INSTITUTE OF PUBLIC ADMINISTRATION AND MANAGEMENT

(University of Sierra Leone)

Module Code & Title: DAA 226 FINANCIAL STATEMENT

Academic Year & Semester: 2023/24 Second Semester

Course & Year: BSc. Applied Accounting Year 2

Lecturer: Mr. Ambalieu Barrie (abarrie@mof.gov.sl)

LECTURE NOTES

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LECTURE 1: Content and Purpose of Financial Reporting
DEFINITION AND PURPOSE OF FINANCIAL REPORTING:

Financial reports are produced for external use and they are used to record and summarize the
financial performance of a company during the previous accounting period.

Types of businesses:

There are three main types of businesses:

1. Sole trader – a single person trading on their own. They may have employees but the sole
trader runs and owns the business.

2. Partnership – two or more sole traders working together to run the business. The partners
will share
in the profits and losses of the business and they are all jointly liable for debts within the
business.

3. Limited company – in this instance the owners of the company, called shareholders, are not
the people managing the company. The directors will manage the company on behalf of the
shareholders.

Users of financial reports:

A stakeholder is anyone who has an interest in the company, so we need to not only think
about the shareholders but also employees, customers, suppliers, investors, the directors of the
company, the government and also the general public. The key stakeholders are:

1. Shareholders: They are not only interested in the profit being generated, but also the
capital growth being seen and dividends being paid out to them.

2. Employees: They will be interested in job security and any possibility of pay-rises or healthy
bonuses.

3. Customers: They will be checking that the company is still going to be trading in the future,
ensuring that they can still buy from this company going forward and they do not risk losing
a supplier.

4. Suppliers: They will be interested in ensuring that the company can pay any outstanding
debts and that they will continue to buy from them.

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 5. Investors: They will be checking to see that future interest payments and capital
repayments are assured, and they will also examine the accounts in detail if there is a
request for further investment in the company.

6. Directors: Like employees, they will be focusing on job security and potential bonus.

7. Government: The government will be looking at the company’s financial reports to ensure
they are paying the right levels of tax.

8. General public: They are interested from the perspective of community involvement,
charitable giving and any environmental impact of the company’s work.

Conceptual framework of financial reporting:

The conceptual framework for financial reporting is made up of four main areas:

1. Objectives:

Key objective of financial reporting is to enable the readers of the accounts to make decisions.

2. Qualitative characteristics:

The qualitative characteristics of financial information include:

Fundamental characteristics Other characteristics

_ Relevance _ Comparability
_ Faithful representation _ Verifiability
_ Timeliness
_ Understandability

a) Relevance: Financial information must be relevant to the needs of the users. For example, a
sales report detailing the sales revenues in the last financial period will not be relevant to
the purchasing manager. A report detailing the current inventories and quantities sold in
the past month is relevant.

Relevance also means that the information highlights important data that will influence
economic decisions. Financial information influences the economic decisions of its users and it
must show all the relevant data. If important data is leftout it will affect decisions made.

b) Faithful representation of financial information: This means that the information accurately
reflects the condition of the business. For example, if profits are falling, the profit and loss

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 should reflect this, even if it is not what the shareholders want to hear.

c) Comparability: This means the information must be comparable to other periods and
departments so trends can be identified and the financial position of the company can be
compared with its competitors. For example, if the sales of a company were presented one
month in units sold, and the next month as revenues,it would be difficult to compare the
performance.

d) Verifiability: Financial information is verifiable. This means that it is true and accurate. If
the same data was given to an independent accountant, they would produce the same
information.
e) Timeliness: This means financial information should be presented in a timely manner
when the users need it to make their decisions. For example, if the purchasing manager
makes a purchase order every Wednesday at 2 o’clock, it is important that they receive the
previous week’s sales report and inventory reportsbefore then.

f) Understandability: Financial information must be understood by its users. There isno point in
a report that nobody can understand. Reports should be clearly laid out and presented with
footnotes providing more information and to help clarification.

