Chapter 1
Introduction to
accounting • The purpose of financial
reporting
• Types of business entity
• Users
• Governance
• The main financial
statements
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Overview - Purpose & Objectives
Statement of financial
Statement of profit or loss
position
Users of financial
Financial statements
information
Governance Introduction
to accounting
Types of business
entities
Limited liability
Sole trader Partnership
company
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Types of business entity 1
What is a business?
• A business of whatever size or nature exists to make a profit.
• Profit occurs when income exceeds expenses.
A business is:
• a commercial or industrial concern
• an organisation which uses economic resources
• an organisation providing jobs
• invests money in resources
Financial data is the name given to the actual transactions carried out by a business eg
sales of goods.
Financial reporting is a way of recording, analysing and summarising financial data.
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Types of business entity 2
Types of business entity
• Sole traders – refers to ownership, sole traders can have employees
• Partnerships – two or more people working together to earn profits
• Limited liability company – owners have liability limited to the amount they pay for their shares.
• A limited liability company has a separate legal identity from its owners.
• In law, sole traders and partnerships are not separate entities from their owners. However, a limited liability
company is legally a separate entity from its owners. Contracts can therefore be issued in the company's name.
• For accounting purposes, all three entities are treated as separate from their owners. This is called the business
entity concept.
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Types of business entity 3
Advantages of being a Sole traders
• Limited paperwork and therefore cost in establishing this type of structure
• Owner has complete control over the business
• Owner is entitled to profits and the ownership of assets
• Less stringent reporting obligations compared with other business structures – no requirement
to make financial accounts publicly available, no audit requirement
• Can be highly flexible
Disadvantages being a Sole traders
• Owner is personally liable for all debts (unlimited liability)
• Personal property may be vulnerable for debts and other business liabilities
• Large sums of capital are less likely to be available to a sole trader, leading to reliance on
overdrafts and personal savings
• May lead to long working hours without the normal employee recreation leave and other
benefits
• May be issues of continuity of business in the event of death or illness of the owner
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Types of business entity 4
Advantages of partnerships
• Less stringent reporting obligations – no requirement to make financial accounts publicly
available, no audit requirement, unless the partnership has LLP status
• Additional capital can be raised because more people are investing in the business
• Division of roles and responsibilities and an increased skill set
• Sharing of risk and losses between more people
• No company tax on the business (profits are distributed to partners and then subject to personal
tax)
Disadvantages of partnerships
• Partners are jointly personally liable for all debts (unlimited liability) unless they have formed an
LLP
• There are costs associated with setting up partnership agreements
• There may be issues of continuity of business in the event of death or illness of the partners
• Slower decision making due to the need for consensus between partners
• Unless a clause is written into the original agreement, when one partner leaves, the partnership
is automatically dissolved and another agreement is required between existing partners
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Types of business entity 5
Advantages of Limited Liability Company
• Limited liability makes investment less risky than being a sole trader or investing in a
• partnership. However, lenders to a small company may ask for a shareholder's personal
• guarantee to secure any loans.
• Limited liability makes raising finance easier (eg through the sale of shares) and there is no limit
on the number of shareholders.
• A limited liability company has a separate legal identity from its shareholders. So a company
continues to exist regardless of the identity of its owners.
• There are tax advantages to being a limited liability company. The company is taxed as a
separate entity from its owners and the tax rate on companies may be lower than the tax rate
for individuals.
• It is relatively easy to transfer shares from one owner to another. In contrast, it may be difficult
to find someone to buy a sole trader's business or to buy a share in a partnership.
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Types of business entity 5
Disadvantages of Limited Liability Company
• Limited liability companies have to publish annual financial statements. This means that anyone
(including competitors) can see how well (or badly) they are doing. In contrast, sole traders and
partnerships do not have to publish their financial statements.
• Limited liability company financial statements have to comply with legal and accounting
requirements. In particular, the financial statements have to comply with accounting standards.
Sole traders and partnerships may comply with accounting standards, eg for tax purposes.
• The financial statements of larger limited liability companies have to be audited. This means that
the statements are subject to an independent review to ensure that they comply with legal
requirements and accounting standards. This can be inconvenient, time consuming and
expensive.
• Share issues are regulated by law. For example, it is difficult to reduce share capital.
• Sole traders and partnerships can increase or decrease capital as and when the owners wish.
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The purpose of financial reporting 1
• 'The objective of financial statements is to provide information about the financial
position, performance and changes in financial position of an entity that is useful to
a wide range of users in making economic decisions.’
There are various groups of people who need information about the activities of a
business.
Users of accounts
• Managers of the company
• Shareholders of the company
• Trade contacts
• Providers of finance to the company
• Taxation authorities
• Employees of the company
• Financial analysts and advisors
• Government and their agencies
• The public
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Tackling the exam
Exam focus point:
The needs of users can be easily examined.
