CHAPTER 1 – FINANCIAL REPORTING

INTRODUCTION

Chartered Institute of Management Accountants’ (CIMA) defines accounting as:

 the classification and recording of monetary transactions;
 the presentation and interpretation of the results of those transactions in order to assess
performance over a period and the financial position at a given date;
 the monetary projection of future activities arising from alternative planned courses of action.

To Illustrate let us consider a company’s annual accounts. Manual or computerized bookkeeping

systems are used to record all monetary transactions throughout the year. The transactions are grouped
and classified before presentation in the two key financial statements viz.

 The profit and loss account or the Income Statement - measures financial performance over the
years
 The balance sheet – states the financial position as at the end of a financial period

Looking ahead now, top management will prepare for their own internal use a budgeted profit and loss
account and balance sheet, based on a set of projected financial transactions for the coming year.

USERS OF ACCOUNTING INFORMATION

The aim of all accounting information is to provide the particular user with relevant and timely data to
make decisions. Who are these users of accounting information and what decisions do they need to
take?

Possible users include:

 shareholders
 management
 suppliers
 customers
 employees
 government
 competitors
 lenders

 Shareholders of limited liability companies will be influenced in their decision to remain investors or
to increase/decrease their holding by receiving information about the financial performance and
financial position of their company.
 Management in companies range from director level down to supervisor level. Each person requires
accounting information to help them in their role. Supervisors may be concerned with operating
costs for a very small part of the undertaking. Directors need to control the overall performance of
the company and make strategic financing and investment decisions. Middle management need
feedback on whether they are meeting their financial targets.
 Suppliers need to assess the creditworthiness of potential and existing customers when setting the
amount and period of credit allowed. This will partly, if not mainly, be based on the financial history
of each customer so the supplier’s accountants will assess the latest profit and loss account and
balance sheet. Other data on payment history may be obtained from credit agencies.
 Customers also need to be reassured, in this case to minimize the risk of their supplies drying up and
disrupting their own output. Firms entering into a joint venture will also need mutual reassurance.
Similar checks to those outlined above for suppliers will need to be carried out.
 Employees and their representatives have a vested interest in the financial health and future
prospects of their employer. They rely on an assessment of the published accounts by experts for
this.
 Government levies tax on the profits earned by businesses and value added tax on the sales value of
most industries. Tax authorities rely on the information provided by companies for these purposes.
 Competitors can make some comparisons, for example, sales per employee, from published
accounting data in a process known as benchmarking. This may provide clues to areas where
performance may be improved particularly if explanations of differences in operating
systems can be obtained.
 Lenders need to be assured that their capital is safe and that theborrowing company can service the
loan or overdraft adequately, so again the financial statements of profit and loss account and
balance sheet will be examined from this viewpoint. Financial reporting

It can be concluded from the above that most users of accounting information are drawing on what is
provided in the published accounts. Only management has access to more detailed, non-published
financial information within a company.

BRANCHES OF ACCOUNTING
Different users of accounting information will require different information and use it for different
purposes. Accounting can be broken down into three main branches:
 Financial accounting;
 Management accounting;
 Financial management.

 Financial accounting is the preparation of financial statements summarizing past events, usually in
the form of profit and loss account and balance sheet. These historic statements are mainly of
interest to outside parties such as investors, loan providers and suppliers.

 Management accounting is the provision of much more detailed information about current and
future planned events to allow management to carry out their roles of planning, control and
decision-making. Examples of management accounting information are product costs and cost data
relevant to a particular decision, say, a choice between make or buy. Also included in management
accounting is the preparation and monitoring of budgeted costs relating to a product, activity or
service. All the above management accounting information is rarely, if ever, disclosed to outside
parties.

 Financial management covers the raising of finance and its deployment in the various resources
needed by a business, in the most efficient way. The cost of capital is influenced by both the capital
Structure adopted as well as the riskiness of the investments undertaken.
Within these three broad areas of accounting there may be further subsets of accounting relating either
to one specific activity, or across the whole spectrum. Examples of these are:
 treasury;
 taxation;
 audit.

 Treasury
Treasury is a finance function usually only found in a very large company or group of companies. It
embraces the management of bank balances so as to raise the maximum interest on positive
balances, or minimize the payment of interest on negative balances. This might entail lending
money overnight on the money markets. Also included here is the management of exchange risk
where financial transactions are denominated in foreign currencies.

 Taxation
Taxation in a small company will be included in the duties of the financial accountant who may need
to call on outside professional advice from time to time. Corporation tax on company profits is not
straightforward and the system of capital allowances can be complex for some large companies,
groups of companies, or multinational companies. Mention should also be made of the ramifications
of value added tax (VAT) and the taxation of employee and director benefits in kind. A specialist
accountant, or team of accountants, is often appointed in large companies to minimize the pain and
maximize the gain from the various taxes and allowances affecting such organizations.

