Financial accounting (abe)


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Financial accounting (abe)

  1. 1. Business Management Study Manuals Diploma in Business Management FINANCIAL ACCOUNTING The Association of Business Executives 5th Floor, CI Tower  St Georges Square  High Street  New Malden Surrey KT3 4TE  United Kingdom Tel: + 44(0)20 8329 2930  Fax: + 44(0)20 8329 2945 E-mail: 
  2. 2. © Copyright, 2008 The Association of Business Executives (ABE) and RRC Business Training All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form, or by any means, electronic, electrostatic, mechanical, photocopied or otherwise, without the express permission in writing from The Association of Business Executives.
  3. 3. Diploma in Business Management FINANCIAL ACCOUNTING Contents Unit Title Page 1 The Nature and Purpose of Accounting 1 The Scope of Accounting 3 Users of Accounting Information 4 Rules of Accounting (Accounting Standards) 6 Accounting Periods 14 The Main Characteristics of Useful Information 14 The Twelve Traditional Accounting Concepts 17 Important Accounting Terms 20 Different Types of Business Entity 22 Auditing in Business 25 2 Business Funding 31 Capital of an Enterprise 33 Dividends 40 Debentures 41 Types and Sources of Finance 44 Management of Working Capital 48 3 Final Accounts and Balance Sheet 53 55 The Trial Balance 55 Trading Account 57 Manufacturing Account 59 Profit and Loss Account 62 Allocation or Appropriation of Net Profit 67 The Nature of a Balance Sheet 69 Assets and Liabilities in the Balance Sheet 71 Distinction between Capital and Revenue 75 Preparation of Balance Sheet 75 4 Presentation of Financial Statements 81 Introduction 83 The UK Companies Act 1985 and Accounting Requirements 83 The Balance Sheet 87 The Income Statement 93 IAS 1: Statement of Changes in Equity 97 Summary of Statements Required by IAS 1 99 Narrative Statements Required in Published Financial Statements 99 Appendix 1: Example of Statement of Accounting Policies 102 Appendix 2: Example of Independent Auditors' Report 110 Appendix 3: Example of Directors' Report 111
  4. 4. Unit Title Page 5 Profit and Cash Flow 115 Availability of Profits for Distribution 116 Cash Flow Statements 119 Funds Flow Statements 130 6 Valuation of Non-Current Assets and Inventories 135 Valuation of Inventories 137 Valuation of Long-Term Contracts 143 The Importance of Inventory Valuation 146 Depreciation 149 Methods of Providing for Depreciation 153 Borrowing Costs and IAS 23 154 Leased Assets and IAS 17 154 IAS 36: Impairment of Assets 156 IAS 40: Investment Properties 157 7 Further Accounting Standards and Concepts 165 Introduction 167 IAS 33: Earnings Per Share 167 IAS 20: Accounting for Government Grants 168 IAS 12: Income Taxes 169 Accounting for Research and Development Expenditure 170 IAS 10: Events after the Balance Sheet Date 171 IAS 37: Provisions, Contingent Liabilities and Contingent Assets 173 IAS 38: Intangible Assets 176 IAS 18: Revenue 178 IAS 24: Related Party Transactions 179 Accounting for Inflation 180 8 Assessing Financial Performance 189 Interpretation of Accounts 191 Ratio Analysis 193 Profitability Ratios 196 Liquidity Ratios 198 Efficiency Ratios 200 Capital Structure Ratios 202 Investment Ratios 203 Limitations of Accounting Ratios 205 Worked Examples 207 Issues in Interpretation 214
  5. 5. Unit Title Page 9 Sources and Costs of Finance 225 Introduction 227 Finance and the Smaller Business 227 Finance and the Developing Business 230 Finance for the Major Company 233 The London Money Market 239 The Cost of Finance 240 Cost of Equity 241 Cost of Preference Shares 243 Cost of Debt Capital 243 Weighted Average Cost of Capital (WACC) 244 Cost of Internally Generated Funds 245 Management of Factors Affecting Share Prices 247 Factors Determining Capital Structure 249 Advantages and Disadvantages of the Principal Financial Alternatives 253 10 Financial Reconstruction 257 Introduction 258 Redemption of Shares 258 Accounting Treatment 259 Example of Redemption of Preference Shares 259 Example of Redemption of Ordinary Shares 262 Redemption of Debentures 265 11 Group Accounts 1: Regulatory and Accounting Framework 269 Introduction 270 IAS 27: Consolidated and Separate Financial Statements 270 IFRS 3: Business Combinations 272 IAS 28: Investments in Associates 274 IFRS 3: Fair Values in Acquisition Accounting 276 Alternative Methods of Accounting for Group Companies 277 Merger Accounting 280 12 Group Accounts 2: The Consolidated Accounts 283 Introduction 284 The Consolidated Balance Sheet 284 The Consolidated Income Statement 298 Group Accounts – Example 306 13 Financial Accounting Examination – The Compulsory Question 323 The Financial Accounting Examination 324 December 2007 Compulsory Question 325 Specimen Examination Compulsory Question 330
  6. 6. 1 © ABE and RRC Study Unit 1 The Nature and Purpose of Accounting Contents Page A. The Scope of Accounting 3 The Purpose of Accounting 3 Financial Accounting and Management Accounting 3 Money as the Common Denominator 3 The Business Entity 4 B. Users of Accounting Information 4 Main Categories of Users 4 Interests of Principal Users 5 C. Rules of Accounting (Accounting Standards) 6 Development of UK Accounting Standards 6 International Accounting Standards 8 Statements of Standard Accounting Practice 9 D. Accounting Periods 14 E. The Main Characteristics of Useful Information 14 Underlying Assumptions 15 Qualitative Characteristics of Financial Statements 16 F. The Twelve Traditional Accounting Concepts 17 Prudence 17 Going Concern 18 Consistency 18 Money Measurement 18 Duality 18 Matching 19 Cost 19 Materiality 19 Objectivity 19 Realisation 19 (Continued over)
  7. 7. 2 The Nature and Purpose of Accounting © ABE and RRC Business Entity Concept 19 Separate Valuation 20 IAS 1: Presentation of Financial Statements 20 G. Important Accounting Terms 20 The Accounting Equation or Basic Formula 20 Assets and Liabilities 21 Capital v. Revenue Expenditure 22 H. Different Types of Business Entity 22 The Sole Trader 22 Partnerships 23 Limited Companies in the UK 23 Accounting Differences Between Companies and Unincorporated Businesses 24 Principle of Limited Liability 24 Promoters and Legal Documents 24 I. Auditing in Business 25 What is an Audit? 25 Types of Audit 25 UK Law and External Audit 26 External Audit Report 27 External Audit Process 28 Expectations Gap 28 Answers to Questions for Practice 30
  8. 8. The Nature and Purpose of Accounting 3 © ABE and RRC A. THE SCOPE OF ACCOUNTING The Purpose of Accounting A business proprietor normally runs a business to make money. He or she needs information to know whether the business is doing well. The following questions might be asked by the owner of a business:  How much profit or loss has the business made?  How much money do I owe?  Will I have sufficient funds to meet my commitments? The purpose of conventional business accounting is to provide the answers to such questions by presenting a summary of the transactions of the business in a standard form. Financial Accounting and Management Accounting Accounting may be split into Financial Accounting and Management Accounting. (a) Financial Accounting Financial accounting comprises two stages:  book-keeping, which is the recording of day-to-day business transactions; and  preparation of accounts, which is the preparation of statements from the book- keeping records; these statements summarise the performance of the business – usually over the period of one year. (b) Management Accounting Management accounting is defined by the Chartered Institute of Management Accountants (CIMA) as follows: "The application of professional knowledge and skill in the preparation and presentation of accounting information in such a way as to assist management in the formulation of policies and in the planning and control of the operations of the undertaking". Management accounting, therefore, seeks to provide information which will be used for decision-making purposes (e.g. pricing, investment), for planning and control. Money as the Common Denominator Accounting is concerned with money measurement – it is only concerned with information which can be given a monetary value. We put money values on items such as land, machinery and stock, and this is necessary for comparison purposes. For example, it is not very helpful to say: "Last year we had four machines and 60 items of stock, and this year we have five machines and 45 items of stock.". It is the money values which are useful to us. There are, though, limitations to the use of money as the common denominator. (a) Human Asset and Social Responsibility Accounting We have seen that accounting includes financial accounting and management accounting. Both of these make use of money measurement. However, we may want further information about a business:  Are industrial relations good or bad?  Is staff morale high?  Is the management team effective?
