Financial
accounting
A company’s financial accounts classify, quantify, and record its transactions.
They are extremely useful for people outside the business, such as creditors and
potential investors, as well as those currently involved with making investment
decisions. For this reason, the accounts should be concise and clearly present the
timing and certainty of future cash flows, so that people looking at the company
can decide whether or not to invest in, lend money to, or do business with it.
Key elements
The profit-and-loss account,
balance sheet, and cash-
flow statements are the
most important financial
statements in an annual
review, supplemented
by the report’s notes.
To understand these
statements, a knowledge
of accounting principles,
depreciation, amortization,
and depletion is vital.
Accountants also need
to understand the legal
requirements that the
statements must satisfy
and how environmental
laws can affect a business
and its accounts.
Accounting
standards
Generally accepted
principles standardize
practice worldwide
to ensure accuracy
and prevent fraud.
See pp.112–113.
International
standards simplify
account reporting.
Companies must
meet environmental
accounting rules
and regulations.
See pp.122–123.
Profit-and-loss
statement
Shows how much
money a company
is making and is
especially useful for
potential investors
and stakeholders.
See pp.114–115.
Outlines revenues
and gains minus
expenses and losses
or operating costs.
Informs a company
if a profit warning
is needed.
Balance sheet
Gives a snapshot of
how much a business
is worth at a certain
time and is a good
indication of its
long-term health.
See pp.116–119.
Balances company’s
assets against its
equity and liabilities.
Lists different types
of assets, including
tangible fixed assets
and current assets.
$
$
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110 111
how finance works
Financial accounting
$74
billion
the total value lost by
shareholders in the 2001
Enron accounting scandal
The accounts of public companies are
given unbiased scrutiny by external
accountants to check that they are
accurate and clear. This is a legal
requirement in most countries,
designed to ensure market
confidence in the business
world and transparency
in corporate finance. A
company may also have
an internal audit process,
which means that its
accounts are checked
before being submitted
to an external auditor.
AUDITING
Cash-flow
statement
Reveals a company’s
liquidity by tracking
the flow of cash—
money or short-term
investments—in and
out of the company.
See pp.120–121.
Shows if a company
can sustain itself,
grow, and pay debts.
Details cash flow
from operating,
investing, and
financing activities.
Environmental
accounting
Accounts for myriad
environmental rules
and regulations that
oblige companies to
mitigate the impact
of business activities.
See pp.122–123.
Showcases green
credentials in
financial statements.
Reveals compliance
with environmental,
social, and
governance criteria.
Depreciation
Accounts for the
decrease in value
over time of tangible
fixed assets in order
to spread the cost
of assets over their
economic life.
See pp.124–127.
Can be calculated
using a number of
different methods.
Tangible fixed
assets include
buildings, plant,
and machinery.
Amortization
and depletion
Account for the
decrease in value
over time of a range
of intangible assets,
loans, and natural
resources.
See pp.128–129.
Intangible assets
include patents,
trademarks, logos
and copyright.
Natural resources
include minerals
and forests.
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how finance works
Financial accounting
$74
billion
the total value lost by
shareholders in the 2001
Enron accounting scandal
The accounts of public companies are
given unbiased scrutiny by external
accountants to check that they are
accurate and clear. This is a legal
requirement in most countries,
designed to ensure market
confidence in the business
world and transparency
in corporate finance. A
company may also have
an internal audit process,
which means that its
accounts are checked
before being submitted
to an external auditor.
AUDITING
Cash-flow
statement
Reveals a company’s
liquidity by tracking
the flow of cash—
money or short-term
investments—in and
out of the company.
See pp.120–121.
Shows if a company
can sustain itself,
grow, and pay debts.
Details cash flow
from operating,
investing, and
financing activities.
Environmental
accounting
Accounts for myriad
environmental rules
and regulations that
oblige companies to
mitigate the impact
of business activities.
See pp.122–123.
Showcases green
credentials in
financial statements.
Reveals compliance
with environmental,
social, and
governance criteria.
Depreciation
Accounts for the
decrease in value
over time of tangible
fixed assets in order
to spread the cost
of assets over their
economic life.
See pp.124–127.
Can be calculated
using a number of
different methods.
Tangible fixed
assets include
buildings, plant,
and machinery.
Amortization
and depletion
Account for the
decrease in value
over time of a range
of intangible assets,
loans, and natural
resources.
