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I N T E R A ADVANCED C T PAPER 6 I V DRAFTING FINANCIAL E STATEMENTS (INTERNATIONAL) T E X BPP is the official provider of training materials for the ACCA's CAT qualification. This Interactive Text forms part of a suite of learning tools, which also includes CD-ROMs T for tuition and computer based assessment, and the innovative, internet-based Learn Online. This text has been specifically written to the current syllabus and Teaching Guide. • Clear language and presentation ••ThiNganHang.comtechniquesPlenty of questions, examples and quizzes to demonstrate and practiseA question and answer bank prepared by BPP Learning Media authors FOR EXAMS IN DECEMBER 2008 AND JUNE 2009 ThiNganHang.com
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First edition 2003 Sixth edition June 2008 ISBN 9870 7517 4832 1 (Previous ISBN 9780 7517 3579 6) British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library All our rights reserved. No part of this publication may be Published by reproduced, stored in a retrieval system or transmitted, in BPP Learning Media Ltd any form or by any means, electronic, mechanical, BPP House, Aldine Place photocopying, recording or otherwise, without the prior London W12 8AA written permission of BPP Learning Media Ltd. www.bpp.com/learningmedia We are grateful to the Association of Chartered Certified Accountants for permission to reproduce past Printed in the United Kingdom examination questions. The suggested solutions in the exam answer bank have been prepared by BPP Learning Media Ltd, unless where otherwise stated. Your learning materials, published by BPPThiNganHang.com Learning Media Ltd, are printed on paper sourced from sustainable, managed forests. © BPP Learning Media Ltd 2008 ii ThiNganHang.com
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Contents Page Introduction How to use this Interactive Text v Approach to examining the syllabus vi Analysis of past papers vi Tackling multiple choice questions vii Part A Introduction to financial reporting 1 Introduction to financial statements 3 2 Non-current assets and inventory 15 3 Review of basic financial accounts 47 4 Accounting conventions 71 Part B Preparation of final accounts 5 Partnership accounts 87 6 Incomplete records 117 7 Limited liability companies 151 Part C The regulatory and conceptual framework 8 The regulatory framework 179 9 Conceptual framework 189 Part D Accounting standards 10 Contingencies and events after the reporting period 207 11 Intangibles and taxation 217 Part E Interpretation of accounts 12 Statement of cash flows 235 13 Ratio analysis 255 Part F Simple consolidated accounts 14 Introduction to group accounts 287 15 The consolidated statement of financial position 297 16 The consolidated income statement 327 Exam question bank 341 Exam answer bank 355 ThiNganHang.comList of key termsIndexReview form and free prize draw 375376 Contents iii ThiNganHang.com
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How to Use this Interactive Text Aim of this Interactive Text To provide the knowledge and practice to help you succeed in the examination for Paper 6 Drafting Financial Statements (International). To pass the examination you need a thorough understanding in all areas covered by the syllabus and teaching guide. Recommended approach (a) To pass you need to be able to answer questions on everything specified by the syllabus and teaching guide. Read the text very carefully and do not skip any of it. (b) Learning is an active process. Do all the questions as you work through the text so you can be sure you really understand what you have read. (c) After you have covered the material in the Interactive Text, work through the Question Bank, checking your answers carefully against the Answer Bank. (d) Before you take the exam, check that you still remember the material using the following quick revision plan. (i) Read through the chapter topic list at the beginning of each chapter. Are there any gaps in your knowledge? If so, study the section again. (ii) Read and learn the key terms. (iii) Look at the exam alerts. These show the ways in which topics might be examined. (iv) Read the chapter roundups, which are a summary of the fast forwards in each chapter. (v) Do the quick quizzes again. If you know what you're doing, they shouldn't take long. This approach is only a suggestion. You or your college may well adapt it to suit your needs. Remember this is a practical course. (a) Try to relate the material to your experience in the workplace or any other work experience you may have had. (b) Try to make as many links as you can to other papers at the Introductory and Intermediate levels. ThiNganHang.com Introduction v ThiNganHang.com