  9. 9. 4 The Nature and Purpose of Accounting © ABE and RRC  What is the employment policy?  Is there a responsible ecology policy? These questions will not be answered by conventional business accounting in money terms but by "human asset accounting" and "social responsibility accounting". These subjects have not yet been fully developed and are outside the scope of your syllabus. (b) Devaluation The value of money does not remain constant, and there is normally some degree of inflation in the economy. We will look at the steps that have been taken to attempt to adjust accounting statements to the changing value of money later in the course. The Business Entity The business as accounting entity refers to the separate identities of the business and its owners.  The Sole Trader There must always be a clear distinction between the owner of the business and the business itself. For example, if Mr X owns a biscuit factory, we are concerned with recording the transactions of the factory. We are not concerned with what Mr X spends on food and clothes. If Mrs Y, works at home, setting aside a room in her house, an apportionment may have to be made.  Partnership Similarly, the partners in a business must keep the transactions of the business separate from their own personal affairs.  Companies In UK law, a company has a distinct "legal personality". This means that a company may sue or be sued in its own right. The affairs of the shareholders must be distinguished from the business of the company. The proprietor of a limited company is therefore distinct from the company itself. We shall return to the issue of business entities later in the unit. B. USERS OF ACCOUNTING INFORMATION We need to prepare accounts in order to "provide a statement that will meet the needs of the user, subject to the requirements of statute and case law and the accounting bodies, and aided by the experience of the reception of past reports". So if we prepare accounts to meet the needs of the user, who is the user? Main Categories of Users The main users of financial accounts are:  Equity investors (shareholders, proprietors, buyers)  Loan creditors (banks and other lenders)  Employees  Analysts/advisers  Business contacts (creditors and debtors, competitors)  The government (The Inland Revenue)
  10. 10. The Nature and Purpose of Accounting 5 © ABE and RRC  The public  Management (board of directors) Users can learn a lot about the running of a business entity from the examination of its accounts, but each category of user will have its own special perspective. We need to look at some of these in more detail. Interests of Principal Users What exactly do each of the users want from the accounts?  Proprietor The perspective of the business proprietor is explained above (but see below for the interests of shareholders).  Inland Revenue The Inland Revenue will use the accounts to determine the liability of the business for taxation.  Banks and other Lending Institutes These require to know if the business is likely to be able to repay loans and to pay the interest charged. But often the final accounts of a business do not tell the lender what he or she wishes to know. They may be several months old and so not show the up- to-date position. Under these circumstances, the lender will ask for cash flow forecasts to show what is likely to happen in the business. This illustrates why accounting techniques have to be flexible and adaptable to meet users' needs.  Creditors and Debtors These will often keep a close eye on the financial information provided by companies with which they have direct contact through buying and selling, to ensure that their own businesses will not be adversely affected by the financial failure of another. An indicator of trouble in this area is often information withheld at the proper time, though required by law. Usually, the longer the silence, the worse the problem becomes.  Competitors Competitors will compare their own results with those of other businesses. A business would not wish to disclose information which would be harmful to its own business: equally, it would not wish to hide anything which would put it above its competitors.  Board of Directors The board of directors will want up-to-date, in-depth information so that it can draw up plans for the long term, the medium term and the short term, and compare results with its past decisions and forecasts. The board's information will be much more detailed than that which is published.  Shareholders Shareholders have invested money in the business and as such are the owners of the business. Normally, the business will be run by a team of managers and the shareholders require the managers to account for their "stewardship" of the business, i.e. the use they have made of the shareholders' funds.  Employees Employees of the business look for, among other things, security of employment.
  11. 11. 6 The Nature and Purpose of Accounting © ABE and RRC  Prospective Buyer A prospective buyer of a business will want to see such information as will satisfy him or her that the asking price is a good investment. C. RULES OF ACCOUNTING (ACCOUNTING STANDARDS) As different businesses use different methods of recording transactions, the result might be that financial accounts for different businesses would be very different in form and content. However, various standards for the preparation of accounts have been developed over the years in order that users can be assured that the information they show can be relied on. We shall be looking at the layout of financial accounts later on in the course, but here we are concerned with general underlying rules. With regard to UK companies, various rules have been incorporated into legislation (through the Companies Acts). UK Companies whose shares are listed on the Stock Exchange are also subject to Stock Exchange rules. In addition, there are also "Statements of Standard Accounting Practice" (SSAPs) and Financial Reporting Statements (FRSs) which are issued by the main UK professional accounting bodies through the Accounting Standards Board (ASB) which must be complied with. There are also rules and regulations for the preparation of financial accounts in other countries of the world, and an international regulatory framework is gaining in importance. Global investment in business is becoming the norm in the 21st century and investors now require comparable information between business entities from different countries of the world. International regulation first began in 1973 with the establishment of the International Accounting Standards Committee Development of UK Accounting Standards (a) Historical Development In 1942, the Institute of Chartered Accountants in England and Wales began to make recommendations about accounting practices, and over time issued a series of 29 Recommendations, in order to codify the best practice to be used in particular circumstances. Unfortunately, these recommendations did not reduce the diversity of accounting methods.  The Accounting Standards Committee In the late 1960s, there was a lot of public criticism of financial reporting methods and the accounting profession responded to this by establishing the Accounting Standards Committee (ASC) in 1970. The ASC comprised representatives of all the six major accounting bodies, i.e. the Chartered Accountants of England and Wales, of Scotland, and of Ireland, the Certified Accountants, the Cost and Management Accountants, and the Chartered Institute of Public Finance and Accountancy. The Committee was set up with the object of developing definitive standards for financial reporting. A statement of intent produced in the 1970s identified the following objectives: – To narrow the areas of difference in accounting practice – To ensure disclosure of information on departures from definitive standards – To provide a wide exposure for new accounting standards – To maintain a continuing programme for improving accounting standards.
  12. 12. The Nature and Purpose of Accounting 7 © ABE and RRC There are various accounting conventions (which we'll look at later) that lay down certain "ground rules" for accounting. However, they do still permit a variety of alternative practices to coexist. The lack of uniformity of practices made it difficult for users of financial reports to compare the results of different companies. There was therefore a need for standards of accounting practice, to try to increase the comparability of company accounts.  Statements of Standard Accounting Practice (SSAP) The procedure for their establishment was for the ASC to produce an exposure draft on a specific topic – e.g. accounting for stocks and depreciation – for comment by accountants and other users of accounting information. A formal statement was then drawn up, taking account of comments received, and issued as a Statement of Standard Accounting Practice (SSAP). Once a statement had been adopted by the accountancy profession, any material departures by a company from the standard practice had to be disclosed in notes to the Annual Financial Accounts. These standards do not have the force of law to back them up, although all members of the accounting profession are required by their Code of Ethics to abide by them.  The Dearing Report Although the ASC had much success during its period of operation and issued 25 SSAPs as well as a number of exposure drafts (EDs), Statements of Intent (SOI), and Statements of Recommended Practice (SORP), there were many serious criticisms of its work, leading to its eventual demise. In July 1987, the Consultative Committee of Accountancy Bodies (CCAB) set up a review of the standard-setting process under the chairmanship of Sir Ron Dearing. The Dearing Report subsequently made a number of very important recommendations. The government accepted all but one of them and in August 1990 a new Standard Setting Structure was set up. (b) The Accounting Standards Board The following structure (Figure 1.1) was recommended by the Dearing Report, with the Financial Reporting Council (FRC) acting as the policy-making body for accounting standard-setting. The Financial Reporting Council (FRC) The Review Panel The Accounting Standards Board (ASB) The Urgent Issues Task Force (UITF) Figure 1.1: Standard Setting Structure
  13. 13. 8 The Nature and Purpose of Accounting © ABE and RRC This gave rise to a slightly different regime for the establishment of standards and these are now embodied in Financial Reporting Standards (FRS).  Financial Reporting Standards (FRS) The ASB is more independent than the ASC was and can issue standards known as Financial Reporting Standards (FRS). The ASB accepted the SSAPs then in force and these remain effective until replaced by an FRS. The ASB develops its own exposure drafts along similar lines to the ASC; these are known as FREDs (Financial Reporting Exposure Drafts).  Statements of Recommended Practice (SORP) Although the ASB believed that Statements of Recommended Practice (SORPs) had a role to play, it did not adopt the SORPs already issued. Not wishing to be diverted from its central task of developing accounting standards, the Board has left the development of SORPS to bodies recognised by the Board. The SORPs issued by the ASC from 1986 differed from SSAPs in that SSAPs had to be followed unless there were substantive reasons to prove otherwise, and non-compliance had to be clearly stated in the notes to the final accounts. A SORP simply sets out best practice on a particular topic for which a SSAP was not appropriate. However, the later SORPs are mandatory and cover a topic of limited application to a specific industry (e.g. local authorities, charities, housing associations). These SORPS do not deviate from the basic principles of the various SSAPs and FRSs currently in issue.  Urgent Issues Task Force (UITF) This is an offshoot of the ASB which tackles urgent matters not covered by existing standards or those which, if covered, were causing diversity of interpretation. In these circumstances, the UITF issues a "Consensus Pronouncement" in order to detect whether or not accounts give a true and fair view.  Financial Reporting Review Panel This examines contentious departures from accounting standards by large companies. The panel has the power to apply to the court for an order requiring a company's directors to revise their accounts. International Accounting Standards (a) Historical Development The International Standards Committee (IASC), established in 1973, was an independent private sector body and had no formal authority. It therefore had to rely on persuasion and the professionalism of others to encourage adoption of the International Accounting Standards (IASs) that it issued. The IASC operated under the umbrella of the International Federation of Accountants (IFAC), which is the worldwide organisation of accountancy bodies and is independent of any country's government. All members of IFAC were originally members of IASC. One of the problems facing the IASC was that it quite often had to issue standards that accommodated two or more alternative acceptable accounting treatments. This situation arose because these alternative treatments were being practised in countries that were members of the IASC. In 1995 the IASC entered into an agreement with the International Organisation of Securities Commission (IOSCO) (the body representing stock exchanges throughout the world) to produce a core set of accounting standards. These standards were to be endorsed by IOSCO as an appropriate reporting regime for business entities in the
