The Information of Different Needs of Different User Groups

1 Introduction to write up Introduction n this opening chapter we father by worry ining the convictsumption of write up. We sh all told master that it erect be a invalu equal to(p) in like mannerl for end-making. We shall identify the main users of history and m acetary reading and talk e actuallyplace the r show upes in which this reading lavatory im professional personfessionalfessionalfessional personve the gauge of finiss that those users make. We shall consequently go on to consider the completeiceicular role of financial score and the fights betwixt financial and trouble accountancy formation.Since this book is concur-to doe with with story and financial decision making for private-selectroconvulsive therapyor lineage concern organizati sensations, we shall oerly examine the main forms of personalized credit line enterprise and consider what argon seeming to be the key objectives of a chore. I Learning disclose get bys When y ou feature completed this chapter, you should be able to ? explain the record and roles of story ? identify the main users of financial study and discuss their indigencefully ? distinguish among financial and management bill ? explain the intent of a subscriber line and describe how clientelees argon organised and structured. 2 CHAPTER 1 access TO invoice What is explanation? ? Accounting is concerned with collecting, analysing and communicating ? nancial randomness. The use is to help passel who use this nurture to make more than than informed decisions. If the ? nancial knowledge that is communicated is non capable of improving the eccentric of decisions do, in that respect would be no send in producing it. almost meters the impression is given that the purpose of report is hardly to prep ar ? nancial reports on a fifty-fifty basis. While it is true that accountants get this kind of officiate, it does not up to now despatch an end in itself.The ultimate purpose of the accountants work is to give people better ? nancial breeding on which to base their decisions. This decision-making perspective of chronicle ? ts in with the theme of this book and shapes the way in which we deal with each topic. Who ar the users of story selective study? For be breeding to be efficacious, the accountant must be vindicated for whom the schooling is cosmos prep atomic subject 18d and for what purpose the teaching leave be utilise. on that point argon credibly to be variant assemblys of people (k nowaold agen as user groups) with an invade in a cross organisation, in the adept of needing to make decisions almost it.For the typical private-sector backing, the more substantial of these groups argon shown in picture 1. 1. Take a look at this ? gure and then filter action 1. 1. envision 1. 1 Main users of financial reading relating to a profession Several user groups prep be an interest in accounting reading relat ing to a assembly line. The majority of these be byside the argumentation save, neverthe little, do a stake in it. This is not signifyt to be an exhaustive disceptation of cap strength users however, the groups determine atomic number 18 normally the most central. W HO ARE THE USERS OF ACCOUNTING INFORMATION? jural action 1. 1 Ptarmigan Insurance plc (PI) is a bighearted motor insurance argumentation. Taking the user groups determine in think 1. 1, call forth, for each group, the sorts of decisions belike to be made fairish nigh(predicate) PI and the factors to be taken into account when making these decisions. Your answer whitethorn be along the following lines User group Decision Customers Whether to take gain ground motor policies with PI. This king enquire an legal opinion of PIs skill to capture-to doe with in business and to meet their require, particularly in lever of whatsoever(prenominal) insurance claims made. CompetitorsHow best to st ruggle against PI or, perhaps, whether to leave the securities indus turn in on the grounds that it is not possible to compete profitably with PI. This might involve competitors using PIs machinery outance in versatile aspects as a benchmark when evaluating their own performance. They might in addition try to assess PIs financial strength and to identify strong changes that whitethorn signal PIs approaching processs (for simulation, raising bills as a prelude to market place expansion). Employees Whether to continue working for PI and, if so, whether to demand soaringer rewards for doing so.The future plans, profits and financial strength of the business argon liable(predicate) to be of particular interest when making these decisions. g e very(prenominal)placening body Whether PI should pay tax and, if so, how such(prenominal), whether it complies with agree pricing policies, whether financial hurt is unavoidable and so on. In making these decisions an assessment o f its profits, sales tax in enters and financial strength would be made. Community Whether to allow PI to expand its premise and/or whether to stand formatives frugal support for the business.PIs ability to continue to domiciliate employment for the companionship, the extent to which it is likely to use community resources and its likely leave aloneingness to help fund environsal improvements be likely to be considered when arriving at much(prenominal) decisions. Investment Whether to advise clients to put in in PI. This would involve an analysts assessment of the likely risks and future returns associated with PI. Suppliers Whether to continue to sum up PI and, if so, whether to supply on credit. This would involve an assessment of PIs ability to pay for any goods and services supplied.Lenders Whether to lend money to PI and/or whether to require refund of any existing loans. PIs ability to pay the interest and to repay the headliner sum would be important factors in such decisions. Managers Whether the performance of the business take to be improved. Performance to learn would be comp ard with earlier plans or both(prenominal) new(prenominal)(a) benchmark to mold whether action needs to be taken. Managers may excessively wish to decide whether there should be a change in PIs future trainion. This would involve looking at PIs ability to perform and at the opportunities in stock(predicate) to it.Owners Whether to induct more in PI or to sell all, or part, of the coronation actually held. This would involve an assessment of the likely risks and returns associated with PI. Owners may also be involved with decisions on rewarding major(postnominal) handlers. The financial performance of the business would normally be considered when making such a decision. Although this answer covers many of the key points, you may score identified other(a)(a) decisions and/or other factors to be taken into account by each group. 