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Approach to examining the syllabus Paper 6 is a three - hour written paper. The written examination currently consists of four compulsory questions as follows: Marks Question 1 30-40 Question 2 25-30 Question 3 15-20 Question 4 15-20 100 Important note for June 2009 exam From the June 2009 exam, the format of the paper is changing to: Marks 10 multiple choice questions of 2 marks each 20 Compulsory written questions 80 100 Analysis of past papers These are the topics examined in past papers Topic Dec June Dec June Dec Jun Dec June 2007 2007 2006 2006 2005 2005 2004 2004 Regulatory framework • • Accounting concepts and • principles Partnership accounts • • • • • • • • Preparation of limited liability • • • • company financial statements Contingencies and events after • the reporting period Statement of cash flows • • • • • Ratio analysis • • • • • • • • Consolidated statement of • • • • financial position Consolidated income statement • • • Associates • • ThiNganHang.comQuestions and answers for all of these sittings can be downloaded from the ACCA website, together withexaminer’s comments on the paper.Note that from the June 2009 exam the examiner will be able to cover a wider range of the syllabus at each sitting. See page (vii) for how to tackle multiple choice questions. vi Introduction ThiNganHang.com
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Tackling Multiple Choice Questions MCQs are now part of all CAT exams. Papers 1 and 2 are examined by CBE, Papers 3 and 4 can be taken by CBE or by a written paper which is 40% MCQs. Paper 5 is now 50% MCQs and Papers 6-10 are 20% MCQs. All MCQs carry 2 marks. The MCQs in your exam contain four possible answers. You have to choose the option that best answers the question. The three incorrect options are called distracters. There is a skill in answering MCQs quickly and correctly. By practising MCQs you can develop this skill, giving you a better chance of passing the exam. You may wish to follow the approach outlined below, or you may prefer to adapt it. Step 1 Skim read all the MCQs and identify what appear to be the easier questions. Step 2 Attempt each question – starting with the easier questions identified in Step 1. Read the question thoroughly. You may prefer to work out the answer before looking at the options, or you may prefer to look at the options at the beginning. Adopt the method that works best for you. Step 3 Read the four options and see if one matches your own answer. Be careful with numerical questions as the distracters are designed to match answers that incorporate common errors. Check that your calculation is correct. Have you followed the requirement exactly? Have you included every stage of the calculation? Step 4 You may find that none of the options matches your answer. • Re-read the question to ensure that you understand it and are answering the requirement • Eliminate any obviously wrong answers • Consider which of the remaining answers is the most likely to be correct and select the option Step 5 If you are still unsure make a note and continue to the next question Step 6 Revisit unanswered questions. When you come back to a question after a break you often find you are able to answer it correctly straight away. If you are still unsure have a guess. You are not penalised for incorrect answers, so never leave a question unanswered! After extensive practice and revision of MCQs, you may find that you recognise a question when you sit the exam. Be aware that the detail and/or requirement may be different. If the question seems familiar read the requirement and options carefully – do not assume that it is identical. ThiNganHang.com Introduction vii ThiNganHang.com
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Introduction to financial statements Chapter topic list 1 Introduction 2 The purpose of accounting information 3 The main financial statements 4 Qualities of good accounting information 5 Organisational structure ThiNganHang.com 3 ThiNganHang.com
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Study guide reference Syllabus reference 1 (a) Explain the need for and objectives of financial statements 1 (b) Identify the users of financial statements and their particular interests 1 in the statements (c) Discuss how the accounting systems of an organisation are affected by its organisational structure, its administrative systems and 1 procedures and the nature of its business transactions 1 Introduction Paper 6 Drafting Financial Statements builds on the knowledge acquired in Paper 1 and Paper 3, enabling you to draft year end financial statements and interpret financial statements for a range of organisations. Exam focus point When you passed Paper 3, you demonstrated that you could: • Understand, describe and apply relevant accounting concepts, policies and standards • Maintain records relating to capital acquisition and disposal • Prepare reconciliations for the preparation of final accounts • Identify, calculate and record appropriate adjustments • Prepare and complete the extended trial balance • Prepare final accounts for a sole trader • Prepare final accounts for a partnership Can you still do all of these things? If not, you will need to revise, as such skills are assumed before you even start your studies for Paper 6! Remember as you work through this text that accounting is an interactive subject. You only get good at it through doing it. Do not 'skip' any of the activities. 