  14. 14. The Nature and Purpose of Accounting 9 © ABE and RRC global marketplace for the raising of finance. This deal was to give IASC its much needed authority. However, to gain IOSCO's backing the IASC had to agree to a restructuring which occurred in 2000. The core standards were completed in 2000 and adopted by IOSCO in May 2000. The European Union, besides issuing Directives on company law (Fourth and Seventh Directives), has also adopted the IASB standards for the preparation of financial statements. (b) International Accounting Standards Board (IASB) The IASC became known as the IASB under the required restructuring in 2000. It is governed by a group of 19 individual trustees, known as the IASC Foundation, with diverse geographical and functional backgrounds. The current Chair of the trustees is Paul A. Volcker, the former chair of the US Federal Reserve Board. The trustees are responsible for the governance, fundraising and public awareness of the IASB. The structure under the trustees comprises the IASB as well as a Standards Interpretation Committee (SIC) and a Standards Advisory Council, as shown below. Trustees Standards Advisory Council IASB SIC Figure 1.2: International Standards Setting Structure The IASB has 12 full-time members and 2 part-time members all of whom have relevant technical experience and expertise. The current chair of the IASB is Sir David Tweedie, who was previously the chair of the UK ASB. The IASB's sole responsibility is to set International Financial Reporting Standards (IFRSs). (Note that the standards issued by the IASC were known as International Accounting Standards (IASs) and several of these have been adopted by the IASB – see the list of standards later in the unit). As such it is at the forefront of harmonisation of accounting standards across the world as it pushes for adoption of its standards with the help of IOSCO. Within the UK this harmonisation process with IASs has already begun. Within the EU all stock exchange listed businesses have to comply with IASs for the publication of their consolidated financial statements as from 1 January 2005. Businesses not listed, which tend to form the majority, can still use the framework of standards established by the individual country. However, within the EU, countries are converging their home standards with the international standards and this process is occurring in other areas of the globe. Within this manual, we intend to use the international standards. You might, therefore, find it useful to have a look at the IASB web site – Statements of Standard Accounting Practice Note that, with the issuing of new accounting standards by the IASB (IFRSs), there are currently both a number of IFRSs and IASs in force. You do not require a detailed knowledge of all the current standards, but you should be aware of what they cover and we briefly review them here. The standards specifically within the range of the syllabus for this
  15. 15. 10 The Nature and Purpose of Accounting © ABE and RRC module will be dealt with in detail in later study units under their own topic headings. (Those not included in the syllabus for this module are indicated by ** in the following list.) International Financial Reporting Standards  IFRS 1 First-time Adoption of International Financial Reporting Standards ** (no UK equivalent) The objective of this standard is to ensure that an entity's first IFRS financial statements contain high quality information that is transparent for users and comparable over time, provides a suitable starting point for accounting under IFRSs and can be generated at a cost that does not exceed the benefits to users.  IFRS 2 Share-based Payment ** (UK equivalent is FRS 20) The objective of this standard is to specify the financial reporting by an entity when it undertakes a share-based transaction. Businesses often grant share options to employees or other parties and until the issue of this standard there was concern over the measurement and disclosure of such transactions.  IFRS 3 Business Combinations (FRS 6 UK similar, but not identical) The objective of this standard is to specify the financial reporting by an entity when it undertakes a business combination. It covers the preparation of consolidated accounting staements using the puchase method (acquisition method) and will be dealt with in detail in study units 11 and 12.  IFRS 4 Insurance Contracts ** (FRS 27 UK similar, but not identical) The objective of this standard is to specify the financial reporting for insurance contracts issued by an entity. An insurance contract ia a contract under which one party, the insurer, accepts significant insurance risk from another party, the policyholder, by agreeing to compensate the policyholder if a specified uncertain future event adversely affects the policyholder.  IFRS 5 Non-current Assets Held for Sale and Discontinued Operations ** (no UK equivalent) The objective of this standard is to specify the accounting for assets held for sale, and for the presentation and disclosure of discontinued operations.  IFRS 6 Exploration for and evaluation of Mineral Resources ** (no UK equivalent) This standard covers the accounting requirements for expenditure incurred in the exploration for and evaluation of mineral resources and whether such expenditure should be regarded as a non-current asset. It also specifies the impairment treatment for such expenditure.  IFRS 7 Financial Instruments: Disclosures ** (FRS 29 UK) This standard is partnered with IAS 32 Financial Instruments: Presentation. IFRS 7 deals with the disclosures that must be made by a business when it has in issue a financial instrument defined as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.  IFRS 8 Operating Segments ** (SSAP 25 UK similar, but not identical) This is basically a disclosure statement identifying when and how information should be disclosed in the financial statements in respect of business segments.
  16. 16. The Nature and Purpose of Accounting 11 © ABE and RRC International Accounting Standards  IAS 1 Presentation of Financial Statements (FRS 3 UK similar, but not identical) We will cover this is some detail in study unit 4. The standard sets out overall requirements for the presentation of financial statements, guidelines for their structure and minimum requirements for their content. It specifies that a complete set of financial statements comprises: – a balance sheet – an income statement (profit and loss statement) – a statement of changes in equity – a cash flow statement – notes and specified disclosure requirements  IAS 2 Inventories (SSAP 9 UK similar, but not identical) We will deal with this in study unit 6. A primary issue in the accounting for inventories is the amount of cost to be recognised as an asset and carried forward until the related revenues are recognised. Inventories are assets – held for sale – in the process of production for such sale – in the form of materials or supplies to be consumed in the production process or the rendering of services. The standard does not cover contruction contracts. These are dealt with under IAS 11  IAS 7 Cash Flow Statements (FRS 1 revised UK similar, but not identical) We will cover this in study unit 5. The standard deals with the preparation of one of the primary financial statements as specified by IAS 1. It deals with cash flows during the period rather the matching of revenue and expenses and, therefore, provides further information to users in terms of performance and liquidity in addition to information provided in the income statement.  IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (FRS 18 UK similar, but not identical) The objective of the standard is to prescribe the criteria for selecting and changing accounting policies used in the preparation of financial statements. Its use should enhance the relevance and reliability of the financial statements produced. This standard is dealt with in study unit 4  IAS 10 Events After the Balance Sheet Date (FRS 21 UK) This is dealt with in study unit 7. The standard deals with events that occur after the balance sheet date and whether these affect the financial statements prepared and/or whether information on these events should be provided in the notes to the accounts.  IAS 11 Construction Contracts (SSAP 9 UK similar, but not identical) Dealt with in study unit 6. The primary issue in dealing with construction contracts that cover more than one accounting period is the allocation of contract revenue and contract costs to the appropriate acconting period.
  17. 17. 12 The Nature and Purpose of Accounting © ABE and RRC  IAS 12 Income Taxes (FRS 16 and 19 UK similar, but not identical) Dealt with in study unit 7. Income taxes are all domestic and foreign taxes which are based on taxable profits. The standard deals with the accounting of both current taxes and deferred taxes.  IAS 16 Property, Plant and Equipment (FRS 15 UK similar, but not identical) Dealt with in study unit 6. The principal issues in accounting for property, plant and equipment (tangible fixed assets) are the recognition of the assets, the determination of their carrying amounts and the depreciation charges and impairment losses to be recognised in relation to them.  IAS 17 Leases (SSAP 21 UK similar, but not identical) This forms part of study unit 6. Businesses do not always purchase the fixed assets they require but, rather,; quite often lease them from another party. These leased assets in substance can be used by the business as if they had purchased them and, therefore, the standard details the recognition and accounting for such leased assets. This is an example of accounting for substance over form.  IAS 18 Revenue ( FRS 5 UK similar, but not identical) Dealt with in study unit 7. Income, as defined in the Framework for the Preparation and Presentation of Financial Statements (see study unit 4), is increases in economic benefits during the accounting period. It further states that income encompasses both revenues and gains. So what is revenue? This standard answers that question and explains how it should be measured.  IAS 19 Employee Benefits ** (FRS 17 UK similar, but not identical) Many businesses, in addition to wages/salaries, provide further benefits to their employees. Such benefits include: – retirement plans – insurance plans such as hospital, dental, life and disability insurance – stock options – profit sharing plans – recreational programmes – vacation schemes, etc. This standard deals with the accounting for all employee benefits except those dealt with under a specific standard. The standard requires the recognition of a liability when an employee has provided service in exchange for employee benefits to be paid in the future and the recognition of an expense when the entity consumes the economic benefit arising from service by an employee in exchange for employee benefit.  IAS 20 Accounting for Government Grants and Disclosure of Government Assistance (SSAP 4 UK similar, but not identical) Dealt with in study unit 7. Government grants should be recognised in the income statement so as to match the expenditure to which they relate. Capital grants relating to capital expenditure should be credited to revenue over the expected useful economic life of the asset.  IAS 21 The Effects of Changes in Foreign Exchange Rates ** (SSAP 20 UK similar, but not identical)
  18. 18. The Nature and Purpose of Accounting 13 © ABE and RRC A business may carry on foreign activities in two ways – it may have transactions in foreign currencies or it may have foreign operations. The objective of this standard is to presribe how to deal with such activities in the financial statements.  IAS 23 Borrowing Costs (no UK equivalent) Dealt with in study unit 6. Businesses often borrow acquire loans, to purchase assets. Normally the interest costs on such assets should be expensed to the income statement in accordance with the matching principle. However, it is possible to put forward an alternative argument that such borrowing costs, the interest, should be capitalised as part of the cost of the asset. This standard deals with the accounting for borrowing costs and whether the alternative treatment can be permitted.  IAS 24 Related Party Disclosures (FRS 8 UK similar, but not identical) Dealt with in study unit 7. The objective of this standard is to ensure that a business's financial statements contain the disclsoures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances with such parties. This disclsoure is necessary because quite often such transactions would not be entered into with unrelated parties.  IAS 26 Accounting and Reporting by Retirement Benefit Plans ** (FRS 17 UK, similar but not identical) This standard deals with the preparation of financial statements by retirement benefit plan (pension schemes) entities.  IAS 27 Consolidated and Separate Financial Statements (FRS 2 UK similar, but not identical) This forms the basis of study units 11 and 12 where we deal with the preparation of financial statements for holding and subsidiary businesses.  IAS 28 Investments in Associates (FRS 9 UK similar, but not identical) Again this is dealt with in study units 11 and 12.  IAS 29 Financial Reporting in Hyperinflationary Economies ** (FRS 24 UK) In an hyperinflationary economy, financial statements are only useful if they are expressed in terms of the measuring unit current at the balance sheet date. Thus, the standard requires restatement of financial statements of businesses operating in an hyperinflationary economy.  IAS 31 Interests in Joint Ventures** (FRS 9 UK similar, but not identical)  IAS 32 Financial Instruments: Presentation ** (FRS 25 UK)  IAS 33 Earnings per Share (FRS 22UK) Dealt with in study unit 7. This statement specifies the determination and presentation of the earnings per share figure/s in the financial statements.  IAS 34 Interim Financial Reporting ** (ASB statement interim reports  IAS 36 Impairment of Assets (FRS 11 UK similar, but not identical) Dealt with in study unit 6. The objective of this standard is to prescribe the procedures that a business applies to ensure that its assets are carried at no more than their recoverable amount. An asset is carried at more than its recoverable amount if its carrying value exceeds the amount to be recovered through the use or sale of the asset. If this is the case, the asset is described as impaired and the standard requires the business to recognise an impairmemt loss.
