Chapter 1: Financial Reporting and the Financial Statements

Association Of Charted Certified Accountant (ACCA)

Types of Business Entities

Businesses exist to make a profit by producing and selling goods and services. Profit is the difference between the income and expenses of a business.

While businesses share a similar purpose, they can still differ significantly. Businesses vary in terms of size, financing, and legal structure. These factors influence what is reported in their financial statements.

A business can operate as a sole trader, a partnership, or a limited liability company.

Exam advice
In the exam, students may be tested on the ability to recognise the key features of each type of business entity.

Sole Traders
A sole trader is an individual who owns, controls, and operates a business alone. The business may also employ people.

Key Features of Sole Traders

Change in Business Ownership
To change the owner of a sole trader business, the existing sole trader would sell their business to the new owner. The sole trader is the only person in charge, so this decision is made without involving others.
Business Continuation
If a sole trader exits the business, it cannot continue unless sold to another individual.
Taxation
Sole traders are personally taxed on the profit the business makes. The tax authorities do not tax the business separately.
Ownership of Business Property
There is no separation of ownership between a sole trader business and its owner.
- Control – A sole trader has complete control over their business. The owner owns the business assets and is fully entitled to all the profits generated by the business.
- Ease of set-up – It is easy for a sole trader to set up and operate a business. There is no need to comply with companies’ legislation.
- Financial Statements – there is no requirement to publish financial statements.
  However, the sole trader may still need to produce financial statements to provide information to the tax authorities or a lender such as a bank.

Flexibility – A sole trader can choose how and when to operate.Legal Action
The sole trader is legally liable for any penalties and fines incurred if a legal dispute occurs and a court judgement is made against the business

Advantages of Sole Traders

Control – A sole trader has complete control over their business. The owner owns the business assets and is fully entitled to all the profits generated by the business.
Ease of set-up – It is easy for a sole trader to set up and operate a business. There is no need to comply with companies’ legislation.
Financial Statements – there is no requirement to publish financial statements.
However, the sole trader may still need to produce financial statements to provide information to the tax authorities or a lender such as a bank.
Flexibility – A sole trader can choose how and when to operate.

Disadvantages of Sole Traders

Liability – A sole trader is fully liable for any debts of the business. Personal possessions may have to be sold to pay off these debts.
Raising Finance – A sole trader may not be able to raise the money needed to develop the business in the longer term. The only available sources of finance may be the owner’s capital or short-term finance from the bank (overdraft).
Business Continuity – The business will cease if the sole trader dies or retires unless arrangements have been made for it to be sold or transferred to someone else.

Activity 1

1. Which one of the following is MOST likely to be interested in a sole trader’s financial statements?

Shareholders
The financial press
Loan note holders
The tax authorities

2. Which of the following statements about sole traders are true?

A sole trader may be able to obtain a bank overdraft.
If a sole trader owes money, the person who is owed the money will only be able to claim against the assets of the sole trader’s business.
A sole trader’s business may suffer if the owner becomes ill.

i) and ii)
i) and iii)
ii) and iii)
i) only
All of them

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Partnerships
A partnership is where two or more people own and operate a business together with a view to making a profit.

Key Features of Partnerships

Change in Business Ownership
All the partners must agree to a new partner being admitted to the partnership. A partner will typically buy into the partnership by investing.
Business Continuation
If a partner leaves a partnership, the partnership automatically ends unless the partnership agreement allows the remaining partners to continue the partnership.
Taxes on Personal Income
The individual partners are liable for tax on their share of the partnership profits. The partnership itself is not liable for tax.
Ownership of Business Property
There is no separation of ownership between a partnership business and its owner (partners).
Legal Action
The partners are legally liable for any penalties and fines incurred if a legal dispute occurs and a court judgement is made against the partnership.

Advantages of Partnerships

Defined Structure and Profit Sharing – A partnership will have a partnership agreement that sets out how the business will be operated including partners joining and leaving and the profit-sharing arrangements.
Raising Finance – If the existing partners bring another partner into the business, the new partner will be required to contribute financially.
Financial Statements – A partnership does not have to publish its financial statements. However, a partnership will need to produce financial statements to show the share of profit between the partners and to provide information to the tax authorities or a lender such as a bank.
Skills and Knowledge – Different partners have different business skills and knowledge. This can enhance the business because they can concentrate on what they do best.
Risks – Having more partners in a partnership will spread the business risk to more people. The impact of poor performance and losses will be reduced for each partner.