Audit
 Audit is another accounting function mainly found in larger organizations. Internal auditors monitor
that accounting procedures, documents and computerized transactions are carried out correctly.
This work is additional or complementary to that undertaken by external auditors who take a
broader approach in providing an independent report to shareholders in the annual report.

PROFESSIONAL ACCOUNTANCY BODIES

All qualified accountants in Sri Lanka belong to one (or more) of the following professional bodies

 Chartered Accountants of Sri Lanka (CA Sri Lanka)

 Chartered Institute of Management Accountants (CIMA Sri Lanka)
 Certified Management Accountants of Sri Lanka (CMA)
 Associate Accounting Technicians (AAT)

ACCOUNTING STANDARDS
Accountancy standards are a most important source of guidance in the detailed presentation of
accounting information to external parties. All professional accountants are obliged to follow the rules
laid down in Financial Reporting Standards (FRSs) when preparing or auditing company accounts for
publication.

The Standards that is applicable in Sri Lanka are the International Financial Reporting Standards issued
by International Accounting Standards Board. This Standard has been adopted by CA Sri Lanka on the
belief that Standards developed on that basis will help to improve the degree of uncertainty of financial
reporting throughout the country which will also be comparable globally.

By Sri Lanka Accounting and Auditing Standards Act No 15 of 1995 authorizes the CA Sri Lanka to issue
SL Accounting Standards and requires “specified business enterprises” to prepare and present their
financial statements in compliance with Sri Lanka Accounting Standards.

Sri Lanka Accounting Standards comprise Accounting Standards prefixed both SLFRS and LKAS.

SLFRS refers to Ari Lanka Accounting Standards corresponding to IFRS

LKAS refers to Sri Lanka Accounting Standards corresponding to IAS

Sri Lanka Accounting Standards are commonly referred to the term of SLFRS. In addition the Institute
has adopted all IFRIC and SIC pronouncements issued by the IASB. Further the Institute of CA Sri Lanka
has sole authority to addendum any request stipulated under IFRIC & SIC

Sri Lanka Accounting Standards further comprise of statements of recommendations practices (SoRPSs),
Statements of Alternate Treatment (SoATs) and Financial Reporting Guidelines issued by the Institute.

THE ANNUAL REPORT AND ACCOUNTS

The content of the annual report and accounts for a listed company, being one that is quoted on a stock
exchange, is more comprehensive than the requirements of unlisted companies which reduce in line
with their size. Disclosure requirements of listed companies derive from three sources:

 statutory law embodied in Companies Acts;

 accounting standards
 listing regulations specified by the Stock Exchange.

Following main items are disclosed in the annual reports and accounts

 Management Reports - Chairman’s statement,

 Operating and financial review – a detailed commentary on the financial
 Directors’ report – a formal report on specific required items, eg dividend
 Report of committees
 Corporate governance – a statement of compliance, or otherwise, with
 Auditors’ report
 Financial statements
 Notes to the financial statements–
 Historic record of financial performance –
ACCOUNTING CONVENTIONS
An accounting convention is a basic principle or concept underlying the preparation of financial
accounts. These statements of profit and loss, balance sheet and cash flow are usually prepared monthly
for management purposes, but particular emphasis is placed on the annual and half-yearly accounts
which are the only ones that inform shareholders and other interested external parties.

Although the basic recording of financial transactions using double entry bookkeeping is a mechanical
exercise, there is, however, also a subjective side to accountancy. The production of the financial
accounts is not totally automatic and various rules, principles or conventions are followed in addition to
statutory and financial reporting standard requirements.

By way of illustration, let us consider some examples where conventions are required, before we can
proceed to answer them.

Examples
1. A company buys a new machine for £10,000 and expects it to last for five years. Does it charge
this cost to the profit and loss account in the year it buys it, or in the year when it will be
scrapped?
2. A retail store buys a quantity of washing machines one month for £4,000 and sells three-
quarters of them for £3,600 in the same month. The remainder are sold in the following month
for £1,200. Should the total cost of £4,000 go into the first month’s profit and loss account or
should it be £3,000?
3. Now suppose that the washing machines in the previous example were bought on credit and the
agreed credit terms with the supplier do not require payment until the end of the following
month. Should the cost to go into the first month’s profit and loss account be nil, or £4,000, or
£3,000?

Answers to these questions could be understood after discussing the main accounting conventions used
by accountants. These accounting conventions are :

 separate entity;
 going concern;
 money measurement;
 double entry bookkeeping;
 realization;
 matching;
 accrual;
 capital and revenue expenditure;
 depreciation;
 stability of the value of money;
 historic cost;
 materiality;
 consistency;
 objectivity;
 prudence.
1. Separate entity. Every business is regarded as an entity on its own. We need to keep its financial
transactions separate from those of other businesses, and from the personal transactions of its
owners, to enable accountants to measure the financial performance of each business.