  19. 19. 14 The Nature and Purpose of Accounting © ABE and RRC  IAS 37 Provisions, Contingent Liabilities and Contingent Assets (FRS 12 UK, similar but not identical) See study unit 7. The standard deals with the appropriate recognition and measurement of provisions and contingencies. It defines a provision as a liability of uncertain timing or amount.  IAS 38 Intangible Assets (FRS 10 UK similar, but not identical) See study unit 7. The standard only permits the recognition of intangible assets if certain criteria are met. An intangible asset is defined as an identifiable non-monetary asset without physical substance, such as research and development costs, broadcasting licences, airline route authority, patents, copyrights, etc.  IAS 39 Financial Instruments: Recognition and Measurement ** (FRS 26 UK)  IAS 40 Investment Property (SSAP 19 UK similar, but not idemtical) See study unit 6. An investment property is property held by a business to earn rentals or for capital appreciation or both, rather than for use in the production or supply of goods or services. The standard deals with the accounting treatment of such investment properties.  IAS 41 Agriculture ** D. ACCOUNTING PERIODS An owner of a business will require financial information at regular intervals. As we have noted, he or she will want to be able to check periodically how well or badly the business is doing. Financial accounts are normally prepared on an annual basis, e.g. twelve months to the 31 March. Preparing accounts on an annual basis facilitates comparisons between one year and previous years and assists forecasting the next year. For example, there may be seasonal factors affecting the business, which will even out over the year. An ice-cream vendor will expect to make more sales in the summer months than in the winter months. He would not be able to tell if business is improving by looking at accounts for six months ended 31 March 20XX and comparing them with accounts for the six months ended 30 September 20XX. True comparison of profit/loss can be gained only when he examines his accounts for the years (say) 31 March 20X1 and 31 March 20X2. Accounts normally have to be prepared annually for tax purposes as tax is assessed on profits of a 12-month accounting period. In the case of limited companies, accounts are prepared annually to the "accounting reference date". It is necessary to calculate annually the amount of profit available for distribution to shareholders by way of dividend. E. THE MAIN CHARACTERISTICS OF USEFUL INFORMATION A number of attempts have been made since the 1970s to create some form of conceptual framework for financial accounting. The IASBs version, the Framework for the Preparation and Presentation of Financial Statements, was issued in 1989. This document is separate from the IASs and IFRSs and basically assembles the body of accounting theory so that standards are formulated on a consistent basis and not in an ad hoc manner. The framework has several sections, but the two we will discuss here are the underlying assumptions in the preparation of financial statements and the qualitative characteristics of such statements.
  20. 20. The Nature and Purpose of Accounting 15 © ABE and RRC Underlying Assumptions These are twofold – accruals and going concern (a) Accruals Accruals is taking into account or matching income and expenditure occurring within an accounting period, whether actual cash is received or paid during the time or not. The reasoning behind the assumption is that profit for the period should represent fairly the earnings of the time covered and, in view of the dynamic nature of any business, it is unlikely that all invoices will have been paid. However, they should be accounted for to give a true picture. A distinction is made between the receipt of cash and the right to receive cash, and between the payment of cash and the legal obligation to pay cash. The accruals assumption requires the accountant to include as expenses or income those sums which are due and payable. You need to remember what the following terms mean:  Receipt – the receipt of cash or cheques by the business, normally in return for goods or services rendered. The receipt may relate to another financial period, e.g. it may be for goods sold at the end of the previous period.  Payment – the payment of cash or cheques by the business in return for goods or services received. Again, a payment may be in respect of goods purchased in the previous financial year or a service to be rendered in the future, e.g. rates payable in advance. Additionally, the term "capital receipt" is used to describe amounts received from the sale of fixed assets or investments, and similarly "capital payment" might relate to an amount paid for the purchase of a fixed (i.e. long-term) asset.  Revenue income – the income which a business earns when it sells its goods. Revenue is recognised when the goods pass to the customer, NOT when the customer pays.  Expenses – these include all resources used up or incurred by a business during a financial year irrespective of when they are paid for. They include salaries, wages, rates, rent, telephone, stationery, etc. To help you understand the significance of these terms, here are a few examples (financial year ending 31 December):  Telephone bill £200 paid January Year 2 relating to previous quarter = Payment Year 2; Expense Year 1.  Debtors pay £500 in January Year 2 for goods supplied (sales) in Year 1 = Receipt Year 2; Revenue Income Year 1.  Rent paid £1,000 July Year 1 for the period 1 July Year 1 to 30 June Year 2 = Payment £1,000 Year 1; Expense Year 1 £500, Expense Year 2 £500. In a later study unit we will see how these matters are dealt with in the final accounts. (b) Going Concern This assumption infers that the business is going on steadily trading from year to year without reducing its operations. You can often see if an organisation is in financial trouble, for example if it lacks working capital, and in these circumstances it would not be correct to follow this concept. It would probably be better to draw up a statement of affairs, valuing assets on a break-up basis rather than reflecting the business as a going concern (i.e. on the
  21. 21. 16 The Nature and Purpose of Accounting © ABE and RRC basis of a sudden sale of all the assets, where the sale prices of the assets would be less than on ordinary sale). Inclusion of other potential liabilities might be necessary to reflect the situation properly – for example, payments on redundancy, pensions accrued, liabilities arising because of non-completion of contracts. Thus, the going concern concept directly influences values, on whatever basis they are measured Qualitative Characteristics of Financial Statements These characteristics are the attributes that make the information provided useful to users. The IASB state that there are four principal characteristics – understandability, relevance, reliability and comparability. We will deal with each of these in turn. (a) Understandability Information provided to users must not be so complex that a user with a reasonable knowledge of business and economic activities and accounting, and a willingness to study the information with reasonable diligence, would not be able to understand it. There is a fine balancing act needed here by preparers of financial statements to ensure that all information relevant to users is given to them even though it may be complex. (b) Relevance To be useful, information must be relevant to the decision-making needs of users. Relevance is closely related to its predictive role – that is the extent to which the information helps users to predict the organisation's future and so make decisions about it. For example, the attempt by a potential investor to predict future profitability and dividend levels will be at least partly based on the financial statements. A sub characteristic to relevance is materiality – Information is material and therefore relevant if its omission or mis-statement could influence the economic decisions of users. Materiality depends of the size of the item or error judged in the particular circumstances. (c) Reliability Information has the quality of 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. There is quite often a conflict between relevant and reliable information. Information may be relevant, but so unreliable in nature or representation that its recognition may be potentially misleading. For example, if the validity and amount of a claim for damages under a legal action are disputed, it may be inappropriate for the business to recognise the full amount of the claim in the balance sheet as this would provide unreliable information. However, to ensure relevance, it would be appropriate to disclose the amount and circumstances of the claim in a note to the accounts. Reliable information also requires several sub-characteristics to be present as follows:  Faithful representation – information provided must represent faithfully those transactions and other events it purports to represent.  Substance over form – transactions need to be accounted for in accordance with their substance not merely their legal form. Substance is not always consistent with legal form. For example, a business may dispose of an asset to another party in such a way that documentation purports to pass legal ownership to that party; nevertheless, though, agreements may exist that ensure that the business
  22. 22. The Nature and Purpose of Accounting 17 © ABE and RRC continues to enjoy the future economic benefits within the asset. In such circumstances a sale would not represent faithfully the transaction entered into. Such agreements are generally referred to as "sale and buy back". Another example of substance over form is a finance lease which we will refer to later.  Neutrality – information must be neutral, that is free from bias and provided in an objective manner. This also ensures that the characteristic of prudence must not override all other characteristics  Prudence – as preparers have to contend with the uncertainties that inevitably surround many events and transactions, then a degree of caution must be brought to bear when making judgements on such events and transactions. This degree of caution is required such that assets or income are not overstated and liabilities or expenses are not understated. For example, when assessing the useful life of plant and equipment, preparers must be cautious in their estimate but not deliberately pessimistic. The exercise of prudence does not allow the creation of hidden reserves or excessive provisions as this would result in the accounts not being neutral.  Completeness – for information to be reliable it must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance. (d) Comparability Users need to be able to compare financial statements of a business through time in order to identify trends in its financial position and performance. Users also need to be able to compare one business with another and, therefore, the measurement and display of the financial effect of transactions and other events must be carried out in a consistent way for different entities. Thus, we have the need for accounting standards from this characteristic. In can be quite difficult to ensure that all four main characteristics and their subcharacteristics are applied when preparing financial statements. In practice, a balancing or trade-off between the characteristics is often necessary. Generally, the aim is to achieve an appropriate balance among the characteristics in order to meet the objectives of financial statements which is to provide useful information to users. F. THE TWELVE TRADITIONAL ACCOUNTING CONCEPTS Over a period of time a number of conventions/concepts have been postulated by various bodies interested in financial statements. Many of these are incorporated in the above characteristics, but for completeness of your study we provide them here. These concepts are incorporated by preparers in current financial statements. Prudence Prudence is proper caution in measuring profit and income. Where sales are made for cash, profit and income can be accounted for in full. Where sales are made on a credit basis, however, the question of the certainty of profits or incomes arises. If there is not a good chance of receiving money in full, no sales are made on credit anyway; but if, in the interval between the sale and the receipt of cash, it becomes doubtful that the cash will be received, prudence dictates that a full provision for the sum outstanding should be made. A provision being an amount which is set aside via the profit and loss account.
