English for Accounting and Auditing BST

English for Accounting and Auditing BST

BIG STEP TRAINING

No 33, Alley 3, Le Van Hien

HOTLINE: 0972.202.138

http://www.facebook.com/toeic.bst

M C TIÊU KHÓA H C

Khóa h c cung c p n n t ng v ti ng Anh trong l nh v c K toán Ki m toán thông qua vi c phân tích và

cung c p ki n th c v nh ng thu t ng , nghi p v c n b n theo các thông l m i nh t c a Qu c t

c ng nh Vi t Nam đ sau khi hoàn thành khóa h c:

 H c viên có đ c n n t ng t t đ nghiên c u các ch ng trình chuyên sâu v l nh v c k toán,

ki m toán nh FIA, ACCA, CIA, CPA

 H c viên có th v t qua các bài thi tuy n d ng và có th tr l i ph ng v n v l nh v c k toán,

ki m toán b ng ti ng Anh

 i v i h c viên là nhân viên v n phòng, h c viên có th nâng cao hi u qu công vi c và làm

vi c t t v i các tài li u v k toán, ki m toán c ng nh tham gia các h i th o đ c di n thuy t

b ng ti ng Anh b i các chuyên gia n c ngoài; có th làm vi c b ng ti ng Anh đ i v i các đ i tác

n c ngoài trong l nh v c k toán - ki m toán

I T NG H C VIÊN

Ch ng trình đ c thi t k phù h p v i đ i t ng là sinh viên và nhân viên v n phòng ho c các

đ i t ng khác mu n tìm hi u v k toán, ki m toán b ng ti ng Anh

 Yêu c u ti ng Anh đ u vào: có trình đ ti ng Anh m c đ c b n (n n t ng t c p 3)

 Yêu c u nghi p v đ u vào: ch ng trình s cung c p cho h c viên nh ng ki n th c c b n v

nghi p v nên m i đ i t ng đ u có th tham gia

S L NG H C VIÊN: Kho ng 20 h c viên/l p

 01 n m kinh nghi m gi ng d y ch ng trình FIA, ACCA

 Kinh nghi m làm vi c trong l nh v c ki m toán đ c l p, ki m toán

n i b , Giám đ c đi u hành

sâu vào hai k n ng c n thi t cho công vi c bao g m các bài c (Reading) và các bài Nghe (Listening) nh m giúp h c viên có các k n ng đ c và d ch tài li u chuyên sâu v k toán ki m toán

c ng nh kh n ng nghe hi u khi ti p xúc ho c nghe thuy t gi ng b i chuyên gia n c ngoài

Bên c nh hai k n ng chính là c và Nghe, h c viên còn đ c đan xen thêm các ho t đ ng làm vi c nhóm, thuy t trình, vi t lu n nh m nâng cao kh n ng Nói (Speaking) và Vi t (Writing) v v n đ

thu c l nh v c k toán, ki m toán

H c viên s ti p nh n các m ng ki n th c theo n i dung c a cu n ―Reading Comprehension‖ d i đây

M i th c m c v ch ng trình h c xin vui lòng liên h BST đ đ c gi i đáp!

English for Accounting and Auditing has been specifically developed for people studying and working

in accounting and auditing who need English to study higher programs or communicate in a variety of situations with colleagues and business partners In this short course, students will learn the language related to accounting and auditing as well as ways to achieve their goals

English for Accounting and Auditing consists of 5 parts (13 lessons), each dealing with a different area

of financial accounting, management accounting, auditing (internal and external), financial management

and taxation Every lesson begins with a Reading which consists of vocabulary and basic knowledge about the subject Each lesson is followed by Listening videos and Activities (short exercise,

brainstorming, or a quiz) and they give students the opportunity to practice the target language with partners in realistic situations, opportunity for discussion

During the course, the lecturer plays an important role in explaining Accounting and Auditing knowledge, providing more learning materials for student to practice as well as acts as an instructor in helping students achieve their goals

Please do not hesitate to contact us if you have any comments about this Reading comprehension, or would like to see additional information or new editions

BIG STEP TRAINING

08/2013

Contents

LESSON 1: INTRODUCTION TO ACCOUNTING 2

LESSON 2: ASSETS, LIABILITIES AND THE ACCOUNTING EQUATION 5

LESSON 3: DOUBLE ENTRY 8

LESSON 4: BASIC ACCOUNTING CONCEPTS AND PRINCIPLES 11

LESSON 5: CASH AND CREDIT TRANSACTIONS 20

LESSON 6: TRIAL BALANCE 23

LESSON 7: FINANCIAL STATEMENTS 26

LESSON 8: EXTERNAL AUDIT 34

LESSON 9: INTERNAL AUDIT 44

LESSON 10: FINANACIAL RATIOS 51

LESSON 11: COST CLASSIFICATION 59

LESSON 12: INFORMATION FOR COMPARISON AND VARIANCES 64

LESSON 13: TAXATION 67

LESSON 0 INTRODUCTION TO ACCOUNTING

What is accounting?

Accounting is the language of business Companies communicate their performance to outsiders and evaluate the performance of their employees using information generated by the accounting system Learning the language of accounting is essential for anyone that must make decisions based on financial information

Accounting is the art of recording, summarizing, reporting, and analyzing financial transactions Bookkeeping is the practice of recording transactions Bookkeepers tend to focus on the details, recording transactions in an efficient and organized manner, and they may or may not see the overall picture

Accountants use the work done by bookkeepers to produce and analyze financial reports Although accounting follows the same principles and rules as bookkeeping, an accountant can design a system that will capture all of the details necessary to satisfy the needs of the business - managerial, financial reporting, projection, analysis, and tax reporting A good accountant will create a system of financial reporting that gives a complete picture of a business Therefore accountants are responsible for determining an organization‘s overall wealth, profitability, and liquidity Without accounting, organizations would have no basis or foundation upon which daily and long-term decisions could be made The budgets for marketing activities, profit reinvestment, research and development, and company growth all stem from the work of accountants Accounting is one of the oldest and most respected professions in the world, and accountants can be found in every industry from entertainment to medicine

Two main branches of accounting are financial accounting and management accounting Financial accounting systems ensure that the assets and liabilities of a business are properly accounted and provide information about profits and so on to external organization: shareholders, customers, suppliers, tax authorities, employees… Management accounting systems provide information specifically for the use of managers within an organization

The data used to prepare financial accounts and management accounts are the same The differences between the financial accounts and the management accounts arise because the data is analysed differently

Financial accounts versus management accounts

Financial accounts Management accounts

Financial accounts detail the performance of

an organisation over a defined period and the

state of affairs at the end of that period

Management accounts are used to aid management record, plan and control the organisation‘s activities to help the decision – making process

