THE CONTEXT AND PURPOSE OF FINANCIAL REPORTING
AND THE ACCOUNTING EQUATION
Introduction
Individuals set up businesses with the aim of making profits. To determine whether the
business has made profits we need to maintain a system of accounting records for business
transactions and other items of financial nature. From the set of accounting records the
information is processed into a set of ‘financial statements’. In a nutshell the purpose of
financial accounting is to report the financial performance and position of an entity.
The process of maintaining a system of records in a systematic and accurate manner is termed
as ‘book-keeping’. The information in the book-keeping system is analysed and summarized
periodically to produce financial statements. Accounting goes beyond the book-keeping
Process and includes the use of information recorded by the book keeping operation to
produce financial reports that enable decisions to be made by several stakeholders.
Types of Business Entity
The term entity is used to describe any form of business organization. There are three main
types of business all aiming to make profit; sole trader, partnership and limited company.
Sole trader : An individual who sets up in business on his own is a sole trader. A sole trader
is owned and managed by one person. The sole trader suffers from unlimited liability. The
owner is personally liable for the debts of the business. If the business does not have enough
money to pay its debts, the owner can be made personally liable to make payment out of his
‘non-business’ assets. The profit of a sole trader is treated as income for taxation
purposes.
Partnership : A partnership is an association of two or more people who pool their resources
to set up a business. A partnership just like a sole trader can have employees but they have no
share in the ownership. A partnership deed is drawn which sets out the terms of the
partnership. The partners are personally responsible for the debts of the business. Alike sole
traders the personal assets of partners are at stake. The share of profit of each partner is
treated as personal income for the purpose of calculating the tax liability.
Limited Company : Ownership of a company is represented by ownership of shares.
Shareholders (owners) appoint directors to manage their business. Unlike a sole traders or a
partnership, a company has a separate legal status. This means that in the eyes of the law a
company is regarded as a person. As such the company can own assets and can sue and be
sued in its own name. A company pays tax separately from its owners. Shareholders in a
limited company benefit from limited liability meaning that their liability is limited to the
amount that they have invested in the business. If the company’s shares are ‘fully paid’
shareholders have no further liability as regards the unpaid debts and further obligations of
their company. This is the main reason why limited company is the most common form of
business organization.
The nature and principles of financial reporting
Financial reporting is concerned with preparing a number of financial reports or financial
statements which will be used by several users. These financial statements are prepared
according to certain rules and principles. Some of the principles have been established by
practice. Some rules and guidelines are provided by accounting standards. Some countries
, have their own set of accounting standards. E.g. UK uses its own accounting standards called
Financial Reporting Standards (FRS). The trend today is to adopt International Financial
Reporting Standards (IFRS) which are issued by the International Accounting Standards
Board (IASB). Accounting is therefore a mixture of established practice, requirements of
accounting standards and national laws. (Emile Woolf, 2009)
The scope and objective of financial reporting
The IASB Framework for the Preparation and Presentation of Financial Statements states that
the objective of financial statements is to provide information about the financial position,
performance and changes in financial position of an entity that is useful to a wide range of
users in making economic decisions.
Users of financial statements
Lenders- Banks and other financial institutions need to assess the ability of the business to
pay what is due to them.
Employees- they are interested in the security of their employment. They want to assess
whether the business will survive and continue to provide employment and pension benefits.
The government and its agencies- for collecting appropriate taxes and for regulating the
activities of the business in the interest of the whole community.
Investors - Investors invest their money to earn a financial return on their investment. They
need information which will help them to make financial decision. In case of shareholders in
a company their decision will involve whether to buy, hold or sell shares in the company.
Customers - Customers might be interested in the financial performance of an entity
especially if they rely on that entity for the long term supply of key goods and services.
The public - The public in general might have an interest in the financial statements of a
company. A company might employ people in the vicinity of its location or could support
local suppliers.
Managers - Managers normally have access to the financial information that they require.
Managers require information about the financial performance of the business. Shareholders
will assess the performance of managers based on the financial performance of the business.
Managers will also use financial statements to prepare forecasts. (Benedict and Elliot, 2009)
Main elements of financial reports
Financial statements present information about:
• The financial position of a business
• The financial performance of a business
• Its cash flows and
• Changes in the financial position during the period
Information about the financial position is provided by the statement of financial position
(previously called balance sheet). The statement of financial position contains information
about assets, liabilities and equity.