  23. 23. 18 The Nature and Purpose of Accounting © ABE and RRC The two main aspects of this concept are that:  Income should not be anticipated and all possible losses should be provided for.  The method of valuation of an asset which gives the lesser value should always be chosen. Prudence is often exercised subjectively on grounds of experience and is likely, in general, to lead to an understatement of profit. The subjectivity involved can lead to variation between accountants in the amount of provision for bad debts, etc. and is bound to create differences between results obtained by the same general method of measurement. Users are therefore provided with pictures of various businesses which although apparently comparable, in fact conceal individual distortions. In long-term credit arrangements, such as hire-purchase agreements, difficulties arise in the actual realisation of income and profit. The date of the sale, whether on a cash or credit basis, is usually regarded as the date of realisation; but if you have money coming in over two or three years, measurement of the actual sum realised is subject to controversy. Going Concern As noted above, this concept assumes that the business is going on steadily trading from year to year without reducing its operations. Consistency This is one of the most useful concepts from the point of view of users who need to follow accounting statements through from year to year. Put simply, it involves using unvarying accounting treatments from one accounting period to the next – for example, in respect of stock valuation, etc. You can only identify a trend with certainty if accounts are consistent over long periods; otherwise, the graph of a supposed trend may only reflect a lack of precision or a change of accounting policies. However, there will usually be changes or inconsistencies in accounting policies over the years and in public accounts it is essential to stress these changes so that users can make proper allowance for differences. Money Measurement Whether in historic or current terms, money is used as the unit of account to express information on a business and, from analysis of the figures, assumptions can be made by the users. As we have seen, though, this concept of a common unit goes only some way towards meeting user needs, though, and further explanation is often needed on non-monetary requirements – such as the experience of the management team, labour turnover, social policy. Duality Each item in a business has two accountancy aspects, reflected in its accounting treatment as follows:  Double-entry book-keeping requires each transaction to be entered twice – once as a debit and once as a credit. The debit represents an increase in the assets of the company or an expense, and the credit entry represents a reduction in the cash balance to pay for the item, or an increase in the level of credit taken.  The assets of a business are shown in one section of a balance sheet and the liabilities in another.
  24. 24. The Nature and Purpose of Accounting 19 © ABE and RRC There is little to criticise in this duality, but we are looking behind the framework at the efficiency of the system and judging it by its success in meeting user needs. Duality falls short in the same sphere as money measurement, because there are areas in which it is not relevant. Matching Often considered the same as the accruals concept, matching calls for the revenue earned in a period to be linked with related costs. This gives rise to accruals and prepayments which account for the difference between cash flow and profit and loss information. This distinction will be clarified when you look at examples later. Cost As money is used to record items in the business accounts, each item has a cost. Accountants determine the value of an asset by reference to its purchase price, not to the value of the returns which are expected to be realised. Many problems are raised by this convention, particularly in respect of the effect of inflation upon asset values. This can also be considered as the historic cost concept. Materiality Accounting for every single item individually in the accounts of a multi-million pound concern would not be cost-effective. A user would gain no benefit from learning that a stock figure of £200,000 included £140 work-in-progress as distinct from raw materials. Neither would it make much difference that property cost £429,872 rather than £430,000. Indeed, rounded figures give clarity to published statements. So, when they are preparing financial statements, accountants do not concern themselves with minor items. They attempt rather to prepare clear and sensible accounts. The concept of materiality leaves accounts open to the charge that they are not strictly accurate, but generally the advantages outweigh this shortcoming. Objectivity Financial statements should be produced free from bias (not a rosy picture to a potential lender and a poor result for the taxman, for instance). Reports should be capable of verification – a difficult problem with cash forecasts. Realisation Any change in the value of an asset may not be recognised until the moment the firm realises or disposes of that asset. For example, even if a sale is on credit, we recognise the revenue as soon as the goods are passed to the customer. However, unrealised gains, such as increases in the value of stock prior to resale, are now widely recognised by non-accountants (e.g. bankers) and this can lead to problems with this concept. Business Entity Concept The affairs of the business are distinguished from the personal affairs of the owner(s). Thus a separate capital account is maintained in the business books, which records the business's indebtedness to the owner(s).
  25. 25. 20 The Nature and Purpose of Accounting © ABE and RRC It is important to draw a clear distinction between the owner of a business and the business itself. As far as accountancy is concerned, the records of the business are kept with a view to controlling and recording the affairs of the business and not for any benefit to the owner, although the completed accounts will be presented to the owners for their information. However, it is sometimes hard to divorce the two interests, especially when you are dealing with a sole trader, whose affairs are intertwined with the business he/she owns and is operating. So if, for example, Pauline owns a sweetshop and takes and eats a bar of chocolate, she is anticipating her profits – as much as she is if she takes a few pence from the till to pay for some private purchase – and such activities should be recorded. Her more personal affairs, however, such as the cost of food, clothing and heat and light for her private residence, must be kept separately from the business records. When we look at the partnership the distinction becomes a little clearer; and when we look at limited companies, where the owners or shareholders may take no part in running the company and the law gives the company a distinct legal personality of its own, then we have a clear-cut division and it is easy to distinguish owner and business. Separate Valuation This concept can be best explained by an example. Assume that A has sold goods on credit to B worth £1000. Thus in A's accounts, B shows up as a debtor for £1000. Meanwhile, B has sold goods on credit to A for £750. Thus, in A's accounts, B shows up as a creditor for £750. No agreement has been made between A and B about setting off one amount against the other. What should we show in the accounts of A in relation to B? You could argue that we should simply show the net debtor of £250 as a current asset. However, this would not show the entire picture in relation to A and B and therefore a true and fair view would not be presented. The traditional concept of separate valuation requires that both the debtor and creditor be shown in A's accounts. IAS 1: Presentation of Financial Statements This standard requires that financial statements present fairly the financial position, financial performance and cash flows of an entity. The standard specifies the need to present information in a manner that provides relevant, understandable, comparable and reliable information – thus incorporating the four essential characteristics from the Framework document. The standard also requires the use of going concern, accruals/matching, consistency, materiality, separate valuation, business entity, etc. In other words, IAS 1 ensures that all the four characteristics and the twelve concepts detailed above in sections E and F must be applied in the preparation of financial statements for users. G. IMPORTANT ACCOUNTING TERMS The Accounting Equation or Basic Formula In any business there are two entities: the business and its owner/s. Capital is provided by the owners in the form of cash or goods, and this capital is used by the business to acquire assets and finance its operations. When accounts are drawn up, the balance sheet will show the assets of the business, net of any liabilities not yet settled, balanced against the owners' capital. We can therefore say that: Capital = Net Assets (i.e. Total Assets  Total Liabilities)
  26. 26. The Nature and Purpose of Accounting 21 © ABE and RRC The capital is what belongs to the owner/s, and the net assets are the assets used in the business. Should the business cease those net assets would be used to raise the cash to repay the owners' capital. As a business progresses both the net assets and the owner's capital increase. Let us assume that an owner invests £10,000 in a business. The opening balance sheet will therefore show: Capital £10,000 = Net assets (cash at bank) £10,000 If a business is successful over the years, the figures will increase, so that after a period we may see, for example: Capital £20,000 = Net assets £20,000 This equation is known as the basic formula and you will notice that both sides have equal values. This is because all modern accounting is based on the principle of double entry. This means that every transaction in the accounts must have two entries, a debit entry in one account and a credit in another. Assets and Liabilities Net assets represent the assets of the business after deducting outstanding liabilities due to third parties. To calculate the net assets we take the total assets and deduct the liabilities.  Assets are the property of the business and include land and buildings, cash, debtors and money in the bank.  Liabilities are what the business owes to outside firms for goods or services supplied, loans made or expenses. You can relate this to your own situation. You probably own various assets – perhaps a flat, a car, and some household effects. At the same time you may well owe money to a credit card company, the newsagent or a finance company. If you are an employee then your employer will owe you money by way of salary or wages. When you are in business then the business will owe you money by way of your capital and profits. The treatment and classification of assets and liabilities in the accounts is of fundamental importance:  Assets involve expenditure and are always shown as debit entries in the accounts. There are two main classes of assets: (i) Non-current assets/Fixed assets, which comprise land and buildings, plant and machinery, motor vehicles, fixtures and fittings – in fact any assets which are to be used in the business for a reasonable period of time generally taken to be greater than one year. (ii) Current assets, which consist of stock for resale, debtors, cash/bank. Current assets are short-term assets, not intended to be retained in the business for long. (Note that expenses also involve expenditure and are always shown as debit entries.)  Liabilities consist of money owing for: (i) Goods purchased on credit (ii) Expenses owing for items like telephone bills, unpaid garage bills, etc. (iii) Loans from, say, the bank, building societies, hire purchase, etc.
