effect is so material
that a qualified opinion is not adequate to
disclose the misleading or incomplete nature
of the financial statements.
The regulation of auditors