Accounting and the Financial Statements

Accounting Definition & Types

• Accounting is the process of producing financial information for decision-making.

• Financial Accounting: Communicates an entity's financial activities to external users through financial statements in the annual report.

  • Focuses on what has happened.

  • External users include investors, lenders, and other creditors.

• Management Accounting: Provides internal reports like budgets and forecasts.

  • Focuses on what will happen.

  • Internal users are management within the organization.

Financial Reporting

• Objective: To provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors for making resource allocation decisions (according to IASB Conceptual Framework).

• Users' Decisions:

  • Buying, selling, or holding equity or debt instruments.

  • Providing or settling loans and other forms of credit.

  • Influencing management decisions (e.g., voting).

• Users Assess:

  • Prospects for future net cash inflows to the entity.

  • Management’s stewardship of the entity’s economic resources.

  • The entity's economic resources, claims against the entity, and changes in those resources and claims.

• Examples of User Decisions:

  • Investors: Should I invest, renew, revise, or dismiss?

  • Creditors/Lenders: Should I lend?

  • Suppliers: Should I supply?

Qualitative Characteristics of Useful Financial Information

• Fundamental Qualitative Characteristics:

  • Relevance: Information that is capable of making a difference in the decisions made by users.

    • Has predictive value or confirmatory value (i.e., provides new information).

  • Faithful Representation: Information that faithfully represents the substance of what it purports to represent.

    • Complete, neutral, and free from error to the maximum extent possible.

    • Affected by the level of measurement uncertainty.

• Prudence/Conservatism:

  • Not a desirable overall quality characteristic.

  • Deliberate understatement of assets, liabilities, income, or expenses is not allowed.

  • Intended to counter natural optimism in management and enhance Financial Reporting and Relevance.

  • Standards might include asymmetric treatments for dealing with assets/income or liabilities/expenses (through conservative treatments) only if regulators believe that doing so enhances Relevance or Faithful Representation.

Business Structures

• Sole Proprietorships/Partnerships:

  • Do not have a separate legal identity from their owners.

  • Owners have personal liability.

• Corporations (Ltd):

  • Have a separate legal identity.

  • Owners (shareholders) do not have personal liability.

• Separate Business Entity: This concept emphasizes that the business is accounted for separately from its owners.

• Basic Financial Statement Preparation: Similar across business structures, but the difference lies in the treatment of capital.

• Corporations have disadvantages such as not controlling their co-owners and double taxation.

• Financial statements and accounting principles are the same regardless of the business structure. The difference is the accounting treatment of capital.

Example (Double Taxation):
Assume individual tax rate is 30% and corporate tax rate is 20%.

Cyprus Tax Example (Before EU):

• Corp Tax Offshore: 4.50%

• Corp Tax Local: 20%

Cyprus Tax Example (After EU):

• Corp Tax - ALL: 12.5%

• Ind. Tax: 0%

• Def. Contb: 17%
  # Financial Statements

• Definition: A set of accounting reports that briefly describe a company’s financial status.

  • Summarized, standardized, and follow Generally Accepted Accounting Principles (GAAP).

  • Prepared at regular intervals.

• GAAP:

  • IFRS (International Financial Reporting Standards) or US GAAP (United States Generally Accepted Accounting Principles).

  • Europe adopted IFRS in 2005; used in > 120 countries.

• Components of Financial Statements:

  • Income Statement / Statement of Comprehensive Income

  • Statement of Financial Position (Balance Sheet)

  • Statement of Changes in Equity

  • Statement of Cash Flows

  • Notes to the Financial Statements (Accounting methods are shown together preceding FS, or methods shown separately for each item)
    *More comprehensive coverage in the annual report.

Statements Detailed

• Statement of Financial Position (Balance Sheet):

  • Shows what the company owns (assets), owes (liabilities), and what belongs to the shareholders (equity) at the end of the reporting period.

  • $Assets - Liabilities = Net \ assets \ (owners’ \ equity)$

• Income Statement:

  • Shows the profitability for the year from operations.

  • $Revenues - Expenses$

• Statement of Changes in Owners’ Equity:

  • Shows how the balance of Owners' Equity changed.

  • A significant part of this statement is the change in Retained Earnings.

  • Retained Earnings show the total profit of the company from its inception up to the specific period that has not yet been returned to the shareholders as dividends.

• Statement of Cash Flows:

  • Shows how the cash of the company changed.

Accounting Categories

• Main Categories:

  • Assets

  • Liabilities

  • Owners’ Equity

• Asset:

  • A present economic resource controlled by the entity as a result of past events.

  • An economic resource is a right that has the potential to produce economic benefits.

  • Economic benefits:

    • Can be exchanged.

    • Can be used to pay off a liability.

    • Can be used to produce products or offer services

• Liability:

  • A present obligation of the entity to transfer an economic resource as a result of past events.

  • An obligation is a duty or responsibility that the entity has no practical ability to avoid.

• Equity:

  • The contribution of owners to the entity.

Assets Detailed

• Examples of Assets:

  • Cash.

  • Debtors, Accounts Receivable.

  • Inventory.

  • Land.

  • Buildings.

  • Machinery.

  • Office equipment.

  • Motor vehicles.

  • Patents.

• Current Assets:

  • Will turn into cash/realize economic benefit in the next 12 months.