Disadvantages of Partnerships

Costs – Drawing up a legally binding partnership agreement will cost money.
Decision Making – The time taken to make decisions may be slow in a partnership if the partners disagree. This can slow down the progression and development of the business.
Profit Sharing – Since profits and losses are shared among the partners, there may be no incentive for any one partner to work harder than the other partners.
Business Continuity – A partnership may need to be dissolved if one of the partners cannot continue working. For the partnership to continue, the remaining partners may need to admit a new partner and establish a new partnership.
Liability – Each partner’s personal assets are at risk if the business fails. Personal bankruptcy can occur.
Disagreements and Disputes – Severe disagreements or disputes not resolved promptly between partners can result in hung decisions or, in the worst-case scenario, the partnership ending.

Limited Liability Companies

A limited liability company is considered to be a legal person in its own right, separate from its owners. Owners (shareholders) hold shares in the company. Shareholders require a return on their investments in the form of dividends or an increase in the value of their shares. Directors may be hired to run the company on behalf of the shareholders, although many small companies are managed by their owners. Shareholders are only liable for the amount of money paid for their shares.

A limited liability company may be a private or public limited company. Public limited companies tend to be larger, and their shares are listed on stock exchanges, which means the public can buy the shares.

A private limited company will have a smaller number of shareholders and may require the approval of existing shareholders before issuing new shares.

Key Features of Limited Liability Companies

Change in Business Ownership
Shareholders can buy and sell shares in a limited company without needing other shareholders to agree. However, smaller companies can restrict the sale to make the shares available to existing shareholders before being placed on the open market.
Business Continuation
If a company’s shareholders change, this does not affect the company’s existence.
Taxation
The limited liability company is liable to tax on the profits it generates (corporate income tax). The individual owners are not liable for tax on the profits of the company but may be liable to tax on dividends they receive from it.
Ownership of Business Property
A limited liability company can own property. The ownership does not need to be in anyone else’s name. Individual shareholders do not have control over the property.
Legal Action
The legal repercussions of a limited liability company are limited to the business only. The owner’s (shareholders’) legal liability is limited to the value of the shares they own. It is the company that is legally liable, not its shareholders.
Advantages of Limited Liability Companies
Liability – Limited liability protects shareholders by limiting their personal liability for the debts of the company to the value of their investment. Personal possessions of the shareholders cannot be used to repay any of the company’s debts.
Raising Finance – Limited liability companies may have easier access to finance. They can issue shares to existing shareholders or in the case of public companies, the public, to raise money for the business.
Business Continuation – A limited liability company can be transferred from one owner to another. If the current shareholders decide to sell their shares, another shareholder can purchase them, and the business will continue to operate as usual.

Disadvantages of Limited Liability Companies

Costs – Setting up a limited liability company requires a substantive initial investment including legal and company registration fees. There is also considerably more administration involved in running a limited liability company compared with a partnership or sole trader, such as the requirement to hold general meetings. In addition, a company is required to produce financial statements in accordance with accounting standards, and may be required to have these audited, incurring professional fees.
Tax – The profits of a limited liability company are taxed. The owners (shareholders) and directors (employees of the company) are also individually taxed.
Publication of Financial Statements – A company cannot keep its business affairs private as it relies on the investment of money (by investors purchasing its shares). A limited liability company must file annual financial statements and certain other documents with the company registrar, making them available for public inspection.

Activity 2

(i) Match each statement to the relevant business entity:

Sole trader
Partnership
Limited liability company

Statement	Business entity
The business will continue even if one of its shareholders dies.
There is a distinction between the business and its owners.
The business is taxed as a distinct entity from those who own it. The business may be subject to different tax rates from its owners.
The owner’s savings are likely to be an essential business finance source.

(ii) For each scenario identify the appropriate business entity:

Scenario	Business entity
Isabella wishes to open a small shop three days a week and wants to spend as little time as possible on business paperwork and formalities.
Oliver wishes to have his own business in a country where limited liability companies must have a minimum of two shareholders.
Riley wishes to operate by himself as a builder but is concerned that he will be personally liable for legal claims by his customers.
Lee has been running an accountancy practice by herself but is concerned that she does not have the expertise to meet all her client’s needs.