See pp.128–129.
Intangible assets
include patents,
trademarks, logos
and copyright.
Natural resources
include minerals
and forests.
US_110-111_Financial_accounting_overview.indd 111 02/12/2014 14:57
International
accounting standards
With increasing globalization, international accounting standards,
assumptions, and principles that help to make accounting easier across
borders are essential for preparing financial statements.
Transactions by
businesses owned
by one group or
individual are kept
separate from
transactions made
by other companies
owned by that group
or individual.
International economic
activity is expressed in
monetary terms, with
all units assumed to be
quantifiable, constant
and not affected by
inflation or deflation.
The financial activities
of a business will carry
on indefinitely.
Different operations
of a business can be
divided into arbitrary
time periods.
Sales of toothbrushes
can be measured daily,
monthly, quarterly, and
so on (when in reality
they are constant, or
subject to variations that
are not predictable).
Makes financial
reporting easier.
The more often
economic activity
is measured, the easier
it is to identify trends.
Measuring activity
often means more
work, and such data
may multiply errors.
Oil reserves will never
run out; gold in a gold
mine will last forever; a
manufacturer will not
go out of business.
Offers a model for
businesses to look at
the long-term future
of their operations.
It is not applicable
to companies
approaching liquidation,
as it assumes that any
assets are worth their
original value.
Current manufacture
of baseball bats is
compared financially
to manufacture that
was carried out 30 years
ago, without taking
inflation into account.
Shows as much of the
company as possible in
financial statements,
as everything a business
owns can be quantified.
It is hard to measure
monetary value of,
for example, the fastest
worker at the baseball-
bat production plant.
It is hard to compare
across time because
of inflation/deflation.
If a group owns
two companies,
one manufacturing
televisions and the
other retailing cell
phones, the financial
statements for each
company are separate.
Helps the group
of companies and
investors compare
financial statements
of each company
with its competitors.
Largely beneficial
Companies that
operate in the
same group but in
different countries
must prove standard
market rates used for
intra-company trading.
All information, past,
present, or future,
which could affect
financial performance
must be disclosed,
usually in the notes of
financial statements.
If a coconut importer
knows that a hurricane
has damaged next year’s
coconut crop, it must
mention this in its
financial statement.
Provides full information
for shareholders and
potential investors.
Companies may try
to “bury” information
likely to put off investors
or lower the share price
in the notes.
Not all countries
are equipped to root
out transgressors.
Standard Example Purpose
Pros and cons
Economic
Entity
assumption
monEtary unit
assumption
GoinG concErn
assumption
timE pEriod
assumption
Full disclosurE
principlE
Accounting standards
US_112-113_International_accounting.indd 112 02/12/2014 14:57
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HOW FINANCE WORKS
Financial accounting
How it works
International Financial Reporting Standards
(IFRS) are the most widely accepted standards
for accounting, and they are used in more than
110 countries. Originally introduced to harmonize
accounting across Europe, they have with time
spread around the world. IFRS are not to be
confused with International Accounting Standards
(IAS), which were in use from 1973 to 2001. Generally
Accepted Accounting Principles (GAAP), which
are known colloquially as accounting standards or
standard accounting practice, are country-specific
guidelines for recording and reporting accounts.
They differ from one jurisdiction to another.
Assets and liabilities are
valued at their buying
price (in countries
with high inflation or
hyperinflation, other
principles, such as
fair value, are used).
If a company bought a
factory 50 years ago for
$100,000, that will be its
stated value today, even
though its market value
now is far higher.
Ensures uniformity
and prevents the
overvaluation of
assets, which was a
feature of the 1929
Wall Street Crash.
Assets, especially
property, acquired
a long time ago are
invariably represented
as being worth less than
their current real value.
The time period in
which a business’s
expenses and revenue
figures are collected
always concurs.
A grocery store
measures costs incurred
and revenues gained
over the same time
period, because when
sales are high, costs
are also likely to be
high, due to the need
to buy more stock.
Avoids different time
scales, which could
present a distorted
picture and erratic
financial results—for
example, with high
revenues from one
period and high costs
in another.
Helps to present
accounts in a
representative manner.
Revenue should
be recorded at the
moment when:
a) goods or services
are exchanged;
b) assets can be
converted to cash;
c) it is earned—not
when it is received.