Limited liability companies must prepare

financial accounts by law

There is no legal requirement to prepare management accounts

The format of published financial accounts is

determined by local law, by IAS (International

Accounting Standards) …

In principle the accounts of different

organization is the same therefore be easily

The format of management accounts is entirely at management discretion: no strict rules govern the way they are prepared or presented

Each organization can devise its own management accounting system and format of

Most financial accounting information is of a

monetary nature

Management accounts incorporate non- monetary measures For example: miles travelled by salesmen, monthly machine hours…

Financial accounts present an essentially

historic picture of past operation

Management accounts are both an historical record and future planning tool

GAAP & IFRS/IAS

In the world of financial accounting there are lots of principles and standards to be followed The IAS, for one, is known worldwide as the International Accounting Standards

Conversely, GAAP, or the Generally Accepted Accounting Principles, is the more Americanized term referring to the accounting standards present in any country The GAAP basically dictates the rules or standards, as well as the conventions to be followed when one records, summarizes, transacts and prepares financial statements within the nation In individual countries this is seen primarily as a combination of national company law, national accounting standards and local stock exchange requirements The concept also includes the effects of non-mandatory sources such as: International accounting standards; Statutory requirements of others countries

In many countries, like the UK, GAAP does not have any statutory or regulatory authority of definition, unlike other countries, such as the USA There are different views of GAAP in different countries

Although the IASC is a powerful entity, it still does not directly control or set the rules for the GAAP Whenever the IASC forms a new accounting standard, some nations just try to incorporate that standard into their country‘s existing set of standards The said standards were already set by the local accounting board of the nation They will be the ones that influence what will be the GAAP for their jurisdiction

Furthermore, it was last in 2001 when IASB took the role of the IASC in setting the actual IAS To date, the IASB has been making and implementing new accounting standards, but is named as the IFRS, or International Financial Reporting Standards Nevertheless, all the other standards, including the IAS, are still included in the IFRS

International Financial Reporting Standards (IFRS) are issued by the International Accounting Standards Board (IASB) International Accounting Standards (IASs) were issued by the antecedent International Accounting Standards Council (IASC), and endorsed and amended by the International Accounting Standards Board (IASB) The IASB will also reissue standards in this series where it considers it appropriate

All transactions of business are recorded, summarized and posted by accountants The diagram below shows how items are entered in the ledgers, ultimately to arrive at the financial statements

Totals Totals

Sales

credit

notes

Purchase invoices

Sales invoices

Wages document

s

Cheques received and paid

Petty cash vouchers

Journal vouchers

Purchase credit notes

Sales day

book

Wages book

Cash book

Petty cash book

day book

Receivables ledger (memorandum)

Payables ledger (memorandum)

General ledger

1 Bank account

2 Receivables ledger control account

3 Payables ledger control account

4 Sales tax control account

5 Other accounts

Income statement

Balance sheet

PRESENTING

Posting of individual amounts in memorandum personal accounts

LESSON 2: ASSETS, LIABILITIES AND THE ACCOUNTING EQUATION

The resources controlled by business are referred to its assets For a new business, those assets originate two possible resources:

 Investors who buy ownership in the business;

 Creditors who extend loans to business

The total assets of business must are equal to sum of the assets contributed by investors and the assets contributed by creditors, the following relationship holds and is referred to as the accounting equation:

An asset is something valuable which a business owns or has the use of Assets are items

belonging to a business and used in the running of business They may be non-current assets or current assets

Examples of assets are factories, office buildings, warehouses, delivery vans, plant and machinery, computer equipment, office furniture, investment, cash, a trade account receivable, goods held in store awaiting sale to customers and raw materials held in store by manufacturing business for use in production …

A liability is something which is owed to somebody else Liabilities are sums of money owed by a

business to outsiders such as a bank or a supplier They may be non-current liabilities or current liabilities

Examples of liabilities are bank loan, overdraft, salaries and wages payable, trade account payable, interest payable and income taxes payable…

Owner’s equity represents the owner‘s investment in the business The amount of owner‘s equity is

the amount of assets minus the amount of liabilities

Examples of owner‘s equity are capital introduced, retained profit…

The basic of a fundamental rule of accounting is the accounting equation

The accounting equation 1:

The accounting equation 2:

The accounting equation 3:

Assets = Capital introduced + (Earned profits – Drawing) + Liabilities Assets = (Capital introduced + Retained profits) + Liabilities

Assets = Owner‘s equity + Liabilities Assets = Owner‘s equity + Liabilities

The accounting equation is the rule of accounting which is that the assets and aggregate of the capital and the liabilities of a business must always be equal The accounting equation holds at all times life of business When the transaction occurs, the total assets of business may change, but the accounting equation will remain in balance To better understand the accounting equation, consider the following examples:

a Obama starts business by paying $30, 000 to business‟ bank

- Business of Obama receives cash as asset, Cash asset will be $30,000

- Obama gives this cash in the form of capital = Owner's equity will be $30,000

Cash $30,000 = Capital introduced $30,000 + 0

$30,000 = $30,000

b Obama purchased furniture for cash $10000

- When we bought furniture with cash, our cash will decrease with $10,000 It means one asset will decrease

- Our furniture asset will increase in business, so we add $10,000 as furniture asset There will no effect on liability side of accounting equation

Cash $20,000

Furniture $10,000 = Capital introduced $30,000 + No effect

$30,000 = $30,000

c Obama Purchased Goods from Sham on credit of $5,000

- With this there will no effect on cash but new goods asset will increase This is called inventory or stock asset So, we will show more $5,000 in asset side of accounting equation

- With we have to pay to sham $5,000, so he is our creditor This will increase our liability

- Inventory asset will decrease (cost $1,000)

- We have to get money of $2,000 So, account receivable will increase with $2,000

- By this dealing we gained $1,000 So, this will increase our initial capital

$36,000 = $36,000

e Obama purchased Computer of $3,000 with business cash for personal use

- Cash will decrease $3,000 for payment for buying computer

- Capital will decrease because he withdraws money for personal use No, business will get power for not paying $3,000 capital in future to businessman Obama

+ Trade payables $5,000

$33,000 = $33,000

LESSON 3 DOUBLE ENTRY

Earlier transactions in the books of accounts were recorded under single entry system But this system had some shortcomings as there was not a complete record of all the transactions Also problems were faced while preparing final accounts Problems were also faced as there was no self balancing system of accounting which could guarantee, to some extent, the accuracy of the books of accounts So a need was felt for some uniformly accepted system of accounting which could help in the verification of the accuracy of books to some extent These problems were solved by the Double Entry System of accounting This system has totally replaced the single entry system This system is now followed universally

We know that, since the total of liabilities plus capital is always equal to total assets, any transaction has a dual effect – if it changes the amount of total assets, it also changes the total liabilities plus capital, vice versa Alternatively, a transaction might use up assets of a certain value to obtain other assets of the same value

