Accounting Basics

CHAPTER 2 Accounting and accountants
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5 2005 Peter Walton and Walter Aerts
Contents

Accounting function Accounting database Recording transactions Organization of data within the general ledger Control and audit
Internal control Internal audit External audit Corporate governance
Accounting profession
Accounting function
Financial accounting system: objectives and scope Uniform accounting procedures Functional transaction processing systems
Financial accounting system
Objectives:
Track all economic transactions of the enterprise Record and process them logically in a database Provide reporting tools and formats to communicate information useful to decision makers Highly dependent on the size of the company
Scope
Business transactions
Decision makers
Data
Information
Tracking and recording of data
Processing of data
Reporting
Uniform accounting procedures
Uniform accounting systems are central to the coordination and management of an international group Internal accounting manuals to standardize procedures and interpretation of data Uniform accounting rules (like IFRS) versus national accounting rules
Fig. 2.1 Group reporting flows

Subsidiaries Local tax accounts
France
Group financial statements
Parent / holding company
Uniform accounting rules
Italy
(Germany)
Netherlands
Functional transaction processing systems
Functional systems capture different types of transactions according to their main features, like

Sales Purchases Payroll Treasury Investment in long-term capacity
Transaction processing implies interactions between the accounting function and operating departments
Accounting database
General Ledger = central accounting database Primary source of information for internal (management) and external reporting purposes
Figure 2.2 The financial accounting database

Register of amounts owed to suppliers Salaries and social charges Goods received from suppliers Other business expenses Bank account cash in and out Finance from shareholders and banks
General Ledger
Reports to management and outsiders
Register of debts owed by clients
Sale of goods to clients
Purchase of long-term assets
Recording transactions
Information flows into the general ledger through several layers of processing Individual (daily) transactions are summarized by period and by type Through summarization aggregates are buit up for the years activities
Fig. 2.3 Building aggregates

(invoices, payments, receipts, expense notes, etc.)
Daily transactions
prepared by week (or month) and by type of transaction Summaries Summaries
total entered into
General Ledger
Recording transactions (cont.)
Journals Capture details of individual transactions Used to build up periodic summaries and feed aggregated data into the general ledger May be organized according to functional transaction processing systems General ledger Collection of summarized, aggregated transaction data Source for the preparation of periodic income statements and balance sheets
Recording transactions (cont.)
Audit trail
Traces the content of aggregates back to transaction details Used to categorize and record transactions within the accounting database according to the double-entry accounting logic State-mandated or voluntary Automated, flexible reporting tools Using specific tags of individual data items, defined and linked through flexible taxonomies
Chart of accounts
XBRL (eXtensible Business Reporting Language)

Organization of data within the general ledger (G/L)
In the G/L, data are stored according to the double-entry system The G/L is organized into a series of accounts (cfr. chart of accounts): data files to record transactions of a particular type Specifics of an account:

Two columns for figures: debits and credits Narrative commentary Cross-referencing details
Control and audit

Internal control Internal audit External audit Corporate governance
Internal control

Defining internal control Components of a system of internal control Control activities

Preventive
controls Detective controls Corrective controls
Defining internal control
Definition of COSO (Committee of Sponsoring Organizations)
Internal control is a process, established, operated and monitored by those charged with governance and management of a company, to provide reasonable assurance regarding the achievement of objectives in the following categories: a) The effectiveness and efficiency of the companys operations; b) The reliability of its financial reporting; c) Its compliance with applicable laws and regulations.
Internal control objectives (COSO)
Sustaining the companys business operations (efficiency and effectiveness concerns) Preparing reliable financial reporting (including financial statements) Compliance with applicable laws and regulations
Components of a system of internal control (COSO)
A system of internal control consists of five interrelated components:
Control environment Risk assessment Control activities Information and communication Monitoring
Each component is relevant for each internal control objective
Components of a system of internal control

