Financial Accounting(F3)

Chapter-1
By Rishav Agrawal ACCA, B.com

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• The accounting system of a business records and summarizes the
financial performance/position of a business over/at a certain period of
time.

• The information is crucial to various stakeholders , who will analyze that

information to make significant economic decisions.

• It is of vital importance that these stakeholders have good quality

information to make good quality decisions.

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 Financial Accounting
• Production of financial statements for external users.

• Report on the directors stewardship.

• Prepared using accounting conventions and standards(IAS, IFRS).

• Public documents, hence less detailed.

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 Management Accounting

• Prepared for internal use by management.

• Used by management to make decisions about the business, hence more detailed
and up to date.
• Information is presented in a way which may be useful to management. E.g.
Operating Unit, Product line.
• Used by management for formulating strategy, planning and controlling activities,
decision making, optimising the use of resources.

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 Users of Financial statements
• Investors- Investment decisions
• Employees- Concerned about job security, promotion.
• Lenders- Should loan be sanctioned, chances of defaulting
• Government- Tax calculation, Economic performance measurement
• Suppliers- Reassurance on payment of dues
• Customers- Assurance on supply in the future
• Public- Effect of the entity on the economy, local environment and local
community
• Competitors- assist decision-making in relation to their own business activities
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 Types of Business entity

1) Sole traders:
• Owned and operated by one individual
• No legal distinction of owner and business
• Unlimited liability- Personal assets may be used to pay debts
• Flexible capital structure- Easily introduce or withdraw capital

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2) Partnership:
• Owned and operated by at least two people
• Jointly share the profits and jointly liable for the losses
• Unlimited liability- Personal assets may be used to pay debts
• More resources available in the form of capital, skills, knowledge, idea
• Capital and current account
• Flexible capital structure- Easily introduce or withdraw capital with
mutual agreement between partners

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3) Limited liability companies:
• Separate legal entities
• Capital invested by shareholders for their share in the company
• Limited liability- Shareholders are not personally liable
• Managed by board of directors
• More formal
• Returns in the form of dividends
• Cannot make drawing from the company

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Basis Company Sole trader and partnership

Belongs to company – not affected by Can take it with them if they leave.
Property Holding change in ownership.

Can be transferred without the consent of New partner cannot be introduced into a
Shares others. firm without consent of all exiting partners

Can be sued and can sue in its own name Judgements affect the members personally.
Suing and being sued but judgements do not affect the members
personally.
Can secure loan over floating charges Not generally permitted by law to secure
Security for loans
loans with a floating charge.
Taxed separately from its shareholders Personally liable for income tax on profits
Taxation made by their business.

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 Disadvantage of incorporation
• Registration and formal document need to be filed with registrar
• Registration fees and legal costs have to be paid, which can be pretty
high
• Financial statements needs to be audited and submitted to the
registrar.
• Companies accounts and other documents are open to public
inspection.
• Strict rules about introduction and withdrawal of capital and profits
• Members may not be part of management of the company

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 Conceptual Framework
• The Framework presents the main ideas, concepts and principles upon which
all International Financial Reporting Standards(IFRS), and therefore financial
statements, are based.
• Comparable to Constitution Framework.
• IASB’s framework (issued in 2010, replaced the 1989 framework) for financial
reporting comprises of:
– Objective of general purpose financial reporting
– Qualitative characteristics of useful financial information
– Elements of financial statements
– Recognition of elements in FS
– Measurement of elements of FS
– Concepts of capital & capital maintenance
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 Purpose of Conceptual Framework
• The purpose of the Framework is to assist the IASB in the
development of financial reporting standards
• To assist preparers of financial statements to develop accounting
policies when reporting standards do not provide sufficient guidance,
or where there is a choice of accounting policy.
• Acts as a reference document to assist in understanding and
interpreting reporting standards.

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 Objective of financial reporting
• To provide financial information about the reporting entity to users of
the financial statements that is useful in making decisions about
providing economic resources to the entity, as well as other financial
decisions.

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 Prudence accounting concept
• Prudence is the exercise of caution when making judgements under
conditions of uncertainty. E.g. Estimating useful life of an asset.
• The helps to ensure that assets and income are not overstated in the
financial statements, and that liabilities and expenses are not
understated.