• Non-Current Assets:

  • Benefit > 12 months.

  • Property, plant and equipment (= fixed assets).

  • Intangible assets.

  • Financial Investments (if to be sold after 12 months).
    *Assets are initially recorded at cost (all necessary costs to get the asset ready for use).
    *Revaluations are permitted (under conditions) in IFRS but are not permitted under US GAAP.

Liabilities Detailed

• Liabilities: Claims on the assets of the company from events that have taken place.

• Current Liabilities:

  • Must be paid within the next 12 months.

  • Creditors or Accounts Payable, Interests, or taxes payable

  • Rent payable

• Long-Term Liabilities:

  • Payments that will be made after 12 months.

  • Loans, Corporate Bonds
    *Loans are divided into two Parts (current and long-term).

Owner's Equity Details

• Owner's Equity: The contribution of owners to the business
  *1. OE = The contribution of owners to the entity
  *Share Capital = Direct contribution: From purchasing shares/investing in the capital of the company
  *Retained Earnings = Indirect contribution: Allowing the company to hold onto its profits (Why?).
  *OE = SC + RE
  Owner's Equity = Share capital + Retained earnings
  *2. OE = The assets that will remain after the company's liabilities have been paid
  *OE = A – L
  1. & 2. The assets that will remain after the company's liabilities have been paid are the assets that have been funded through the contribution (direct or indirect) of the owners.

$A – L = SC+RE$
$A= L + OE (= SC+RE)$
*Basic Accounting Equation == Statement of Financial Position (In UK SFP shown as : A-L = OE)

Income Statement

• Net Income (Loss) for the year = Revenues – Expenses

• Revenues: From providing services or selling goods.

  • Increase revenue à increase Cash or AR

• Expenses: Anything needed to generate revenue.

  • Increase expense à Decrease cash, or increase Liabilities (SP)

  • (Dividends: NOT an expense)

Income Statement Format (Before IFRS 18)

• Minimum Line Items (IAS 1.82-82A):

  • Revenue

  • Finance costs

  • Tax expense
    *Gains/Losses from the sale of PPE are typically non-operating they result from the disposal of long-term assets that were previously used in the business operations à arise from transactions that are not part of the company's core operational activities.

• Subtotals Required:

  • Income before tax

  • Net Income (Net profit)
    Basic form of the Income Statement – Service company (Before IFRS 18)

$Operating \ Revenue - Operating \ expenses = Operating \ Income$ =1 (=? EBIT)
Other non-operating items
Add: non operating gains
Subtract: non operating expenses
= Net Income before tax=2
Less: Income tax (= computed based on Taxable income)
= Net Income=3
*(IFRS: only 2 & 3 currently required. Proposal for 1)

IFRS 18 – Income Statement (Jan 1, 2027)

• Categories of income and expenses:

  • Operating category

    • Income and expenses from an entity's main business activities and any income and expenses that are not classified in other categories

  • Investing category

    • Income and expenses from investments made individually and largely independently of the entity's main business activities

  • Financing category

    • Income and expenses relating to obtaining finance to fund the entity's main business activities and/or investing activities
      *Income and expenses from assets that generate a return individually and largely independently of other resources held by an entity

• All income and expenses from liabilities from transactions that involve only the raising of finance E.g., bank loans

Statement of changes in owners’ equity

*Shows how Owner’s equity changed during the year.
Statement of Retained Earnings (change in Retained Earnings):
$RE \ 1/1/Χ5 XX$
Add: $Net \ Income 20X5 XX$
Less: $Dividends 20X5 (XX)$
$RE \ 31/12/X5 XX$

How NI affects SFP: Case 1 - No dividends paid:

$CHANGE= OE = A – L +37000 = +37000$

How NI affects SFP: Case 2- Dividends paid $5000:

$CHANGE=OE = A – L+32000 = +32000$

Financial Statements

• Balance sheet / Statement of financial position Depicts the Accounting equation
  $Assets = Liabilities + Owners’ \ equity$
  (what the company owns) (what the company owes) (what belongs to the shareholders)
  Cash flow Statement Statement of OE Income Statement

Users of Accounting Information

• Financial Accounting primarily addresses external users.

• The goal is to provide the best possible information to investors and creditors so that:

  • They can decide whether to finance the business.

  • They can evaluate the management of the business by the Management

• This is achieved with information needed to assess:

  • Liquidity/Solvency – Ability to repay short-term/all obligations

  • Profitability (Increase in value/dividend) – Ability to make a profit

Reliability of Financial Reporting (FR)Achieving Reliability:

• Historical information.

• Following GAAP (Generally Accepted Accounting Principles).

• Auditing:
  Auditor’s responsibilities for the audit of the consolidated financial statements:
  Identify and assess the risks of material misstatement of the consolidated financial statements and of the combined management report,
  Evaluate the appropriateness of accounting policies used by management and the reasonableness of estimates made by management and related disclosures

Auditor’s report Opinion:

In our opinion, on the basis of the knowledge obtained in the audit – the accompanying consolidated financial statements comply, in all material respects, with the IFRSs as adopted by the EU..

Financial vs. Managerial Accounting

Financial vs. Managerial Accounting
Accounting = financial information
Financial Accounting : users External
Managerial Accounting: users inernal