Monitoring Information & Risk Control assessment activities Communication Control environment
IC system components (COSO extracts)
Control Environment
The control environment sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure. Control environment factors include the integrity, ethical values and competence of the entity's people; management's philosophy and operating style; the way management assigns authority and responsibility, and organizes and develops its people; and the attention and direction provided by the board of directors.
IC system components (cont.)
Risk Assessment
Every entity faces a variety of risks from external and internal sources that must be assessed. A precondition to risk assessment is establishment of objectives, linked at different levels and internally consistent. Risk assessment is the identification and analysis of relevant risks to achievement of the objectives, forming a basis for determining how the risks should be managed. Because economic, industry, regulatory and operating conditions will continue to change, mechanisms are needed to identify and deal with the special risks associated with change.
Control Activities
Control activities are the policies and procedures that help ensure management directives are carried out. They help ensure that necessary actions are taken to address risks to achievement of the entity's objectives. Control activities occur throughout the organization, at all levels and in all functions. They include a range of activities as diverse as approvals, authorizations, verifications, reconciliations, reviews of operating performance, security of assets and segregation of duties.
Information and Communication
Pertinent information must be identified, captured and communicated in a form and timeframe that enables people to carry out their responsibilities. Information systems produce reports, containing operational, financial and compliance-related information, that make it possible to run and control the business. They deal not only with internally generated data, but also information about external events, activities and conditions necessary to informed business decision-making and external reporting. Effective communication also must occur in a broader sense, flowing down, across and up the organization. All personnel must receive a clear message from top management that control responsibilities must be taken seriously. They must understand their own role in the internal control system, as well as how individual activities relate to the work of others. They must have a means of communicating significant information upstream. There also needs to be effective communication with external parties, such as customers, suppliers, regulators and shareholders.
Monitoring
Internal control systems need to be monitored--a process that assesses the quality of the system's performance over time. This is accomplished through ongoing monitoring activities, separate evaluations or a combination of the two. Ongoing monitoring occurs in the course of operations. It includes regular management and supervisory activities, and other actions personnel take in performing their duties. The scope and frequency of separate evaluations will depend primarily on an assessment of risks and the effectiveness of ongoing monitoring procedures. Internal control deficiencies should be reported upstream, with serious matters reported to top management and the board.
Control activities
Control activities usually involve a policy component and a procedure component

Policy: establishes what should be done Procedure: actions necessary to implement a policy Preventive controls: P&P designed to prevent an error or fraud from occurring Detective controls: P&P designed to detect an error or fraud as soon as posible Corrective controls: P&P to correct problems in a timely manner
Classification of control activities:
Separation of functions
Separation of functions (segregation of duties) as a preventive control measure It calls for the separation of the four basic functions of transaction processing

Authorizing transactions Executing transactions Recording transactions Safeguarding resources resulting from consummating transactions
The objective is mainly to provide an environment where fraud becomes difficult
Defining internal audit

Internal auditing is an independent, objective
assurance and consulting activity designed to add value and improve an organisations operations. It helps an organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes.
Institute of Internal Auditors
Internal audit process
Primary task:

Examine and evaluate the adequacy and effectiveness of the internal control system Evaluate the quality of performance in carrying out assigned responsibilities
Can be considered to be part of the monitoring component of a IC system Its scope potentially covers all activities within the company
Independence of internal audit
Independence with regard to the acitivities they audit, is essential for the internal audit function Independence should be assured through:
Organizational
the company Recognition of professional objectivity
position and authority within
Internal audit Hierarchical position (1)
CEO
Production manager
Marketing manager
...
CFO
Accounting
Treasury
...
Internal Audit
CEO
Internal Audit
Production manager
Marketing manager
...
CFO
General assembly
Board of directors Management committee
Audit committee
CEO
Internal audit
Institute of Internal Auditors (IIA)
As an international professional body, the IIA provides authoritative guidance Standards for the Professional Practice of Internal Auditing establish ethical (attribute standards) and practice (performance standards) guidelines Certification programme leading to the designation of Certified Internal Auditor
Standards for the Professional Practice of Auditing
Attribute standards 1000 - Purpose, Authority, and Responsibility 1100 - Independence and Objectivity 1200 - Proficiency and Due Professional Care 1300 - Quality Assurance and Improvement Program Performance Standards 2000 Managing the Internal Audit Activity 2100 Nature of Work 2200 Engagement Planning. 2300 Performing the Engagement 2400 Communicating Results 2500 Monitoring Progress 2600 Management's Acceptance of Risks
External audit
External audit = independent audit of a companys financial statements carried out by external auditors
Also referred to as statutory audit
The external auditor expresses an opinion on the representational fairness of the financial statements in conformity with generally accepted accounting principles Reassurance for outside stakeholders that the financial statements are a valid representation of the companys financial position and performance
External auditors
Largest four international networks of external auditors:

PricewaterhouseCoopers
KPMG Ernst
(PwC)
& Young Deloitte
These Big Four dominate the audit market for multinational companies
Basic statutory audit tasks
The basic statutory audit consists of two tasks:
To check that the accounting database effectively picks up all the companys activities and is correct To check that the financial statements are a correct representation of the accounting database, use appropriate accounting policies and are a reasonable representation of the companys real state
Report of the external auditor
The external auditor signs a public report
a standard attestation regarding the representational fairness of the financial statements
The public report may be accompanied by a management letter
Directed to company management (not published) Comments on the audit findings, highlights potential areas of weakness and makes recommendations
Corporate governance
Corporate governance issues arise whenever ownership of a company is separated from its management Central concern = how managements freedom of action may be limited by outside interests Many countries have specific rules, regulations and guidance on corporate governance
Corporate governance recommendations
Chairman of the Board of Directors (BOD) should not be the CEO Appointment of independent or non-executive directors BOD committees with independent directors :
Compensation committee Audit committee Nomination committee
Accounting profession
Main categories of accounting professionals:

Independent auditor Independent accountant Company accountant Specialists licensed to carry out the independent audit required by company law University degree + professional examinations + at least three years as a student in a public auditing firm International variation in nature of scope of statutory audit and in constraints on auditor/client relationship
Independent auditor
Accounting profession (cont.)
Independent accountant
External professionals offering accounting services to (generally small) companies May also provide tax and general consulting services, but not statutory audit services Internal accounting specialists, but not necessarily governed by a professional organization No formal educational prerequisites
Company accountant

Accounting Basics

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CHAPTER 2 Accounting and accountants

Internal control Internal audit External audit Corporate governance

Financial accounting system

Tracking and recording of data

Uniform accounting procedures

Fig. 2.1 Group reporting flows

Group financial statements

Parent / holding company

Uniform accounting rules

Functional transaction processing systems

Sales Purchases Payroll Treasury Investment in long-term capacity

Figure 2.2 The financial accounting database

Reports to management and outsiders

Register of debts owed by clients

Sale of goods to clients

Purchase of long-term assets

Fig. 2.3 Building aggregates

total entered into

Recording transactions (cont.)

Recording transactions (cont.)

XBRL (eXtensible Business Reporting Language)

Organization of data within the general ledger (G/L)

Control and audit

Internal control Internal audit External audit Corporate governance

Defining internal control Components of a system of internal control Control activities

controls Detective controls Corrective controls

Defining internal control

Definition of COSO (Committee of Sponsoring Organizations)

Internal control objectives (COSO)

Components of a system of internal control (COSO)

A system of internal control consists of five interrelated components:

Each component is relevant for each internal control objective

Components of a system of internal control

IC system components (COSO extracts)

IC system components (cont.)

IC system components (cont.)

IC system components (cont.)

Information and Communication

IC system components (cont.)

Control activities usually involve a policy component and a procedure component

Classification of control activities:

The objective is mainly to provide an environment where fraud becomes difficult

Defining internal audit

Institute of Internal Auditors

Internal audit process

Independence of internal audit

the company Recognition of professional objectivity

position and authority within

Internal audit Hierarchical position (1)

Internal audit Hierarchical position (2)

Internal audit Hierarchical position (3)

Board of directors Management committee

Institute of Internal Auditors (IIA)

Standards for the Professional Practice of Auditing

Also referred to as statutory audit

Largest four international networks of external auditors:

& Young Deloitte

Basic statutory audit tasks

The basic statutory audit consists of two tasks:

Report of the external auditor

The external auditor signs a public report

a standard attestation regarding the representational fairness of the financial statements

The public report may be accompanied by a management letter

Corporate governance recommendations