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(i)

Statement	Business entity
The business will continue even if one of its shareholders dies.	Limited liability company. A limited liability company is legally separate from its owners.
There is a distinction between the business and its owners.	Limited liability company. A limited liability company is legally separate from its owners.
The business is taxed as a distinct entity from those who own it. The business may be subject to different tax rates from its owners.	Limited liability company. Since the business is taxed separately from its owner, this is a characteristic of a limited liability company.
The owner’s savings are likely to be an essential business finance source.	Sole trader. In a sole trader business, raising finance would be a challenge. Therefore, the business will be dependent on funds from the owner.

(ii)

Scenario	Business entity
Isabella wishes to open a small shop three days a week and wants to spend as little time as possible on business paperwork and formalities.	Sole trader. Isabella wishes to run a simple business part-time.
Oliver wishes to have his own business in a country where limited liability companies must have a minimum of two shareholders.	Sole trader. Oliver wishes to have 100% of his business. This is only possible through a sole trader.
Riley wishes to operate by himself as a builder but is concerned that he will be personally liable for legal claims by his customers.	Limited liability company. Riley will need to form a private limited liability company where he would not be concerned about his legal liability.
Lee has been running an accountancy practice by herself but is concerned that she does not have the expertise to meet all her client’s needs.	Partnership. Lee needs to gain the expertise to service all her clients and should enter into a partnership to join forces and resources with another like-minded accountant.

Definition

Financial reporting is the recording, analysing, and summarising of financial data to present the financial performance and position of a business.

The financial statements produced from this data are analysed by users, such as potential investors and lenders, when making decisions about providing finance to the business.

Recording
A bookkeeper records all business transactions promptly so that the information is updated. The records should show enough information about each transaction to enable the correct categorisation of the transaction for the purpose of preparing financial statements to meet legal requirements.
For example, a business records information such as sales to customers and the purchase of goods from suppliers.
Many transactions may be recorded automatically by computerised accounting systems – for example, in a retail store, as barcodes on the products are scanned at checkout, details of sales and inventory movements are automatically recorded.
Analysing
A bookkeeper sorts the transactions into appropriate categories.
For example, transactions are categorised according to their accounting type so that managers can identify the main expenses of the business or how much cash it has received from each customer.
Summarising
Complete accounting records usually contain too many details for the needs of most interested parties. Therefore, businesses summarise their financial performance and position in annual financial statements. This enables users to obtain an overview of the business without looking through detailed accounting records.
Financial data is summarised in the financial statements at the end of each accounting period.
Analysis of Financial Statements
Users compare items in the statements with prior year(s) to see how things have changed over time. Analysing the reports helps users make informed financial decisions. Therefore, financial statements need to be accurate.
For example, users compare the value of assets in the statement of financial position against previous years to identify if new investments have been made. Financial statements are also analysed using financial ratios to allow comparisons to be made with competitors.

Statement of Financial Position
Definition
The statement of financial position is a primary statement that shows the financial position of a business at a point in time. This includes the assets owned, liabilities owed and the capital/equity balance. The statement of financial position is sometimes referred to as the “balance sheet”.

The “financial position” can be defined as a company’s net worth (assets minus liabilities). The statement of financial position shows the carrying amount of the entity at a particular date for:

Assets (resources controlled)
Liabilities (obligations owed)
Owners’ capital or equity (how the business is financed)

Example 1 – Sole trader

Abu is a sole trader who operates Glara, a business that manufactures goods and sells them to tourists. Glara has a workshop and a small shop.

Glara’s statement of financial position is shown below:

Glara’s Statement of Financial Position as at 31 December 20X4
	$	$
Non-Current Assets
Property	X
Equipment	X
Motor vehicles	X
		X
Current Assets
Inventories	X
Trade Receivables	X
Prepayments	X
Cash at bank and in hand	X
		X
TOTAL ASSETS:		X

Capital
Capital introduced	X
Retained earnings	X
Total capital:		X

Non-Current Liabilities
Bank loan		X

Current Liabilities
Trade Payables	X
Accruals	X
Overdraft	X
		X
TOTAL CAPITAL AND LIABILITIES:		X