  27. 27. 22 The Nature and Purpose of Accounting © ABE and RRC Capital v. Revenue Expenditure When assets such as buildings, plant and machinery, motor vehicles, tools, etc. are bought, they are purchased not for resale but for use in running the business. This type of asset is known as a non-current asset/fixed asset. Non-current assets help to create profit, and expenditure on them is known as capital expenditure. As well as the cost of the asset there are additional costs such as carriage on machinery or the legal costs of acquiring land and buildings. If a prefabricated building is erected, there would be additional costs such as the materials used (cement and bricks for the foundations), and the labour costs incurred to erect the building. All these costs are included in the cost of the building and are referred to as capital expenditure. This class of expenditure is kept separate from revenue expenditure, which relates to the day-to-day running of the business. Examples of revenue expenditure include expenses such as petrol for the delivery vans, telephone charges for the sales department, etc. You should have no difficulty in distinguishing between capital and revenue expenditure. Remember that capital is spent to buy fixed assets which are used to create profits, while revenue is spent in the creation of profit. We will remind you of the difference between these two types of expenditure in later study units. Effects of not Complying with the Rule If we include non-current assets in revenue expenditure, we will reduce the profit and at the same time fail to disclose the non-current assets. This in turn means that any depreciation (see later in course) will not be taken. If we add revenue items in the non-current assets, we have the opposite effect, i.e. more profit and depreciation incorrectly charged. The UK Companies Act 1989 includes the following directive in relation to published company accounts: "The balance sheet shall give a true and fair view of the state of affairs as at the end of the financial year. The profit and loss account shall give a true and fair view of the profit or loss of the company for the financial year." If we mix capital and revenue expenditure, not only will the accounts be incorrect but they will also contravene the law. H. DIFFERENT TYPES OF BUSINESS ENTITY We can now return to the issue of business entities and distinguish them in more sophisticated ways. The Sole Trader A sole trader is a business person trading on his or her own account. A sole trader bears total responsibility for business debts and, if in difficulty, may even need to sell personal assets to discharge liabilities. A sole trader is a business which is owned by one person, although we should remember that the business may employ several others. Capital is introduced by the owner and the profits will be used in two main ways:  As drawings (the proprietor's wages).  As retention of profits which will be used to finance the business in future.
  28. 28. The Nature and Purpose of Accounting 23 © ABE and RRC Partnerships A partnership is a group of people working together with a view to generating a profit. The basic structure of a partnership is governed in the UK by the Partnership Act 1890. There will often be a deed of partnership which lays down in writing the rights and responsibilities of the individual partners, but there is no legal requirement for any partnership agreement to be put into writing. There are two types of partnership: (a) Ordinary or General Partnership This consists of a group of ordinary partners, each of whom contributes an agreed amount of capital, with each being entitled to participate in the business activity and to share profits within an agreed profit-sharing ratio. Each partner is jointly liable for debts of the partnership unless there is some written agreement to the contrary. This is the most common form of partnership. (b) Limited Partnership This must consist of at least one ordinary partner to take part in the business, and to be fully liable for debts as if it were an ordinary partnership. Some partners are limited partners who may take no part in the business activity and whose liability is limited to the extent of the capital which they have agreed to put in. Such firms must be registered and are not common. Limited Companies in the UK There are four main characteristics which distinguish a limited company:  The legal nature of the business  Statutory rules governing the form and content of published accounts  Separation of ownership from the management of the business  Limited liability of the shareholders A company is completely separate in law from its shareholders and as such it may be sued in the courts. On its formation the shareholders subscribe for shares in the company in return for money (or money's worth). The shareholders then collectively own the company and are entitled to share in the profits generated by it. Several types of limited companies exist: (a) Private companies These must comprise one or more members (shareholders) and may not offer shares to the public at large. A private company's name must end with "Limited" or "Ltd". (b) Public companies A public company is a company limited by shares which must have at least two members and an authorised capital of at least £50,000, at least one quarter of which must be paid up. There is no maximum number of members prescribed and the company can offer its shares to the public. A public company's name must end with the words "public limited company" or "plc". (c) Quoted companies Quoted (listed) companies are those whose shares are bought and sold on a recognised stock exchange. Large organisations may have a full listing on the London Stock Exchange, whilst smaller firms may be listed on the Alternative Investment Market. The latter was established to provide a market for younger companies which
  29. 29. 24 The Nature and Purpose of Accounting © ABE and RRC could not afford the costs of a full listing on the Stock Exchange. Quoted companies must be public companies, although not all public companies will have a stock exchange listing. (d) Unquoted companies These are companies which do not have a full listing on a recognised stock exchange. An unquoted company may be a private or a public company and some shares may be traded through the Alternative Investment Market. Accounting Differences Between Companies and Unincorporated Businesses The following table summarises the main accounting differences between the alternative types of business: Item Sole Traders and Partnerships Companies Capital introduced To the capital account As issued share capital Profits withdrawn by the owners As drawings As dividends Profits left in the business In a capital account As a revenue reserve Loans made from outside investors As loan accounts As loan accounts Principle of Limited Liability The principle of limited liability means that a member agrees to take shares in a company up to a certain amount, and once he has paid the full price for those shares he is not responsible for any debts that the company may incur, even if it becomes insolvent within a few months of his becoming a member. This provides a safeguard against the private personal estate of a member being attached to make good the company's debts. (Remember sole traders and partners in such circumstances can lose the whole of their business and private wealth.) Promoters and Legal Documents Promoters are the people who comply with the necessary formalities of company registration. They find directors and shareholders, acquire business assets and negotiate contracts. They draw up the memorandum and articles of the new company and register them with the Registrar of Companies. The memorandum of association is said to be the "charter" of the company and it must state the company's objects as well as other details such as its name and address and details of authorised capital. The articles of association are the internal regulations or by-laws of the company, dealing with such matters as the issue and forfeiture of shares, procedure at meetings, shareholders' voting powers, appointment, qualification, remuneration and removal of directors. When the promoters have arranged all the formalities and satisfied themselves that the statutory regulations have been complied with, they apply for a certificate of incorporation which brings the company into existence as a legal being, known as a registered company.
  30. 30. The Nature and Purpose of Accounting 25 © ABE and RRC I. AUDITING IN BUSINESS What is an Audit? An audit is a process by which an independent suitably qualified third party expresses an opinion on whether a set of financial statements of a business represent a true and fair view of its financial affairs for an accounting period. Not all businesses are required to have an audit. In the UK, only large companies and some public bodies are required by law to have an audit. So why are small companies, partnerships and sole traders, for example, not audited by law? The answer to this question is in the very nature of an audit. The audit is a check on the truth and fairness of the financial statements prepared by the management of the organisation for the users. One of the key users of these financial statements, as we saw earlier, is the owners and they need to know that the statements have been prepared competently, with integrity and are free from mistakes as best they can be. If the management and the owners are the same people, as is the case with sole traders, partnerships and generally small companies, then there is no need for such an audit. It has been known for those involved in the preparation of financial statements to bend the rules of accounting, as detailed in accounting standards, in order to provide a more favourable picture of the entity. There can be many reasons for them doing this – for example:  their salary or bonus may be based on the profit figure declared;  they may not wish information that shows a poor liquidity position to be in the public domain;  to protect the organisation from liquidation. You might like to gather information from the internet on the demise of Enron and WorldCom to illustrate the above points. Types of Audit There are two types of audit – external audit and internal audit. (a) External audit An external audit is carried out by persons from outside the organisation who investigate the accounting systems and transactions and ensure, as far as they are able, that the financial statements have been prepared in accordance with the underlying books, the law and applicable accounting standards. The external auditor needs, from his investigation, to place him/herself in a position to express an opinion whether the financial statements being reported upon show a true and fair view or not. This opinion, if positive, provides considerable reassurance to users of financial statements, particularly the current shareholders, the owners, that these accounts are reliable. It is important to identify what an external audit is not. It is not an attempt to find fraud, and it is not a management control. Fraud may be discovered during an audit, and the auditor will usually be well placed to give advice to management about potential improvements in the internal control system, but these benefits are incidental. (b) Internal audit Internal audit forms part of the internal management control system of a business. It is carried out at management discretion and is not imposed by law. Many organisations set up an internal audit function to check on financial records, quality or cost control to ensure the organisation achieves the best performance it can. Internal auditors, who
  31. 31. 26 The Nature and Purpose of Accounting © ABE and RRC do not need to be qualified accountants, report to management not the owners. The functions of internal audit can include:  Ensuring the adequacy of internal controls  Reviewing the reliability of records and books  Preventing fraud, waste and extravagance  Enforcing management decisions  Undertaking ad hoc investigations  Securing the asset base  Substituting for external auditors under their supervision  Undertaking value for money audits Relationship between internal and external audit When carrying out an external audit the auditor may make use of the internal audit function during the course of the audit. If the external auditor does rely on the work of internal audit, he will have to assure him/herself that the work has been:  Carried out by suitably competent and proficient people  Well documented and evidenced in accordance with findings  Used appropriate audit tests and techniques, such that reasonable conclusions have been drawn and acted upon  Carried out without undue influence from others The external auditor will need to test the work of the internal audit function to confirm its adequacy. UK Law and External Audit Within the UK the 1985 Companies Act requires that all limited companies, except small companies, are required to have an audit which they pay for. Thus, a private family-run company, as long as it is not defined as small, will require an external audit as will a large plc such as Tesco or BT. A small company is defined as a private limited company, which is not part of a larger group, and is not a banking or insurance company. Its turnover must be £5.6m or less, its balance sheet totals £2.8m or less and it should employ fewer than 50 people. The 1985 Companies Act also states that external auditors must be a member of a Recognised Supervisory body (RSB). The current RSBs in the UK are:  Institute of Chartered Accountants in England and Wales (ICAEW)  Institute of Chartered Accountants in Scotland (ICAS)  Institute of Chartered Accountants in Ireland (ICAI)  Association of Chartered Certified Accountants (ACCA)  Association of Authorised Public Accountants (AAPA) The Act also states that a person may not be an auditor if he/she is an officer or employee of the company, or is in business partnership with an officer or employee of the company being audited. This is the extent to which specified individuals are excluded from acting as an external auditor. So, could you think of anyone who may have a close relationship with a company who could be an auditor of that company?