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 Qualitative characteristics
The attributes that make information provided in financial statements useful
to others.
a)Fundamental qualitative characteristics
-Relevance
-Faithful representation
b)Enhancing qualitative characteristics
-Comparability
-Verifiability
-Timeliness
-Understandability
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 Relevance
Information is relevant if:

• it has the ability to influence the economic decisions of users, and

• is provided in time to influence those decisions.
• is material

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 Material concept
• information is material if its omission or misstatement could influence
the economic decisions of users.
• a cut-off point – if any information does not pass the test of the
threshold quality, it is not material and does not need to be
considered further.

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 Qualities of relevance

• Predictive value - enables users to evaluate or assess past, present or

future events.
• Confirmatory value - helps users to confirm or correct past
evaluations and assessments.

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 Faithful representation
The Information presented should be the truth.

To be a perfectly faithful representation, financial information would possess

the following characteristics:
• Completeness - must contain all the necessary descriptions and explanations.
• Neutrality - Information should be free from bias. Should not have been
manipulated.
• Free from error - Free from material errors. A material error or an omission
can cause the financial statements to be false or misleading
• Focus on substance over form
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 Enhancing qualitative characteristics

1)Comparability-
Users must be able to
• Compare the financial statements of an entity with its past and future FS
• Compare the financial statements of different entities with one another.

For this to be the case there must be:

• Consistency
• adequate disclosures

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2) Verifiability – Should be verifiable directly or in directly to assure
users that information faithfully represents economic events.

3) Timeliness - having information available to decision makers in time

to be capable of influencing their decisions. The older the
information is, the less useful it becomes.

4)Understandability- Clear and concise. Users should be able to under

the information present.

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 Elements of Financial Statements
1. Asset – A present economic resource controlled by the entity as a result
of past events. E.g.- Building, Factory.
2. Liability – A present obligation of the entity to transfer an economic
resource as a result of past events. E.g.- Loans.
3. Equity – This is the 'residual interest' in the assets of the entity after
deducting all liabilities
4. Income – This consists of the increases in assets, or decreases in
liabilities, that result in increases in equity, other than those relating to
contributions from holders of equity claims e.g.- Sales, Discount
received.
5. Expense – This consists of the decreases in assets or increases in
liabilities that result in decreases in equity, other than those relating to
distributions to holders of equity claims. E.g.- Depreciation, purchase.

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 Non Current and current distinction
Items are classified as current if they are expected to be
• Realized in the normal course of entity’s operating cycle or within 12
months or, held for trading purposes only or is cash or cash
equivalent (for assets).
• Settled in the normal course of entity’s operating cycle or is held for
trading purposes only or is due to be settled within 12 months after
the reporting date (for liabilities).
• All other items are classified as non-current

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 Components of Financial Statements

1. The statement of financial position- summarises the assets, liabilities

and equity balances of the business
2. The statement of profit or loss and other comprehensive income-
summarises the revenues earned and expenses incurred.
3. The statement of changes in equity- summarises the movement in
equity balances
4. The statement of cash flows- summarises the cash paid and received
throughout the reporting period.
5. The notes to the financial statements-a statement of accounting policies
and any other disclosures required to enable to the shareholders and
other users of the financial statements to make informed judgements
about the business
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 Important accounting concepts
• Materiality- An item is regarded as material if its omission or
misstatement is likely to change the perception or understanding of
the users of that information
• Substance over form - the economic reality must be accounted for
and not just the strict legal form.
• The going concern assumption - Financial statements are prepared
on the assumption that the entity will continue to operate for the
foreseeable future (i.e. it has neither the need nor the intention to
liquidate or significantly curtail its operations).

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• The business entity concept- The financial accounting information
presented in the financial statements relates only to the activities of the
business and not to those of the owner. From an accounting perspective
the business is treated as being separate from its owners.
• The accrual basis of accounting - Transactions are recorded when revenues
are earned and when expenses are incurred. This pays no regard to the
timing of the cash payment or receipt.
• Prudence – Caution must be taken to ensure items are not over or under
stated.
• Consistency - Users of the financial statements need to be able to compare
the performance of an entity over a number of years.

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