A toy-maker takes an
order for 500 toys in
July, delivers it in
September, and is paid
for it in December. The
revenue is recorded in
September, when the
goods were exchanged.
Matches the time
period when work
was undertaken to
payment, as with the
matching principle.
Revenue may not
always be received.
If there are doubts
about a recipient’s
ability to pay, the
company can make
an allowance for
doubtful accounts.
If there are alternatives
for reporting on an
item, accountants
should choose to report
the lower amount of
income or asset gain.
If a company is
involved in a lawsuit,
it must report the
potential losses rather
than the potential gains,
in the notes of the
financial statement.
Prevents companies
from overestimating
money they will make in
the future, then running
into debt if it does not
materialize.
Requires a degree
of objectivity from
accountants: if this
objectivity is absent,
financial reports can
be misleading.
Accountants may
make a professional
decision to go against
any one of the other
principles.
An oil refinery buys
a $100 whiteboard,
which could last
10 years. Under the
matching principle,
it should be billed for
$10 each year, but the
accountant enters it
as a one-time cost.
Saves time for small,
almost insignificant
transactions when
there is no risk of
it being applied
misleadingly.
Saves time on
accountancy.
Makes information
easier to read—for
example, figures can be
rounded to the nearest
dollar, thousand, or
even million dollars.
HISTORICAL COST
PRINCIPLE
MATCHING
PRINCIPLE
REVENUE
RECOGNITION
PRINCIPLE
CONSERVATISM PRINCIPLE OF
MATERIALITY
Accounting standards
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112 113
HOW FINANCE WORKS
Financial accounting
How it works
International Financial Reporting Standards
(IFRS) are the most widely accepted standards
for accounting, and they are used in more than
110 countries. Originally introduced to harmonize
accounting across Europe, they have with time
spread around the world. IFRS are not to be
confused with International Accounting Standards
(IAS), which were in use from 1973 to 2001. Generally
Accepted Accounting Principles (GAAP), which
are known colloquially as accounting standards or
standard accounting practice, are country-specific
guidelines for recording and reporting accounts.
They differ from one jurisdiction to another.
Assets and liabilities are
valued at their buying
price (in countries
with high inflation or
hyperinflation, other
principles, such as
fair value, are used).
If a company bought a
factory 50 years ago for
$100,000, that will be its
stated value today, even
though its market value
now is far higher.
Ensures uniformity
and prevents the
overvaluation of
assets, which was a
feature of the 1929
Wall Street Crash.
Assets, especially
property, acquired
a long time ago are
invariably represented
as being worth less than
their current real value.
The time period in
which a business’s
expenses and revenue
figures are collected
always concurs.
A grocery store
measures costs incurred
and revenues gained
over the same time
period, because when
sales are high, costs
are also likely to be
high, due to the need
to buy more stock.
Avoids different time
scales, which could
present a distorted
picture and erratic
financial results—for
example, with high
revenues from one
period and high costs
in another.
Helps to present
accounts in a
representative manner.
Revenue should
be recorded at the
moment when:
a) goods or services
are exchanged;
b) assets can be
converted to cash;
c) it is earned—not
when it is received.
A toy-maker takes an
order for 500 toys in
July, delivers it in
September, and is paid
for it in December. The
revenue is recorded in
September, when the
goods were exchanged.
Matches the time
period when work
was undertaken to
payment, as with the
matching principle.
Revenue may not
always be received.
If there are doubts
about a recipient’s
ability to pay, the
company can make
an allowance for
doubtful accounts.
If there are alternatives
for reporting on an
item, accountants
should choose to report
the lower amount of
income or asset gain.
If a company is
involved in a lawsuit,
it must report the
potential losses rather
than the potential gains,
in the notes of the
financial statement.
Prevents companies
from overestimating
money they will make in
the future, then running
into debt if it does not
materialize.
Requires a degree
of objectivity from
accountants: if this
objectivity is absent,
financial reports can
be misleading.
Accountants may
make a professional
decision to go against
any one of the other
principles.
An oil refinery buys
a $100 whiteboard,
which could last
10 years. Under the
matching principle,
it should be billed for
$10 each year, but the
accountant enters it
as a one-time cost.
Saves time for small,
almost insignificant
transactions when
there is no risk of
it being applied
misleadingly.
Saves time on
accountancy.
Makes information
easier to read—for
example, figures can be
rounded to the nearest
dollar, thousand, or
even million dollars.
