Week 1 New Flashcards
Define accounting
Often called the ‘language of business’
The process of identifying (select relevant economic transactions), analysing, recording (bookkeeping & summarising info) and communicating (preparing financial statements) economic transactions (reliable and relevant financial information)
Reliable and relevant information put together so users (e.g. shareholders and managers) can make an informed decision (accountants may also help users interpret the
What obligations do accountants have?
1) They need to ensure that financial statements comply with statutory (act of parliament- law made by UK parliament), professional and listing requirements (requires accountant to possess technical expertise)
2) They also need to ensure that financial statements present the substance of the commercial transactions of the company- requires commercial awareness from the accountant and important that the accountant does not operate in isolation
Define financial reporting
Financial reporting is a way of recording, analysing and summarising financial data
- transactions are summarised in the financial reports/statements
What is the purpose of financial reporting?
Financial reporting enables businesses to record,
analyse and summarise financial data.
This data can then be used to satisfy one of the many, but most prominent, functions of a business which is to make a profit (excess income over expenditure) for the owners (shareholders if applicable)
Are income and revenue the same?
Yes pretty much and they are interchangeable
What is a business?
A business is a commercial or industrial concern (manufacturing business) which exists to deal in the manufacture, resale or supply of goods and services
A business is an organisation which uses economic resources to create goods or services which customers will buy
A business is an organisation providing jobs for people
A business invests money in resources (for example buildings, machinery, employees) in order to make even more money for its owners
A business exists to make a profit
Define profit
Profit is the excess of income (revenue) over expenditure
When expenditure exceeds income (revenue), the business is running at a loss
How many types of business entity are there?
3 types
What are the 3 types of business entity?
1) Sole traders
2) Partnerships
3) Limited liability company
What is a proprietorship/sole trader?
generally owned by 1 person but can have employees
- usually small service type business e.g. newsagent
- unlimited liability (owner is personally liable for all debts of business)- no separation between owner and entity (legally owner and business treated as one- same legal identity)
What are partnerships?
- owned by 2 or more people- partnership agreement
- usually retail and service type business
- unlimited personal liability- owners personally share responsibility for debts of business for example in the case that a business fails or to settle any legal proceedings (e.g. a lawsuit due to employee injury on the job)
- profits of the business will be shared between partners BUT not necessarily in equal measure
What is a limited liability company?
- ownership divided into shares
- owners have liability limited to the amount they pay for their shares
- limited liability company has a separate legal identity from its owners- owner separate to entity- owner protected under state corporation law
Limited liability company can be shortened to LLC
It is an American business structure (treat as different/separate from plc and ltd)
What is financial accounting?
Mainly a method of reporting the financial performance and financial position of a business
It is NOT primarily concerned with providing information towards the more efficient running of the business
They still are an interest to management BUT their principal function is to satisfy the information needs of persons not
involved in running the business
They provide historical (past) information
What is management accounting?
Management accounting information is required by management (internal users of the firm) and there needs go far beyond those of other (external) account users
This is because managers have the responsibility of planning and controlling the resources of the business which is why they need much more detailed information
They also need to plan for the future (e.g. budgets, which predict future revenue
and expenditure)
Management (or cost) accounting analyses data to provide information as a basis for managerial action. The concern of a management accountant is to present accounting information in the form most helpful to management
What is the objective of financial statements?
According to the International Accounting Standard (IAS):
‘The objective of financial statements is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic
decisions’
Who requires/are the users of financial statements?
1) Shareholders
2) National taxation authorities e.g. HMRC
3) Creditors
4) Managers of company- to know future growth prospects as well as financial performance of company over the last accounting period (remember financial accounting looks at the past)
5) Employees of the company
What are employee reports?
Some companies voluntarily provide specially prepared financial information for issue to their employees. These statements are known as ‘employee reports’
What is the IASB?
International Accounting Standards Board
What is the IASB responsible for and what must accountants make sure of a result?
The IASB is responsible for issuing International Financial Reporting Standards (IRSs)
These require companies to publish certain additional information. Accountants, as members of professional bodies, are placed under a strong obligation to ensure that company financial
statements conform to the requirements of IFRSs
What is the trend seen with the size of the firm and the users of its financial statements?
