Requirements of the Companies Act 1985
The Companies Act 1985 specifically states that the directors of every company shall prepare for the company for each financial year:
- A balance sheet as at the last day of the year,
- A profit and loss account.
In addition they should include:
- A directors’ report
- An auditors’ report, and
- Notes to the accounts.
Financial accounts will also normally include a cash flow statement and a chairman's statement.
Statutory audit requirements
In the case of ‘large’ companies the financial statements must also be audited by an independent auditor. This audit is to provide assurance to the shareholders of the company that the financial statements, as prepared by the directors of the company, are true and fair. The audit is required to bridge the information gap between the owners of the business and the management of the business.
Up until 1994, all companies were required to have an audit but it has been acknowledged that small companies are usually owner managed and thus an audit provides no extra assurance to the owners of the business. In addition, the costs associated with an independent audit of a small company were often excessive and could impose hardship on those companies.
In essence, companies whose turnover is below £90,000 and whose total assets do not exceed £1.4m are fully exempt from the statutory audit requirement. Companies with turnover between £90,000 and £350,000, and with total assets under £1.4m, are also exempt from audit but require an independent accountant’s report. It should be noted however, that certain companies, for example banks, insurance companies, public companies, are never exempt from the requirement of a statutory audit.
There is no similar legal requirement for sole traders and partnerships to prepare financial accounts.
Financial accounts and the fundamental accounting concepts
'It is fundamental to the understanding and interpretation of financial accounts that those who use them should be aware of the main assumptions on which they are based.' SSAP 2
The fundamental accounting concepts are defined as broad basic assumptions which underlie the periodic financial accounts of companies. These concepts as set out in SSAP 2 include:
- The going concern concept,
- The accruals concept,
- The consistency concept, and
- The prudence concept.
The going concern concept
This concept underpins the preparation of financial statements. Preparing accounts under this concept means that the business will continue in operational existence for the foreseeable future. This means in particular, that the profit and loss account and balance sheet assume no intention or necessity to liquidate or curtail significantly the scale of operations. Therefore it must be established when preparing the accounts whether the going concern concept will apply or not. This concept differs from the others for this reason - it may or may not apply. The others apply automatically.
The accruals concept
This concept is sometimes referred to as the matching concept. Revenue and costs are recognised as they are incurred, not as the money is actually received or paid. In addition, income and expenditure are matched where possible. This ensures that revenue and profits and the associated costs incurred in earning them are included in the same profit and loss account.
Where application of the accruals concept is inconsistent with the prudence concept, prudence prevails.
To illustrate the accruals concept, consider a business that receives a regular telephone bill. These bills are normally received in arrears. The accruals concept requires that the telephone charge should be accounted for in the period in which the telephone was used. User Ltd normally incurs telephone charges of £200 per month. Its year end is 31 December and the next quarterly bill is due on 31 January. User Ltd needs to recognise two months telephone costs in its 31 December accounts. This ensures that the telephone costs incurred during the year are matched with the revenue they helped to generate.
The double entry would be:
The consistency concept
This concept requires that like items within each accounting period, and from one period to the next, should have consistent accounting treatment.
The prudence concept
This concept is sometimes known as conservatism. It ensures that revenue and profits are not anticipated, but recognised only when they are realised in the form of cash or of other assets whose transfer into cash can be assessed with reasonable certainty.
A provision for all known liabilities should be made as soon as their existence becomes apparent. Where the amount is not known with certainty a best estimate should be used.
Management accounts
As the name might suggest, management accounts are prepared for management for the purpose of management. Management accounts are designed to accumulate summary accounting information that management can then use to make decisions, to plan and to control the operations of the business.
Management accounting can be sub-divided into two parts: cost accounting and management accounting.
What is the purpose of cost accounting?
Cost accounting is defined by The Chartered Institute of Management Accountants (CIMA) as:
"That part of management accounting which establishes budgets and standard costs and actual costs of operations, processes, departments or products and the analysis of variances, profitability or social use of funds".
It is primarily a cost gathering procedure, which provides the financial accountant with information for stock valuation and provides the management accountant with information to estimate future costs.
What is the purpose of management accounting?
Management accounting information should allow managers to assess the viability of alternative business strategies, choose between alternative decisions and evaluate the performance of business segments. The management accountant has a varied range of techniques to assist her including budgeting and forecasting.
The form and content of management accounts is the decision of those who need and will use the information. The frequency of the preparation of these accounts is again the decision of the management. To be of use they should be prepared at least quarterly if not monthly.
It is important to note that the source of the information used to prepare management accounts is the same as that for the financial accounts. In fact, a company may start with year end management accounts and reformat them in order to produce the financial accounts. The information contained in both accounts is essentially the same but the way in which this information is disclosed can be quite different.