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Financial Accounting For Dummies®

Visit www.dummies.com/cheatsheet/financialaccountinguk to view this book's cheat sheet.

Table of Contents

Introduction

About This Book

Conventions Used in This Book

What You’re Not to Read

Foolish Assumptions

How This Book Is Organised

Part I: Getting Started with Financial Accounting

Part II: Looking at Some Accounting Basics

Part III: Bonding with the Balance Sheet

Part IV: Investigating Income and Cash Flow

Part V: Analysing the Financial Statements

Part VI: Tackling More Advanced Financial Accounting Topics

Part VII: The Part of Tens

Icons Used in This Book

Where to Go from Here

Part I: Getting Started with Financial Accounting

Chapter 1: Seeing the Big Picture of Financial Accounting and International Accounting

Knowing the Objective of Financial Accounting

Preparing financial statements

Showing historic performance

Providing results for the annual accounts

Getting to Know the Users of Financial Statements

Identifying the most likely users

Recognising their needs

Providing information for decision making

Understanding the Key Characteristics of Financial Accounting Information

Relevance

Reliability

Comparability

Consistency

Understandability

Setting out qualitative characteristics under the IASB’s Conceptual Framework

Understanding the Limitations of Financial Accounting

Considering Your Ethical Responsibilities

Following the accountant’s code of conduct

Having integrity

Maintaining objectivity

Achieving independence and objectivity

Introducing the Conceptual Framework of Financial Accounting

Chapter 2: Making a Career in Financial Accounting

The Making of a Financial Accountant

Getting educated

Aiming for chartered or chartered certified status

Looking at some alternative qualifications

Keeping up to date with changes in IFRSs

Considering Your Employment Opportunities

Working for a practice or setting up in practice

Working for a company

Working in public finance

Looking at the Future of Financial Accounting

Examining the evolution of financial accounting

Factoring in the changing nature of business

Chapter 3: Introducing the Primary Financial Statements

Understanding How Healthy a Business Actually is

Reporting Assets and Liabilities in the Balance Sheet

Understanding the structure of a balance sheet

Studying the balance sheet components

Seeing an example of a balance sheet

Posting Profit or Loss: The Income Statement/Profit and Loss Account

Studying the income statement components

Seeing an example of an income statement

Showing Us the Money: The Statement of Cash Flows

Seeing how companies raise and spend cash

Taking a look at each section of the statement of cash flows

Seeing a statement of cash flows

Looking at the differences between a UK cash flow statement and an IFRS one

Chapter 4: Acronym Alert! Setting the Standards for Financial Accounting

Walking through the Origins of Number Crunching

Understanding the Role of the Professional Bodies

Getting to grips with the Financial Reporting Council

Taking a look at the International Accounting Standards Board (IASB)

Perusing the Code of Ethics for Professional Accountants

Following Regulatory Issues

Introducing the London Stock Exchange

Monitoring accountancy firms in the UK

Recognising Big Brother: The Financial Reporting Council

Getting to know the Financial Reporting Council (FRC)

Understanding generally accepted accounting practice (GAAP) in the UK

Looking at IFRSs

Part II: Looking at Some Accounting Basics

Chapter 5: Doing the Books: The Process behind Financial Accounting

Shedding Some Light on Bookkeeping

Analysing the Effect of Business Transactions

Seeing how the fundamental accounting equation works

Getting familiar with accounts

Defining debits and credits

Seeing how debits and credits work

Getting to Grips with Journals

Using journals to record cash transactions

Recording credit transactions

Finding out about other journals

Seeing examples of common journal entries

Bringing It All Together in the Ledger

Realising what a ledger is

Posting transactions to the ledgers

Viewing an example of a general ledger

Recognising the purpose of the trial balance

Chapter 6: Taking a Butcher’s at Accounting Methods Under UK GAAP and IFRS

Distinguishing between Key Accounting Methods

The cash basis

The accruals basis

Sorting through Standards for Other Types of Accounting

Management accounting

Not-for-profit accounting

Government accounting

International accounting (IFRS)