3. Fundamental accounting concepts:

When preparing financial statements, there are a number of fundamental accounting concepts:

A. Materiality: This relates to the significance of transactions, balances and errors that are in the
financial information. The IASB framework gives an indication of what is or isn’t material by saying:

"Information is material if its omission or misstatement could influence the economicdecisions of users
taken on the basis of the financial statements." (IASB Framework)
Example:
The materiality concept gives us a cut-off point where financial information becomes relevant.
Materiality is relative to the size and individual circumstances of a company. Forexample, a large
multinational may not view a $300 error the same way a small shop or market stall would.

Materiality is linked with reliability, and true and fair view. If the omission of this data willcompromise
the true and fair view, it is material and must be included.

B. Substance over form: This concept means that the economic substance of a transaction should be
recorded in the financial statements, and not just their legal form. This protectsthe true and fair
view of accounts.

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 Example:
When preparing the financial statements, you must ask: "What is the underlying transaction?” For
example, consider a company that has leased a car and does not own thecar until it has finished
paying an agreed 36 monthly installments. The company must however cover all the expenses
associated with ownership, like repairs and maintenance. The legal form of this transaction is that the
company does not own the car and it should not be recorded in the accounts. However, the
substance of the transaction is that the company has full use of the car and incurs all the risks and
responsibilities of ownership.
In this situation, we look at the economic reality. Not recording the leased asset would mean that the
financial statements are not telling the full story. Therefore, the asset and the liabilityshould be
recorded in the financial statements. For further guidance on leases see IAS 17.

C. Going concern: Under the going concern assumption, the business is viewed as continuing for the
foreseeable future. IAS 1 defines the future as 12 months from the reporting date. Financial
statements prepared on this basis assume that the organization does not intend toliquidate or reduce
its operations. If the management decide that the business cannot continue, the financial statements
should not be prepared on the going concern basis. Instead they are prepared on the “break-up”
basis.

D. The business entity concept: This concept sets out that the business is separate from its owners.
Financial statements of a business should only contain the business’s expenses, and not the personal
ones of the owners. This is also why owners’ equity is shown as a liability in the balance sheet, because
the business owes it to the owners.

E. The accruals concept: This is a very important concept in accounting. This principle states expenses
must be recorded when they are incurred, and not when they are paid. The samefor revenues that
they are recorded when the sale is agreed, not when the money is received. An accrual is an expense
for which no invoice has been received. As there is no invoice, the final price is not known, so it is
estimated.
Example:
Utility bills are one of the most common accruals. The business is using electricity, yet the bill is
received quarterly and not received on time for the year end accounts. The accountant estimates the
cost as an accrual to recognise the cost. Without the accrual, the information would be misleading.
The company’s electricity cost would not be complete. When the final bill is received, the accrual is
reversed out and the actual bill entered into the accounts. There may be small differences, but these
are usually immaterial.

F. The fair presentation concept: The financial statements must "present fairly" the financialposition,
financial performance and cash flows of an entity.

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 Fair presentation requires the faithful representation of the effects of transactions, other events, and
conditions. This concept may require additional disclosures in the accounts togive a fair presentation
of the financial information.

G. The consistency concept: This concept states that once an accounting principle is adopted itshould be
applied consistently year on year. This enables comparisons to be made between years.

This is particularly relevant when selecting an inventory valuation method, as different methods can
offer different valuations. If the valuation changed every year, the users of the financial statements
would not be able to compare them. It could also mean the financial statements are not true and fair,
especially if the change in valuation method is not documented. If the accounting principle or method
is changed, which should not happen regularly, this change and the reasons for it, must be
documented in the financial statements.

4. Definition, recognition and measurement:

There are four types of figures we will need to report on:

Item Definition Recognition and measurement

A resource owned by the business
Assets →
that
gives rise to future economic
benefits.
A present obligation as a result of a We should never overestimate
Past assets
event which will lead to the or underestimate liabilities
Liabilities → economic (Prudence
benefit passing from the business
concept).
to
another party.
Income → Any increase in economic benefit

(revenue and other gains). Income and expense must be

recognized in the accounting

periods
Decreases in economic benefits
to which they relate rather than on
During
the accounting period (losses,
Expenses → impairment).
cash basis (Accruals concept).

NOTE: As a general rule; assets, liabilities, income and expenses are only recorded and reported

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 when they can be measured reliably.