Title – The statement of financial position shows the closing position of Glara’s assets, capital and liabilities balance at the financial year-end of 31 December 20X4.
Non-Current Assets – Assets come first on Glara’s statement of financial position. Non-current assets are assets that Glara intends to use to generate profits over more than 12 months. They include the workshop and shop that Glara occupies, equipment items, and motor vehicles.
Current Assets – These assets can be converted into cash or consumed by the business within the next 12 months.
- Inventories are goods that Glara will use for manufacturing or will sell in the future.
- Trade receivables are amounts owed by customers for goods or services received, expected to be received after the period end.
- Prepayments are expenses paid in advance.
- Cash at bank and in hand includes money Glara holds in its bank account or on its premises.
Note: Current assets are usually presented in the order in which they can be turned into cash most easily (increasing liquidity order). For conversion into cash:
1. Inventory takes the longest time
2. Trade and other receivables, and prepayments are relatively liquid and take less time
3. Cash is the most liquid asset.

Capital – Capital is the owner’s interest in the business. It comprises the cash invested into the business by the owner (capital introduced), any profits (or losses) generated minus any owner’s withdrawals (retained profits). The detail may be shown as follows:

Capital
introduced Retained
profits

Capital brought forward X X

Profit for the year – X

Capital introduced X

Less: Drawings – (X)

Capital at the end of the year X X

For Glara, capital brought forward is the capital from previous years that has been kept in the business. In a limited company’s financial statements, capital is called equity.
Non-Current Liabilities – These are the liabilities of Glara that will be settled (paid) in more than 12 months. For example, long-term bank loans.
Current Liabilities – These liabilities will be settled (paid) within 12 months.
- Trade payables are money owed by Glara to its suppliers for goods or services received, which it will pay after the period end.
- Accruals are other expenses incurred that have not yet been paid or invoiced.
- A bank overdraft is a negative balance on a bank account. Glara may not plan to repay the overdraft for some time, but it is treated as a current liability because the bank could demand it be cleared at any time.
The total assets should equal the total capital and liabilities.

The statement of financial position in the above example is for a sole trader.
The statement of financial position of a limited liability company is presented slightly differently, according to accounting standards. This is covered in Chapter 15.
Activity 3

State whether the following statements are true or false.

Prepayments are a current liability.
The company’s bank account balance is always a current asset.
A current liability is due to be settled within six months of the reporting date.
Drawings are added to capital in a sole trader’s statement of financial position.

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Statement of Profit or Loss and Other Comprehensive Income

The statement of profit or loss and other comprehensive income can be prepared either as a single statement or as two separate statements:

Single statement presenting comprehensive income
Two statements
- A statement of profit or Loss
- A statement of other comprehensive income (which begins with profit or loss for the period)

Note that all types of business entities prepare a statement of profit or loss; however, only companies are required to present other comprehensive income (although sole traders and partnerships may choose to do so).

2.4.1 Statement of Profit or Loss

Definition
The statement of profit or loss is a primary financial statement summarising an entity’s financial performance in terms of profit or loss in a year.

This statement comprises:

a summary of trading transactions (sales − cost of sales = gross profit)
all other items of income and expenditure relating to business activities.

It shows the profit or loss for the period after taking account of all items of expenditure (including interest and tax), excluding components of other comprehensive income.

2.4.2 Other Comprehensive Income

Other comprehensive income consists of items of income and expense which are not recognised in the statement of profit or loss. While various items of income and expenditure are treated as other comprehensive income, the only item you are likely to encounter in the FA /FFA exam is a surplus arising on revaluation of a property. This is not recognised in profit or loss (because it is not realised as cash).

As mentioned above, other comprehensive income must be presented by companies, however sole traders and partnerships may also choose to include this information. The following example of a statement of profit or loss and other comprehensive income is for a sole trader. Chapter 15 discusses the required presentation of the statement of profit or loss and other comprehensive income for companies in accordance with IFRS® Accounting Standards .

Example 2 – Sole trader

Glara’s statement of profit or loss and other comprehensive income is shown below:

Glara’s Statement of Profit or Loss and Other Comprehensive Income for the year ended 31 December 20X4
	$	$
Sales	X
Less: Sales returns	(X)
		X
Cost of Goods Sold
Opening inventory	X
Purchases	X
Less: Purchase returns	(X)
	X
Less: Closing inventory	(X)
		(X)
Gross Profit		X

Other Income		X

Expenses	X
Electricity	X
Rental	X
Repairs	X
Sundry expenses	X
Discounts allowed	X
Loan interest	X
		(X)