Considering the Conceptual Framework and Other Principles

The objective of financial reporting

Characteristics of financial statement information

Elements of the financial statements

Financial statement measurements

Part III: Bonding with the Balance Sheet

Chapter 7: Looking at Assets

Homing in on the Historic Cost Convention

Keeping Track of Non-Current (Long-Term) Assets

Meeting the tangibles: Property, plant, and equipment (PP&E)

Investigating intangible assets

Learning about Current Assets

Short-term investments

Inventory

Trade receivables

Loans receivable

Prepaid expenses

Cash

Studying the Asset Section of the Balance Sheet

Chapter 8: Grappling with Liabilities

Seeing How Businesses Account for Liabilities

Keeping Control of Current Liabilities

Trade payables/creditors

Sundry creditors

Payroll and income taxes

Deferred income

Other short-term liabilities

Planning for Long-Term Obligations

Managing long-term debt

Anticipating contingent liabilities

Accounting for Bond Issuances

Understanding the basics

Accounting for bonds sold at face value

Addressing interest payments

Getting and amortising a premium

Reporting a bond discount

Redeeming and converting bonds

Chapter 9: Examining the Equity Section

Distinguishing between Different Types of Business Entities

Sole trader

Partnership

Limited liability partnership

Limited companies

Sifting Through Share Capital

Recording Retained Earnings

Spotting Reductions in Shareholders’ Funds

Paying dividends

Buying back shares

Getting to grips with share splits

Seeing Increases in Shareholders’ Funds

Boning up on bonus issues

Rifling through a rights issue

Seeing a Sample Equity Section of the Balance Sheet

Part IV: Investigating Income and Cash Flow

Chapter 10: Understanding Profit or Loss

Presenting the Profit and Loss Account in One of Two Ways

Figuring out format one

Working through format two

Seeing an example IFRS income statement

Defining Different Types of Businesses

Peeking at service providers

Selling goods to Joe Public

Manufacturing a product

Examining Income Statement Sections

Revenue and other income

Contra revenue accounts

Cost of sales

Gross profit

Distribution and administrative expenses

Heading toward the bottom line

Earnings per share

Watching Out for Unusual Income Statement Items

Discontinued operations

Exceptional items

Arriving at the Final Product

Chapter 11: Figuring Out the Statement of Cash Flows under UK GAAP and IFRS

Understanding the Difference between Cash and Profit

Seeing how non-cash transactions affect profit

Distinguishing costs from expenses

Getting to Grips with the Statement of Cash Flows

Walking through the Cash Flow Sections

Knowing about net cash from operating activities

Gaining an understanding of investing activities

Finding out about financing activities

Getting a heads up on the different headings in a UK GAAP cash flow statement

Recognising Methods for Preparing the Statement of Cash Flows

Using the direct method

Using the indirect method

Interpreting the Statement of Cash Flows

Looking at Two Sample Statements of Cash Flows

Chapter 12: Discovering and Understanding Depreciation

Discovering How Depreciation Affects All Financial Statements

Mastering Costs

Defining costs and expenses in the world of business

Making sense of the matching principle

Identifying the different types of costs

Learning which items are depreciated

Distinguishing between Depreciation Methods

Walking through the straight-line method

Running through the reducing balance method

Seeing how the methods compare

Pro-rating the depreciation charge

Preparing a Depreciation Schedule

Chapter 13: Dealing with and Accounting for Inventory

Discovering How the Valuation of Inventory Affects the Accounts

Seeing How Service Organisations Deal with Inventory

Classifying Inventory

Accounting for the purchase of goods

Accounting for the manufacturing of goods

Getting to Know Inventory Valuation Methods

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

Weighted average

Comparing inventory assumptions

Preparing an Inventory Worksheet

Doing It Right Under IFRS: Knowing the Restrictions

Part V: Analysing the Financial Statements

Chapter 14: Using Ratios and Other Tools

Learning about Liquidity

Conquering the current ratio

Putting the acid test to work

Working with working capital

Grasping the gearing ratio

Measuring Profitability

Explaining trend analysis

Going through the gross profit ratio

Focusing on return on investment

Homing in on return on equity

Exploring the Cash Position

Calculating debtor/receivables days

Working out creditor/payables days

Inventory turnover

Analysing Financial Statements