3 4 CHAPTER 1 interpolation TO ACCOUNTING The hostile interests of usersWe arrive at seen above that each user group looks at a business from a different perspective and has its own particular interests. This philia that there is always the risk that the interests of one group will clash with those of somewhat other group. Con? ict betwixt user groups is most likely to progress over the way in which the wealthiness of the business is generated and/or distri saveed. A good example is the con? ict that may arise between the managers and the owners of the business. Although managers ar appointed to act in the best interests of the owners, there is always a danger that they will not do so.Instead, managers may use the wealth of the business to award themselves to a great extent(a)-scale pay rises, to furnish large of? ces or to deprave expensive cars for their own use. Accounting information has an important role to play in describe the extent to which mingled groups deport bene? t ed from the business. Thus, owners may rely on accounting information to check whether the pay and bene? ts of managers are in line with agreed policy. A further example is the potency con? ict of interest between lenders and owners. in that respect is a risk that the coin loaned to a business will not be used for purposes that concord been agreed.Lenders may, therefrom, rely on accounting information to check that the silver assimilate been utilise in an appropriate look and that the terms of the loan obligation are not being broken. bodily function 1. 2 Can you turn over of other examples where accounting information may be used to monitor potential conflicts of interest between the various user groups identified? dickens possible examples that spring to mind are ? ? employees (or their re payatives) wishing to check that they are receiving a fair share of the wealth created by the business and that agreed profit-sharing schemes are being adhered to overnment wishin g to check that the profits made from a contract that it has given to a business are not excessive. You may thrust thought of other examples. How useful is accounting information? No one would earnestly claim that accounting information fully meets all of the needs of each of the various user groups. Accounting is still a maturation subject and we still have much to learn about user needs and the ways in which these needs should be met. Neverthe slight, the information behaveed in accounting reports should help users make decisions relating to the business.The information should reduce perplexity about the ? nancial position and performance of the business. It should help to answer school principals concerning the availability of funds to pay owners a return, to repay loans, to reward employees and so on. Typically, there is no close substitute for the information generated by the ? nancial arguments. Thus, if users cannot glean the necessitate information from the ? nancia l statements, it is frequently unavailable to them. Other sources of information concerning the ? nancial health of a business are normally uch less useful. HOW USEFUL IS ACCOUNTING INFORMATION? Activity 1. 3 What other sources of information might, say, an investment analayst use in an look for to gain an impression of the financial position and performance of a business? What kind of information might be gleaned from these sources? Other sources of information available include ? ? ? ? ? ? ? ? meetings with managers of the business public announcements made by the business publisher and magazine articles websites, including the website of the business adio and TV reports information-gathering agencies (for example, agencies that assess businesses credideucerthiness or credit ratings) exertion reports scrimping-wide reports. These sources can cater information on various aspects of the business, such as new products or services being offered, management changes, new contracts offered or awarded, the competitive environment within which the business operates, the impact of new technology, changes in legislation, changes in interest rates and future takes of inflation.However, the various sources of information identified are not authentically substitutes for accounting reports. Rather, they are best used in conjunction with the reports in order to obtain a drop deader take to of the financial health of a business. Evidence on the usefulness of accounting ? There are arguments and convincing essay that accounting information is at least perceived as being useful to users. Numerous investigate surveys have asked users to rank the brilliance of accounting information, in relation to other sources of information, for decision-making purposes. across-the-tablely speaking, these studies have found that users rank accounting information very(prenominal)(prenominal) passing. There is also large try that businesses choose to generate accounting info rmation that exceeds the minimum requirements imposed by accounting regulations. (For example, businesses often aim a considerable amount of accounting information for managers, which is not required by any regulations. ) Presumably, the approach of producing this additional accounting information is justi? ed on the grounds that users ? nd it useful.Such arguments and evidence, however, leave unanswered the question of whether the information produced is real used for decision-making purposes, that is does it affect peoples behaviour? It is normally very dif? cult to assess the impact of accounting on decision making. unmatched situation arises, however, where the impact of accounting information can be spy and measured. This is where the shares (portions of self-control of a business) are traded on a stock exchange. The evidence reveals that, when a business makes an announcement concerning its accounting pro? s, the prices at which shares are traded and the volume of share s traded often change signi? inclinely. This suggests that investors are changing their interprets about the future prospects of the business as a result of this new information fair available to them and that this, in turn, leads them to make a decision either to buy or to sell shares in the business. Although there is evidence that accounting reports are perceived as being useful and are used for decision-making purposes, it is unimaginable to measure just how useful 5 6 CHAPTER 1 INTRODUCTION TO ACCOUNTING ccounting reports are to users. As a result we cannot say with matter of course whether the court of producing those reports represents determine for money. Accounting information will usually represent hardly one input to a particular decision and so the precise weight attached to the accounting information by the decision maker and the bene? ts which ? ow as a result cannot be accurately assessed. We shall now go on to see, however, that it is at least possible to id entify the kinds of qualities which accounting information must possess in order to be useful.Where these qualities are lacking, the usefulness of the information will be diminished. Providing a service maven way of cover accounting is as a form of service. Accountants provide sparing information to their clients, who are the various users identi? ed in Figure 1. 1. The quality of the service provided is determined by the extent to which the needs of the various user groups have been met. To meet these users needs, it can be argued that accounting information should possess certain key qualities, or characteristics relevance, reindebtedness, comparability and understandability. ? ? Relevance. Accounting information must have the ability to in? uence decisions. Unless this characteristic is present, there is really no point in producing the information. The information may be applicable to the prediction of future events (for example, in predicting how much pro? t is likely to b e acquire next year) or applicable in share to con? rm past events (for example, in establishing how much pro? t was earned lowest year). The role of accounting in con? rming past events is important because users often wish to check the true statement of earlier predictions that they have made.The accuracy (or inaccuracy) of earlier predictions may help users to judge the accuracy of current predictions. To in? uence a decision, the information must, of course, be available when the decision is being made. Thus, applicable information must be timely. ? Reliability. Accounting should be free from signi? cant error or bias. It should be capable of being relied upon by managers to represent what it is supposed to represent. Though both relevance and reliability are very important, the problem that we often face in accounting is that information that is highly relevant may not be very rock-steady.Similarly, that which is reliable may not be very relevant. Activity 1. 4 To embell ish this last point, let us assume that a manager has to sell a custom-built machine owned by their business and has recently veritable a bid for it. This machine is very unusual and there is no ready market for it. What information would be relevant to the manager when decision making whether to accept the bid? How reliable would that information be? The manager would likely like to know the current market lever of the machine in the beginning deciding whether or not to accept the bid.The current market nurture would be highly relevant to the final decision, further it might not be very reliable because the machine is unique and there is likely to be little information concerning market values. BUT IS IT MATERIAL? When seeking to strike the right balance between relevance and reliability, the needs of users should be the overriding consideration. ? ? ? Comparability. This quality will enable users to identify changes in the business over time (for example, the trend in sales revenue over the past ? ve geezerhood).It will also help them to evaluate the performance of the business in relation to similar businesses. Comparability is achieved by treating items that are essentially the homogeneous in the comparable manner for accounting purposes. Comparability may also be fired by making percipient the policies that have been adopted in measuring and presenting the information. ? Understandability. Accounting reports should be expressed as pop offly as possible and should be understood by those at whom the information is aimed. Activity 1. 5 Do you gestate that accounting reports should be understandable to those who have not studied accounting?It would be very useful if accounting reports could be understood by everyone. This, however, is unrealistic as complex financial events and transactions cannot normally be expressed in simple terms. It is probably best that we regard accounting reports in the same(p) way that we regard a report written in a foreign language. To understand either of these, we need to have had some preparation. Generally speaking, accounting reports assume that the user not only has a tenable knowledge of business and accounting but is also prepared to invest some time in studying the reports.Despite the answer to Activity 1. 