HISTORICAL COST
PRINCIPLE
MATCHING
PRINCIPLE
REVENUE
RECOGNITION
PRINCIPLE
CONSERVATISM PRINCIPLE OF
MATERIALITY
Accounting standards
US_112-113_International_accounting.indd 113 10/11/2016 12:21
How it works
The purpose of the profit-and-loss statement is to show
the profitability of a business during a given period.
Along with the cash-flow statement and the balance
sheet, it is the most important financial statement a
business produces, as it shows investors how
profitable the company is. The statement usually
works by showing revenues and gains, less expenses
and losses from business activities, as well as the
sale and purchase of assets. Businesses that are sole
proprietorships or partnerships are generally not
required to submit profit-and-loss statements.
Profit-and-loss
statement
A profit-and-loss statement is a financial statement that shows all
revenues, costs, and expenses during an accounting period. It is also
known as an income statement, or an income and expense statement.
How to read a profit-and-loss statement
Profit-and-loss statements commonly illustrate the financial performance of a business
over a particular month, quarter, or year. The key pieces of information are the figures for
turnover (or revenue) and operating profit. If profits are going to be lower than expected,
the company may put out a profit warning in advance of releasing the statement.
Profit on ordinary activities before taxation 138.5 137.5
Taxation on profit on ordinary activities (30.6) (44.3)
Profit attributable to shareholders 107.9 93.2
Operating profit 224.0 219.0
Interest payable and similar charges (86.9) (81.7)
Interest receivable 2.9 1.2
Other finance costs (1.5) (1.0)
Turnover 492.1 467.5
Operating costs (268.1) (248.5)
Amount of money taken by the
business over a certain time; in this
case, there was a 5.3 percent increase
in turnover from the previous year
Profit earned from the business’s core
operations after expenses have been
taken off, but before taxes have been
deducted; it does not include money
made on investments
Profit before tax after all
income and expenses have been
taken into account, excluding
extraordinary payments
Level of profit that can
be paid out in dividends to the
company’s shareholders.
Year 2013
£m
Year 2012
£m
Case study: profit-and-loss statement
This statement taken from the 2013 annual review of Wessex Water, a UK utility company,
shows it was making a healthy profit (at the time, the exchange rate was £1 = $1.58).
Figures in parentheses represent negative numbers.
$
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how finance works
Financial accounting
Case study: operating costs
This table breaks down the company’s operating costs in more detail. It is important to
read any notes regarding depreciation and ordinary and extraordinary costs and gains.
Manpower costs 51.7 45.3
Materials and consumables 29.1 26.7
Other operational costs 67.6 63.8
Depreciation 120.3 114.0
Amortization of grants and contributions (0.8) (0.8)
Loss/(gain) on disposals of fixed assets 0.2 (0.5)
268.1 248.5
Operating leases for plant and machinery 1.5 1.2
Research and development 0.1 0.1
Directors’ remuneration 2.1 1.8
Fees paid to the auditor 0.2 0.2
Manpower costs including basic pay
and pensions, overtime payments,
staff training, and maternity leave
Term given to the gradual decline in an
asset’s value, caused by factors such as
wear and tear and market conditions.
Decrease in value over time of
intangible assets or loans
Leasing costs for buildings
and equipment
Research and development carried
out to improve the reliability and
effectiveness of services
Directors’ remuneration including
base salaries and benefits, pensions,
car and health benefits, share options,
and bonuses
Year 2013
£m
Year 2012
£m
Payroll
Salaries and wages paid to staff, temporary
contractors, and indirect labor
Utilities
Water, electricity, and gas; postage and
shipping; transportation
Insurance
Insurance on fixed assets and personal
liability insurance for employees
Phone/internet bills
Cost of telephone, broadband internet,
and mobile devices used by employees
Advertising
Sales and marketing of the company and
its products
Office supplies
Stationery such as pens, paper, and filing
systems, office printers, furniture, lighting
Legal fees and professional services
Accounting and legal fees, payable to
accountants, auditors, and legal advisers
Interest on loans
Interest paid on money borrowed, which
counts as a business expense
Tax
Varying among jurisdictions, this may
include payroll tax and corporation tax
Entertainment
Legitimate costs of business entertaining,
subject to certain criteria being met
TYPICAL EXPENSES
Figures in parentheses represent negative numbers.
Profit or loss on the sale of fixed assets
%
$
$
$
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