Using horizontal analysis

Comparing with vertical analysis

Chapter 15: Delving into the Disclosures

Touching on How Corporate Governance Works

Recognising How Companies Work in the UK

Reviewing the Notes to the Financial Statements

Knowing how the notes interact with the accounts

Explaining significant accounting policies

Looking for information about important events

Putting the Onus on the Preparer

Chapter 16: Reporting to Shareholders

Seeing Why Private and Public Companies Treat Annual Reports Differently

Fulfilling Three Purposes

Serving a marketing and PR function

Stating financial performance and goals

Meeting regulatory requirements

Reading the Annual Report to Shareholders

Meeting the chair of the board of directors

Highlighting key financial information

Promoting company achievements

Looking into the future

Getting to know key management and board members

Making Sense of Other Sections in the Annual Report

Glancing at Form 10-K

Looking at the report of the auditors

Part VI: Tackling More Advanced Financial Accounting Topics

Chapter 17: Accounting for Business Combinations

Explaining What Constitutes a Merger or Acquisition

Dealing with a Business Combination

Post 2008: The acquisition method

Grappling with goodwill

Knowing what to do with goodwill under IFRSs

Reviewing Issues Affecting Mergers and Acquisitions

Understanding contingent considerations

Saying farewell to management: Golden goodbyes

Accounting for acquisition-related costs

Identifying other issues

Dealing with Investments in Other Companies

Considering simple investments

Utilising the equity method

Consolidating financial statements

Classifying Types of Reconstructions

Chapter 18: Accounting for Income Taxes

Identifying Accounting Profit versus Taxable Profit

Figuring out accounting profit

Taking a look at taxable profit

Explaining why the two types of profits differ

Taking Advantage of Tax Losses

Identifying loss carrybacks

Understanding loss carryforwards

Presenting a Side-by-Side Comparison of Book Values and Tax Calculations

Taking Deferred Tax Liabilities or Assets to the Balance Sheet

Seeing the Difference between UK GAAP and IFRS for Deferred Tax

Chapter 19: Accounting for Leases

Reviewing Lease Basics

Identifying the advantages of leasing

Introducing the lessor and lessee

Accounting by the Lessee

Looking at operating leases

Walking through finance leases

Presenting a finance lease in the financial statements

Accounting by the Lessor

Operating leases

Finance leases

Sale and leaseback transactions

Chapter 20: Reporting Changes in Policies and Estimates and Correcting Errors

Coping with Accounting Changes

Reporting changes in accounting policies

Changing a company’s estimates

Correcting Errors

Looking at common types of errors

Letting cancelling errors lie

Restating the financial statements

Part VII: The Part of Tens

Chapter 21: Ten Financial Accounting Shenanigans

Reporting Revenue in the Wrong Period

Massaging the Figures: Reporting Fictitious Income

Getting Income Classification Wrong

Failing to Record Liabilities

Reporting Liabilities in the Wrong Period

Inflating Asset Values

Changing Accounting Policies Inappropriately

Failing to Disclose Related-Party Transactions

Capitalising Expenses Inappropriately

Hiding Reportable Contingencies

Chapter 22: Ten Industries with Special Accounting Standards

Airlines

Finance Companies

Franchisors

Oil and Gas Companies

Government Contractors

Healthcare Entities

Film Production Companies

Not-for-Profit Organisations

House Builders

Computer Software

About the Authors
Cheat Sheet

Introduction

Accountancy is known as the language of business because it communicates financial and economic facts about a business to all sorts of interested parties – both internal (employees of the company) and external (people not employed by the company in question). External users include investors, creditors, banks and regulatory agencies such as HM Revenue and Customs and the stock markets.

Focusing on the external users of accounting information, this book is about financial accounting. Financial accounting serves the needs of external users by providing them with understandable, materially correct financial statements. Three financial statements exist: the income statement (often termed the profit and loss account in the UK and also known internationally as the statement of comprehensive income or statement of profit or loss), balance sheet (known internationally as the statement of financial position) and the cash flow statement (known internationally as the statement of cash flows). This book is a step-by-step guide on how to prepare all three.