2 The purpose of accounting information 2.1 What is a business? FAST FORWARD Businesses of whatever size or nature exist to make a profit. You should know by now what a business is. There are a number of different ways of looking at it. Some ideas are listed below. • A business is a commercial or industrial concern which exists to deal in the manufacture, re-sale or supply of goods and services. ThiNganHang.com•• customers will buy.A business is anA business is an organisation which uses economic resourcesorganisation providing jobs for people. to create goods or services which • A business invests money in resources (for example it buys buildings, machinery and so on, it pays employees) in order to make even more money for its owners. This last definition introduces the important idea of profit. Business enterprises vary in character, size and complexity. They range from very small businesses (the local shopkeeper or plumber) to very large multinationals. But the objective of earning profit is common to all of them. Key term Profit is the excess of income over expenditure. When expenditure exceeds income, the business is running at a loss. 4 1: Introduction to financial statements ⏐ Part A Introduction to financial reporting ThiNganHang.com
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One of the jobs of an accountant is to measure income, expenditure and profit. It is not such a straightforward problem as it may seem and in later chapters we will look at some of the theoretical and practical difficulties involved. 2.2 Assets and liabilities FAST FORWARD An asset is something which a business owns. A liability is something which a business owes. An asset is something valuable which a business owns or has the use of. Examples of assets are factories, office buildings, warehouses, delivery vans, lorries, plant and machinery, computer equipment, office furniture, cash and also goods held in store awaiting sale to customers, and raw materials and components held in store by a manufacturing business for use in production. Some assets are held and used in operations for a long time. An office building might be occupied by administrative staff for years. A machine might have a productive life of many years before it wears out. Other assets are held for only a short time. The owner of a newsagent shop, for example, will have to sell his newspapers on the same day that he gets them, and weekly newspapers and monthly magazines also have a short shelf life. The more quickly a business can sell the goods it has in store, the more profit it is likely to make, provided, of course, that the goods are sold at a higher price than what it cost the business to acquire them. You have come across assets in your earlier studies. Now consider a more formal definition, taken from an important document, the International Accounting Standard Board's Framework (considered in more detail in Chapter 9). Key term An asset is a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity. A machine is an asset because it gives: Rights to future economic benefits The machine will be used in the business to make products and earn revenue. Because of past events The machine was purchased at some time in the past. A liability is something which is owed to somebody else. 'Liabilities' is the accounting term for the debts of a business. 2.3 Examples of liabilities (a) A bank loan or bank overdraft. The liability is the amount which must eventually be repaid to the bank. (b) Amounts owed to suppliers for goods purchased but not yet paid for. For example, a boatbuilder might buy some timber on credit from a timber merchant, which means that the boatbuilder does ThiNganHang.comnot have to pay for the timber until some time after it has been delivered. Until the boatbuilder pays what he owes, the timber merchant will be his creditor for the amount owed. (c) Taxation owed to the government. A business pays tax on its profits but there is a gap in time between when a company declares its profits and becomes liable to pay tax and the time when the tax bill must eventually be paid. (d) Amounts invested in a business by its shareholders or owners. This is explained in detail later. The Framework also defines a liability. Key term A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Part A Introduction to financial reporting ⏐ 1: Introduction to financial statements 5 ThiNganHang.com
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A bank loan is a liability because it gives: An outflow of economic benefits The loan must be repaid. Because of past events The loan was taken out in the past. The Framework is covered in more detail in Chapter 9. 