We can say then that there are two sides to every business transaction Out of this concept has developed the system of accounting known as the ―double entry‖ system of bookkeeping, so called because every transaction is recorded twice in the accounts

Double entry bookkeeping is the system of accounting which reflects the fact that:

- Every financial transaction gives rise to two accounting entries, one a debit and the other a credit, and so

- The total value of debit entries is therefore always at any time to the total value of credit entries Each asset, liability, item of expense or item of income has a ledger account in which debits and credits are made Which account receives the credit entry and which the debit depends on the nature

Double-entry accounting has the following advantages over single-entry:

- Accurate calculation of profit and loss in complex organisations

- Inclusion of assets and liabilities in the bookkeeping accounts

- Preparation of financial statements directly from the accounts

- Easier detection of errors and fraud

T-Accounts

Transactions are recorded in ledger accounts, also known as ―T‖ accounts because how they are normally drawn up on the page Each ledger account has a debit side on the left and a credit side on the right The typical layout of a ledger account is as follows:

Name of ledger account

Examples of Double Entry

a Purchase of machine by cash

Debit Machine (Increase in Asset) Credit Cash (Decrease in Asset)

b Payment of utility bills

Debit Utility Expense (Increase in Expense) Credit Cash (Decrease in Asset)

c Interest received on bank deposit account

Debit Cash (Increase in Asset) Credit Finance Income (Increase in Income)

d Receipt of bank loan principal

Debit Cash (Increase in Asset) Credit Bank Loan (Increase in Liability)

e Issue of ordinary shares for cash

Debit Cash (Increase in Asset) Credit Share Capital (Increase in Equity)

Balancing ledger accounts

Once all the transactions for an accounting period have been posted to the ledger accounts, the balance on each account can be determined At the end of an accounting period, a balance is struck

on each account in turn This means that all the debits on the account are totalled and so are all the credits

- If the total debits exceed the total credits there is a debit balance on the account

- If the total credits exceed the total debits then the account has a credit balance

Action:

Step 1 Calculate a total for both sides of each ledger account

Step 2 Deduct the lower total from the higher total

Step 3 Insert the result of Step 2 as the balance c/d on the side of the account with the lower

total

Step 4 Check that the totals on both sides of the account are now the same

Step 5 Insert the amount of the balance c/d as the new balance b/d on the other side of the

account The new balance b/d is the balance on the account

Example: balance this ledger account:

Receivables account

Balance b/d 10,000 Transaction A 15,000 Transaction B 5,000

Transaction C 2,000 Transaction D 4,000 Transaction E 5,000 Transaction F 5,000

LESSON 4 BASIC ACCOUNTING CONCEPTS AND PRINCIPLES

Accounting follows a certain framework of core principles which makes the information generated through an accounting system valuable Without these core principles accounting would be irrelevant and unreliable These principles are the building blocks that form the basis of more complex and specialized principles called GAAP or generally accepted accounting principles such as the International Financial Reporting Standards, US GAAP, etc They deal with matters like accounting for revenue, accounting for income taxes, accounting for business combinations, etc

These principals include:

Accrual concept

Business transactions are recorded when they occur and not when the related payments are received or made This concept is called accrual basis of accounting and it is fundamental to the usefulness of financial accounting information

Examples:

1 An airline sells its tickets days or even weeks before the flight is made, but it does not record the payments as revenue because the flight, the event on which the revenue is based has not occurred yet

2 An accounting firm obtained its office on rent and paid $120,000 on January 1 It does not record the payment as an expense because the building is not yet used While preparing its quarterly report on March 31, the firm expensed out three months' rent i.e 30.00 [$120,000/12*3] because 3 months equivalent of time has expired

3 A business records its utility bills as soon as it receives them and not when they are paid, because the service has already been used The company ignored the date when the payment will be made

Accounting standards strictly require accounting on accrual basis However, there is an alternative called cash basis of accounting Under the cash basis events are recorded based on their underlying cash inflows or outflows Cash basis is normally used while preparing financial statements for tax purposes, etc

Going Concern Concept

Financial statements are prepared assuming that the company is a going concern which means that the business will continue in operation for the foreseeable future, and that there is no intention to put the company into liquidation or to make drastic cutbacks to the scale of operations

The status of going concern is important because if the company is a going concern it has to follow the generally accepted accounting standards

Examples

1 An oil and gas firm operating in Nigeria is stopped by a Nigerian court from carrying out operations in Nigeria The firm is not a going concern in Nigeria, because it has to shut down

2 A nationalized refinery is in cash flows problems but the government of the country provided

a guarantee to the refinery to help it out with all payments, the refinery is a going concern despite poor financial position

3 A bank is in serious financial troubles and the government is not willing to bail it out The Board of Directors has passed a resolution to liquidate the business The bank is not a going concern

4 A merchandising company has a current ratio below 0.5 A creditor $1,000,000 demanded payment which the company could not make The creditor requested the court to liquidate the business and recover his debts and the court grants the order The company is no longer a going concern

Business Entity Concept

In accounting we treat a business or an organization and its owners as two separately identifiable parties This concept is called business entity concept It means that personal transactions of owners are treated separately from those of the business

Businesses are organized either as a proprietorship, a partnership or a company They differ on the level of control the ultimate owners exercise on the business, but in all forms the personal transactions of the owners are not mixed up with the transactions and accounts of the business Examples

1 A CPA has 3 rooms in a house he has rented for $3,000 per month He has setup a member accounting practice and uses one room for the purpose Under the business entity concept, only 1/3rd of the rent or $1,000 should be charged to business, because the other 2 rooms or $2,000 worth of rent is expended for personal purposes

single-2 The CPA received $900 bill for utilities He paid the whole amount using his business account $600 is to be considered a withdrawal because only $300 (1/3rd) related to business and the other $600 was for domestic purpose

3 Assuming each public accounting business is required to pay $100 to a local association of CPAs each month If the CPA pays that amount from a personal bank account the amount shall be considered additional capital

Monetary Unit Assumption

In accounting we can communicate only those business transactions and other events which can be expressed in monetary units This is called monetary unit assumption

There are certain other frameworks for reporting business performance such as triple bottom line which focuses on "people, planet profit" the three pillars; corporate social responsibility reporting, etc Accounting focuses on the financial aspects of the business and that too for matters which can be expressed in terms of currencies

One aspect of the monetary unit assumption is that currencies lose their purchasing power over time due to inflation, but in accounting we assume that the currency units are stable in value This is alternatively called stable dollar assumption

However, there are exceptional circumstances called hyperinflation when the accounting standards require adjustment of prior period figures