You also find out the purposes of the financial statements:

check.png To report on the financial position of the company – what types of assets the company owns and what types of liabilities it owes.

check.png To show how well the company performs over a period of time, which is referred to as an accounting period. You measure performance by seeing whether the company made or lost money during the accounting period.

A lot of people considering starting out in the world of accountancy are often afraid they won’t do well in their accountancy studies because they haven’t done well in maths. Forget about the maths – that’s why you have a computer and a calculator! Financial accounting is less about adding and subtracting and more about using logic-based skills. Added to the mix is the importance of gaining a working understanding of the standards set in place by authoritative accountancy bodies.

The reason I’ve written this book is to breathe some life into the subject of financial accounting and make it more understandable to students, trainee accountants and those seeking a career change into the world of accountancy.

About This Book

This book, like all For Dummies books, is written so that each chapter stands on its own. I always assume that whatever chapter you’re reading is the first one you’ve tackled in the book. Therefore, you can understand the concepts I explain in each chapter regardless of whether it’s your first chapter or your last.

However, certain terms and concepts are relevant to more than one subject in this book. To avoid writing the same explanations over and over, whenever I refer to a financial accounting term, method or other type of fact that I fully explain in another chapter, I give you a brief overview and direct you to the chapter where you can get more information. For example, I may suggest that you ‘flick to Chapter 13’ (which, by the way, discusses the statement of cash flows).

Also, in this book I break financial accounting down to its lowest common denominator. I avoid using jargon that only accountants with several years’ experience already under their belts will understand. Please keep in mind that the list of financial accounting topics and methods I present in this book isn’t exhaustive. I simply can’t cover every possible transaction and event related to preparing financial accounting data and statements. This book is meant to give a basic introduction to the world of financial accounting in a down-to-earth, easy-to-understand and light-hearted manner.

Conventions Used in This Book

Following are some conventions I use that you need to bear in mind while reading this book:

check.png I introduce new terms in italic with an explanation immediately following. For example, liquidity refers to a company’s ability or lack thereof to meet current financial obligations. To put it even more simply, does the company have enough cash to pay its bills?

check.png Many accounting terms have acronyms (which you’ll soon be bandying about with your fellow novice accountants after you gain some familiarity or experience with the topic). The first time I introduce an acronym in a chapter, I spell it out and place the acronym in brackets. For example, I may discuss the Association of Chartered Certified Accountants (ACCA).

check.png I use bold text to highlight key words in bulleted lists.

check.png All web addresses are in monofont typeface so that they’re set apart from the rest of the text.

What You’re Not to Read

It would be great if you read every word of this book, but I realise that people lead busy lives and sometimes just want to get the specific information they need. So if you’re short on time, you can safely skip the following without jeopardising your understanding of the subject at large:

check.png Material marked with a Technical Stuff icon: These paragraphs contain extra financial accounting information that, while useful, isn’t critical to your understanding of the topic at hand.

check.png Sidebars: These grey-shaded boxes contain asides that I think you’ll find interesting but that, again, aren’t vital to understanding the fundamental concepts of a certain accountancy topic.

Foolish Assumptions

I assume you don’t have more than a basic understanding of accountancy, and I’m guessing you’re one of the following people:

check.png A financial accounting student who just isn’t getting it by reading (and rereading) the relevant textbook.

check.png A non-accountancy student currently enrolled in either business or another course who’s considering changing direction to go down the accountancy route.

check.png A business owner (particularly someone operating a small business with a relatively small/modest turnover) who wants to attempt preparing her own financial statements or just wants to have a better understanding about the financial statements prepared by the in-house or external accountant.

check.png A brand-new accountant working in financial accounting who needs a plain-English refresher of accountancy concepts.

How This Book Is Organised

To help you find the financial accounting facts you need, this book is organised into parts that break down the subject of financial accounting into easily digestible portions that all relate to one another.

Part I: Getting Started with Financial Accounting

This part introduces you to the world of financial accounting. You receive an initiation into the purpose, constraints and responsibilities of financial accountants; various financial accounting career options; and the sorts of professional courses you need to pursue these careers. I also provide an overview of the three financial statements. For the business owner, it provides information about the education, training, certification and experience of the stranger who comes into your business asking about private accountancy-related facts.

