6
Constructing Financial Statements
and the Framework of Accounting
This chapter introduces each of the principal financial statements, beginning with
the Profit and Loss account and Balance Sheet. It begins with an overview of the
regulations governing financial statements and describes the matching principle,
which emphasizes prepayments, accruals and provisions such as depreciation. The
chapter then describes the Cash Flow statement and the management of working
capital. It concludes with an introduction to agency theory.
Financial accounting
Accounting provides an account– an explanation or report in financial
terms – about the transactions of an organization. Accounting enables managers
to satisfy thestakeholdersin the organization (owners, government, financiers,
suppliers, customers, employees etc.) that theyhave acted in the best interests of
stakeholders rather than themselves.
These explanations are provided to stakeholders through financial statements
or reports, often referred to as the company’s ‘accounts’. The main financial reports
are the Profit and Loss account, the Balance Sheet and the Cash Flow statement.
The first two of these were introduced briefly in Chapter 3.
The presentation of financial reports must comply with Schedule 4 to the Com-
panies Act, 1985, which prescribes the form and content of accounts. Section 226
of the Act requires the financial reports to represent a ‘true and fair view’ofthestate
of affairs of the company and its profits. The Companies Act requires directors
to state whether the accounts have been prepared in accordance with accounting
standards and to explain any significant departures from those standards. For
companies listed on the Stock Exchange, there are additional rules contained in
the Listing Requirements, commonly known as theYellow Book,whichrequires
the disclosure of additional information.
There is a legal requirement for the financial statements of companies (other than
very small ones) to beaudited. Auditors are professionally qualified accountants
who have to conduct anaudit– an independent examination of the financial
statements – and form an opinion as to whether the financial statements form a
true and fair view and have been prepared in accordance with the Companies Act.