Question

The context and purpose of financial reporting

1 The scope and purpose of, financial statements for external reporting

(a) Define financial reporting – recording, analysing and summarising financial data.

(b) Identify and define types of business entity – sole trader, partnership, limited liability company.

(c) Recognise the legal differences between a sole trader, partnership and a limited liability company.

(d) Identify the advantages and disadvantages of operating as a limited liability company, sole trader or partnership.

(e) Understand the nature, principles and scope of financial reporting.

Answer 1

The context and purpose of financial reporting

Financial reporting plays a vital role in world economies. Its primary purpose is to provide relevant and useful information to the owners of a company where there is a division between the ownership and control of that company. This occurs mainly in public limited companies, where share capital is sold to the public through a stock market/exchange system. The diverse and potentially geographically dispersed shareholders do not get involved in the management of their company; they appoint directors to do this on their behalf. The owners receive an annual statement summarising the performance and position of their company so that they can assess how well their investment has performed during the reporting period.

Without this reporting system investors would be less inclined to part with their capital as they would have no way of monitoring how effectively the company is being run by the directors, the appointed stewards of the company who are supposed to be operating in the best interests of the shareholders.In order to meet the needs of the users of the financial statements companies have to implement accounting systems that provide the information needed. It is also important that this system is regulated to ensure that the information provided to the users is in an appropriate format and that it is useful to their informational requirements. This is achieved through a financial reporting framework, the basis of which is a conceptual framework.

1 The scope and purpose of, financial statements for external reporting

External reporting is the issuance of financial statements to parties outside of the reporting entity. The recipients are usually investors, creditors, and lenders, who need the information to evaluate the financial condition of the reporting entity. At its most formal level, external reporting involves the issuance of a complete set of audited financial statements, which include an income statement, balance sheet, and statement of cash flows. The recipients may allow the issuance of unaudited financial statements for interim periods.

(a) Define financial reporting – recording, analysing and summarising financial data

Ans:

Financial reporting is the disclosure of financial results and related information to management and external stakeholders (e.g., investors, customers, regulators) about how a company is performing over a specific period of time.

Financial reports are usually issued on a quarterly and annual basis and include the following:

• Balance Sheet or Statement of Financial Position – reports on a company’s assets, liabilities, and owners’ equity at a given point in time, usually the end of a fiscal quarter or year.
• Income Statement or Profit and Loss Report – reports on a company’s income, expenses, and profits over a period of time, such as a fiscal quarter or year. This includes sales and the various expenses incurred during the stated period.
• Statement of Changes in Equity or Statement of Retained Earnings – reports on the changes in equity of the company during the stated period, such as a fiscal quarter or year.
• Cash Flow Statement – reports on a company’s cash flow activities, including its operating, investing, and financing activities. These are typically referred to as sources and uses of cash.

For publicly held corporations, these financial reports can be very detailed and complex. They typically include extensive footnotes, as well as a management discussion and analysis (MD&A). The notes provide details about each item on the balance sheet, income statement, and cash flow statement, including insights into the accounting method used.

Financial reporting for private and public companies must be performed in accordance with generally accepted accounting guidelines (GAAP). For example, US companies must report their results under US GAAP, whereas companies in most international markets report under International Financial Reporting Standards (IFRS). These accounting guidelines provide principles and rules that must be followed to ensure accuracy, consistency, and comparability in financial results.

(b) Identify and define types of business entity – sole trader, partnership, limited liability company

Ans:

What Is a Business Entity?

In simplest terms, a business entity is an organization created by an individual or individuals to conduct business, engage in a trade, or partake in similar activities. There are various types of business entities—sole proprietorship, partnership, LLC, corporation, etc.—and a business’s entity type dictates both the structure of that organization and how that company is taxed.

Types of Business Entities: An Overview

1) Sole Proprietorship

2) General Partnership (GP)

3) Limited Partnership (LP)

4) C-Corporation

5) Limited Partnership (LP), etc.

Main Three Business entites are defined below
Sole Proprietorship

A sole trader is a self-employed person who owns and runs their own business as an individual. A sole trader business doesn’t have any legal identity separate to its owner, leading many to say that as a sole trader you are the business. In this article, we look at what a sole trader is, how to get started and your ongoing responsibilities.