2.4 The business as a separate entity FAST FORWARD A business is a separate entity from its owner. So far we have spoken of assets and liabilities 'of a business'. But can an intangible entity such as a business own assets in its own name, or have liabilities in its own name? There are two aspects to this question: the strict legal position and the convention adopted by accountants. Many businesses are carried on in the form of limited companies. The owners of a limited company are its shareholders, who may be few in number (as with a small, family-owned company) or very numerous (for example in the case of a large public company whose shares are quoted on the Stock Exchange). The law recognises a company as a legal entity, quite separate from its owners. A company may, in its own name, acquire assets, incur debts, and enter into contracts. If a company's assets became insufficient to meet its liabilities, the company as a separate entity might become 'bankrupt', but the owners of the company could not usually be required to pay the debts from their own private resources: the debts are not debts of the shareholders, but of the company. The case is different, in law, when a business is carried on not by a company, but by an individual (a sole trader) or by a group of individuals (a partnership). Case Study Suppose that Fiona Middleton sets herself up in business as a hairdresser trading under the business name 'Hair by Fiona'. The law now recognises no distinction between Fiona Middleton, the individual, and the business known as 'Hair by Fiona'. Any debts of the business which cannot be met from business assets must be met from Fiona's private resources. However, in accounting a business is treated as a separate entity from its owner(s). This applies whether or not the business is recognised in law as a separate entity, ie it applies whether the business is carried on by a company or by a sole trader. This is known as the entity concept. Key term Entity concept: A business is a separate entity from its owner. At first sight this seems illogical and unrealistic; students often have difficulty in understanding it. Nevertheless, it is an idea which you must try to appreciate. It is the basis of a fundamental rule of accounting, which is that the assets and liabilities of a business must always be equal. We will look at this rule in more detail in a later chapter, but a simple example may clarify the idea of a business as a separate entity from its owners. ThiNganHang.com2.5 Example: the business as a separate entityOn 1 July 20X6, Courtney Spice decided to open up a stall in the market, to sell herbs and spices. She had saved up some money in her building society account, and had $2,500 to put into her business. When the business is set up, an accountant's picture can be drawn of what it owns and what it owes. The business begins by owning the cash that Courtney has put into it, $2,500. But does it owe anything? The answer is yes. The business is a separate entity in accounting terms. It has obtained its assets, in this example cash, from its owner, Courtney Spice. It therefore owes this amount of money to its owner. If Courtney changed her mind and decided not to go into business after all, the business would be dissolved by the 'repayment' of the cash by the business to Courtney. The amount owed by a business to its owners is often known as capital. 6 1: Introduction to financial statements ⏐ Part A Introduction to financial reporting ThiNganHang.com
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2.6 The need for accounts Why do businesses need to produce accounts? If a business is being run efficiently, why should it have to go through all the bother of accounting procedures in order to produce financial information? The answer is simple. A business should produce information about its activities because there are various groups of people who want or need to know that information. This sounds rather vague: to make it clearer, we should look more closely at the classes of people who might need information about a business. We need also to think about what information in particular is of interest to the members of each class. Because large businesses are usually of interest to a greater variety of people than small businesses we will consider the case of a large company whose shares can be purchased and sold on the Stock Exchange. 2.7 Users of accounting information FAST FORWARD There are various groups of people who need information about the activities of the business. The people who might be interested in financial information about a large company may be classified as follows. (a) Managers of the company. These are people appointed by the company's owners to supervise the day-to-day activities of the company. They need information about the company's financial situation as it is currently and as it is expected to be in the future. This is to enable them to manage the business efficiently and to take effective control and planning decisions. (b) Shareholders of the company, ie the company's owners. These will want to assess how effectively management is performing its stewardship function. They will want to know how profitably management is running the company's operations and how much profit they can afford to withdraw from the business for their own use. (c) Trade contacts, including suppliers who provide goods to the company on credit and customers who purchase the goods or services provided by the company. Suppliers will want to know about the company's ability to pay its debts; customers need to know that the company is a secure source of supply and is in no danger of having to close down. (d) Providers of finance to the company. These might include a bank which permits the company to operate an overdraft, or provides longer-term finance by granting a loan. The bank will want to ensure that the company is able to keep up with interest