The larger the entity, the greater the interest from various groups
of people
What financial information would investors/shareholders/owners want?
- information about profits (as dividends taken from this) … ability to pay dividends
- further growth prospects
- chance of capital growth (increase in the value of an asset)
What financial information would employees want?
- profitability of the firm they work at
- future/long-term growth outlook/prospects
- job security
- likelihood of receiving bonuses (link to profitability as typically earned when firm doing well financially)
- number of employees
- ability of firm to pay retirement benefits
What financial information would lenders/creditors want?
- banks for example might demand a forecast of a company’s expected future cash flows as a precondition of
granting an overdraft/loan (creditors will be less inclined to lend to companies which are struggling to pay there debt or on the verge of bankruptcy) - need to know whether return on finance will continue to be met (… require up to date information regarding profitability and cash flows)
- other debt the firm has
- the likelihood of the firm repaying the capital (total) amount
What financial information would suppliers want?
- ability to pay and to do so on time (… is firm earning enough profit to allow for this- does it have a positive working capital … lots of liquid cash available which can be used to pay suppliers)
- as a result of the info above the supplier can then decide whether they should continue to supply the firm
What financial information would customers want?
- ability of the firm/entity to continue supplying the good/service … future growth prospects important here
- profitability of the firm to determine the value of the goods/services they bought compared to the amount of profit the firm/entity earned
What financial information would the government and its agencies (e.g. HMRC etc) want?
- profits made (so that corporation/corporate income tax liability can be calculated)
- sales tax liability (America)
- size of company
- firm/entity growth rates
- foreign trade (to calculate national growth figures e.g. GDP etc)
What financial information would the public want?
- contribution of the firm/entity to the local economy/society the firm/entity operates in
- ranges if activities/goods/services provided by the firm/entity
What can equity also be known as?
Other names for equity include:
- net wealth
- capital
What is the statement of financial position?
A list of all the assets owned by the entity and all the liabilities owed by the entity at a particular date allowing the equity/net wealth/capital to be calculated
What is the accounting equation?
Assets = Liabilities + Equity/Net Wealth/Capital
OR
Total Assets = Total Liabilities + Total Equity/Total Capital/Total Net Wealth
OR
Assets = Liabilities + Equity + or - any profit/loss made on asset as a result of a change in the amount you owe and … the net wealth (equity)- basically change in amount owed and amount which yours broken down
What is an asset?
An economic resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity
What is revenue/income?
Increases in economic benefits during the accounting period in the form of inflows of assets (e.g. cash, inventory, accounts receivables etc) or decreases of liabilities which … result in increases in equity (remember equity is equal to assets minus liabilities) BUT excluding the contribution from equity participants (equity participants owners of shares in a entity/firm and … contribution includes money earned from the purchase of these shares)- so basically money earned from investors buying shares does not count as income- CHECK but for the time being could just ignore the last clause
What is the statement of profit and loss?
A record of income generated and expenditure incurred over a given period
What is a liability?
Present obligation of the entity arising from past events. It is expected to be settled through an outflow from the entity of economic benefits
What is an expense?
Decreases in economic benefits during the accounting period in the form of outflows of assets (e.g. cash, inventory, accounts receivables etc) or increases in liabilities which … result in decreases in equity (remember equity is equal to assets minus liabilities) BUT excluding the distributions to equity participants (equity participants are owners of shares in a entity/firm and … distribution includes money paid as dividends- so basically money paid to investors as dividends does not count as expense- maybe because given own section in SOFP under dividends because retained earnings broken into revenues minus expenses minus dividends- CHECK but for the time being could just ignore the last clause
What is Equity/Capital/Net Wealth?
Residual value of the asset of the entity after deducting all of the liabilities (obligations against it)
What is relationship between the income statement/statement of profit and loss and the statement of financial position (SoFP)?
The accounting equation used in the statement of financial position (SoFP):
Assets = Liabilities + Equity
OR
Assets = Liabilities + Equity +/- profit/loss
Profit/loss can also be written as sales revenue minus expenses which are components of the income statement …
Assets = Liabilities + Equity + (Sales Revenue - Expenses)
What are the responsibilities of governing authorities, specifically directors, in accounting?
