Module 1 Introduction to Financial Statements At the end of the module students should be able to: Understand and explain the purpose of accounting information Understand and identify the purpose of each of the main financial statements Determine and explain the qualities of good accounting information Identify and explain the organizational structure of different types of business entities

Introduction Financial reporting is a way of recording, analyzing and summarizing financial data Financial data is the name given to actual transactions carried out by the business Recorded in the books of prime entry Transactions are analysed in the books of prime entry and totals posted to ledger accounts Transactions are then summarized in the financial statements

The purpose of accounting information According to IASB, “ The objective of financial statements is to provide information about financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.” In other words….to fulfill the requirements and need of users of financial statements and accounting information

Users of financial statements and accounting information Managers of the company (need it most) Shareholders of the company Trade contacts ( suppliers and customers) Providers of finance to the company Taxation authorities Employees of the company Financial analysts and advisers Government and their agencies

Users of financial statements and accounting information The public Accounting information is summarised in financial statements to satisfy information needs of these different groups. Not all will be equally satisfied.

The Main Financial Statements The principal financial statements of a business are the statement of financial position and the income statement.

Statement of financial position A list of all the assets owned and all the liabilities owed by a business as at a particular date. Snapshot of the financial position of the business at a particular moment. Monetary amounts are attributed to each of the assets and liabilities

Statement of financial position Assets Something valuable which a business owns or can use. 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 (IASB)

Statement of financial position Liabilities Something which is owed to somebody else. 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 (IASB)

Statement of financial position Capital or equity The amounts invested in a business by the owner are amounts that the business owes to the owner. This special kind of liability is called capital. In a limited liability company, capital usually takes form of shares (equity).

Statement of financial position Capital or equity Equity is the residual interest in the assets of the entity after deducting all its liabilities (IASB) Example of statement of financial position (Illustration M1(1) Excel File)

Statement of financial position Used to be called Balance Sheet Called in that way as assets will always be equal to liabilities plus capital (or equity).

Income Statement A record of income generated and expenditure incurred over a given period. Shows whether the business has had more revenue than expenditure (a profit) or vice versa (loss).

Income Statement Revenue (Income) is the income generated by the business for a period. Income is increases in economic benefits during accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants (IASB)

Income Statement Expenses are the costs of running the business for the same period. Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants (IASB)

Income Statement The period chosen will depend on the purpose for which the statement is produced. Income statement which forms part of the published financial statements of a limited liability company will be for a period of a year. Management might want to keep a closer eye on a company’s profitability by preparing monthly or quarterly statements. Illustration M1(2)

Purpose of financial statements Both the statement of financial position and the income statement are summaries of accumulated data. For limited companies, there are other financial statements required by legislation such as statement of comprehensive income and statement of cash flow.

Qualities of good accounting information The four principal qualitative characteristics are understandability, relevance, reliability and comparability. Others are fair presentation, consistency and the business entity concept.

Understandability Users must be able to understand financial statements Assumed to have some business, economic and accounting knowledge and to be able to apply themselves to study the information properly.

Relevance Only relevant information can be useful. Information should be released on a timely basis to be relevant to users. Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations (IASB Framework)

Reliability Information must also be reliable to be useful. The user must be able to depend on it being a faithful representation. Information has the quality and reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent (IASB).

Comparability Through time to identify trends Users must be able to compare an entity’s financial statements: Through time to identify trends With other entity’s statements, to evaluate their relative financial position, performance and changes in financial position. Disclosure of accounting policies is important in order for users to make valid comparison

Fair presentation Financial statements are required to give a fair presentation or present fairly in all material respects the financial results of the entity. Compliance with IFRSs will almost always achieve this. IAS 1

Consistency To maintain consistency, the presentation and classification of items in the financial statements should stay the same from one period to the next, except as follows: Significant change in the nature of operations or review of the financial statements indicates a more appropriate presentation Change is required by an IFRS

Business entity concept Financial statements always treat the business as a separate entity.

Organizational Structure Sole Traders Partnerships Limited Liability Companies

Sole Traders A sole trader owns and runs a business, contributes the capital to start an enterprise, runs it with or without employees and earns the profits and stands the loss of the venture. In law, a sole trader is not legally separate from the business they operate.

Sole Traders Advantages Limited paperwork and cost Complete control by owner Entitled to profits / ownership of assets Less stringent reporting obligations Highly flexible

Sole Traders Disadvantages Unlimited liability Complete control by owner Entitled to profits / ownership of assets Less stringent reporting obligations Highly flexible

Partnerships Occur when two or more people decide to run a business together Generally formed by contract and legally binding Partnership agreements outlined the proportionate amount of capital invested, allocation of profits between parties, the responsibilities of each of the parties, allocation of salary and procedures for dissolving partnerships.

Partnerships Partnerships are not separate legal entities from their owners Limited Liability Partnership (LLP)

Partnerships Advantages Less stringent reporting obligations Can raise additional capital – more people Divisions of roles and responsibilities Sharing of risk and losses No company tax on profits ( personal tax only)

Partnerships Disadvantages Unlimited liability Costs associated with setting up. Issues of continuity of business in the event of death or illness Slower decision making – consensus among partners Partnership dissolves in event of death of a partner

Limited Liability Companies Concept of Limited Liability Shareholders of limited companies are only responsible for the amount paid for their shares Legally a separate entity Shareholders may be individuals or other companies Shareholders vs Directors

Limited Liability Companies Advantages Limited liability Easier to raise finance Separate legal identity Tax advantages Easy to transfer shares

Limited Liability Companies Disadvantages Requirement to publish annual financial statements Comply with legal and accounting requirements To undergo statutory audit Share issues regulated by law

End of Module 1