REGULATORY FRAMEWORK:

In order to ensure that all company accounts are prepared on the same basis, and therefore
achieve the objective of financial reporting (to allow the readers of the accounts to make
decisions), accounting standards need to be followed. Accounting standards are being assessed
and developed on a constant basis and as new standards are developed these are published
and enforced by various regulatory bodies.

The most recent accounting standards to be published are named the International Financial
Reporting Standards (IFRS) and these are developed and published by the International
Accounting Standards Board (IASB) under the watchful eye of the IFRS Foundation. The IFRS
Foundation is the supervisory body to the IASB and their job is to monitor these enforceable
and global financial reporting standards, as well as promoting use of them. When the IASB
wasset up they also adopted the, then current accounting standards, called International
Accounting Standards (IASs).

In order to help the members of the IFRS Foundation and the IASB do their job there is also an
IFRS Advisory Council assisting them in their roles. This board is made up of a wide range of
representatives from groups that are affected by and interested in the IASB's work and meets
three times a year to discuss the development and implementation of IFRSs.

In short the regulatory framework (comprising of the mentioned three regulatory bodies) can
be summed up in the following diagram:

The regulatory framework

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 1. THE INTERNATIONAL FINANCIAL REPORTING STANDARDS FOUNDATION

The IFRS Foundation is the legal entity under which the International Accounting Standards
Board (IASB) operates. The foundation is governed by 22 trustees and its main objectives are:

− To develop one set of financial reporting standards that are in the public’s interest;

− To promote the use of these standards for a wide range of organisation types and sizes; and

− To promote and facilitate adoption of International Financial Reporting Standards (IFRSs)

through the convergence of national accounting standards and IFRSs.

2. THE INTERNATIONAL ACCOUNTING STANDARDS BOARD

The International Accounting Standards Board, or the IASB, is an independent, private-sector

body that develops and approves sets of international financial reporting standards.

International Financial Reporting Standards (IFRS Standards) is a single set of accounting

standards that the IASB develops. The intention is that those standards should be capable of
being applied on a globally consistent basis by investors and other users of financial statements
with the ability tocompare the financial performance of publicly listed companies on a like-for-
like basis with their international peers.

The goal of the IASB is to:

− Raise the standard of financial reporting and harmonise accounting standards.

− The IASB is responsible for all the technical matters of the IFRS Foundation.

3. THE IFRS ADVISORY COUNCIL

The International Financial Reporting Standards Advisory Council is the formal advisory body to
the International Accounting Standards Board (the IASB) and the trustees of the IFRS
Foundation.

It has a wide range of representatives from groups that are affected by and interested in the
Board's work. The Advisory Council acts as a sounding board for the International Accounting
Standards Board, and advises the IASB on its:

− Technical agenda;

− Project priorities;

− Project issues related to the application and implementation of IFRSs;

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 − Possible benefits and costs of certain proposals.

The Advisory Council also provides advice on single projects, mainly looking at the practical
application and implementation issues, including matters relating to existing standards that
may need to be considered by the IFRS Interpretations Committee.

If the IASB ultimately takes a position on an issue that is different than the polled expression of
the Advisory Council, the IASB gives the Advisory Council its reasons for coming to its position.

4. THE IFRS INTERPRETATIONS COMMITTEE

The IFRS Interpretations Committee is the interpretative body for the IFRS Foundation. Its duty
is to review widespread accounting issues that have arisen within the context of current
International Financial Reporting Standards (IFRSs) on a timely basis. The work of the
Interpretations Committee is aimed at reaching agreement on the appropriate accounting
treatment (IFRIC Interpretations) and providing authoritative guidance on those issues.

In developing interpretations, the Interpretations Committee works closely with similar national
committees. The interpretations cover both:

− Newly identified financial reporting issues not specifically dealt with in IFRSs;
− Issues where unsatisfactory or conflicting interpretations have developed, or seem likely
to develop in the absence of authoritative guidance.

Their interpretations need to be approved by the IASB and have the same authority as a
standard issued by the IASB. The Interpretations Committee has 14 voting members drawn
from a variety of countries and professional backgrounds. Members are appointed by the
trustees of the IFRS Foundation.