payments, and eventually to repay the amounts advanced. (e) The tax authorities, who will want to know about business profits in order to collect the tax payable by the company. The tax authorities may also be responsible for collecting sales taxes. (f) Employees of the company. These should have a right to information about the company's financial situation, because their future careers and the size of their wages and salaries depend on it. (g) Financial analysts and advisers, who need information for their clients or audience. For example, ThiNganHang.com(h) stockbrokers will need information to advise investors in stocks and shares; credit agencies willwant information to advise potential suppliers of goods to the company; and journalists needinformation for their reading public.Government and their agencies. Governments and their agencies are interested in the allocation of resources and therefore in the activities of enterprises. They also require information in order to provide a basis for national statistics. (i) The public. Enterprises affect members of the public in a variety of ways. For example, enterprises may make a substantial contribution to a local economy by providing employment and using local suppliers. Another important factor is the effect of an enterprise on the environment, for example as regards pollution. Accounting information is prepared in financial statements to satisfy the information needs of these different groups. Not all will be equally satisfied. Part A Introduction to financial reporting ⏐ 1: Introduction to financial statements 7 ThiNganHang.com
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Managers of a business need the most information, to help them take their planning and control decisions; and they obviously have 'special' access to information about the business, because they can get people to give them the types of statements they want. When managers want a large amount of information about the costs and profitability of individual products, or different parts of their business, they can arrange to obtain it through a system of cost and management accounting. Question Accessing information It is easy to see how 'internal' people get hold of accounting information. A manager, for example, can just go along to the accounts department and ask the staff there to prepare whatever accounting statements he needs. But external users of accounts cannot do this. How, in practice, can a business contact or a financial analyst access accounting information about a company? Answer The answer is that limited liability companies (though not other forms of business such as partnerships) are usually required to make certain accounting information public. This may be done by filing information centrally, as a government requirement. Alternatively, the public may have the right to apply for such information. Question Accounting information Which of the following statements is particularly useful for managers? A Financial statements for the last financial year B Tax records for the past five years C Budgets for the coming financial year D Bank statements for the past year Answer The correct answer is C. Managers need to look forward and make plans to keep the business profitable. Therefore the most useful information for them would be the budgets for the coming financial year. In addition to management information, financial statements are prepared and perhaps published for the benefit of other user groups, which may demand certain information. (a) The national laws of a country may provide for the provision of some accounting information for shareholders and the public. (b) National taxation authorities will receive the information they need to make tax assessments. ThiNganHang.com(c) A bank might demand a forecast of a company's expected future cash flows as a pre-condition of granting an overdraft. (d) The International Accounting Standards Board (IASB) has been jointly responsible for issuing International Accounting Standards (IASs) now to be called International Financial Reporting Standards (IFRS) and these require companies to publish certain additional information. Accountants, as members of professional bodies, are placed under a strong obligation to ensure that company accounts conform to the requirements of the IASs. (e) Some companies provide, voluntarily, specially prepared financial information for issue to their employees. These statements are known as 'employee reports'. 8 1: Introduction to financial statements ⏐ Part A Introduction to financial reporting ThiNganHang.com