As a sole trader, you have absolute control over your business, its assets and profits after tax. Alongside this control, this business model offers comparative simplicity, versatility and a number of other advantages.

Partnership (GP)

A partnership is a kind of business where a formal agreement between two or more people is made and agreed to be the co-owners, distribute responsibilities for running an organization and share the income or losses that the business generates.

In India, all the aspects and functions of the partnership are administered under ‘The Indian Partnership Act 1932’. This specific law explains that partnership is an association between two or more individuals or parties who have accepted to share the profits generated from the business under the supervision of all the members or behalf of other members.

limited liability company (LLC)

A limited liability company (LLC) is a business structure in the United States whereby the owners are not personally liable for the company's debts or liabilities. Limited liability companies are hybrid entities that combine the characteristics of a corporation with those of a partnership or sole proprietorship.

While the limited liability feature is similar to that of a corporation, the availability of flow-through taxation to the members of an LLC is a feature of partnerships (and not an LLC).

Limited liability companies (LLCs) are a business structure that is allowed under state statutes. The regulations surrounding LLCs vary from state to state.3 LLC owners are generally called members.Many states don't restrict ownership, meaning anyone can be a member including individuals, corporations, foreigners and foreign entities, and even other LLCs. Some entities, though, cannot form LLCs, including banks and insurance companies.

An LLC is a more formal partnership arrangement that requires articles of organization to be filed with the state.6 An LLC is much easier to set up than a corporation and provides more flexibility and protection.LLCs may elect not to pay federal taxes. Instead, profits and losses are listed on the personal tax returns of the owner(s). Or, the LLC may choose a different classification, such as a corporation.5 7 If fraud is detected or if a company hasn't met legal and reporting requirements, creditors may be able to go after the members.

(C) Recognise the legal differences between a sole trader, partnership and a limited liability company.

Ans:

Sole Propietorship/Trader

This is the simplest form of business to start where you carry on business on your own account. You are liable to income tax and Class 4 National Insurance on your profits. You can employ people including your spouse for work done.

Your business format is not set in stone forever and you can change between them. It is fairly simple for a sole trader to take on a partner and become a partnership and for a partnership to become a Limited Company. There are however more complications with changing from a Limited Company to a sole trader or partnership.

• Recommended for businesses where a single individual manages and controls the business with least statutory compliance.
• Suitable For Small Shops with less capital requirement like:
  • Automotive repair/ parts shops
  • Small bakery
  • Tailoring shop
• Ownership: Proprietor only
• Managed by: Proprietor only
• Liabilities: Unlimited including personal assets
• Formalities : No registration required; some sectors may require licenses. No Audit and minimum statutory filings
• Ease-operation: Easiest
• Running Cost & Taxes: Least. Profit taxed as Personal income
• Credit- worthiness / Ability to raise funds: Totally dependent upon the goodwill & creditworthiness of its Proprietor

Partnership

A partnership is two or more people carrying on business together with a view to making profit.

The partners are all joint and severally liable for partnership debts, although this does not apply to personal tax bills based on partnership profits.

It is advisable to have a partnership agreement to document the agreement between the partners. However, the partnership is often between husband and wife and there is no agreement.

• Recommended for: People who want different functions of the business to be taken care by individual partners and profit shared
• Suitable For: Small scale industries like handicraft, wholesale and retail trade small service concerns like transport agencies, real estate brokers
• Ownership: Partners
• Managed by: Partners
• Liabilities: Unlimited
• Formalities: Optional registration with Registrar. Optional St Audit (unless contribution > 25 lacs)
• Ease-operation: Easy
• Running Cost & Taxes: Less. Effective tax of 30.9% on income of partnership. No further income tax liability of partners.
• Credit- worthiness / Ability to raise funds: Dependent upon goodwill and creditworthiness of its partners

Limited Liability Company

LLP’s are treated like a normal partnership for tax purposes but have the protection of Limited Liability.

A LLP is a separate legal entity and can enter into contracts and deeds, sue and be sued. With normal partnerships every partner has to be party to certain documents and litigation.

Floating charges can be granted over its assets in its own name, which normal partnerships can’t do. As with Limited Companies, there is public availability of accounts.