Assets
Assets are rights or access to future economic benefits controlled by an entity as a result of
past transaction or events. At this stage we can take assets to be what the business owns. They
can be classified as:
AND THE ACCOUNTING EQUATION
Introduction
Individuals set up businesses with the aim of making profits. To determine whether the
business has made profits we need to maintain a system of accounting records for business
transactions and other items of financial nature. From the set of accounting records the
information is processed into a set of ‘financial statements’. In a nutshell the purpose of
financial accounting is to report the financial performance and position of an entity.
The process of maintaining a system of records in a systematic and accurate manner is termed
as ‘book-keeping’. The information in the book-keeping system is analysed and summarized
periodically to produce financial statements. Accounting goes beyond the book-keeping
Process and includes the use of information recorded by the book keeping operation to
produce financial reports that enable decisions to be made by several stakeholders.
Types of Business Entity
The term entity is used to describe any form of business organization. There are three main
types of business all aiming to make profit; sole trader, partnership and limited company.
Sole trader : An individual who sets up in business on his own is a sole trader. A sole trader
is owned and managed by one person. The sole trader suffers from unlimited liability. The
owner is personally liable for the debts of the business. If the business does not have enough
money to pay its debts, the owner can be made personally liable to make payment out of his
‘non-business’ assets. The profit of a sole trader is treated as income for taxation
purposes.
Partnership : A partnership is an association of two or more people who pool their resources
to set up a business. A partnership just like a sole trader can have employees but they have no
share in the ownership. A partnership deed is drawn which sets out the terms of the
partnership. The partners are personally responsible for the debts of the business. Alike sole
traders the personal assets of partners are at stake. The share of profit of each partner is
treated as personal income for the purpose of calculating the tax liability.
Limited Company : Ownership of a company is represented by ownership of shares.
Shareholders (owners) appoint directors to manage their business. Unlike a sole traders or a
partnership, a company has a separate legal status. This means that in the eyes of the law a
company is regarded as a person. As such the company can own assets and can sue and be
sued in its own name. A company pays tax separately from its owners. Shareholders in a
limited company benefit from limited liability meaning that their liability is limited to the
amount that they have invested in the business. If the company’s shares are ‘fully paid’
shareholders have no further liability as regards the unpaid debts and further obligations of
their company. This is the main reason why limited company is the most common form of
business organization.
The nature and principles of financial reporting
Financial reporting is concerned with preparing a number of financial reports or financial
statements which will be used by several users. These financial statements are prepared
according to certain rules and principles. Some of the principles have been established by
practice. Some rules and guidelines are provided by accounting standards. Some countries
, have their own set of accounting standards. E.g. UK uses its own accounting standards called
Financial Reporting Standards (FRS). The trend today is to adopt International Financial
Reporting Standards (IFRS) which are issued by the International Accounting Standards
Board (IASB). Accounting is therefore a mixture of established practice, requirements of
accounting standards and national laws. (Emile Woolf, 2009)
The scope and objective of financial reporting
The IASB Framework for the Preparation and Presentation of Financial Statements states that
the objective of financial statements is to provide information about the financial position,
performance and changes in financial position of an entity that is useful to a wide range of
users in making economic decisions.
Users of financial statements
Lenders- Banks and other financial institutions need to assess the ability of the business to
pay what is due to them.
Employees- they are interested in the security of their employment. They want to assess
whether the business will survive and continue to provide employment and pension benefits.
The government and its agencies- for collecting appropriate taxes and for regulating the
activities of the business in the interest of the whole community.
Investors - Investors invest their money to earn a financial return on their investment. They
need information which will help them to make financial decision. In case of shareholders in
a company their decision will involve whether to buy, hold or sell shares in the company.
Customers - Customers might be interested in the financial performance of an entity
especially if they rely on that entity for the long term supply of key goods and services.
The public - The public in general might have an interest in the financial statements of a
company. A company might employ people in the vicinity of its location or could support
local suppliers.
Managers - Managers normally have access to the financial information that they require.
Managers require information about the financial performance of the business. Shareholders
will assess the performance of managers based on the financial performance of the business.
Managers will also use financial statements to prepare forecasts. (Benedict and Elliot, 2009)
Main elements of financial reports
Financial statements present information about:
• The financial position of a business
• The financial performance of a business
• Its cash flows and
• Changes in the financial position during the period
Information about the financial position is provided by the statement of financial position
(previously called balance sheet). The statement of financial position contains information
about assets, liabilities and equity.
Assets
Assets are rights or access to future economic benefits controlled by an entity as a result of
past transaction or events. At this stage we can take assets to be what the business owns. They
can be classified as:
