This chapter in focus This chapter introduces the nature and purpose of financial accounting: what it is, who is interested in it, how it is used. It sets the scene as we endeavour to make sense offinancial accounting. We discover that financial accounting is about placing financial values on the transac- tions that occur in a particular period - be it a day, a week, a month, a year, the recording of those values, and the compilation and presentation of financial information in a range of financial statements. We identify those financial statements – the income statement, the cash flow statement, and the balance sheet, and look in outline at theircontent and uses. We see that the financial statements contain information which is ofuse to a range of interested parties for a range of reasons. We identify those users and the reasons they are interested in financial accounting information. In so doing we distinguish between financial accounting for external reporting purposes, and manage- ment accounting for internal information purposes. We also look at the types oforganizations which exist and some of the characteristics. The chapter sets a foundation for the content of subsequent chapters in this book. Chapter First thoughts about financial accounting By the end of this chapter you will you will be able to: Explain the nature and role of financial accounting. Identify different types of organizations Distinguish between the limited liability and unlimited liability status of owners of businesses Understand in principle the nature of financial valuation of transactions Identify the main financial statements – income statement, cash flow state- ment, balance sheet -used to present and communicate to users of financial information Identify the main users of financial information and discuss their needs Distinguish between financial accounting and management accounting. Intended outcomes 2
This chapter introduces the nature and purpose of financial accounting: what it is, who
is interested in it, how it is used. It sets the scene as we endeavour to make sense of
financial accounting.
We discover that financial accounting is about placing financial values on the transac-
tions that occur in a particular period - be it a day, a week, a month, a year, the
recording of those values, and the compilation and presentation of financial informationin a range of financial statements. We identify those financial statements – the income
statement, the cash flow statement, and the balance sheet, and look in outline at their
content and uses. We see that the financial statements contain information which is of
use to a range of interested parties for a range of reasons. We identify those users and
the reasons they are interested in financial accounting information. In so doing we
distinguish between financial accounting for external reporting purposes, and manage-
ment accounting for internal information purposes. We also look at the types of
organizations which exist and some of the characteristics.
The chapter sets a foundation for the content of subsequent chapters in this book.
Chapter First thoughts about financialaccounting
By the end of this chapter you will you will be able to:
Explain the nature and role of financial accounting.
Identify different types of organizations
Distinguish between the limited liability and unlimited liability status of
owners of businesses
Understand in principle the nature of financial valuation of transactions
Identify the main financial statements – income statement, cash flow state-
ment, balance sheet -used to present and communicate to users of financial
information
Identify the main users of financial information and discuss their needs
Distinguish between financial accounting and management accounting.
This chapter is designed as an introduction. Accordingly, it imparts information, and
provides illustrations and examples, setting a foundation for later chapters. Consequently
there are no end-of-chapter exercises as there is plenty of work to do later on in other
chapters!
Imagine you start up a business. Think about the types of financial transactions your
business might become involved with. There would be funding transactions: cash from
yourself, perhaps from other owners, possibly a bank loan. The business would then
buy equipment to use over a number of years. Rent might have to paid, along with
salaries, insurance, power costs, in addition to bank loan interest. Even some of the
bank loan might be paid back! And, of course, it is to be hoped that customers buy the
goods/services your business is offering for sale, and thus they might actually pay
some cash to the business. Whatever the types of transactions they will need to
recorded, on paper in a book, or on a spreadsheet on a computer, or on a main frame
computer. We look more closely at some of the intricacies associated with what we
record and how later in this chapter. Before that, we should consider who uses
accounting information and why.
From what we have read earlier, we have established that Accounting accounts for
financial values of the transactions of an business taking place in a particular financial
period. Businesses devote a considerable amount of time, effort and resources to
placing financial values on those transactions. The resulting financial information,particularly when presented in the formats of the income statement, cash flow state-
ment and balance sheet, are of use to a range of interested parties. These provide
financial information for a range of users to help them make better judgements and
decisions concerning a business. Accordingly Accounting may be said reflect the process
captured in figure 2.1.
The users of accounting information
Accounting for what?
Accounting is the process of
Identifying
Collecting Measuring
Analysing, and
Communicating the financial information of an organization to enable users
Figure 2.1 A first glance at the process of Accounting
of the information to make informed judgements and decisions.
Reliability is concerned with ensuring that accounting information is free from
significant errors or bias. In a large business there are large volumes of transactions and
as they are being recorded it is possible that mistakes are made. Also, if a business has a
building which it purchased five years ago for £1 million and it states that the building is
today worth £2 million, a user may make a decision based on that information. If the
information were incorrect – say the value were only £200,000 and not £2 million, the
user would make in an inappropriate decision based on information which turned outto be unreliable. Bias is another are of concern which produces unreliability. For exam-
ple, directors of a business may decide to try and overstate profits on the basis that the
share price may increase, and they may receive higher bonuses. (As an aside, larger
incorporated business – companies – are required to have their accounts audited by
independent auditors.)
Financial statements should reflect information that is material – significant in the eyes
of users. For example, if there is the real threat of a possible court case for injury com-
pensation and the business feels it may well find itself paying out a large sum of cash
damages in the future, this should be reflected in the accounts. There may other aspects
of business life which are not significant and their inclusion would serve to only gener-
ate information overload.
To be understandable, accounting reports and financial statements should be presented
in ways users can access and understand easily. Sometimes reports will be supplemented
by diagrams and pictures, using bar charts and graphs.
The quality of comparability enables users to make comparisons period by period. For
example, one aspect of accounting we consider later in this book is depreciation (do not
‘
‘
‘
‘
30 Making Sense of Accounting for Business
worry about its nature yet!). If in one year depreciation is calculated on one particular
basis and presented in the accounts on that basis, if next year depreciation is calculated on
a completely different basis then it is difficult to make year by year sensible comparisons.
As we discover later there are more complicated matters associated with comparability.
It is tempting to assume the accounting process will generate page after page of account-
ing information. Indeed, this is entirely possible. However, recording, generating and
presenting financial information takes time and cost money. There is no point in gener-
ating information which is of little practical use, particularly if it costs more money to
produce than the value of the benefit it will bring. Accordingly, a cost-benefit analysis
should be applied. This trade-off is presented in Figure 2.3.
The cost-benefit idea applies whether the information being generated is for users
who external to the business or internal. This raises the matter of the distinction
between information for external use and for internal use.
The distinction between financial accountingand management accounting: a closer look
Accounting has two main strands – management accounting and financial accounting.
Management accounting seeks to meet the needs of the business’s managers as they
seek to manage the business: planning ahead and making decisions. Financial account-
ing is concerned with external reporting: seeking to meet the needs of a range of external
user groups. These two strands differ in terms of the types of reports produced, the level
The cost of accounting information versus its usefulness
of reporting detail, the time horizon, the degree of standardization, and the range and
quality of information provided. Externally, financial statements such as income state-
ments, cash flow statements and balance sheets are usually prepared on an annual basis
and provide summarized information. External reporting is usually standardized across
organizations and is subject to regulation. Management accounting information also
Figure 2. The cost-benefit trade-off for the generation of accounting information
(Atrill and McClaney, 2008)
31First thoughts about financial accounting
3
includes detailed cost statements for products and services, budget statements and a
range of other information useful for the day to day running of the business. The level of
detail is much greater than in external reporting and is prepared often on a monthly or
even weekly basis. There is no external regulation and the formats are not standardized.
Types of organizations (including businesses)
There are many organizations across the world. Some are commercial businesses, some are
voluntary sector organizations such as charities, some are public sector organizations. All
are involved in activities an transactions and the accounting system in any organization
must concern itself with accounting for those activities and transactions. It is appropriate
to pause and consider as a backdrop to the study of accounting these differing types of
organizations, and their distinguishing characteristics. These are detailed in figure 2.4.
There are two important aspects we must draw from the content of figure 2.4. One is
concerned with the reality of unlimited/limited liability and the other with the notion of
an organization as an entity in its own right for accounting purposes. In an unlimitedliability business, the owner or owners have no protection if the business fails. If the
business owes £1 million and has no realistic chance of paying its bills, the people/
business owed the £1 million can sue the owner(s) for that sum. It is possible the
personal possessions of the owner(s) could seized by a court and sold to pay the debts. If
a business incorporates – it becomes a limited company, the owner s) have liability to pay
the business’ debts limited to the amount invested by them in the company. This protec-
tion comes at a cost as the company has to comply with greater regulation. Once a
business is incorporated as a company, the company has a legal existence of its own. It is
the company which enters into contracts and is responsible for its affairs. There is a clear
legal distinction between the owner(s) – shareholders owning a share of the company,and the company itself. The company’s accounting system thus accounts for the
The organizational world may be divided broadly into two sectors:
PRIVATE SECTOR: Commercial Businesses
NOT FOR PROFIT SECTOR: Voluntary
Organizations, Charities, Universities, Unions, PublicBodies such as Regional Authorities (in the UK = Council)
This text is concerned with BUSINESS ORGANIZATIONS
There are three main forms of business organization:
> Sole proprietorship – easy to set up and flexible to operate but
the owner has unlimited liability – also known as Sole Trader
> Partnership – easy to set up and spreads the burdens of
ownership but partners usually have unlimited liability and there are
ownership risks if the partners are unsuitable
> Limited company – limited liability for owners but obligationsimposed on the way a company conducts its affairs.
Figure 2.4 Types of organizations and some distinguishing characteristics
(
32 Making Sense of Accounting for Business
activities and transactions of the company in its own right. Where unlimited liability
staus exists, although there is no legal distinction between the owner(s) and the busi-
ness, for accounting purposes the business is treated as an entity, and it is the activities
and transactions of the business which are accounted for.
Building upon our earlier first look at a range of types of transactions, we now meet theconcept of the business cycle and the associated flow of finance. Businesses obtain fund-
ing from a range of sources. This funding is then used to a) acquire assets – buildings,
equipment, motor vehicles as examples, and b) to help pay day to day operating
costs – salaries, power, insurance, materials as examples. The business is then required to
undertake operations with a view to generating profit. The profit generated when day
to operating costs are deducted from sales is usually referred to as the operating profit.
Thereafter, the business will take account of any interest it has paid or interest it has
Meeting the business cycle and flow of finance in a business
received, producing the net profit. In an unlimited liability business, any tax on profits is
the personal responsibility of the owner(s) and does not enter into the financial state-
ments. Again, in such businesses, if profits are withdrawn, these are referred to as
drawings. In an incorporated business, a company, the company is responsible for tax on
its profits. After any tax obligations have been deducted, what remains – the profit after
tax, belongs to the owners, the shareholders. The shareholders will discuss with thedirectors how much the company needs for reinvestment and how much should be
withdrawn – dividends – by the owners. What is not withdrawn is retained by the com-
pany. Such retentions still belong to the shareholders and are, in effect, an additional
investment. This process can be captured within the business cycle and is shown in
Figure 2.5. Note that the terminology used is in relatively plain language.
The Business Cycle Concept
OperatingProfit
ReinvestedProfits
ObtainFinancingSales
Assets
Owners’Earnings
Net
Profit
InterestOut & In
Dividends
Taxation
Day to DayOperating Costs
For LimitedCompanies
Dividendsor
Drawings
Figure 2. The business cycle (adapted from Parkinson, 1997)
33First thoughts about financial accounting
5
The task of the accounting process is to account for the financial flows – the flow of
finance – which accompany the stages in the business cycle. In particular, the accounting is
concerned with comparing the balance sheet at the start of the financial period at the start
of a financial period (perhaps a particular year) with the balance sheet at the end of the
financial period). The balance sheet may be seen as being a photograph of the financial
position of the business at a particular point in time. It shows the sources of funding and
the assets funded by the funding, with those assets being available for use by the businessto enable profits to be generated. If the opening and balance sheets are compared, it may
well be that the pictures presented differ. It is not unreasonable to ask why there are differ-
ences. This is because during the year there will have been many activities and transactions
undertaken by the business. As a consequence, the closing balance sheet is likely to differ
from the opening balance sheet. The asset of cash will have changed as cash will have been
entering and leaving the bank on a regular basis. New equipment may have been pur-
chased, or sold. Sales are likely to have been generated. Insurance, power costs, other costs
may have been incurred and paid. The owners may have withdrawn profits, re-investing
the remainder. The accounting process should enable the business at the end of the finan-
cial period to show the opening and closing balance sheets and account for, explain, how
the differences between them have occurred. It this explanation we look at next in outline.