Part II: Looking at Some Accounting Basics

In this part, I lay the foundation of the basics of financial accounting that you’re likely to come across in your day-to-day working life as a financial accountant or as an accountancy student. You discover how to enter accounting transactions into a company’s books through the use of journal entries. You also find out about the general ledger, which is the place where accountants record the impact of transactions taking place in a business during a particular accounting period. Finally, you find out about the two different methods of accounting, the cash-based method and the accruals-based method – though I concentrate on the accruals method because this is the one financial accountants use.

Part III: Bonding with the Balance Sheet

This section contains three chapters, each explaining a different section of the balance sheet. The three sections of the balance sheet are assets, liabilities and equity, and together they show the financial position of a company. Assets are resources a company owns, liabilities are what a company owes and equity is the difference between assets and liabilities, which equals the total of each owner’s investment in the business.

Part IV: Investigating Income and Cash Flow

This part looks at the income statement and the statement of cash flows. The income statement shows a company’s revenue and expenses, the end result of which shows whether a company made or lost money during the accounting period. The statement of cash flows shows the cash received by a company and the cash paid by a company during the accounting period. It tells users of the financial statements how well the company is managing its sources and uses of cash.

Part V: Analysing the Financial Statements

After all your hard work preparing the financial statements, in this section you find out about key measurements that users of the financial statements perform to gauge the effectiveness and efficiency of the business. I provide the complete picture on a company’s annual report, which informs the shareholders about the company’s operations for the past year. And you get an overview of corporate governance and interpretations of the explanatory notes and other information found in most companies’ annual reports.

Part VI: Tackling More Advanced Financial Accounting Topics

Here, I delve into other financial accounting topics, like accounting for income taxes and leases. Knowing about these topics makes your financial accounting experience well-rounded, preparing you in case you decide to continue on your journey through the world of accountancy and, perhaps, enrolling on one of the chartered qualification courses.

Part VII: The Part of Tens

I wrap up the book by explaining ten financial statement deceptions to look out for when preparing financial statements. These include ways to inflate income by understating expenses and hiding unfavourable information from the users through use of accountancy lingo. I also provide some helpful information about industries that may deviate from generally accepted accounting practice (GAAP) while doing their bookwork and preparing their financial statements.

Icons Used in This Book

Throughout the book, you see the following icons in the left-hand margin:

tip.eps Text accompanied by this icon contains useful hints that you can apply during your studies (or on the job) to make your studies (or work) a bit easier and more successful.

remember.eps When you see this icon, get those brain cells in gear, because it sits next to information you want to commit to memory.

warning_bomb.eps Looking for what not to do in the world of financial accounting? Check out paragraphs next to this icon because they alert you to what can trip you up during your studies or working in the field.

technicalstuff.eps This icon includes information that enhances the topic under discussion but isn’t necessary to understand the topic.

example.eps This icon shows you that a financial accounting concept is demonstrated by working through an example.

Where to Go from Here

Each chapter stands on its own, so no matter where you start, you won’t feel like you’ve missed anything fundamental beforehand. Your motivation for purchasing this book will probably dictate which chapters you want to read first and which you’ll read only if you have some spare time in the future.

If you’re an accountancy student, flip to the chapter explaining a topic you’re a little confused with after reading your textbook. Business owners can get a good overview of the financial accounting process by starting with Chapters 1 and 3; these two chapters explain the nuts and bolts of financial accounting and its concepts. Otherwise, check out the table of contents or index for a topic that interests you, or jump in anywhere in the book that covers the financial accounting information you’re wondering about.

Part I

Getting Started with Financial Accounting

9781118554371-pp0101.eps

pt_webextra_bw.TIF Go to www.dummies.com/extras/financialaccounting for online bonus content.

In this part . . .

check.png Understand why financial accounting is so important to many different individuals and businesses.

check.png Come to grips with the key characteristics of financial accounting.

check.png Chart a career in financial accounting.

check.png Get a handle on the primary financial statements.

check.png Go to www.dummies.com/extras/financialaccounting for online bonus content, including an extra Part of Tens chapter: ‘Ten Differences Between Some National Standards and IFRS’.