Accounting and Auditing

Basic accounting principles and partnership accounts

Accounting rests on concepts and conventions that guide judgment where rules leave room. The business entity concept treats the firm as separate from its owners, so personal drawings are not business expenses. The money measurement concept records only what can be expressed in money. The going concern concept assumes the firm will continue, which justifies carrying assets at cost rather than liquidation value. The accounting period concept divides continuous life into periods for reporting. The accrual concept recognises revenue when earned and expenses when incurred, regardless of cash movement, while the matching concept pairs expenses with the revenues they help earn. Consistency requires the same methods over time unless a change is justified and disclosed, prudence requires caution against overstating assets and income, and materiality permits ignoring trivial items. The dual aspect concept is the foundation of double entry: every transaction affects at least two accounts, and total debits always equal total credits, which is why the accounting equation, assets equal liabilities plus capital, always holds.

Journal, ledger, trial balance and final accounts form the accounting cycle. Errors are classified as errors of omission, commission, principle and compensating errors, and a suspense account holds a difference in the trial balance until the error is found. Rectification follows the logic of reversing the wrong entry and recording the right one. Depreciation allocates the cost of an asset over its useful life; the straight-line method spreads cost evenly, while the written-down value method charges a fixed percentage of the reducing balance, giving higher charges early. Provisions differ from reserves: a provision is a charge against profit for a known liability whose amount is uncertain, while a reserve is an appropriation of profit retained in the business.

Partnership accounting is governed by the partnership deed, and in its absence by default rules that interest on capital and salary are not allowed, partners share profits equally, no interest is charged on drawings, and interest on a loan from a partner is allowed. The profit and loss appropriation account distributes profit after interest on capital, salaries, commission and interest on drawings. On admission of a new partner, the incoming partner brings capital and a share of goodwill, because existing partners sacrifice part of their future profit. Goodwill may be valued by average profit, super profit or capitalisation methods, and the sacrificing ratio, old share minus new share, decides who is compensated. Revaluation of assets and liabilities on admission, retirement or death is recorded through a revaluation account, with profit or loss shared in the old ratio. On retirement, the outgoing partner is paid capital plus share of goodwill, revaluation profit and reserves, and the amount may be paid at once or transferred to a loan account. On death, the executors receive a similar settlement, with profit up to the date of death estimated by time or turnover. On dissolution, realisation account records sale of assets and payment of liabilities, with the order of payment following legal priority, and any deficiency of an insolvent partner is borne by solvent partners in their capital ratio under the Garner versus Murray rule.

Corporate accounting

A company is a separate legal person whose capital is divided into shares. Authorised capital is the maximum the company may issue, issued capital is what is actually offered, subscribed capital is what the public applies for, and paid-up capital is what has actually been received. Shares may be issued at par, at a premium or, within legal limits, at a discount. A premium on issue is a capital receipt credited to securities premium, usable only for specified purposes such as issuing bonus shares or writing off preliminary expenses, never for paying dividends. Calls in arrears reduce the amount received, calls in advance are a liability until adjusted, and forfeiture cancels shares for non-payment of calls, with reissue possibly at a discount limited by the amount previously forfeited. Underwriting covers shares not taken up by the public, for a commission.

Debentures are borrowed capital, issued with a promise to pay interest and repay principal. They may be issued at par, premium or discount, and redeemed at par or premium, with the combinations creating different entries for discount or loss on issue. Redemption may be from profits, from fresh issue, by conversion, or by purchase in the open market, and a debenture redemption reserve is created where required to protect debenture holders. Buy-back of shares allows a company to return surplus cash to shareholders, reduce capital and improve ratios, but it is restricted by conditions on reserves, debt-equity limits and funding from free reserves or fresh issue proceeds, and the shares bought back must be extinguished.

Amalgamation combines two or more companies into one. In the nature of merger, the pooling of interests method combines assets, liabilities and reserves at book values with continuity of ownership. In the nature of purchase, the purchase method records assets at fair values and recognises goodwill or capital reserve as the difference between purchase consideration and net assets acquired. Internal reconstruction reorganises capital without liquidation: share capital is reduced, accumulated losses are written off, assets are revalued, and a capital reduction account absorbs the adjustments. Liquidation winds up the company, and the liquidator's statement of affairs and deficiency account show realisations, payments to preferential and other creditors, and the surplus or shortfall for shareholders. Holding company accounts add consolidation, with minority interest, goodwill or capital reserve on acquisition, and elimination of inter-company balances and unrealised profits.

Cost and management accounting

Cost accounting records, classifies and analyses cost so that managers can control it and price sensibly. Cost is classified by nature into material, labour and expenses, by function into production, administration, selling and distribution, by behaviour into fixed, variable and semi-variable, and by traceability into direct and indirect. Prime cost is direct material plus direct labour plus direct expenses. Works cost adds factory overheads, cost of production adds administration overheads, and total cost or cost of sales adds selling and distribution overheads, with profit added to reach selling price. Overheads are allocated where a cost centre uses a cost wholly, apportioned where a cost is shared on a suitable base, and absorbed into products using a rate such as machine hours or labour hours. Under-absorption or over-absorption arises when actual overheads differ from absorbed overheads.