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2.8 Non-commercial undertakings It is not only businesses that need to prepare accounts. Charities and clubs, for example, prepare financial statements every year. (An excess of income over expenditure is known as a surplus; an excess of expenditure over income is known as a deficit.) Accounts also need to be prepared for public sector organisations. 2.9 Section summary A business exists to make a profit. In accounting, though not in law, it is a separate entity from its owner(s). Accounts are prepared so that owners, managers, lenders and other interested parties can see how the business is doing. 3 The main financial statements FAST FORWARD The main financial statements of a business are the statement of financial position and the statement of comprehensive income. In this section we look briefly at the two principal financial statements drawn up by accountants: the statement of financial position and the statement of comprehensive income. Exam focus IAS 1 has been revised. We will look at this in more detail in Chapter 7. However, you should note the point following points: • The term 'balance sheet' has been replaced with the term 'statement of financial position'. • IAS 1 revised now requires a single 'statement of comprehensive income'. This can be shown as one statement or split into two sections as follows: – Income statement – Statement of other comprehensive income This Study Text will continue to use the term 'income statement' for the statement showing revenue to profit for the year. The statement of comprehensive income will be covered in Chapter 7 as it is most relevant in the context of limited company accounts. Key term The statement of financial position is simply a list of all the assets owned by a business and all the liabilities owed by a business as at a particular date. It is a snapshot of the financial position of the business at a particular moment. Assets are the business's resources so, for example, a business may buy buildings to operate from, plant and machinery, inventory to sell and cars for its employees. These are all resources which it uses in its ThiNganHang.comoperations Additionally, it may have bank balances, cash and amounts of money owed to it. These provide the funds it needs to carry out its operations, and are also assets. On the other hand, it may owe money to the bank or to suppliers. These are liabilities. Key term An income statement is a record of income generated and expenditure incurred over a given period. This shows whether the business has had more income than expenditure (a profit) or vice versa (a loss). The period chosen will depend on the purpose for which the statement is produced. The income statement which forms part of the published annual accounts of a limited liability company will be made up for the period of a year, commencing from the date of the previous year's accounts. On the other hand, management might want to keep a closer eye on a company's profitability by making up quarterly or monthly income statements. Organisations which are not run for profit (charities etc) produce a similar statement called an income and expenditure account which shows the surplus of income over expenditure (or a deficit where expenditure exceeds income). Part A Introduction to financial reporting ⏐ 1: Introduction to financial statements 9 ThiNganHang.com
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3.1 Accruals basis It is very important to grasp the principle, which is applied in nearly all businesses' accounts, that accounts are not prepared on a cash basis but on an accruals (or earnings) basis. That is, a sale or purchase is dealt with in the year in which it is made, even if cash changes hands in a later year. This is important because most businesses, even if they do not sell on credit, make purchases on credit. If cash accounting is used, then accounts do not present a true picture of the business's activities in any given period. Accountants call this convention an application of the accruals concept. This is discussed in more detail in Chapter 4 of this Interactive Text, but in the meantime is explained briefly by means of the example below. 3.2 Example: accruals concept Emma has a business printing and selling T-shirts. In May 20X7 she makes the following purchases and sales. Invoice date Numbers bought/sold Amount Date paid Purchases $ 7.5.X7 20 100 1.6.X7 Sales 8.5.X7 4 40 1.6.X7 12.5.X7 6 60 1.6.X7 23.5.X7 10 100 1.7.X7 What is Emma's profit for May? Solution $ Cash basis Sales 0 Purchases 0 Profit/loss 0 Accruals basis Sales ($40 + $60 + $100) 200 Purchases 100 Profit 100 Obviously, the accruals basis gives a truer picture than the cash basis. Emma has no cash to show for her efforts until June but her customers are legally bound to pay her and she is legally bound to pay for her purchases. Her statement of financial position as at 31 May 20X7 would therefore show her assets and liabilities as follows. $ ThiNganHang.comAssets Receivables ($40 + $60 + $100) 200 Liabilities Payables 100 Net assets 100 Proprietor's capital 100 Capital is a special form of liability, representing the amount owed by the business to its proprietor(s). In Emma's case it represents the profit earned in May, which she, as sole proprietor of the business, is entitled to in full. Usually, however, capital will also include the proprietor's initial capital, introduced as cash and perhaps equipment or other assets. 10 1: Introduction to financial statements ⏐ Part A Introduction to financial reporting ThiNganHang.com