THE ROLE OF INTERNATIONAL FINANCIAL REPORTING STANDARDS

There is a level of subjectivity when preparing financial statements. By preparing accounts with
IFRS, the level of subjectivity is controlled as the statements are prepared according to the
assumptions of the standards. This allows greater comparability between companies.

IFRSs have improved and harmonised financial reporting around the world. The IFRSs are used
in the following ways:

1. As national requirements, where the country has adopted the IFRS and financial
statements must be presented according to IFRS.

2. Some countries will use the IFRS as the basis for all or some national requirements.

3. International and domestic regulation authorities may insist that companies prepare their
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 financial statements under IFRS, giving greater transparency and comparability.

4. Companies themselves may adopt the standards as they are the highest standard of
financial reporting. GAAP

GAAP = Generally Accepted Accounting Practices

− These are a set of rules governing accounts preparation on a local level.

− They vary by country and are usually set by local laws, statutory and stock exchange
requirements.

− These standards are being replaced, or are being harmonised to be the same as IFRS in
many countries.

CORPORATE GOVERNANCE:

Corporate Governance is defined as the system or process by which companies are directed
and controlled it is based on the principle that companies are accountable for their actions and
therefore broad based systems of accountability need to be built into the government's
structures of companies. Corporate governance has an external and internal source.

External sources are:

− Laws

− Mandatory and voluntary codes

Internal corporate governance is how the external governance, so the laws and codes are
complied with and integrated into the culture and values of the organization. It is the director's’
responsibility to implement and maintain good corporate governance standards within a
company. They do this by actively putting systems in place and by investigating and disciplining
staff who don’t comply. They must do this to ensure the company is adequately managed to
protect the shareholders’ interests. The shareholders own the company but appoint the
directors to manage the company for them.

Unfortunately, there is no shortage of examples of corporate scandals where directors have

acted in their own interests and not of the shareholders. Over the years there have been many
codes and standards have been issued, these were combined into “The Combined Code on
Corporate Governance”. All listed companies must report their compliance with this code in
their financial statements.

Key objective of a corporate governance framework is to improve performance and

accountability, with the aim of generating long-term shareholder value. This objective is
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 supported by ensuring that:

− The management of the company is effective;

− The directors are appraised and paid in a fair manner;

− The resources of the company are being used as effectively as possible;

− There are effective internal controls in place, such that the control at the top of the
management chain passes down through the company.

Financial statements are audited by an independent external party to provide reasonable

assurance that the financial statements are a true and fair reflection of the financial position of
the company.

Duties and Responsibilities of those Charged with Governance

PREPARATION OF THE FINANCIAL STATEMENTS

Good corporate governance must be followed when preparing the financial statements. The
annual financial statements are the main communication between the Board of Directors and
the shareholders and must give the shareholders a clear picture of the company.

For assurance over the company and the financial statements the shareholders may have the
company audited annually, if not already obliged to do so by law.

1. The financial statements must be prepared so they give a true and fair view of the
company’s position. They must be prepared, using consistent and suitable accounting
policies to reflect this. The requirement to produce financial statements that are true andfair
is so important that it usually included in company legislation. Systems must be implemented
to ensure that the financial statements reflect this.

2. All the principal risks facing the business must be assessed and show what actions are
being taken to reduce them.

3. All important issues must be disclosed in the accounts, if not in the main body they must be
included in the notes.

4. The financial statements should assess the ability of the company to continue to exist. Its
ability to meet its liabilities considering its current position and the risks the company
faces. The financial statements must also state if they are prepared on the going concern
basis, that the financial statements are prepared on the assumption that the company will
continue.
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 THE DUTIES AND RESPONSIBILITIES OF DIRECTORS

The directors’ role is:

− To define the purpose of the company;

− To define the values by which the company will perform its daily duties;

− To identify the stakeholders relevant to the company;

− To develop a strategy combining these factors;

− To ensure implementation of this strategy.

As you can see their role is extremely important. And they have many duties and
responsibilities such as:

− Complying with the company’s constitution;

− To act in the employee's best interests;

− To act in a way that is most likely to promote the success of a company;

− To exercise reasonable care, skill and due diligence;

− To exercise their own independent judgement;

− To declare any personal interests in transactions;

− To avoid conflicts of interest.