Explaining the differences between opening and closingbalance sheets
Immediately above we have noted that because of activities and transactions the
closing balance sheet may well differ from the opening one. To explain, to account for
the differences, it would make sense to record and present the financial value of, for
example, the sales, wages paid, asset purchased and so on. This is easier said than
done, given the nature of business transactions. For example, imagine the sales gener-
ated in a financial year total £150,000. It would not be unreasonable to assume that the
accounting system will record and present sales of £150,000 as being one cause of
differences between opening and closing balance sheets. However, imagine that all of
the sales are on credit terms and by the end of the year, because bills/invoices are
lodged somewhere in a payment process system, only £135,000 of the total sales valueof £150,000 has been received in cash. This creates a challenge: present sales as
£150,000 or as £135,000? In fact, both are recorded and presented. On the cash flow
statement the £135,000 is recorded. The income statement (also known as the profit
statement or profit and loss account) records the financial value of the sales in the
period, £150,000. Similarly, imagine the business has some operating expenses of
£5,000 each month, paid for with one month’s delay. Consequently the financial value
of these particular operating expenses is £60,000 for the year (12 months £5,000)
but the total cash paid is £55,000. The system records the expenses as £60,000 on the
income statement but only £55,000 on the cash statement. For sales, the ‘missing’
£15,000 does not disappear. At the end of the year it is shown as an asset of £15,000 on
the balance sheet. The ‘missing’ £5,000 for the bills not paid appears on the year endbalance sheet as a source of funding. It is a source of funding on the basis that if a
supplier provides a business with goods/services and does not receive payment imme-
diately, for the length of time it takes to pay the bill, the business ‘holds on’ to the
money and retains it for a while and is able to use it for other purposes. What happens
on the balance sheet is that the Funding section is usually divided into funding from
owners, referred to as equity and funding from others such as suppliers and banks.
Funding from non-owners are usually referred to as liabilities.
,
34 Making Sense of Accounting for Business
A further challenge is found in accounting for the purchase and use of assets such as
equipment. Imagine our business purchases a piece of equipment for £50,000, and it will
be used for five years. The cash statement will show a decrease of £50,000. The income
statement will, however, not show a charge of £50,000. If year 1’s income statement were
charged with all of the £50,000 it would be somewhat unfair on the measurement of year
1’s profit. After all, years 2 through to 5 will benefit from the use of the equipment.
Perhaps each income statement for each of the five years should receive a charge for the
use of the equipment based on the purchased price. It would not be unreasonable to
charge depreciation of £10,000 for each year, derived from £50,000 divided by five years.
(The accountants call this straight line depreciation. There are other possible approaches
Clearly, the process of accounting is thus not as straightforward as merely recording
cash in and out. There are principles to be applied as the accounting system records and
generates financial information as the financial statements are being prepared.
One challenge faced by those meeting the principles of financial accounting for the
first time is that of terminology. Not only is there the challenge of meeting it for the first
time and understand it (let alone remembering it!) is the reality that often accountants
use more than one term to describe the same idea or object. Figure 2.7 shows the busi-
ness cycle with alternative terms which are sometimes used in the world of accounting.
Compare the terms used in figure 2.7 with those shown in figures 2.5 and 2.6. Their
meaning is the same and they are used synonymously and inter-changeably in the world
of accounting. It is important that these terms are understood and grasped as they are
used throughout this text.
35First thoughts about financial accounting
Look atfigure 2.6. This reflects our considerations of financial accounting thus far.
Accounting for the Business Cycle
Finance 13
Operating
Profit
Reinvested
Profits
Obtain
FinancingSales
Assets
Owners’
Earnings
Net
Profit
Interest
Out & In
Taxation
Day to Day
Operating Costs
The accountantsattach numbers tothe boxes and theboxes are groupedtogether, thosegroups becomingfinancial statements
The BALANCE SHEET
comprises AllSOURCES OF FUNDING
represented by INVESTMENT
IN ASSETS to be used in the
business.
The CASH FLOW STATEMENT
summarises ALL cash ins/out
in a period. The INCOME
STATEMENT summarises the
period’s VALUE (irrespective
of cash flow timing) of
operational transactions
For Limited
Companies
Dividendsor
Drawings
Figure 2.6 Accounting for the business cycle (adapted from Parkinson, 1997)
example.