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For example, if Emma had begun her business on 30 April 20X7 by opening a business bank account and paying in $100, her statement of financial position immediately after this transaction would look like this. $ Assets Bank 100 Proprietor's capital 100 On 31 May 20X7 the statement of financial position would look like this. $ Assets Receivables 200 Bank 100 300 Liabilities Payables 100 Net assets 200 Proprietor's capital Brought forward 100 Profit for the period 100 Carried forward 200 This simple example shows that both the statement of financial position and the income statement are summaries of a great many transactions. In later chapters we will look in detail at the ways in which these transactions are recorded and financial statements prepared. Accountancy textbooks often write 20X5 or 20X6 and so on for dates instead of 2005 etc. You will find both conventions in this Interactive Text, but in the Pilot Paper only 'real dates' (2006 etc) are used. 3.3 Articulation of the income statement and the statement of financial position In simple terms, at the end of the accounting period, the profit for the year is added to the profit brought forward in the statement of financial position to arrive at the profit carried forward in the statement of financial position. You can see this in the example of Emma above. Look at the example below. This is an illustration of the link between the income statement and the statement of financial position. INCOME STATEMENT STATEMENT OF FINANCIAL POSITION Revenue 100 Assets 200 Cost of sales (60) Liability 100 Gross profit 40 Capital 30 Expenses (10) Profits brought forward 40 Net profit 30 Profit for the year 30 200 ThiNganHang.comTry the activity below. It will familiarise you with some of the ideas you have just studied. Question Organisations and users State one type of profit-making organisation. For this organisation: (a) Give an example of an external user of the financial statements. (b) Describe one type of decision which would be made by the users with the assistance of the financial statements of the organisation. Part A Introduction to financial reporting ⏐ 1: Introduction to financial statements 11 ThiNganHang.com
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Answer Tutorial note. You were asked for only one example – our answer gives three for completeness. Other reasonable types of organisation and user would also be acceptable. (a) Type of organisation Example of user Sole trader Supplier Partnership Bank Limited company Shareholder (b) User Possible decisions Supplier Whether to carry on supplying goods on credit (eg by looking at liquidity position) Bank Whether to continue an overdraft facility (by assessing profitability and liquidity) Shareholders Whether to increase or decrease holding or whether to remove directors. They will assess liquidity, profitability, gearing and the stewardship of management. 4 Qualities of good accounting information FAST FORWARD You should be able to identify the qualities of good accounting information. Below are some features that accounting information should have if it is to be useful. (a) Relevance. The information provided should satisfy the needs of information users. In the case of company accounts, clearly a wide range of information will be needed to satisfy a wide range of users. (b) Comprehensibility. Information may be difficult to understand because it is skimpy or incomplete; but too much detail is also a defect which can cause difficulties of understanding. (c) Reliability. Information will be more reliable if it is independently verified. In many countries, the law requires that the accounts published by limited companies should be verified by auditors, who must be independent of the company and must hold an approved qualification. (d) Completeness. A company's accounts should present a rounded picture of its economic activities. (e) Objectivity. Information should be as objective as possible. This is particularly the case where conflicting interests operate and an unbiased presentation of information is needed. In the context of preparing accounts, where many decisions must be based on judgement rather than objective ThiNganHang.comfacts, this problem often arises. Management are often inclined to paint a rosy picture of acompany's profitability to make their own performance look impressive. By contrast, auditorsresponsible for verifying the accounts are inclined to take a more prudent view so that they cannotbe held liable by, say, a supplier misled into granting credit to a shaky company. (f) Timeliness. The usefulness of information is reduced if it does not appear until long after the period to which it relates, or if it is produced at unreasonably long intervals. What constitutes a long interval depends on the circumstances: management of a company may need very frequent (perhaps daily) information on cash flows to run the business efficiently; but shareholders are normally content to see accounts produced annually. (g) Comparability. Information should be produced on a consistent basis so that valid comparisons can be made with information from previous periods and with information produced by other sources (for example the accounts of similar companies operating in the same line of business). 12 1: Introduction to financial statements ⏐ Part A Introduction to financial reporting ThiNganHang.com
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