Examples

1 The company's property, plant and equipment on 2009 balance sheet amounted to $2 billion During 2010 inflation was 10% The monetary unit and stable dollar assumption prohibits any adjustment to current or prior period figures to account for the inflation

2 The BP oil spill in Gulf of Mexico was a natural disaster but accounting only reports the financial impact in the form of claims paid, damages paid, cleanup costs, etc This is due to the limitation imposed by the monetary unit assumption

Time Period Principle

Although businesses intend to continue in long-term, it is always helpful to account for their performance and position based on certain time periods because it provides timely feedback and helps in making timely decisions

Under time period assumption, we prepare financial statements quarterly, half-yearly or annually The income statement provides us an insight into the performance of the company for a period of time The balance sheet (also known as the statement of financial position) provides us a snapshot of the business' financial position (assets, liabilities and equity) at the end of the time period The statement of cash flows and the statement of changes in equity provide detail of how the company's financial position changed during the time period

One implication of the time period assumption is that we have to make estimates and judgments at the end of the time period to correctly decide which events need to be reported in the current time period and which ones in the next

Revenue recognition and matching principles are relevant to time period assumption Revenue recognition principle provides guidance on when to record revenue while matching concept tells us how to reach an accurate net income figure by creating 1-1 correspondence between revenues and expenses

Revenue Recognition Principle

Revenue recognition principle tells that revenue is to be recognized only when the rewards and benefits associated with the items sold or service provided is transferred, where the amount can be estimated reliability and when the amount is recoverable

Accrual basis of accounting is used in recognizing revenue which tells that revenue is to be recognized ignoring when the cash inflows occur

Examples

1 A telecommunication company sells talk time through scratch cards No revenue is recognized when the scratch card is sold, but it is recognized when the subscriber makes a call and consumes the talk time

2 A monthly magazine receives 1,000 subscriptions of $240 to be paid at the beginning of the year Each month it recognizes revenue worth $20,000 [($240 ’ 12) × 1,000]

3 A media company recognizes revenue when the ads are aired even if the payment is not received or where payment is received in advance

In case where payment is received before the event triggering recognition of revenue happens, the debit goes to cash and credit to unearned revenue In case the event triggering revenue recognition occurs before payment is received, the debit goes to accounts receivable and credit to revenue Revenue is the item which is the easiest to misstate, hence more stringent rules and guidance is required in this area IAS 18 Revenue deals with recognition of revenue

Full Disclosure Principle

Full disclosure principle is relevant to materiality concept It requires that all material information has

to be disclosed in the financial statements either on the face of the financial statements or in the notes to the financial statements

5 Tax rate is expected to change in near future This information needs to be disclosed

6 The draft for a new legislation is presented in the legislative of the country in which the company operates If passed, the law would subject the company to significant cleanup costs The company has to disclose the information in the notes

7 The company sold one of its subsidiaries to the spouse of one of its directors The information is material and needs disclosure

Historical Cost Concept

Accounting is concerned with past events and it requires consistency and comparability that is why it requires the accounting transactions to be recorded at their historical costs This is called historical cost concept

Historical cost is the value of a resource given up or a liability incurred to acquire an asset/service at the time when the resource was given up or the liability incurred

In subsequent periods when there is appreciation is value, the value is not recognized as an increase

in assets value except where allowed or required by accounting standards

on balance sheet at its historical costs less accumulated depreciation

The concept of historical cost is important because market values change so often that allowing reporting of assets and liabilities at current values would distort the whole fabric of accounting, impair comparability and makes accounting information unreliable

Matching Principle

In order to reach accurate net income figure, the expenses incurred to earn the revenues recognized during the accounting period should be recognized in that time period and not in the next or previous This is called matching principle of accounting

Examples

1 $2,000,000 worth of sales is made in 2010 Total purchases of inventory were $1,000,000 of which $100,000 remained on hand at the end of 2010 The cost of earnings is $2,000,000 revenue is $900,000 [$1,000,000 minus $100,000] and this should be recognized in 2010 thereby yielding a gross profit of $1,100,000

2 A hospital pays $20,000 per month to 5 of its doctors Monthly sales are $500,000 $100,000 worth of monthly salaries should be matched with $500,000 of revenue generated

Matching principle is relevant to the time period assumption, the revenue recognition principle and it

is at the heart of accrual basis of accounting

Matching Vs Accruals Vs Cash Basis

In the accounting community, the expressions 'matching principle' and 'accruals basis of accounting' are often used interchangeably Accruals basis of accounting requires recognition of income and expenses in the accounting periods to which they relate rather than on cash basis Accruals basis of accounting is therefore similar to the matching principle in that both tend to dissolve the use of cash basis of accounting

However, the matching principle is a further refinement of the accruals concept For example, accruals basis of accounting requires the recognition of the estimated tax expense in the current accounting period even though the actual settlement of the provision may occur in the subsequent period However, matching principle would also necessitate the recognition of deferred tax in the accounting periods in which the temporary differences arise so as to 'match' the accounting profits with the tax charge recognized in the accounting period to the extent of the temporary differences

Relevance and Reliability

Relevance and reliability are two of the four key qualitative characteristics of financial accounting information The others being understandability and comparability

Relevance requires that the financial accounting information should be such that the users need it and it is expected to affect their decisions

Reliability requires that the information should be accurate and true and fair

Relevance and reliability are both critical for the quality of the financial information, but both are related such that an emphasis on one will hurt the other and vice versa Hence, we have to trade-off between them Accounting information is relevant when it is provided in time, but at early stages information is uncertain and hence less reliable But if we wait to gain while the information gains reliability, its relevance is lost

Examples

1 After the balance sheet date but before the date of issue a company wants to dispose of one

of its subsidiaries and is in final stages of reaching a deal but the outcome is still uncertain If the company waits they are expected to find more reliable information but that would cost them relevance The information would be outdated and no longer very relevant

2 After the balance sheet date during the time when audit is carried out, it becomes clear which debts were realized and where were not hence it improves the reliability of allowance for bad debts estimate but the information loses its relevance due to too much time being taken Timeliness is the key to relevance

Materiality Concept

Financial statements are prepared to help the users with their decisions Hence, all such information which has the ability to affect the decisions of the users of financial statements is material and this property of information is called materiality Items are material if their omission or misstatement would influence the economic decisions of users based on the financial statements

Examples

1 The government of the country in which the company operates in working on a new legislation which would seriously impair the company's operations in future Although there are no figures involved but the impact is so large that disclosure is imminent

2 The remuneration paid to the executives and the directors is material

3 The accounting policies are material because they help the users understand the figures Materiality might be based on a percentage of sales such as 0.5% of sales or on total assets Materiality is helpful in determining which figures are to be reported on income statement and balance sheet and which one in the notes It is also helpful in helping decide which items should appear as line items and which ones are aggregated with others