Profit		X

Other Comprehensive Income
Gains on property revaluation		X

Total Comprehensive Income		X

Title – The statement of profit or loss and other comprehensive income reports the income, expenses and other comprehensive income for Glara‘s accounting period of 1 January 20X4 to 31 December 20X4.
Sales – Sales (or revenue) is the income generated by Glara‘s normal trading activities.
Cost of Goods Sold – This is the cost of the goods Glara sells during the year. It includes purchases made during the period and opening and closing inventory adjustments.
Gross Profit – the surplus that Glara has made from its trading activities. It would be a gross loss if the cost of goods sold exceeded sales revenue.
Other Income – This is income generated by a business from anything other than its normal trading activities. This can include any interest earned from Glara’s bank deposits.
Expenses – These are costs incurred in the day-to-day running of the business.
Profit – is the excess of income after all business expenses have been paid. The profit amount is transferred to the retained earnings section of the statement of financial position, thus increasing capital.
(If a net loss is made, a negative amount is transferred, thus reducing the business’s capital).
Other Comprehensive Income – highlights any profit or losses not reflected in the statement of profit or loss.
An example is a revaluation of a non-current asset, which may give rise to a revaluation gain. For instance, a building valued at $750,000 is now worth $850,000. This is a revaluation gain of $100,000, which is classified as other comprehensive income.

As a reminder, the statement of profit or loss and other comprehensive income in the above example is for a sole trader.

The statement of profit or loss and other comprehensive income of a limited liability company is presented slightly differently, according to accounting standards. This is covered in Chapter 15.
Activity 4

Arrange the items in the order they must appear in the statement of profit or loss, reading from top (number 1) to bottom (number 7).

Line Item	Order Number
Loan interest
Cost of goods sold
Property revaluation loss
Other income
Profit
Gross profit
Sales revenue

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Statement of Cash Flows

Definition
The statement of cash flows is a primary statement that shows an overall view of the inflows and outflows of cash over the period and the balance of cash at the end of the period compared with the balance at the start of the period.

The statement of cash flows is required to be prepared for companies only. It is a historical statement. It shows cash inflows and outflows that have already taken place. Users can see where cash in the business has come from and how it has been spent.

The cash position of a business is one of the most important measures of its financial situation. If a business runs out of cash, it cannot survive even though it is making profits.

The statement of cash flows classifies the movement of cash into three categories:

Operating activities
Investing activities
Financing activities

Example 3 – Limited company

Kenravi Co is a large limited company that manufactures clothing. The statement of cash flows is shown below:

Kenravi Co Statement of Cash Flows for the year ended 30 April 20X5
	$	$
Cash Flows from Operating Activities
Cash generated from operations	X
Income taxes paid	(X)
Net cash from operating activities		X

Cash Flows from Investing Activities
Purchase of property, plant and equipment	(X)
Proceeds from sale of equipment	X
Interest received	X
Dividends received	X
Net cash used in investing activities		X

Cash Flows from Financing Activities
Proceeds from issue of share capital	X
Receipt of new loans	X
Repayment of loans	(X)
Interest paid	(X)
Dividends paid	(X)
Net cash used in financing activities:		X

Net increase in cash and cash equivalents		X
Cash and cash equivalents at beginning of period		X
Cash and cash equivalents at end of period		X

Title – Kenravi Co’s statement of cash flows shows the cash receipts and payments of the business during the period. Some of the amounts in the statement of cash flows and statement of profit or loss will be the same. However, the statement of profit or loss includes figures that are not cash movements, such as depreciation, which is not included in the statement of cash lows.
Cash Flows from Operating Activities – Cash flows from operating activities relating to Kenravi Co’s operations and income taxes paid by the company.
Cash Flows from Investing Activities – Cash flows from investing activities show Kenravi Co’s asset investments. The cash flows from investment can be positive (the sale of assets) or negative (the purchase of assets).
Kenravi Co may also invest in financial investments or other businesses. The interest and dividends received from these investments are included under this heading.
Cash Flows from Financing Activities – Cash flows from financing activities are monies Kenravi Co has received from finance providers. These would be from shareholders or lenders. The heading also includes money that the company has repaid to providers of finance.
Dividends paid to Kenravi Co’s shareholders are included here, and the interest paid on loans. If Kenravi Co has issued shares for cash, those receipts will be included in cash flows from financing activities.
Net increase in cash and cash equivalents – The totals for each category are added together to arrive at a net figure, which is Kenravi Co’s movement in cash over the year. If cash receipts have exceeded payments, there will be an increase; if payments have exceeded receipts, there will be a decrease.
Cash and cash equivalents include the bank overdraft. Cash equivalents are short-term investments that can easily be converted into cash.
Cash and cash equivalents at end of the period – This figure links the bank and cash figure or figures in Kenravi Co’s statement of financial position with the movement in cash flows. It shows the difference in cash flows between the period’s start and end.

