Chapter 1 Introduction to accounting

Question 1

1.1 The purpose of accounting

Answer 1

Accounting consists of two elements recording and summarising.
Recording transactions must be recorded as they occur in order to provide up-to-date information for management. Summarising the transactions for a period are summarised in order to provide information about the company to interested parties. The statement of profit or loss reflects the performance of a business over a period of time, the statement of financial position reflects the position of a business at a point in time.
Profit making business entities:
- Sole trader: owned and management by one person (although there might be any number of employees) and the trader is fully and personally liable for any losses that the business might make.
- Partnership: a business owned jointly by a number of partners and each partner is jointly and severally liable for any losses that the business makes. (this is just referring to a general partnership and not an LLP).
Companies:
Companies are more complex and have the following characteristics:
- Owned by shareholders (or members)
- There can be any number of shareholders
- Shareholders elect the directors to run the business
- Almost always have limited liability
- This means that the shareholders will not be personally liable for any losses the company incurs
- Their liability is limited to the nominal value of the shares that they own
- The company is a separate legal entity from its owners
Non-profit making entities: charities, clubs and societies and government (or public sector) organisations also need to prepare financial statements and accounting information.

Question 2

2.1 The main financial statements

Answer 2

According to IAS 1, a full set of financial statements is made up of:
- Statement of financial position
- Statement of profit or loss
- Statement of changes in equity
- Statement of cash flows
- Notes to the financial statements

Question 3

2.2 Statement of financial position

Answer 3

A statement of financial position is a list of the assets and liabilities of the business. It is a snapshot of the assets the business owns and the liabilities the business owes at a point in time. The purpose is to show the total value of the net assets at the end of each accounting period.

Question 4

2.3 Statement of profit or loss

Answer 4

This shows the revenue and the expenses of a business for the accounting period, showing the business performance over that period of time. The purpose is to show the amount of profit or loss the business made during the last accounting period.

Question 5

3.1 Capital and revenue expenditure

Answer 5

Capital expenditure is incurred either to acquire long-term assets (kept in a business for more than one year), or to improve or enhance the earning capacity of long-term assets. This expenditure is recorded in the statement of financial position within non-current assets.
Revenue expenditure is incurred either for trade purposes including purchases of raw materials or items for resale, expenditure on salaries, selling and distribution expenses, administrative expenses, and finance costs, or to maintain the existing earning capacity of long-term assets. This expenditure is recorded in the statement of profit or loss.

Question 6

4.1 Ethical considerations

Answer 6

Financial statements are regulated by legislation, application of judgement using accounting concepts, accounting and financial reporting standards, GAAP, and the need for fair presentation. Financial statements of limited liability companies are most closely regulated.

Question 7

4.2 Accounting concepts and individual judgement

Answer 7

Many figures in financial statements are derived from the application of judgement, thus meaning different conclusions with the same facts can occur. Judgement can be made on valuation of buildings and determining whether expenditure is revenue or capital. The exercise of judgement in accounting should be underpinned by ethical principles.

Question 8

4.3 IESBA code of ethics – fundamental principals

Answer 8

• Integrity: an accountant should be straightforward and honest in all professional and business relationships
• Objectivity: should not allow bias, conflict of interest or undue influence of others to override professional or business judgements
• Professional competence and due care: accountant has a continuing duty to maintain knowledge and skill at the level required to ensure a client receives competent professional service based on current developments. They should act diligently and in accordance with applicable technical and professional standards when providing professional services
• Confidentiality: respect confidentiality of information acquired as a result of business relationships and not disclose to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose. It should not be used for personal advantage
• Professional behaviour: an accountant should comply with relevant laws and regulations and should avoid any action that discredits the profession.

Question 9

4.4 ICAEW code of ethics

Answer 9

ICAEW code of ethics is derived from the IESBA code, it states accountants are expected to demonstrate the highest standards of professional conduct and take into consideration the public interest and maintain the reputation of the profession. Accountants are to follow the spirit as well as the letter of guidance.

Question 10

4.5 Principles based system

Answer 10

The IESBA and ICAEW codes are principles based. The advantages of this approach are as follows:
- Onus is on the individual to consider the situation and follow the spirit of the guidance
- Principles encourage compliance, whereas rules can result in individuals seeking ways to find a smart way around those rules
- Principles are more adaptable to a multitude of situations
- Rules often cannot keep up with a rapidly changing environment
- Principles based systems can still prohibit certain situations where safeguards are not feasible