2. Going concern. When preparing financial statements, the assumption is made of continuity; that
is the business will continue to be in operation continuously. The recording of transactions and
valuation of assets are different if the business is to cease its operation if it is to face liquidation.
3. Money measurement. Accountants can only record transactions that have a money
measurement. Money is the means of adding transactions together, which is only possible when
we can express transactions in money terms. For this reason, internally generated goodwill
never appears in a list of assets as its value is unknown until someone wants to take over the
business and buy the goodwill. Only if we buy up another company and pay for its goodwill will
it appear as a financial transaction.

4. Double entry bookkeeping. Most people have heard of this even if they are hard put to define it
precisely! It refers to the dual aspects of recording financial transactions. By this is meant that
every transaction is recorded twice, in two different ledger accounts, recognizing the giving and
receiving aspects separately. This topic is examined in the following chapter.

5. Realization. With the exception of some retail trade, most businessto-business sales are done on
credit rather than for immediate cash settlement. It is therefore important to define when
exactly a sale takes place. Is it when goods or services change hands or when the cash is finally
received by the supplier? The realization concept adopts the former timing, so we place a sale in
the month the goods and services are delivered to the customer, regardless of when the
cash is received.

6. Matching. This principle requires accountants to match the cost of sales against the value of
those same sales in the same time period when determining the profit or loss.

7. Accrual - Expenses which relate to any accounting period must be included in that period’s profit
and loss account irrespective of when they are paid for. If an invoice has been received for
goods or services supplied to the business, the bookkeeping system will automatically
include that expense in the profit and loss account. However, if the goods or services have been
received but no invoice received by the period end, then an ‘accrual’ is raised to get the cost
into the bookkeeping system. Conversely, if an expense has been paid for but not yet received,
then an adjustment is made for the prepayment. The two principles of realization and accrual
are crucial to measuring business performance accurately over short periods of time.

8. Capital and revenue expenditure. The expenditure that is consumed and has no value remaining
is charged to the profit and loss account as revenue expenditure and matched against revenue
or income. Some expenditure, however, lasts for many accounting periods. Buildings and
equipment are examples of items which it would be unfair to charge in full to any one
accounting period. This is deemed to be capital expenditure and is placed in the balance sheet.

9. Depreciation. The value of most capital expenditure reduces as the assets wear out over time.
Depreciation is the process of reducing the value in the balance sheet by transferring part of it
to the profit and loss account each period. Hence capital expenditure becomes revenue
expenditure bit by bit over the asset’s expected lifetime.
10. Historic cost accounting. In general terms, accountants ignore inflation and assume the stability
of money in financial statements. We tend to prefer the certainty of what things cost, to some
other subjective estimate. We may amend this approach for certain items, such as land and
buildings, and revalue them from time to time. Current cost accounting is when due allowance
for inflation is made on all financial transactions in the profit and loss account and balance
sheet.
11. Materiality. This convention might be used to overrule a strict interpretation of another
convention. For example, the purchase of a calculator which is to be used for a longer period of
time is purchase of an asset and should be treated as capital expenditure and depreciated each
accounting period. Such administrative effort for a trivial sum of money is pointless, so
businesses usually set a minimum sum below which capital expenditure is treated as revenue
expenditure for expediency. Another example of materiality might be not bothering to count
and value small amounts of stationery left at the end of each period to include them in stocks. In
this case stationery is charged as revenue expenditure on purchase regardless of when it will be
used.

12. Consistency. Where there is a subjective judgement made in accountancy, this will be adhered
to from one year to another. An example of this might relate to the method used to calculate
depreciation. Alternative methods are available, as discussed in a later chapter, but the chosen
method should be consistently applied year after year.

13. Objectivity. Accountants try to produce financial accounting statements as objectively as

possible, but as a number of items require an element of judgement this may not always be
achieved.

14. Prudence. A salesperson will count a sale when an order is received whereas the realization
concept used by accountants requires the product to first be delivered to the customer. This is
one example of prudence where a profit is not anticipated before it is realized. This might seem
at odds with the treatment of a loss to be incurred in the future when an accountant provides
for the estimated loss immediately. Accountants view prudence as anticipating a loss but never
anticipating a profit.

All these accounting conventions find their way into the financial statements of profit and loss account
and balance sheet. We first need to find out how all the information going into those statements is
recorded, and then see how we sort out which information goes into which statement.

QUESTIONS
1. Name the two key financial statements that measure a business’s financial performance and financial
position.
2. List as many users of accounting information as you can and the purposes to which they put that
information.
3. What are the main two or three branches of accountancy?
4. What are the contents of a listed company’s annual report and accounts?
5. List as many accounting conventions as you can, stating their purpose.