  32. 32. The Nature and Purpose of Accounting 27 © ABE and RRC Well, to start with, a shareholder of the client company can audit that company, as can a debtor or creditor of the client company. In addition, in law, the spouse, for example, of a director of the client company can audit that company. However, RSBs impose stricter guidelines than the law on who can audit and a spouse would be specifically excluded under their rules. By law external auditors are appointed by and report to the shareholders, the owners, of the company. In practice, though, the choice of auditor is delegated to directors with shareholders voting on that choice, on a simple majority basis, at the annual general meeting, AGM, of the company. The Companies Act also provides the external auditor with several rights during the audit. These are the right to:  Have access to all of the client's records  Require from officers of the client, any information and explanations as they think necessary  Attend any general meetings of the client  Receive a copy of any written resolutions  Speak at general meetings  Require the calling of a general meeting for the purpose of laying the accounts and reports for the company. External Audit Report The audit report, as we have previously stated, is addressed to the shareholders of the company and is the auditor's opinion as to whether the financial statements show a true or fair view. The report should also:  State which financial statements have been audited  Place emphasis on the fact that it is management's responsibility to prepare the financial statements and the auditor's purely to audit them  State that compliance with auditing standards in carrying out the audit has been adhered to  Provide a brief overview of the work done to provide the auditor with the evidence for the opinion  Provide details of the auditor and the date of the report  Provide details of "emphasis of matter" – this is where an issue arises during the audit that does not affect the opinion, but the auditor believes it should be brought to the attention of recipients of the report. An auditor may not be able to state that the financial statements provide a true and fair view after his audit, in which case he must provide a modified report to that effect. The external report is included within the published financial statements. You might find it useful to obtain several sets of financial statements – you will find many freely available under a company's website on the internet – and read the audit report. You will also find these published financial statements useful reference points for other topics we will deal with in this manual.
  33. 33. 28 The Nature and Purpose of Accounting © ABE and RRC External Audit Process The steps an auditor will take to carry out the audit from the time he/she is appointed until signing off the audit report are as follows:  Find out as much as possible about the potential client before accepting the audit  Carry out detailed investigations and document the client's structure, management, systems and accounting processes  Draft a programme of audit work  Carry out investigations and receive explanations necessary to support the audit opinion An audit syllabus would cover all of these steps in much detail. However, with the financial accounting syllabus, the detail of these steps is not required. Expectations Gap Finally in this section on auditing, we need to deal with what an audit is not. This is best illustrated by considering the "expectations gap". The expectations gap is the name given to the difference between what the public think auditors do and what they actually do. When large organisations such as Enron, Worldcom, Parmalat, etc., fail or get in to difficulties, whether through poor management or fraud, auditors are often the first people the public blame. They are often criticised in the press for failing to meet the expectations of the public. However, these expectations are quite often unrealistic and do not form part of the external auditors' duties. The general public, research has shown, think that auditors check every single transaction, prepare the financial statements, guarantee that financial statements are correct (whatever correct means), are responsible for finding and reporting frauds however small, and are responsible for detecting illegal acts by directors. You should be able to see from the short review of auditing here that none of this is realistic and/or correct. One important legal case in the UK that sets out the role of the external auditor was the Kingston Cotton Mill case in 1896. The judge in the case established that the auditor's role was similar to that of a "watchdog not a bloodhound". The judge further elaborated on this famous phrase, stating that an auditor had to use reasonable skill and judgement appropriate to the circumstances in carrying out his audit, but that he was not expected to investigate every transaction and should use his /her professional abilities to support the audit opinion given. Thus, we can conclude that it is the job of the auditor to ensure that enough testing work is carried out to support the audit opinion and to be alert to the possibility of fraud. If during their work they discover omissions or frauds, then they must of course investigate and report them. Questions for Practice As this is the only point in the study manual that we will consider the topic of audit, you might find it useful to consider the following two questions. We provide brief answers on the following page, but do try and answer them without looking at these answers. 1. Many companies within the UK have to undergo an external audit by law. Non- statutory audits are quite often undertaken by other organisations, but they are costly. What would persuade a partnership to undergo a non-statutory external audit?
  34. 34. The Nature and Purpose of Accounting 29 © ABE and RRC 2. What is a qualified audit report? Outline the likely effect on a UK company of such a report.
  35. 35. 30 The Nature and Purpose of Accounting © ABE and RRC ANSWERS TO QUESTIONS FOR PRACTICE 1. The following circumstances/issues might persuade a partnership to undergo a external audit:  To settle the profit sharing between partners equitably especially if complicated profit sharing arrangements exist  To provide credibility to figures within the financial statements after asset revaluations or creation of non-purchased goodwill on the death or retirement of a partner, or other change in the partnership arrangement  To support an application to third parties for loan finance  To enhance the credibility of the accounts provided to tax authorities  The need for financial advice from a expert/professional to advance the business You might well have thought of other reasons as well. 2. A qualified audit report is one in which the auditor has reservations and which have a material effect on the financial statements. Circumstances under which a qualified audit report might occur are:  Where there has been limitation on the scope of the audit, and hence an unresolvable uncertainty, which prevents the auditor from forming an opinion, or  Where the auditor is able to form an opinion but, even after negotiation with the directors, disagrees with the financial statements. The likely effect of a qualified audit report will be to significantly reduce the reliability of the financial statements in the eyes of any user of such statements. This may well then impact on the company's ability to raise finance or trade on credit. This could lead to a fall in share price and eventual liquidation.
  36. 36. 31 © ABE and RRC Study Unit 2 Business Funding Contents Page A. Capital of an Enterprise 33 Features of Share Capital 33 Types of Share 33 Types of Capital 34 Share Issues 35 Bonus Issues 37 Rights Issues 37 Redeemable Shares 38 Purchase of Own Shares 40 Advantage of Purchasing/Redeeming Shares 40 B. Dividends 40 Preference Dividends 40 Ordinary Dividends 40 Interim Dividends 41 C. Debentures 41 Types of Debenture 41 Rights of Debenture Holders 42 Gearing 42 Issues at Par and at a Discount 42 Redemption of Debentures 43 Restrictions on Borrowings 43 D. Types and Sources of Finance 43 Balancing Fixed and Working Capital 43 Types of Business and Capital Structure 44 Long-term Funds 44 Shorter-term Funds 46 Interest Rate Exposure 46 Sources of External Finance 46 Examples of Business Financing 47 (Continued over)
  37. 37. 32 Business Funding © ABE and RRC E. Management of Working Capital 48 Working Capital Cycle 48 Striking the Right Balance 49
  38. 38. Business Funding 33 © ABE and RRC A. CAPITAL OF AN ENTERPRISE (Within this unit all references to companies are UK based in respect of terminology and legal requirements) Virtually every enterprise must have capital subscribed by its proprietors to enable it to operate. In the case of a partnership, the partners contribute capital up to agreed amounts which are credited to their accounts and shown as separate liabilities in the balance sheet. A limited company obtains its capital, up to the amount it is authorised to issue, from its members. A public company, on coming into existence, issues a prospectus inviting the public to subscribe for shares. The prospectus advertises the objects and prospects of the company in the most tempting manner possible. It is then up to the public to decide whether they wish to apply for shares. A private company is not allowed to issue a prospectus and obtains its capital by means of personal introductions made by the promoters. Once the capital has been obtained, it is lumped together in one sum and credited to share capital account. This account does not show how many shares were subscribed by A or B; such information is given in the register of members, which is a statutory book that all companies must keep but which forms no part of the double-entry book-keeping. Features of Share Capital  Once it has been introduced into the company, it generally cannot be repaid to the shareholders (although the shares may change hands). An exception to this is redeemable shares.  Each share has a stated nominal (sometimes called par) value. This can be regarded as the lowest price at which the share can be issued.  Share capital of a company may be divided into various classes, and the articles of association define the respective rights of the various shares as regards, for example, entitlement to dividends or voting at company meetings. Types of Share (a) Ordinary Shares The holder of ordinary shares in a limited company possesses no special right other than the ordinary right of every shareholder to participate in any available profits. If no dividend is declared for a particular year, the holder of ordinary shares receives no return on his shares for that year. On the other hand, in a year of high profits he may receive a much higher rate of dividend than other classes of shareholders. Ordinary shares are often called equity share capital or just equities. Deferred ordinary shareholders are entitled to a dividend after preferred ordinary shares. (b) Preference Shares Holders of preference shares are entitled to a prior claim, usually at a fixed rate, on any profits available for dividend. Thus when profits are small, preference shareholders must first receive their dividend at the fixed rate per cent, and any surplus may then be available for a dividend on the ordinary shares – the rate per cent depending, of course, on the amount of profits available. So, as long as the business is making a reasonable profit, a preference shareholder is sure of a fixed return each year on his investment. The holder of ordinary shares may receive a very low dividend in one year and a much higher one in another.
  39. 39. 34 Business Funding © ABE and RRC Preference shares can be divided into two classes:  Cumulative Preference Shares When a company is unable to pay dividends on this type of preference share in any one year, or even in successive years, all arrears are allowed to accumulate and are payable out of future profits as they become available.  Non-cumulative Preference Shares If the company is unable to pay the fixed dividend in any one year, dividends on non-cumulative preference shares are not payable out of profits in future years. (c) Redeemable Shares The company's articles of association may authorise the issue of redeemable shares. These are issued with the intention of being redeemed at some future date. On redemption the company repays the holders of such shares (provided they are fully paid-up) out of a special reserve fund of assets or from the proceeds of a new issue of shares which is made expressly for the purpose of redeeming the shares previously issued. Redeemable shares may be preference or ordinary shares. (d) Participating Preference Shares These are preference shares which are entitled to the usual dividend at the specified rate and, in addition, to participate in the remaining profits. As a general rule, the participating preference shareholders take their fixed dividend and then the preferred ordinary shareholders take their fixed dividend, and any balance remaining is shared by the participating preference and ordinary shareholders in specified proportions. (e) Deferred, Founders or Management Shares These normally rank last of all for dividend. Such shares are usually held by the original owner of a business which has been taken over by a company, and they often form part or even the whole of the purchase price. Dividends paid to holders of deferred shares may fluctuate considerably, but in prosperous times they may be at a high rate. You should note that this type of share has nothing to do with employee share schemes, where employees are given or allowed to buy ordinary shares in the company for which they work, at favourable rates – i.e. at less than the market quotation on the Inventory Exchange. Types of Capital (a) Authorised, Registered or Nominal These terms are synonymously used for capital that is specified as being the maximum amount of capital which the company has power to issue. Authorised capital must be stated in detail as a note to the balance sheet. (b) Issued (Allotted) or Subscribed Capital It is quite a regular practice for companies to issue only part of their authorised capital. The term "issued capital" or "subscribed capital" is used to refer to the amount of capital which has actually been subscribed for. Capital falling under this heading will comprise all shares issued to the public for cash and those issued as fully-paid-up to the vendors of any business taken over by the company. (c) Called-up Capital The payment of the amount due on each share is not always made in full on issue, but may be made in stages – for example, a specified amount on application and a further
  40. 40. Business Funding 35 © ABE and RRC amount when the shares are actually allotted, with the balance in one or more instalments known as calls. Thus, payment for a £1 share may be made as follows:  25p on application  25p on allotment  25p on first call  15p on second call  10p on third and  final call. If a company does not require all the cash at once on shares issued, it may call up only what it needs. The portion of the subscribed capital which has actually been requested by the company is known as the called-up capital. Note that a shareholder's only liability in the event of the company's liquidation is to pay up any portion of his shares which the company has not fully called up. If a shareholder has paid for his shares, he has no further liability. (d) Paid-up Capital When a company makes a call, some shareholders may default and not pay the amount requested. Thus the amount actually paid up will not always be the same as the called-up capital. For example, suppose a company has called up 75p per share on its authorised capital of 20,000 £1 shares. The called-up capital is £15,000, but if some shareholders have defaulted, the actual amount paid up may be only £14,500. In this case, the paid-up capital is £14,500, and the called-up capital £15,000. Paid-up capital is therefore the amount paid on the called-up capital. (e) Uncalled Capital or Called-up Share Capital Not Paid If, as in our example, a company has called up 75p per share on its authorised capital of £20,000 £1 shares, the uncalled capital is the amount not yet requested on shares already issued and partly paid for by the public and vendors. In this example the uncalled capital is £5,000. Share Issues When a company issues shares, it can call for the whole value of the share or shares bought to be paid in one lump sum, or it can request the payment to be made in instalments. Generally, a certain amount is paid upon application, a certain amount on notification that the directors have accepted the offer to subscribe (the allotment), and a certain amount on each of a number of calls (the instalments). For our purposes we only need to look at shares which are payable in full upon application. (a) Shares at Par This means that the company is asking the investor to pay the nominal value, e.g. if a company issues 100,000 ordinary shares at £1, which is the par value, then the cash received will be £100,000. We can follow the entries in the accounts: Dr Cr £ £ Cash 100,000 Share capital 100,000
  41. 41. 36 Business Funding © ABE and RRC The balance sheet will show: £ Current assets Cash £100,000 Share capital Authorised, issued and fully paid 100,000 £1 shares £100,000 The basic rules of double entry apply and as you can see the basic formula is the same: Capital (£100,000) = Net assets (Cash: £100,000) (b) Shares at a Premium A successful company, which is paying good dividends or which has some other favourable feature, may issue shares at a price which is higher than the nominal value. For example, as in the last example, if the £1 share is issued it may be that the applicant will be asked to pay £1.50. The additional amount is known as a premium. The entries in the accounts will now be: Dr Cr £ £ Cash 150,000 Share capital 100,000 Share premium a/c 50,000 The balance sheet will show: £ Current assets Cash 150,000 Share capital Authorised, issued and fully paid 100,000 £1 shares 100,000 Share premium account 50,000 150,000 Notes:  The share premium is treated separately from the nominal value and must be recorded in a separate account which must be shown in the balance sheet. The Companies Act requires that the account is to be called the share premium account, and sets strict rules as to the uses to which this money can be put.  The basic formula will now be: Capital (£150,000) = Net Assets (Cash: £150,000)
  42. 42. Business Funding 37 © ABE and RRC and this means that the additional sum paid belongs to the shareholders and as such must always be shown together with the share capital. Bonus Issues When a company has substantial undistributed profits, the capital employed in the business is considerably greater than the issued capital. To bring the two more into line it is common practice to make a bonus issue of shares. Cash is not involved and it adds nothing to the net assets of the company – it simply divides the real capital into a larger number of shares. This is illustrated by the following example. A company's balance sheet is as follows: £000 Net assets 1,000 Ordinary shares 500 Undistributed profits 500 1,000 We can see that the real value of each share is £2, i.e. net assets £1,000 ÷ 500, but note that this is not the market value – only what each share is worth in terms of net assets owned compared with the nominal value of £1. Now suppose the company issued bonus shares on the basis of one new share for each existing share held. The balance sheet will now be as follows: £000 Net assets 1,000 Ordinary shares 1,000 Each shareholder has twice as many shares as before but is no better off since he owns exactly the same assets as before. All that has happened is that the share capital represents all the net assets of the company. This does, of course, dilute the equity of the ordinary shareholders, but a more substantial share account can often enable a company to obtain further finance from other sources. It can also be used as a defence against a takeover because the bidder cannot thereby obtain control and distribute the reserves. Rights Issues A useful method of raising fresh capital is first to offer new shares to existing shareholders, at something less than the current market price of the share (provided that this is higher than the nominal value). This is a rights issue, and it is normally based on number of shares held, as with a bonus issue, e.g. one for ten. In this case, however, there is no obligation on the part of the existing shareholder to take advantage of the rights offer, but if he does the shares have to be paid for. The Companies Act requires that, before any equity shares are issued for cash, they must first be offered to current shareholders. Example A company with an issued share capital of £500,000 in £1 ordinary shares decides to raise an additional £100,000 by means of a one-for-ten rights issue, at a price of £2 per share. The issue is fully subscribed and all moneys are received. The book-keeping entries are:
  43. 43. 38 Business Funding © ABE and RRC Dr: Cash £100,000 Cr: Share capital a/c £50,000 Cr: Share premium a/c £50,000 Note the credit to share premium account. You should also note that neither bonus nor rights issues can be allotted if they would cause the authorised capital to be exceeded. Redeemable Shares Redeemable shares may not be issued at a time when there are no issued shares of the company which are not redeemable. This means that there must be at all times some shares which are not redeemable. Only fully-paid shares may be redeemed and, if a premium is paid on redemption, then normally the premium must be paid out of distributable profits, unless the premium effectively represents a repayment of capital because it was a share premium paid when the shares were issued. In that case the share premium may be paid from the share premium account. When shares are redeemed, the redemption payments can be made either: (a) From the proceeds of a new issue of shares, or (b) From profits. If (b) is chosen then an amount equal to the value of the shares redeemed has to be transferred from the distributable profits to an account known as the capital redemption reserve. The Act makes it clear that when shares are redeemed it must not be taken that there is a reduction of the company's authorised share capital. By issuing redeemable shares the company is creating temporary membership which comes to an end either after a fixed period or at the shareholder's or company's option. When the temporary membership comes to an end the shares that are redeemed must be cancelled out. To avoid the share capital contributed being depleted, a replenishment must be made as mentioned earlier, i.e. by an issue of fresh shares or by a transfer from the profit and loss account. (Note: In the illustration which follows we have adopted a "standard" balance sheet which we will discuss later. For the present, you need not be concerned with regard to how the balance sheet is constructed.)