This is not an exhaustive list of directors’ duties.

WHEN PREPARING THE FINANCIAL STATEMENTS

The directors are responsible for:

− Keeping proper accounting records;

− Preparing financial statements for each financial year in accordance with the applicable
reporting, Financial Reporting Framework;

− These financial statements must fairly present the activities of the business;

− The directors must establish and maintain a system of internal controls that ensures the
financial statements are free from material error. These systems should also prevent
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 and detect error and fraud;

− The directors are also responsible for filing the company’s financial statements and
other returns with the relevant authorities such as the tax collectors on a timely basis.

THE DUTIES AND RESPONSIBILITIES OF AUDITORS

Auditors may test the financial statements to ensure they are correct, on the shareholder's’
behalf. This is called an audit. The Auditor gives an opinion to the shareholders whether the
statements are compliant with the financial reporting framework and if they give a true and fair
view of the financial statements.

The auditor must:

− Be independent - so they must work independently of the directors and shareholders;

− Be objective - so have no personal interest in the outcome of the audit;

− Act with integrity - this means being honest, truthful and deal with all parties fairly.

If anything affects an auditor from being independent, objective or from acting with integrity, it
is the auditor’s duty and responsibility to take steps to avoid such conflicts, even to go as far as
refuse the engagement and making the shareholders aware of the reasons.

Auditors are external to the company however an audit committee may be formed. This
committee should be made up of independent non-executive directors, with at least one
individual having expertise in financial management.

The Audit Committee is responsible for:

− Oversight of internal controls; approval of financial statements and other significant

documents prior to agreement by the full board.

− Liaising with external auditors.

− High level on the compliance matters.

− And reporting to the shareholders.

Sometimes the committee may carry out investigations and deal with issues reported by
whistleblowers. Not every company will have a specific audit committee, in these cases the
responsibilities lie with the board of directors.

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 Users and Stakeholders Needs
INTERNAL AND EXTERNAL STAKEHOLDERS:

As you probably already know, financial statements are prepared for a wide range of users who
can be grouped into two groups:

1) Internal users. This group includes:

a) Investors. Their main concern is their investment and its security. Reports
prepared for them should show profitability and growth so they can appraise
and value their investment;

b) Owners. Often they are also the investors so have similar needs. Owners will also
need the financial information for their own personal tax returns;

c) Managers. They should make decisions on the operations or observe any trends
of the business. Management accounts break down the information by product
or geographical location to see costs, profitability, etc.;

d) Employees. They need the financial data to know if the company is stable and
will continue into the future and to see if it will be able to maintain employee
pensions and salaries. Employee representatives such as trade unions will want
to look at the profitability and use them to negotiate better wages and working
conditions.

2) External users.

a) Future and potential investors. They need information to decide if they should
invest their money into this company or into another one. They want to know
the current and future returns and risk to an investment they make. Most of the
information they need can be found in the financial statements or in a
prospectus the company would prepare to attract investors;

b) Financial institutions. Their main concern is the ability to repay loans either for
existing loans or ones the company applies for. They will want to look at current
and previous profitability and they need information to decide if loans should be
approved and if the company can pay them back;

c) Suppliers. They need to know the ability of the company to pay its debts as they
fall due. The bigger the client is for the supplier, the more important their financial
statements are. Suppliers will use a company's financial information todecide what credit
terms to give if goods that were sold on credit will be paid, and what priority their debt
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 will have among the company's other creditors;

d) Consumers. They want assurance over the stability of a company, particular for
large purchases like software systems. If an investment is made in software, the
consumer would want to be sure that they can contact the company in the
future for support and upgrades;

e) Government and other state agencies. They want to know the tax bill of a
company and will use their financial statements to calculate it. State bodies will
also use the financial statements to ensure the organization is compliant with
other regulations and if they are eligible for grants;

f) General public. It uses a company’s financial data to see the impact on the local
economy. Knowing that there is a profitable local company is good for local
confidence and indicates the economy’s health;

g) Special interest groups (e.g., Greenpeace). They use financial information to

check the company's impact on social and environmental issues.