• Pass-through taxation
• No restrictions on the number of members allowed
• Members have flexibility in structuring the company management
• Does not require as much annual paperwork or have as many formalities as corporations.
• Owners are not personally responsible for business debts and liabilities
• More expensive to form than sole proprietorships and general partnership,
• Ownership is typically harder to transfer than with a corporation
• Limited Life

(D) Idetify the advantages and disadvantages of operating as a limited liability company, sole trader or partnership.

Limited Liability Company

A Limited Liability Company (LLC) is business structure that provides the limited liability protection features of a corporation and the tax efficiency and operational flexibility of a partnership.

Unlike shareholders in a corporation, LLC’s owners are not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.

The owners of an LLC have no personal liability for the obligations of the LLC. An LLC is the entity of choice for a businesses seeking to flow through losses to its investors because an LLC offers complete liability protection to all its members.

ADVANTAGES OF AN LLC

• It limits liability for managers and members.
• Superior protection via the charging order.
• Flexible management.
• Flow-through taxation: profits are distributed to the members, who are taxed on profits at their personal tax level. This avoids double taxation.
• Good privacy protection, especially in Wyoming.
• This is a premier vehicle for holding appreciating assets, such as real estate, stock portfolios, and intellectual property.
• Extraordinary flexibility in the ability to allocate profits and losses to members in varying amounts.

DISADVANTAGES OF OPERATING AN LLC

• Some states, including California, charge extra fees for operating an LLC.
• Income splitting is available, but unlike an S Corp, in a business operating as an LLC all income may be subject to payroll or self-employment taxes.
• Some states do not allow professional groups (i.e., doctors or dentists) to operate through an LLC.
• Transferability restrictions – consent of membership is required for each and every transfer of membership interests. (This can also be a plus.)
• Single Member LLCs face reduced asset protection. Many states do not honor asset protection for LLCs with a single owner.

Sole Trader/Propietorship

Advantages of Sole Proprietorship

1. Beginning a sole proprietorship is easy. Unlike other business structures, starting a sole proprietorship requires less paperwork and time to create a legal sole proprietorship.
2. It is cheap to start a sole proprietorship. Where other business structures have increased fees and filings to open for business, sole proprietorships tend to be affordable models to start and maintain.
3. There are some tax benefits for a sole proprietorship. Instead of the business having to file its own tax return, sole proprietors claim businesses gains and losses on their own individual tax return. Also, the sole proprietorship is taxed using individual income tax rates rather than corporate making it simpler and cheaper to comply with your tax obligations.
4. Sole proprietors can employ others and grow their business. Sole proprietorships can hire others and enjoy the tax benefits from doing so. Additionally, spouses of the owner can work for the sole proprietorship without being declared as an employee.
5. Owners have complete and direct control over all decision making. Because the owner is the business, the owner makes all decisions for the business rather than sharing power with a partner or corporate board. This allows owners the freedom to drive the business in the direction they desire.

Disadvantages of Sole Proprietorship

1. Owners are fully liable. If business debts become overwhelming, the individual owner’s finances will be impacted. When a sole proprietorship fails to pay its debts, the owner’s home, savings, and other individual assets can be taken to satisfy those debts.
2. Self-employment taxes apply to sole proprietorships. Owners must pay self-employment taxes on the business income.
3. Business continuity ends with the death or departure of the owner. Because the owner and the sole proprietorship are one, if the owner dies or becomes incapacitated then the business dies with them and the money and assets of the business become part of the individual’s estate. The assets and money are subjected to inheritance taxes and can have a great impact on employees of the sole proprietorship.
4. Raising capital is difficult. Initial funds of the business are generated by the owner and raising funds for the business can be hard since they cannot issue stocks or other investment income. Loans may also be difficult if the owner does not have enough credit to secure additional money.

Partnership

Advantages

• 1. Easy Formation : Registration is not compulsory in the case of Partnership firm. It can be formed without any legal formality and expenses. Thus they are simple and economical to form and operate.
  
  2. Larger Resources : Due the more number of members the partnership firm has larger resources for the business operations as compared to sole proprietorship.
  