Activity 5

For each of the following items, state whether they belong to the operating, investing or financing activities in the statement of cash flows.

Purchase of buildings
Income taxes paid
Profit on sale of motor vehicle
Dividends paid

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Statement of Changes in Equity
The fourth primary financial statement is the statement of changes in equity, which is required to be prepared by companies only. This statement reconciles the equity account balances at the start and end of the year. This is covered in more detail in Chapter 13. For now, just be aware that there is another statement.

Stakeholders

A stakeholder is anyone who can affect the business or is affected by the business. Stakeholders include shareholders, employees, customers, suppliers, and people or organisations that live close to the business’s location and are impacted by it in some way.

Since the financial statements are an important record of the performance of the business, many stakeholders are interested in them. Different stakeholder groups will be interested in different areas of the financial statements. The financial statements need to include enough detail to satisfy the information requirements of different stakeholders.

3.1.1 Internal Stakeholders

Business Owners
Shareholders want information about the financial return on their investment. Information about the financial performance is shown in the statement of profit or loss and other comprehensive income. They are also interested to know whether their investment is safe, and that the company is not in the verge of going into liquidation. Information about liquidity and the financial position can be found in the statement of financial position. All this information will help shareholders to decide whether to hold or sell their shares.

Owners may manage the business themselves or appoint managers to do it for them. Owner-managers need detailed financial data to run the business effectively and efficiently and make business decisions. Much of this information is found in the management accounts, which are not available to the public, rather than in the financial statements.
Employees of the company
Employees such as accountants and salespeople may be interested in the company’s information as part of their work scope within the business. Employees may also be interested in the company’s financial standing to assess their job stability.

The table below summarises the information needs of internal users of financial information:

Users/ Stakeholders	Information Needs
Investors (owners) and their advisers	Providers of capital are concerned with the risk and return of their investment. They need the following information: for decision-making (to buy, hold or sell) to assess the entity’s ability to pay interest or dividends.
Management (interested in management accounts rather than published financial information)	To plan, make decisions and control operational activities. Financial analysis of the financial statements may form part of a “management review”.
Employees	Stability and profitability of employers. Ability to provide remuneration, retirement benefits and employment opportunities.

3.1.2 External Stakeholders

Prospective investors
Potential shareholders want information about the possible financial return if they decide to invest in the company.
Customers
Some customers will rely on the company to provide them with regular supplies. They will be interested in whether the company is financially strong enough to continue to trade. They will also be interested in the profits that the company is making, considering them from the viewpoint of the prices they must pay the company.
Suppliers
Suppliers sell goods and services to the company. Their main concern will be that the company will be financially secure enough to pay their invoices, and continue to purchase goods and services from them.
Government and Local Authorities
The government will be interested to know if the company is complying with the law and how it uses its resources. This will help the government understand what is happening in the economy and influence government policy.

The taxation authorities report to the government. They will be interested in the company’s profits to calculate the tax to pay.
External Lenders
Loan finance providers lend the company money for repayment in the future. Naturally, they want to be sure that the company will pay the principal and the interest on the loan every year. Loan finance providers will therefore be interested in how much money and resources the company has and whether it looks like the company may find it difficult to repay what it owes.
Auditors
In most jurisdictions, companies above a certain size are required to have an audit each year. Auditors examine whether the financial statements present a true and fair view of the results and financial position of the company. Auditors also review whether the annual financial statements agree with the detailed accounting records that the company keeps. They will also work to check how reliable the company’s accounting records are.
The Public
The public will be interested in various aspects of the company, such as its contribution to the economy by providing jobs. Some companies – for example, water and electricity suppliers – deliver essential public services. The public will also be interested in anything the financial statements say about the company’s impact on the natural environment.