The Main Elements of Financial Reports

A complete set of financial statements has:

− A statement of financial position at the end of the period;

− A statement of profit or loss and other comprehensive income for the period;

− A statement of changes in equity for the period;

− A statement of cash flows (cash flow statement) for the period; and

− Notes to the accounts.

The statement of financial position is a statement of all the assets and liabilities of a business
at a certain date. It is a picture of the organisation's position on a particular date. The
statement of financial position is also called the:

− Balance sheet; or

− Statement of financial condition.

The statement of profit or loss and other comprehensive income records the income received
and expenses incurred over a certain period. When the income is higher than expenditure, then
the company is profitable. The statement of profit or loss and other comprehensive income is

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 also known as:

− Income statement;

− Statement of comprehensive income; and

− Profit and loss.

The statement of changes in equity presents an entity’s profit or loss for a period, items of
income and

expense recognized in other comprehensive income for the period, the effects of changes in
accounting policies and corrections of errors recognized in the period, and the amounts of
investments by, and dividends and other distributions to, equity investors during the period.

The statement of cash flows for the period is the financial statement that shows how changes
in balance sheet accounts and income affect cash and cash equivalents. It breaks down this
analysis into operating, investing and financing activities. It is also known as a cash flow
statement.

Notes to the accounts provide additional information about the company's operations and
financial position. They are an integral part of the financial statements. The notes are required
by the full disclosure principle.

THE ELEMENTS OF THE STATEMENT OF FINANCIAL POSITION:

STATEMENT OF FINANCIAL POSITION:
The statement of financial position shows the breakdown of assets and liabilities of a business.

An asset is an economic resource controlled by an entity which is expected to have future

economic benefits and is the result of a past financial transaction. In the statement of financial
position assets are divided into current and non-current.

A non-current asset is an asset that the business owns and will use for more than one year. It is
not for resale. For example, a car or van. Non-current assets are depreciated on an annual
basis. The depreciation rate reflects the annual usage of the asset.

Current Assets are assets that the company will benefit from for less than one year. In the
statement of financial position above, we see the current assets are inventories – these are
expected to be sold within the year.

A liability is a financial obligation that must be paid by the company at some time in the future.
They are split into current and non-current liabilities.

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 Current liabilities are amounts falling due within the year. In the statement of financial position
above, the company has trade payables, which are amounts owed to suppliers due for payment
within the year. Accrued expenses are expenses incurred before the period end but the invoice
has not been received.

Non-current liabilities fall due after one year, for example, long-term loans.

The net assets in the statement of financial position equal the capital of the organization.
Netassets are calculated as follows:

(Non-current assets + current assets) – (non-current liabilities + current liabilities)

The capital section represents the owner's interest in the business. This is also called net worth.
Equity are amounts invested by an owner in a business. In a limited company, monies invested
are usually shares, so share capital is also called equity capital. Capital brought forward from
previous years is added to the current year’s profit or loss. Loans to or from the owners are
added or deducted respectively.

THE STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME:

Revenue, also known as turnover, is all sales made in the period including those that haven’t
been paid for. Sales on credit are included in revenue, and the balance due to the company is
shown under trade receivables in the statement of financial position.

Cost of sales is the cost of the goods sold, and includes all the costs linked with the production
of the product.

Gross profit is revenue less cost of goods sold.

Other expenses are expenses that do not go directly into producing the product or service, but
are business expenses. For example, in a chocolate shop the cocoa would be included in the
cost of sales and the marketing expense would be included in other expenses. Other expenses
are deducted from the gross profit to give the net profit.

Other comprehensive income is where income from activities outside the normal activities of a
business would go. It is income that doesn’t appear in the statement of profit and loss. It is
often abbreviated to OCI.

GROSS AND NET PROFIT MARGINS

To compare gross and net profits, gross and net profit margins are used.

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 Gross Profit Margin Net Profit Margin

Gross Profit / Revenue x 100 Net Profit / Revenue x 100

These are expressed as percentages of revenue, and the higher the percentage the better.

Now, different companies and years can be compared and the efficiency of converting revenues
to profits found.

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