Substance Over Form

While accounting for business transactions and other events, we measure and report the economic impact of an event instead of its legal form This is called substance over form principle Substance over form is critical for reliable financial reporting It is particularly relevant in case of revenue recognition, sale and purchase agreements, etc

Examples

1 A lease might not transfer ownership to the leasee but the leasee has to record the leased items as an asset if it intends to use it for major portion of its useful life or where the present value of lease payment is fairly equal to the fair value of the asset, etc Although legally the leasee is not the owner, so the leased item is not his asset, but from the perspective of the underlying economics the leasee is entitled to the benefits embedded in the use of the item and hence it has to be recorded as an asset

2 A company is short of cash, so it sells its machinery to the bank and obtains it back on a lease It is called sale and leaseback Although the legal ownership has transferred but the underlying economics remain the same and hence under the substance over form principle the sale and subsequent leaseback are considered one transaction

3 If two companies swap their inventories they will not be allowed to record sales because not sales has occurred even if they have entered into valid enforceable contracts

Prudence Concept

Accounting transactions and other events are sometimes uncertain but in order to be relevant we have to report them in time We have to make estimates requiring judgment to counter the uncertainty While making judgment we need to be cautious and prudent Prudence is a key accounting principle which makes sure that assets and income are not overstated and liabilities and expenses are not understated

Examples

1 Bad debts are probable in many businesses, so they create a special contra-account to accounts receivable called allowance for bad debts which brings the accounts receivable balance to the amount which is expected to be realized and hence prevents overstatement of assets An expense called bad debts expense is also booked to stop net income from being overstated

2 Some liabilities are contingent upon future occurrence or non-occurrence of an event such a law suit, etc We judge the probability of occurrence of that event and if it is more than 50%

we record a liability and corresponding expense at the most likely amount Hence, we stop liability and expense from being understated

3 Periodic evaluations of assets are made to make sure their carrying value does not exceed the benefits expected to be derived from the asset, and if it does exceed, the impairment of fixed asset is recorded by reducing its carrying amount

Understandability Concept

Understandability is one of the four qualitative characteristics of financial accounting information Understandability refers to the quality of financial information which makes it understandable by people with reasonable background knowledge of business and economic activities

Understandability requires the information presented in financial reports to be concise, complete and clear in presentation The information should be presented so as to facilitate the user of the information

However, understandability never prescribes any complex information to be omitted altogether due to its underlying difficulty in understanding It just requires us to disclose the information systematically instead of presenting it haphazardly

Examples

1 Understandability would require the financial statements to be identified by presenting the name of the financial statement, the name of the entity and the period covered by the statement

2 Understandability also requires the notes to be properly numbered and cross-referred to the original balance sheet and income statement items For example the note number of disclosure on leases should be mentioned in front of the lease payable line item appearing on the face of a balance sheet

3 Financial instruments and derivatives are specialized instruments which require rigorous understanding of finance to properly understand the underlying economics In such complexity we cannot omit the disclosure because it is not easily understandable

Comparability Principle

Comparability is one of the key qualities which accounting information must possess Accounting information is comparable when accounting standards and policies are applied consistently from one period to another and from one region to another The characteristic of comparability of financial statements is important because it allows us to compare a set of financial statements with those of prior periods and those of other companies Comparability can usually be achieved through a combination of consistency and disclosure

Examples

1 We can compare 20X2 financial statements of ExxonMobil with its 20X1 financial statements

to know whether performance and position improved or deteriorated

2 We can compare the ExxonMobil financial statements with that of BP if both are prepared in accordance with same set of accounting standards, such as IFRS or US GAAP, etc

3 When preparing 20X3 financial statements we are required to present with each of the 20X3 figure the corresponding 20X2 figures This is done to add the characteristic of comparability

to the financial statements

Examples

1 Company A has been using declining balance depreciation method for its IT equipment According to consistency concept it should continue to use declining balance depreciation method in respect of its IT equipment in the following periods If the company wants to change it to another depreciation method, say for example the straight line method, it must provide in its financial report, the reason(s) for the change, the nature of the change and the effects of the change on items such as accumulated depreciation

2 Company B is a retailer dealing in shoes It used first-in-first-out method of inventory valuation in respect of shoes at Branch X and weighted average inventory valuation method

in respect of similar shoes at Branch Y Here, the auditors must investigate whether there are any valid reasons for the different treatment of similar inventory located at different locations

If not, they must direct the company to use any one of the valuation method uniformly for the whole class of inventory

LESSON 5 CASH AND CREDIT TRANSACTIONS

Business transactions are the interactions between businesses and their customers, suppliers and others with whom they do business Transactions can be very simple, like buying a newspaper, or extremely complex, taking a long time and involving many companies or agencies New technologies and management approaches are developing around the management of business transactions The main types of business transaction are sale and purchase

Sales and purchases occur in two different ways, by cash or on credit

Cash transaction is one where the buyer pays cash to the seller at the time the goods or services

are transferred Cash book is a book of prime entry which records the receipts and payments of cash With the help of cash book and bank statement can be checked at a point of time

A simple cash book is prepared like any ordinary account The receipts are recorded in the debit side and the payments are recorded in the credit side of the cash book

Simple Cash book

Example1: Enter the following transaction in a simple cash book

May-05 Received from Ram 5,000

10,000 5,000 8,000

May -28 Paid Susan

Balance c/f

2,000 21,000

Petty cash

In every business, there will be a number of small expenses that have to be paid for in notes and coins, instead of by cheque or by other methods of payment To make these payments, a supply of cash has to be kept on the business premises This cash is called petty cash

The petty cash book is the book of prime entry which keeps a cumulative record of the small amount

of cash received into and paid out of the cash float There is usually an imprest system for petty

cash, whereby a certain amount of cash is held in the box, say $200 At regular interval or when cash run low, vouchers are added up and recorded, and the total of the vouchers is used as the amount by which to top up the imprest to $200 again

$

Total of voucher = top-up X

Example 2: The imprest amount is $100, and at the end of March the petty cashier decides to top up

the float in the petty cash box

Mar-01 Balance $100 for petty cash

Mar-10 Paid postage and telegram 25 Mar-15 Sale of postage stamps 30 Mar-25 Paid for sundry expenses 50

Solution:

Credit transaction

With credit transactions, the point in time when a sale or purchase is recognised in the accounts of the business is not the same as the point in time when cash is eventually received or paid for the sale or purchase There is a gap in time between the sale or purchase and the eventual cash settlement