Directors:
- main aim is to create wealth for shareholders
- must act honestly in best interest of company
- they must have a Fiduciary position (director must act on behalf of the owners/shareholders and putting their clients’ interests ahead of their own, with a duty to preserve good faith and trust)
- responsible for preparation of financial statements (doesn’t necessarily mean they prepare them themselves)
- must show reasonable competence
What is corporate governance?
The system by which companies/entities/firms are directed and controlled
Why is corporate governance important?
Remember corporate governance is the way by which commoners are directed and controlled-it is the structure of rules, practices, and processes used to direct and manage a company
… it is important because of the conflict that arises between owners (equity shareholders- principals) and management (agents employed by company’s owners to manage company on their behalf)- conflict known as ‘agency theory’
Management without corporate governance have difficulty making decisions that are both in the best interests of the shareholders and their own … corporate governance is needed so that directors can make these decisions for management
What is agency theory?
The conflict that arises between owners and management
What is an audit?
Work performed by auditors (independent experts) to provide an informed professional independent opinion on whether financial statements portray a true and fair view
Why must audits be carried out?
The financial statements of limited companies share required by the Companies Act of 2006 to give a true and fair view of the company’s financial position at the reporting period date and of its profit or loss for the reporting period (basically saying that entity/firms statement of financial position and statement of profit and loss/income statement should give a true and fair view)- REMEMBER that statement of financial provides snapshot of business performance at a reporting period date whereas the statement of profit and loss/income statement shows the business performance over a reporting period
How do financial statements provide a true and fair view (have a clean audit report)?
If they contain sufficient information (in both quantity and quality) to satisfy the reasonable expectations of the users of the financial statements
What is the objective/purpose of an audit?
Purpose of audit is to enhance the degree of confidence of the intended users of the financial statements
This is achieved by the auditor expressing an opinion on whether the financial statements are well prepared in all material respects and in accordance with an applicable financial reporting framework
What is a general overview of the process of an audit?
1) Figures reported in the statement of profit and loss/income statement have occurred/exist, are complete, are accurate, are properly prepared under the accruals concept and are classified correctly
2) The items reported in the statement of financial position have occurred/exist, are complete, items properly reflect the rights and obligations of an asset or liability, items are included at the correct valuation and disclosed in accordance with accounting standards and company law
3) That the presentation and disclosure of the information in both statements is complete, appropriately classified, understandable and accurate
Who appoints the auditors and when do they do so?
The auditors are appointed by the equity shareholders at the annual General Meeting (AGM)
What must auditors do during and following their appointment and audit process?
Auditors must act on the behalf of the owners/equity shareholders and report to them in the annual published financial statements with an audit report
What is the function of an auditor?
To report their opinion on whether the financial statements give a true and fair view of state of affairs that have taken place over the last accounting period and that the profit of the company has been properly prepared in accordance with the Companies Act of 2006
What is an audit report with a positive opinion on a company’s financial statements called?
Called unmodified (opinion), unqualified (opinion) or a clean audit report
What is an audit report with a negative opinion on a company’s financial statements called?
Audit report with negative opinion called a modified audit report, adverse opinions or qualified audit reports
How many types of modified audit reports are there (those that generate a negative opinion)?
2 types of modified audit reports
What are the 2 types of modified audit reports (those that generate a negative opinion)?
1) Those modified audit reports where matters arise that do not affect the auditors opinion
2) Those modified audit reports where matters arise that do affect the auditors opinion
How many types of a modified audit report (generating negative opinion) are there that can also be regarded as clean (generating positive opinion)?
1 type
When can a modified audit report (generating negative opinion) also be regarded as clean (generating positive opinion)?
When the auditor wants to emphasise some matter to the reader of the financial statements
What is the expectations gap?
This is the gap between the auditor’s role and opinion and the public’s perception of the auditor’s role
Why is there an expectation gap?
Many members of the public believe that auditors:
- look for fraud when they undertake an audit
- just say the financial statements are accurate
- are responsible for the financial statements and … should give warnings about the future of the entity when they suspect it is going to fail
Does the audit report say whether the financial statements are correct?