For example, you could be given a list of types of information and asked which user group would be most interested in
this information.
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Discussion question
Required
What information would these users of financial information be interested in?
(a) Investors
(b) Employees
(c) Lenders
(d) Suppliers
(e) Customers
(f) Governments and their agencies
(g) Public
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Answer to discussion question
Users of financial information
(a) Investors
— Profitability
— Future prospects
— Likely risk and return
— Chance of capital growth
— Ability to pay dividends
(b) Employees
— Profitability
— Long-term growth
— Security of their job
— Likelihood of bonus
— Number of employees
— Ability to pay retirement benefits
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Answer to discussion question (cont'd)
(c) Lenders
— Whether return on finance will continue to be met
— Other providers and security of their debt
— Likelihood of repayment of capital amount
(d) Suppliers
— Likelihood of payment on time
— Likelihood of payment at all
— Whether they should continue to supply
(e) Customers
— Ability of entity to continue supplying
— Profitability as a measure of value for money of
goods bought
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Answer to discussion question (cont'd)
(f) Governments and their agencies
— Statistics
— Size of company
— Growth rates
— Average payment periods
— Foreign trade
— Profits made
— Corporate income tax liability
— Sales tax liability
(g) Public
— Contribution to local economy
— Information about trends in the prosperity of the entity
— Range of activities provided
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The main financial statements 1
• The statement of financial position is a list of all the assets owned and all the liabilities owed by a business at a
particular date.
• Asset: A present economic resource controlled by an entity as a result of past events. An economic resource is
a right that has the potential to produce economic benefits.
• Liability: A present obligation of the entity to transfer an economic resource as a result of past events.
• Equity: The residual interest in the assets of an entity after deducting all its liabilities
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The main financial statements 3
• A statement of profit or loss is a record of income generated and expenditure incurred over a given period.
• Revenue is the income generated by the operations of a business for a period.
• Expenses are the costs of running the business for the same period.
• Income is increases in economic benefits during the 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.
• 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.
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Governance
Corporate governance is the system by which companies and other entities are directed and controlled.
Directors
• Main aim – to create wealth for shareholders.
• Have a duty of care to show reasonable competence; may have to indemnify the company against loss caused by
their negligence.
• Are in a fiduciary position in relation to the company which means that they must act honestly in what they
consider to be the best interests of the company and in good faith.
• Are responsible for the preparation of the financial statements of the company.
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Governance
In the UK, the Companies Act 2006 sets out seven statutory duties of directors. Directors should:
• Act within their powers
• Promote the success of the company
• Exercise independent judgment
• Exercise reasonable skill, care and diligence
• Avoid conflicts of interest
• Not accept benefits from third parties
• Declare an interest in a proposed transaction or arrangement
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Governance
When exercising this duty directors should consider:
• The consequences of decisions in the long term
• The interests of their employees
• The need to develop good relationships with customers and suppliers
• The impact of the company on the local community and the environment
• The desirability of maintaining high standards of business conduct and a good reputation
• The need to act fairly as between all members of the company
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Governance
Directors are responsible for the preparation of the financial statements of the company. Specifically, directors are
responsible for:
• Preparation of the financial statements in accordance with the applicable financial reporting framework (eg IFRSs)
• Internal controls necessary to enable the preparation of financial statements that are free from material
misstatement, whether due to error or fraud
• The prevention and detection of fraud
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Governance
Directors' responsibility is to
• Ensure that the entity complies with the relevant laws and regulations.
• Explain their responsibility for preparing accounts.
• Report that the business is a going concern, with supporting assumptions and qualifications as necessary.
• Present a balanced and understandable assessment of the company's position and prospects in the annual
accounts and other reports.
• Explain the basis on which the company generates or preserves value and the strategy for delivering the
company's longer-term objectives.
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Chapter Summary
1 Accounting
• Accounting is a way of recording, analysing and summarising a business's transactions.
2 Accounting records
• All businesses must keep sufficient accounting records in order to be able to produce
accurate information about the entity's activities.
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Chapter Summary
3 The concept of business entity
• The business entity concept states that a business is a separate entity from its owners.
4 Types of business entities
• There are three main types of businesses. For sole traders and partnerships the
owners have unlimited liability and bear all the risks and reap all the rewards of being
in business. For a limited liability company the shareholders' liability is limited to the
extent of their investment.
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Chapter Summary
5 Users of financial information
• Financial statements are used by a wide variety of users, each with different
information needs. Satisfying the investors' needs will mean that the majority of other
users' needs are also met.
6 Proforma financial statements
• Companies must follow a prescribed format when producing their financial
statements, there is however no set format for a sole trader's statement of profit or
loss and statement of financial position.
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Chapter Summary
7 Governance
• Corporate governance is the process by which businesses are directed and controlled
by those responsible for running the business.
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