When a company orders and receives goods (or services) in advance of paying for them, we say that

the company is purchasing the goods on account or on credit The supplier of the goods on credit is

referred to as a creditor

There is a need for personal accounts, most commonly for customers and suppliers, and these are contained in the receivables ledger and payables ledger Personal account include details of transactions which have already been summarised in ledger accounts (e.g sales invoices are recorded in sales and total receivables, payments to suppliers in the cash and total payables accounts) The personal accounts do not therefore form part of the double entry system, as otherwise transactions would be recorded twice over (i.e two debits and two credits for each transaction) They are memorandum accounts only

The receivables ledger consists of a number of personal receivables accounts They are separate accounts for each individual customer, and they enable a business to keep a continuous record of how much a customer owes the business at any time

A control account is an account in the general ledger in which a record is kept of the total value of a number of similar but individual items A receivables control account is an account in which records are kept of transactions involving all receivables in total It should agree with the total of the individual balances and act as a check to ensure that all transactions have been recorded correctly in the individual ledger accounts

Example 1: On 15 May 201X Cosmo purchased paper, card and frames worth $2,000 from Honor

Soper on credit:

Debit When invoices are entered in the sales day book

Credit When entries are made in the cash book in respect of payments received from customer or in

the sales returns day book for goods (or services) returned

Example 2: Pet makes a sale for $1,000 worth of goods to Janice on credit

Section summary

Control

accounts Posted from With Agrees with

Part of general ledger double entry?

Total

receivables

Sales day book Sales returns day book Cash receipts day book Totals

Receivables ledger balances in total



Total payables

Purchase day book Purchase returns day book Cheque payments day book

Totals Payable ledger

balances in total 

Memorandum

accounts Posted from With Agrees with

Part of general ledger double entry?

Receivables

ledger As for control a/c

Individual transactions

LESSON 6 TRIAL BALANCE

We have already seen that, via the technique of double entry bookkeeping, the dual aspect of accounting transactions is reflected in the accounts using debits and credits It follows that if each transaction involves equal debit and credit entries, the total of all debits will equal the total of all credits

Although there is no foolproof method for making sure that all entries have been posted to correct ledger account, a technique which shows up the more obvious mistakes is to prepare a trial balance Trial Balance is a list of closing balances of ledger accounts on a certain date and is the first step towards the preparation of financial statements It is usually prepared at the end of an accounting period to assist in the drafting of financial statements Ledger balances are segregated into debit balances and credit balances Asset and expense accounts appear on the debit side of the trial balance whereas liabilities, capital and income accounts appear on the credit side If all accounting entries are recorded correctly and all the ledger balances are accurately extracted, the total of all debit balances appearing in the trial balance must equal to the sum of all credit balances

Purpose of a Trial Balance

- Trial Balance acts as the first step in the preparation of financial statements It is a working paper that accountants use as a basis while preparing financial statements

- Trial balance ensures that for every debit entry recorded, a corresponding credit entry has been recorded in the books in accordance with the double entry concept of accounting If the totals of the trial balance do not agree, the differences may be investigated and resolved before financial statements are prepared Rectifying basic accounting errors can be a much lengthy task after the financial statements have been prepared because of the changes that would be required to correct the financial statements

- Trial balance ensures that the account balances are accurately extracted from accounting ledgers

- Trail balance assists in the identification and rectification of errors

Example:

Following is an example of what a simple Trial Balance looks like (please see the next page):

1 Title provided at the top shows the name of the entity and accounting period end for which the trial balance has been prepared

2 Account Title shows the name of the accounting ledgers from which the balances have been extracted

3 Balances relating to assets and expenses are presented in the left column (debit side) whereas those relating to liabilities, income and equity are shown on the right column (credit side)

4 The sum of all debit and credit balances is shown at the bottom of their respective columns

ABC LTD Trial Balance as at 31 December 2012 Account Title Debit Credit

Limitations of a trial balance

If the basic principle of double entry has been correctly applied throughout the period it will be found that the credit balances equal debit balances in total It does not matter in what order the various accounts are listed in the trial balance, because it is not a document that a business has to prepare

It is just a method used to test the accuracy of the double entry bookkeeping methods

If the balances of the trial balance are not equal, there must be an error in recording of transactions

in the accounts or an error in balancing the individual accounts

A trial balance, however, will not disclosure the following types of errors

- The complete omission of a transaction, however neither a debit nor a credit is made (an error of omission) For example, if an invoice for purchases worth $200 was mislaid before it was recorded, the books would still balance Both purchases and creditors would be understated by

$200

- The posting of a debit or credit to the correct side of the ledger, but to a wrong account (sometimes called errors of commission) For example, if the invoice referred to above was entered as a credit to the account of a different supplier and the debit either correctly to purchases or incorrectly to an expense account, the books would be incorrect, but they should still balance

- Compensating errors (e.g debit error of $100 is exactly cancelled by credit $100 error elsewhere) These are uncorrected errors which by coincidence cancel out

- Error of principle (e.g cash received from customers being debited to the receivables account and credited to bank instead of the other way round) Another example of an error of principle is where a purchase of, say, $200 has been credited to sales and debited to receivables instead of debited to purchases and credited to payables

- Posting incorrect amounts An example of this type of error would be when an invoice is misread and instead of the correct amount of say $600, $800 is posted as both a debit and credit The trial balance would still balance

- Error of original entry This arises where the original entry has been wrongly recorded in the day book

- Error of reversal In this case debit and credit entries have been reserved

Possible errors which will be revealed by the trial balance: those errors which will be revealed by the trial balance are:

- Error of partial omission (error of single entry) In this case either the debit or the credit entry will

be missing

- Error of transposition, e.g $209 posted as $290 This will be detected where the error is made on one entry If the transposition error is made in both debit and credit postings, this will not be picked up by the trial balance

- Both entries posted to either debit or credit

- The wrong amount on one entry

When an occurred error results in an imbalance between total debits and total credits in the ledger accounts, the first step is to open a suspense account A suspense account is an account showing a balance equal to the difference in a trial balance A suspense account is a temporary account which can be opened for a number of reasons The most common reasons are as follows:

- A trial balance is drawn up which does not balance

- The bookkeeper of a business knows where to post the credit side of a transaction, but does not know where to post the debit (or vice versa)

LESSON 7 FINANCIAL STATEMENTS

A financial statement is a formal record of the financial activities of a business, person, or other entity Relevant financial information is presented in a structured manner and in a form easy to understand They typically include basic financial statements, accompanied by amanagement discussion and analysis

For large corporations, these statements are often complex and may include an extensive set

ofnotes to the financial statements and management discussion and analysis The notes typically describe each item on the balance sheet, income statement and cash flow statement in further detail Notes to financial statements are considered an integral part of the financial statements