No, the audit report does not say that the financial statement are correct
How do auditors check transactions in practice?
Auditors only check a sample of transactions not every transaction and … cannot guarantee that fraud will be detected
Does an audit guarantee that a company/firm/business will succeed in the future?
No, an audit does not guarantee that a company will succeed in the future
Who are responsible for the financial statements?
Management (more senior members of a business/entity/firm that are involved in the running of a business) are responsible for the financial statements they prepare or that are prepared on their behalf
Who is responsible for the running of a company/entity/business?
Management are fully responsible for the running of the company/entity/business
How should auditors abide by the law?
Auditors should be independent (separate from the firm/business/company), auditors should carry out their work with integrity, objectivity (be impartial and fair), they should be technically up to date, be competent and maintain competence and be able to defend their audit work
How important is ethics in the auditing industry?
Auditing industry is reliant on ethics for survival as ethics underpins the whole point of an audit
How can one be a practicing auditor?
To be an auditor, an accounting practice must be registered under law with a Recognised Supervisory Body (RSB) and be eligible for appointment as an auditor under the rules of that body
When is an auditors integrity supported?
Supported when an auditor is sufficiently competent with an up-to-date record of continuing professional development and when an auditor is visibly independent from the client being audited
How many threats/potential issues may an auditor face with regards to their independence from the client (firm being audited)?
6 potential threats/issues
List the threats/potential issues an auditor may face with regards to their independence from the client (firm being audited)?
1) Business relationships
2) Financial interests
3) Employment relationships
4) Family and other personal relationships
5) Length of service
6) Fees (remuneration), gifts and hospitality
What are business relationships as a threat/potential issue an auditor may face with regards to their independence from the client (firm being audited)?
A business relationship between the auditor and client (entity being audited) is only allowed if the transactions that have taken place between the 2 parties are in the normal course of business, are at arm’s length (transactions in which two or more unrelated and unaffiliated parties agree to do business, acting independently and in their self-interest) and immaterial/insignificant/unimportant to both parties
What are financial interests relationships as a threat/potential issue an auditor may face with regards to their independence from the client (firm being audited)?
An auditor should not have any direct financial interest in an audit client
They should also not have any indirect material/important/significant financial interest in the audit client
What are employment relationships as a threat/potential issue an auditor may face with regards to their independence from the client (firm being audited)?
An audit member of staff can ONLY work on a part-time basis for a client
They MUST not hold a management role nor make management decisions
What are family and other personal relationships as a threat/potential issue an auditor may face with regards to their independence from the client (firm being audited)?
These relationships should between the auditor and the client should be reported immediately
A decision should be taken as to whether this reduces independence and to what extent and therefore if it is necessary to select an audit team that has no links with the client being audited
What is length of service as a threat/potential issue an auditor may face with regards to their independence from the client (firm being audited)?
The audit firm should rotate the engagement partner (the auditor responsible for the effective functioning of all phases in the audit) on audit engagements (arrangement that an auditor has with a client to perform an audit of the client’s accounting records and financial statements) as close relationships between the client and the individual auditor may foster/develop over time which may reduce the perceived independence
In plc’s rotations should be at least every 5 years
What are fees (remunerations), gifts and hospitality as a threat/potential issue an auditor may face with regards to their independence from the client (firm being audited)?
The fee from a non-listed (company who is not permitted to sell its shares on a stock exchange) should not exceed 15% of the audits firms total fee income
The fee from a listed (company who is permitted to sell its shares on a stock exchange) should not exceed 10% of the audits firms total fee income
Auditors or their family should not accept gifts from audit clients unless the amount is insignificant
Also the provision of non-audit services by an audit firm/auditor e.g. tax advice is severely restricted
What are some ethical issues facing management?
- globalisation (in itself a positive for trade as the world is more interconnected allowing for more international/global trade) but downsides that may come with it include child labour, low wages (exploitation)
- pollution
- bribery/corruption- norm in certain countries
- employee welfare- conditions of working environment- health and safety, pensions (long term welfare)