The table below is a summary of the information needs of external users of financial information:

Users	Information Needs
Prospective investors	Risks and returns (profitability and future growth) of investing may be assessed (by a financial analyst) based on published financial information.
Financial institutions (e.g. banks and other lending companies)	Information used: to decide whether to provide/extend loan facilities to determine whether repayments (principal and interest) can be settled when due.
Suppliers (may have greater interest if dependent on an entity as a major customer)	Information used to determine: whether amounts owed will be paid when due what prior claims the finance providers have on the entity’s assets.
Customers	Continuance of supply of goods/services is essential for long-term involvement with, or dependence on, the entity.
Government entities and their agencies (e.g. tax authorities)	Allocation of resources and, therefore, activities of the entity. Information used to regulate activities, determine taxation policies and as the basis for national income and similar statistics.
General public and media	Information used to measure the following: contribution to the local economy (e.g. number of employees and patronage of local suppliers) trends and recent developments in prosperity and range of activities.
Environmental groups	How the entity works to keep the environment “green” is increasingly reported in annual reports.

Activity 6

State whether the following statements are True or False.

Shareholders will be the most interested stakeholders in a partnership’s financial statements.
Auditors are particularly interested in the reliability of the figures shown in the financial statements.
Employees will want to use the financial statements to assess how well the business will do in the future.
Loan finance providers are likely to be interested in how much the business pays out to its owners each year.
Management’s primary source of daily financial information is the annual financial statements.
Tax authorities are interested in the financial statements of partnerships, sole traders and companies.

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Syllabus Coverage

This chapter covers the following Learning Outcomes.

A. The context and purpose of financial reporting

The context and purpose of financial statements for external reporting

Define financial reporting – recording, analysing and summarising financial data.
Identify and define types of business entity – sole trader, partnership, limited liability company.
Explain the legal differences between a sole trader, partnership and a limited liability company.
Identify the advantages and disadvantages of operating as a sole trader, partnership or limited liability company.
Define the nature, principles and scope of financial reporting.

Stakeholders’ needs

Identify the users of financial statements and state and differentiate between their information needs.

The main elements of financial statements

Describe the purpose of each of the financial statements:

Statement of financial position
Statement of profit or loss and other comprehensive income
Statement of changes in equity
Statement of cash flows

Summary and Quiz

A sole trader is self-employed.
A partnership is a business owned and managed for the mutual benefit of two or more partners.
A limited liability company is a legal entity that is separate from the shareholders.
Financial reporting includes:
- recording transactions (“bookkeeping”)
- preparation of financial statements (“accounting”)
- presentation of financial statements (“reporting”)
The main components of financial statements are the statements of:
- financial position (includes assets and liabilities)
- profit or loss (includes income and expenses)
- changes in equity (if relevant, for transactions with investors)
- cash flows (cash flows in and out of the business).
Users of financial statements are internal (e.g. owners, managers and employees) and external (e.g. potential investors, banks and customers).
Financial statement users have widely differentiated information needs.

SSC

CLAT

CUET

Clerk

Police

Patwari

Railway

CUET

CUET PG

LAW

12th Commerce

SSC

CLAT

CUET

Clerk

Police

Patwari

Railway

CUET

CUET PG

LAW

12th Commerce

SSC

CLAT

CUET

Clerk

Police

Patwari

Railway

CUET

CUET PG

LAW

12th Commerce

SSC

CLAT

CUET

Clerk

Police

Patwari

Railway

CUET

CUET PG

LAW

12th Commerce

Types of Business Entities

Exam adviceIn the exam, students may be tested on the ability to recognise the key features of each type of business entity.

Sole TradersA sole trader is an individual who owns, controls, and operates a business alone. The business may also employ people.

Key Features of Sole Traders

Advantages of Sole Traders

Disadvantages of Sole Traders

Activity 1

PartnershipsA partnership is where two or more people own and operate a business together with a view to making a profit. Key Features of Partnerships

Advantages of Partnerships

Disadvantages of Partnerships

Limited Liability Companies

Key Features of Limited Liability Companies

Disadvantages of Limited Liability Companies

Activity 2

Definition

Statement of Profit or Loss and Other Comprehensive Income

2.4.1 Statement of Profit or Loss

2.4.2 Other Comprehensive Income

Statement of Cash Flows

Activity 5

Exam advice
In the exam, students may be tested on the ability to recognise the key features of each type of business entity.

Sole Traders
A sole trader is an individual who owns, controls, and operates a business alone. The business may also employ people.

Partnerships
A partnership is where two or more people own and operate a business together with a view to making a profit.

Key Features of Partnerships