Purpose of financial statements

Financial statements are a structured representation of the financial position and financial performance of an entity The objective of financial statements is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions Financial statements also show the results of the management‘s stewardship of the resources entrusted to it To meet this objective, financial statements provide information about an entity‘s:

a) Assets;

b) Liabilities;

c) Equity;

d) Income and expenses, including gains and losses;

e) Contributions by and distributions to owners in their capacity as owners; and

f) Cash flows

This information, along with other information in the notes, assists users of financial statements in predicting the entity‘s future cash flows and, in particular, their timing and certainty

A complete set of financial statements comprises:

a) A statement of financial position as at the end of the period;

b) A statement of comprehensive income for the period;

c) A statement of changes in equity for the period;

d) A statement of cash flows for the period;

e) Notes, comprising a summary of significant accounting policies and other explanatory information; and

f) A statement of financial position as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements

A INCOME STATEMENT

The income statement is one of the major financial statements used by accountants and business owners The income statement is sometimes referred to as the profit and loss statement (P&L), statement of operations, or statement of income

The income statement shows in detail how the profit or loss of a period has been made The income statement matches the revenue earned in a period with the costs incurred in earning it It is usual to

distinguish between a gross profit (sales revenue less the cost of goods sold) and a net profit (being the gross profit less the expenses of selling, distribution, administration etc) If costs exceed revenue the business made a loss

The income generated will be used to finance the activities of the business which incur costs: purchasing ready-made goods for onward sale, purchasing equipment, paying expenses such as staff salaries, stationery, lighting and heating, rent and so on

Periodically the organization will prepare an income statement The period of time that the statement covers is chosen by the business and will vary For example, the heading may state:

"For the Three Months Ended December 31, 2012"

"For the Four Weeks Ended December 27, 2012"

"For the Fiscal Year Ended June 30, 2012"

People pay attention to the profitability of a company for many reasons For example, if a company was not able to operate profitably - the bottom line of the income statement indicates a net loss - a banker/lender/creditor may be hesitant to extend additional credit to the company On the other hand,

a company that has operated profitably - the bottom line of the income statement indicates a net income - demonstrated its ability to use borrowed and invested funds in a successful manner A company's ability to operate profitably is important to current lenders and investors, potential lenders and investors, company management, competitors, government agencies, labour unions, and others

The format of the income statement or the profit and loss statement will vary according to the

complexity of the business activities

An entity shall present an analysis of expenses recognised in profit or loss using a classification based on either their nature or their function within the entity, whichever provides information that is reliable and more relevant

Expenses are sub-classified to highlight components of financial performance that may differ in terms

of frequency, potential for gain or loss and predictability This analysis is provided in one of two forms:

The first form of analysis is the „nature of expense‟ method An entity aggregates expenses within

profit or loss according to their nature (for example, depreciation, purchases of materials, transport costs, employee benefits and advertising costs), and does not reallocate them among functions within the entity This method may be simple to apply because no allocations of expenses to functional classifications are necessary An example of a classification using the nature of expense method is as follows:

Changes in inventories of finished goods and

Raw materials and consumables used x

Depreciation and amortisation expense x

The second form of analysis is the „function of expense‟ or „cost of sales‟ method and classifies

expenses according to their function as part of cost of sales or, for example, the costs of distribution

or administrative activities At a minimum, an entity discloses its cost of sales under this method separately from other expenses This method can provide more relevant information to users than the classification of expenses by nature, but allocating costs to functions may require arbitrary allocations and involve considerable judgment An example of a classification using the function of expense method is as follows:

An entity classifying expenses by function shall disclose additional information on the nature of expenses, including depreciation and amortisation expense and employee benefits expense

If the net amount of revenues and gains minus expenses and losses is positive, the bottom line of the profit and loss statement is labelled as net income If the net amount (or bottom line) is negative, there is a net loss

Revenues and gains

Revenues from primary activities are often referred to as operating revenues

Revenues from secondary activities are often referred to as non-operating revenues These are the amounts a business earns outside of purchasing and selling goods and services As is true with operating revenues, non-operating revenues are reported on the profit and loss statement during the period when they are earned, not when the cash is collected

Gains such as the gain on the sale of long-term assets, or lawsuits result from a transaction that is outside of the primary activities of most businesses A gain is reported on the income statement as the net of two amounts: the proceeds received from the sale of a long-term asset minus the amount listed for that item on the company's books (book value) A gain occurs when the proceeds are more than the book value This gain should not be reported as sales revenues, nor should it be shown as part of the merchandiser's primary activities Instead, the gain will appear in a section on the income statement labelled as "non-operating gains" or "other income" The gain is reported in the period when the disposal occurred

Expenses and Losses

Expenses involved in primary activities are expenses that are incurred in order to earn normal operating revenues Under the accrual basis of accounting, the cost of goods sold is matched with the related sales on the income statement, regardless of when the supplier of the merchandise is paid

The income statements or profit and loss statements of merchandisers and manufacturers will use a separate line for the cost of goods sold The other expenses involved in their primary activities will either be grouped together as operating expenses or subdivided into the categories "selling" and

"administrative."

Expenses from secondary activities are referred to as non-operating expenses For example, interest

expense is a non-operating expense because it involves the finance function of the business, rather than the primary activities of buying/producing and selling

Losses such as the loss from the sale of long-term assets, or the loss on lawsuits result from a

transaction that is outside of a business's primary activities A loss is reported as the net of two amounts: the amount listed for the item on the company's books (book value) minus the proceeds received from the sale A loss occurs when the proceeds are less than the book value

Using the above multiple-step income statement as an example, we see that there are three steps needed to arrive at the bottom line Net Income:

Step 1 Cost of goods sold is subtracted from net sales to arrive at the gross profit

Gross profit = Net sales – Cost of goods sold Gross profit = $100,000 – $75,000 Gross profit = $25,000

Step 2 Operating expenses are subtracted from gross profit to arrive at operating income

Operating income = Gross profit – Operating expenses Operating income = $25,000 – $13,000 Operating income = $12,000

Step 3 The net amount of non-operating revenues, gains, non-operating expenses and losses is

combined with the operating income to arrive at the net income or net loss

Net income = Operating income + Non-operating items

Net income = $18,000

B STATEMENT OF FINANCIAL POSITION (Balance sheet)

A statement of financial position shows the financial position of a business at a given moment in time

It is a statement of the assets, liabilities and owner‘s equity of a business at a given point in time It is draw up ―as at‖ a particular date Typically, the statement is prepared to show the assets, liabilities and owner‘s equity as at the end of the accounting period to which the financial statements relate

A statement of financial position is therefore very similar to the accounting equation In fact, there are only two differences between a statement of financial position and the accounting equation, which are as follows:

- The manner of format in which the assets and liabilities are presented

- The extra detail which is usually contained in a statement of financial position

For many businesses, the way in which assets and liabilities are categorised and presented is a matter of choice, and you may come across different formats The format below should help you see how a typical statement of financial position is compiled