  3. Flexibility in operation : Due to the limited number of partners there is flexibility in the operations of business as the partners can amend any objectives or change any operations any time by mutual consent.
  
  4. Better Management : Business of a partnership firm is very well managed by all the partners as they take interest in the daily affairs of business because of the ownership, profit and control.
  
  5. Sharing of Risk : In partnership every partner bears the risks individually as it is easier compared to sole proprietorship.
  
  6. In a partnership firm interest of every partner is protected against any fraud.

Disadvantages

• 1. Instability : A partnership firm does not exist for an indefinite period of time. The death, insolvency or lunacy of a partner may lead to dissolution of the partnership firm.
  
  2. Unlimited Liability : Liability of every partner in a partnership firm is unlimited as any of the partners may be called upon to pay all the debts even from its personal properties. A single wrong decision by one partner can lead other partners in heavy losses and liabilities.
  
  3. Lack of Harmony : According partnership agreement every partner has equal rights. Some situations might occur in which one or the other partner will not agree on the same thing which will cause difference of opinion resulting mistrust and disharmony among the partners.
  
  4. Limited Capital : Due to the restriction on the maximum number of members, a limited amount of capital can be raised.
  
  5. No legal status : A partnership firm does not have a legal status like a Joint Stock Company.
  
  6. In a partnership firm it is not easy to transfer ownership. Consent of every partner is required in order to transfer ownership.

(E)Understand the nature, principles and scope of financial reporting

Nature

Financial Reports are prepared using facts relating to events, which are recorded chronologically. Thus, we have to first record all these facts in monetary terms. Then, we have to process them using all applicable rules and procedures. Finally, we can now use all this data to generate Financial Reports

Based on this understanding, the nature of Financial Reports depends on the following points:

1. Recorded facts: We need to first record facts in monetary form to create the statements. For this, we need to account for figures of accounts like fixed assets, cash, trade receivables, etc.
2. Accounting conventions: Accounting Standards prescribe certain conventions applicable in the process of accounting. We have to apply these conventions while preparing these statements. For example, the valuation of inventory at cost price or market price, depending on whichever is lower.
3. Postulates: Apart from conventions, even postulates play a big role in the preparation of these statements. Postulates are basically presumptions that we must make in accounting. For example, the going concern postulate presumes a business will exist for a long time. Hence, we have to treat assets on a historical cost basis.
4. Personal judgments: Even personal opinions and judgments play a big role in the preparation of these statements. Thus, we have to rely on our own estimates while calculating things like depreciation.

Principles

Financial reporting standards provide principles for preparing financial reports and determine the types and amounts of information that must be provided to users of financial statements, including investors and creditors, so that they may make informed decisions.

1.) Principle of Consistency

Accountants commit to applying the same standards throughout the reporting process, from one period to the next, to ensure financial comparability between periods. Accountants are expected to fully disclose and explain the reasons behind any changed or updated standards in the footnotes to the financial statements.

2.) Principle of Sincerity

The accountant strives to provide an accurate and impartial depiction of a company’s financial situation.

3.) Principle of Permanence of Methods

The procedures used in financial reporting should be consistent, allowing comparison of the company's financial information.

4.) Principle of Non-Compensation

Both negatives and positives should be reported with full transparency and without the expectation of debt compensation.

5.) Principle of Prudence

Emphasizing fact-based financial data representation that is not clouded by speculation.

6.) Principle of Continuity

While valuing assets, it should be assumed the business will continue to operate.

7.) Principle of Periodicity

Entries should be distributed across the appropriate periods of time. For example, revenue should be reported in its relevant accounting period.

8.) Principle of Materiality / Good Faith

Accountants must strive to fully disclose all financial data and accounting information in financial reports.

Aims and Scope

Financial Reporting provides a forum for quality research contributions with theoretical, practice and policy implications using either quantitative or qualitative research methodologies, with the objective to promote an European debate among scholars.

Topics of interest for the journal are:

 accounting information (standard setting process, impact and application of accounting standards, theoretical foundations of accounting);

 financial disclosure;

 social and environmental accounting and accountability;

 intellectual capital reporting;

 auditing of financial reporting;

 corporate governance and accountability;

 relationship between management accounting and financial accounting;

 information systems;

 relationship between academy and practice on accounting topics.