delve further beneath the surface of the intricacies of financialLater we willaccounting. For the moment we will illustrate our considerations thus far with a simple
Terminology for the Business CycleTerminology for the Business Cycle
EARNINGS BEFORE
INTEREST& TAX (EBIT)
RESERVES
FUNDINGREVENUE
ASSETS
PROFIT FOR
YEAR (PAT)
PROFITBEFORE TAX
NET FINANCING
INCOME/(COSTS)
Dividends
Taxation
OPERATING
For Limited
Companies
Dividends
or
DrawingsEXPENSES
Figure 2.7 The business cycle with alternative terminology(adapted from Parkinson, 1997)
Illustrating the principles: a simple example
Imagine a sole trader starts a business with £10,000 cash, comprising £5,000 of their
own money as capital and a bank loan of £5,000 (repayable over five years at an annual
interest rate of 10%) and places that cash in a business bank account. The trader
intends to buy and sell calculators designed for use by those studying accounting. The
business pays rent of £1,000 in cash for the year and buys equipment, to be used for
five years, for £5,000 cash. It also buys across the year calculators from suppliers, on
credit terms, receiving bills totalling £20,000 but by the end of the year £5,000 of that
sum remains unpaid. Also, of the calculators the business had purchased for resale, on
75% ( £15,000 of the £20,000 cost) had been sold, with the balance still in the store-
room waiting to be sold in a future period. Sales are on credit terms and sales total
£40,000 across the year. By the end of the year, however, £10,000 of that £40,000 has
not been paid by the customers. There are other costs for power and insurance totalling
£1,000 which have all been paid for in cash. Interest payments to the bank totalled£500 and at the end of the year the business repaid £1,000 of the bank loan. At the end
of each month, the owner withdrew £12,000 in cash as drawings, taking out some of the
profits made by the business but belonging to the owner.
From our earlier considerations we are aware that the business should at the end of the
year show the opening balance sheet, the closing balance sheet, and an income statement
and cash flow statement to explain the differences between the opening and closing
balance sheets. Of course, as this is new business there is no opening balance sheet to show.
The cash statement, prepared on a simple cash in, cash out basis is shown in table 2.1.
The figures are shown in two columns for no other reason than to facilitate clear presenta-
tion of sub-totals. Note that when published, the cash flow statement is rearranged into a
different format. We look at published cash flow statements later.
The income statement (also known as the profit statement or profit and loss account)
is shown in table 2.2. Note that the statement is prepared not on a cash basis but on thebasis of financial values of what has taken place in the financial year, irrespective of
whether or not the cash flow takes place at the same time. It shows the value of total
sales and matches against the sales values the financial value of expenses incurred
(whether paid or not) in generating those sales. This is referred to by accountants as the
matching principle . It is well illustrated by the depreciation charge of £1,000 (derived
from equipment cost of £5,000 divided by the useful life of 5 years). As the equipment is
to be used over five years the total cost of £5,000 is matched to the periods benefiting
from its use, that is, five periods. Another example of the matching principle is shown
where the expense cost of the calculators of £15,000 (75% of the total purchased for
£20,000) is matched against the sales for this period. Note how the ordering and
presentation maps onto the ordering shown in the business cycle figures we met earlier.
As this is a trading business, buying and reselling goods rather than selling services, the
income statement shows a section at the top which details the cost of goods sold
matched against the sales achieved for those goods. This section is sometimes referred
to as the trading section of the income statement. The difference is referred to as gross
profit and the business will wish to make enough gross profit to cover the other
expenses for the year. Also note that the interest expense of £500 appears on this state-
ment. The £1,000 of the bank loan that has been repaid does not appear here as it is a
reduction the amount owed to the bank It will be shown on the balance sheet (which
we look at in table 2.3), with the cash having been reduced by £1,000 and the amount
(the liability) owing to the bank being correspondingly reduced on the balance sheet.
Example 2.1continued
Simple cash flow statement for Year 1
Item £ £
Cash inflows
Capital from owner 5,000
Cash proceeds from bank loan 5,000Cash from credit customers 30,000
Key points This chapter provides insights into the purpose and nature of financial
accounting. It distinguishes between financial and management accounting. It
identifies the idea of the business cycle and its relationship with the realities of
business life. It establishes the need for businesses to record the financialvalue of transactions they are involved with in a particular period. It then
shows how they are presented in three core financial statements: the income
statement, the cash flow statement, and the balance sheet. In so doing it high-
lights the significances of the distinction between profit and cash, and the idea
of the matching principle. It also introduces key terms used in the language of
the world of accounting.
This chapter is very important if we are to understand the process of
financial accounting. Check your learning from this chapter against the
intended outcomes stated at its start. Accounting is a cumulative subject and it
is difficult to read one chapter and make sense of it without having read all of
the previous chapters. Establish a firm foundation for your subsequent consid-
erations, as we embark on making sense of financial accounting.
40 Making Sense of Accounting for Business
The balance sheets shown in Tables 2.3 and 2.4 are for a business which belongs to a sole
trader: it is an unlimited liability entity, it is not a limited company.
Accounting regulation for Ppublic limited companies requires the following terminology: Fixed assets = Non-current assets. Long term liabilities = Non-current liabilities.
A note on balance sheet terminology
Additionally, public limited companies refer to the balance sheet as the statement of