Assets

Assets are things that the company owns or has the use of Usually these asset accounts will

have debit balances Contra assets are asset accounts with credit balances (A credit balance in an

asset account is contrary - or contra - to an asset account's usual debit balance) Examples of contra asset accounts include: Allowance for Doubtful Accounts; Accumulated Depreciation

Non-current assets

A non-current asset is an asset acquired for use within the business (rather than for selling to a customer), with a view to earning income or making profits from its use, either directly or indirectly, over more than one accounting period An item must satisfy two further conditions:

- It must be used by the business

- The asset must have a ―life‖ in use of more than one year

Non-current assets are for long-term use and include land, buildings, leasehold improvements, equipment, machinery and vehicles Intangible assets: These are assets that you cannot touch or see but that have value Intangible assets include franchise rights, goodwill, non-compete agreements, patents and many other items

Current assets

Current assets are items owned by the business with the intention of turning them into cash within one year Assets are ―current‖ in the sense that they are continually flowing through the business They include cash, stocks and other liquid investments, accounts receivable, inventory and prepaid expenses

An entity shall classify an asset as current when:

- It expects to realise the asset, or intends to sell or consume it, in its normal operating cycle;

- It holds the asset primarily for the purpose of trading;

- It expects to realise the asset within twelve months after the reporting period; or

- The asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period

An entity shall classify all other assets as non-current

Liabilities

An entity shall classify a liability as current when:

- It expects to settle the liability in its normal operating cycle;

- It holds the liability primarily for the purpose of trading;

- The liability is due to be settled within twelve months after the reporting period; or

- It does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification

An entity shall classify all other liabilities as non-current

Current liabilities are accounts payable of the business that must be paid within a short period of time (by convention, within a year) Currents are debts which are payable within one year

Examples of current liabilities include loans repayable in one year, bank overdrafts, trade payables and income tax due

Owner’s equity

Owner‘s equity will include the amounts invested by the owner(s) in the business, plus profits earned and retained by the business Components include common stock, paid-in-capital (amounts invested not involving a stock purchase) and retained earnings (cumulative earnings since inception of the business less dividends paid to stockholders), Treasury Stock, Share premium, etc

Owner's equity is sometimes referred to as the book value of the company, because owner's equity

is equal to the reported asset amounts minus the reported liability amounts

"Owner's Equity" is the words used on the balance sheet when the company is a sole proprietorship

If the company is a corporation, the words Stockholders' Equity is used instead of Owner's Equity Contra owner's equity accounts are a category of owner equity accounts with debit balances (A debit balance in an owner's equity account is contrary - or contra - to an owner's equity account's usual credit balance) An example of a contra owner's equity account is a sole proprietorship‗s Drawing An example of a contra stockholders' equity account is Treasury Stock

C STATEMENT OF CASH FLOW

The cash-flow statement is designed to convert the accrual basis of accounting used to prepare the income statement and balance sheet back to a cash basis This may sound redundant, but it is necessary The accrual basis of accounting generally is preferred for the income statement and balance sheet because it more accurately matches revenue sources to the expenses incurred generating those specific revenue sources However, it also is important to analyze the actual level of cash flowing into and out of the business

The period of time that the statement covers is chosen by the company For example, the heading may state "For the Three Months Ended December 31, 2012" or "The Fiscal Year Ended September

30, 2012"

The cash-flow statement is one of the most useful financial management tools you will have to run your business The cash flow statement organizes and reports the cash generated and used in the following categories:

1 Net cash flow from operating activities: Operating activities are the daily internal activities of a

business that either require cash or generate it They include cash collections from customers; cash paid to suppliers and employees; cash paid for operating expenses, interest and taxes; and cash revenue from interest dividends

2 Net cash flow from investing activities: Investing activities are discretionary investments made

by management These primarily consist of the purchase (or sale) of equipment

3 Net cash flow from financing activities: Financing activities are those external sources and

uses of cash that affect cash flow These include sales of common stock, changes in short- or long-term loans and dividends paid

4 Net change in cash and marketable securities: The results of the first three calculations are

used to determine the total change in cash and marketable securities caused by fluctuations

in operating, investing and financing cash flow This number is then checked against the change in cash reflected on the balance sheet from period to period to verify that the calculation has been done correctly

Because the income statement is prepared under the accrual basis of accounting, the revenues reported may not have been collected Similarly, the expenses reported on the income statement might not have been paid You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information As a result, savvy business people and investors utilize this important financial statement

Here are a few ways the statement of cash flows is used

1 The cash from operating activities is compared to the company's net income If the cash from operating activities is consistently greater than the net income, the company's net income or earnings are said to be of a "high quality" If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash

2 Some investors believe that "cash is king" The cash flow statement identifies the cash that is flowing in and out of the company If a company is consistently generating more cash than it

is using, the company will be able to increase its dividend, buy back some of its stock, reduce debt, or acquire another company All of these are perceived to be good for stockholder value

3 Some financial models are based upon cash flow

LESSON 8: EXTERNAL AUDIT

An external audit is a type of assurance engagement that is carried out by an auditor to give an independent opinion on a set of financial statements The objective of an audit of financial statements

is to enable the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework

An assurance engagement is one in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria The outcome of the evaluation or measurement of a subject matter is the information that results from applying the criteria

The need for certain companies‘ financial statements to be audited by an independent external auditor has been a cornerstone of confidence in the world‘s financial systems

The benefit of an audit is that it provides assurance that management has presented a ‗true and fair‘ view of a company‘s financial performance and position An audit underpins the trust and obligation

of stewardship between those who manage a company and those who own it or otherwise have a need for a ‗true and fair‘ view, the stakeholders

In general, an audit consists of evaluation of a subject matter with a view to express an opinion on whether the subject matter is fairly presented There are different types of audits that can be performed depending on the subject matter under consideration, for example:

1 Audit of financial statements

2 Audit of internal control over financial reporting

3 Compliance audit

Companies prepare their financial statements in accordance with a framework of generally accepted accounting principles (GAAP) relevant to their country, also referred to broadly as accounting standards or financial reporting standards The fair presentation of those financial statements is evaluated by independent auditors using a framework of generally accepted auditing standards (GAAS) which set out requirements and guidance on how to conduct an audit, also referred to simply

as auditing standards

How is the audit conducted?

- The organisation's management prepares the financial statements They must be prepared in accordance with legal requirements and financial reporting standards

- The organisation's directors approve the financial statements

- Auditors start their examination by gaining an understanding of the organisation's activities, and considering the economic and industry issues that might have affected the business during the reporting period

- For each major activity listed in the financial statements, auditors identify and assess any risks which could have a significant impact on the financial position or financial performance, and also some of the measures (called internal controls) that the organisation has put in place to mitigate those risks