Marginal costing separates fixed and variable costs and argues that only variable cost is the cost of a product, while fixed cost is a period cost written off against contribution. Contribution is sales minus variable cost, and the profit-volume ratio is contribution divided by sales. Break-even sales equals fixed cost divided by the profit-volume ratio, and margin of safety is actual sales minus break-even sales. These tools support make-or-buy, product mix, shut-down, export order and limiting-factor decisions: when a resource is scarce, rank products by contribution per unit of the limiting factor, not by contribution per unit alone. Standard costing sets predetermined costs, compares them with actuals, and investigates variances. Material price variance reflects price change, material usage variance reflects quantity change, labour rate variance reflects wage change, and labour efficiency variance reflects time change. Fixed overhead variances split into expenditure and volume, and volume further into capacity and efficiency. Budgetary control complements this: functional budgets are built from sales forecasts, a master budget summarises them, flexible budgets adjust for activity levels, and zero-based budgeting justifies every item from scratch rather than rolling last year's figures forward.

Management accounting extends this to responsibility centres, cost, revenue, profit and investment centres, and to transfer pricing between divisions. Activity-based costing improves on traditional absorption by tracing overheads to activities and then to products through cost drivers, which matters most when overheads are large and products differ in complexity. Relevant costing is the guiding principle for short-term decisions: only future costs that differ between alternatives matter, sunk costs are ignored, and opportunity cost, the value of the next best alternative forgone, is included.

Financial statement analysis and standards

Financial statements are analysed to judge liquidity, solvency, efficiency and profitability. Liquidity ratios test short-term survival: the current ratio divides current assets by current liabilities, and the quick ratio removes inventory, which may not convert to cash quickly. Solvency ratios test long-term structure: debt-equity, proprietary ratio, and interest coverage, which divides earnings before interest and tax by interest, showing how many times interest is covered. Activity ratios test efficiency: inventory turnover, receivables turnover and payables turnover, with average collection period derived from receivables turnover. Profitability ratios test earning power: gross profit ratio, net profit ratio, return on capital employed, and return on equity. DuPont analysis decomposes return on equity into profit margin, asset turnover and leverage, showing whether a return comes from operations, efficiency or borrowing. Ratios must be read over time and against peers, not in isolation.

Cash flow analysis under the standard on cash flow statements divides flows into operating, investing and financing activities. Operating flows show cash generated from the core business, investing flows show purchase and sale of long-term assets, and financing flows show borrowing, repayment, share issues and dividends. A firm can be profitable yet cash-poor if profits are locked in receivables and inventory, which is why the cash flow statement is not a duplicate of the profit and loss account. Accounting standards provide the rules that make statements comparable. They prescribe recognition, measurement, presentation and disclosure for items such as inventories, revenue, property, leases, employee benefits, borrowing costs and financial instruments. Convergence with international standards improves comparability across countries but requires judgment in areas such as fair value measurement and impairment.

Auditing and recent trends

Auditing is the independent examination of financial information to express an opinion on whether it presents a true and fair view. It differs from accounting, which prepares the records, and from investigation, which seeks a specific fact such as fraud. Internal audit serves management by reviewing controls, risk and compliance continuously, while external audit serves shareholders and other stakeholders by giving an independent opinion. Statutory audit is required by law, while internal, cost, tax, management and secretarial audits serve particular purposes. The auditor must be independent in fact and appearance, exercise professional scepticism, and follow auditing standards on planning, evidence, sampling, risk assessment and reporting.

Audit evidence must be sufficient and appropriate: sufficiency concerns quantity, appropriateness concerns relevance and reliability, with external evidence generally more reliable than internal evidence and documentary evidence stronger than oral assertion. Vouching traces entries back to source documents, verification confirms the existence, ownership and value of assets and liabilities, and internal control evaluation tests whether the client's systems can be relied upon. The auditor assesses materiality, the magnitude that could influence users' decisions, and audit risk, composed of inherent risk, control risk and detection risk. An unmodified opinion states the statements are true and fair, a qualified opinion states they are true and fair except for a stated matter, an adverse opinion states they are materially misstated, and a disclaimer states the auditor cannot form an opinion because of insufficient evidence. Emphasis of matter draws attention to a disclosed matter without qualifying the opinion.

Recent trends are reshaping the work. Continuous auditing uses technology to test transactions as they occur rather than months later. Data analytics allows testing of whole populations instead of samples. Forensic audit investigates fraud, misstatement and financial crime, combining accounting with legal and investigative skills. Risk-based auditing concentrates effort where misstatement risk is highest. Corporate governance expectations have raised the role of audit committees, rotation of auditors, and reporting on internal financial controls. The enduring principle remains unchanged: an audit provides reasonable, not absolute, assurance, because it relies on sampling, judgment and the possibility of collusion or management override, and the auditor's report must communicate its scope and limits honestly.

Partnership events compared

Costing decisions at a glance