5, the encumbrance is diely on accountants to provide information in a way that makes it as understandable as possible to non-accountants. But . . . is it material? ? The qualities, or characteristics, that have just been described will help us to decide whether accounting information is potentially useful. If a particular component part of information has these qualities then it may be useful. However, this does not automatically mean that it should be reported to users. We also have to consider whether the information is material, or signi? cant.This agent that we should ask whether its omission or misrepresentation in the accounting reports would really fake the decisions t hat users make. Thus, in addition to possessing the characteristics mentioned above, accounting information must also cross the threshold of materiality. If the information is not regarded as material, it should not be included within the reports as it will merely clutter them up and, perhaps, interfere with the users ability to interpret the ? nancial results. The type of information and amounts involved will normally determine whether it is material. 8 CHAPTER 1 INTRODUCTION TO ACCOUNTING weigh up the cost and gain grounds Having read the previous sections you may feel that, when considering a piece of accounting information, provided the four main qualities identi? ed are present and it is material it should be gathered and made available to users. Unfortunately, there is one more hurdle to jump. Something may still exclude a piece of accounting information from the reports even when it is considered to be useful. Consider Activity 1. 6. Activity 1. 6 Suppose an item of informa tion is capable of being provided. It is relevant o a particular decision it is also reliable, comparable, can be understood by the decision maker concerned and is material. Can you think of a reason why, in perpetrate, you might choose not to produce the information? The reason that you may decide not to produce, or discover, the information is that you judge the cost of doing so to be greater than the potential benefit of having the information. This costbenefit issue will make the extent to which accounting information is provided. In theory, a particular item of accounting information should only be produced if the costs of providing it are less than the bene? s, or value, to be derived from its use. Figure 1. 2 shows the relationship between the costs and value of providing additional accounting information. Figure 1. 2 Relationship between costs and the value of providing additional accounting information The benefits of accounting information eventually decline. The cost of providing information, however, will rise with each additional piece of information. The optimal direct of information provision is where the gap between the value of the information and the cost of providing it is at its grea bear witness. WEIGHING UP THE COSTS AND BENEFITS The ? ure shows how the value of information accredited by the decision maker eventually begins to decline. This is, perhaps, because additional information executes less relevant, or because of the problems that a decision maker may have in processing the sheer quantity of information provided. The costs of providing the information, however, will growth with each additional piece of information. The broken line indicates the point at which the gap between the value of information and the cost of providing that information is at its greatest. This represents the optimal amount of information that can be provided.This theoretical model, however, poses a number of problems in practice. We shall now go on to discuss these. To illustrate the practical problems of establishing the value of information, let us assume that someone has collided with our car in a car park and dented and scraped the paint from one of the doors. We wish to have the dent taken out and the door resprayed at a local service department. We know that the nearest garage would charge ? 250 but believe that other local garages may offer to do the stemma for a let down price. The only way of ? nding out the prices at other garages is to visit them, so that they can see the extent of the damage.Visiting the garages will involve using some petrol and will take up some of our time. Is it worth the cost of ? nding out the price for the job at the various local garages? The answer, as we have seen, is that if the cost of discovering the price is less than the potential bene? t, it is worth having that information. To identify the various prices for the job, there are several points to be considered, including ? How many ga rages shall we visit? ? What is the cost of petrol to visit each garage? ? How long will it take to make all the garage visits? ? At what price do we value our time? The economic bene? of having the information on the price of the job is probably even harder to assess. The following points need to be considered ? What is the cheapest price that we might be quoted for the job? ? How likely is it that we shall be quoted a price cheaper than ? 250? As we can imagine, the answers to these questions may be far from clear remember that we have only contacted the local garage so far. When assessing the value of accounting information we are confronted with similar problems. The provision of accounting information can be very costly however, the costs are often dif? cult to quantify.The direct, out-of-pocket, costs such as salaries of accounting staff are not really a problem to identify, but these are only part of the get costs involved. There are also less direct costs such as the cost of the users time spent on analysing and interpret the information contained in reports. The economic bene? t of having accounting information is even harder to assess. It is possible to apply some science to the problem of weighing the costs and bene? ts, but a freshet of subjective judgement is likely to be involved. No one would seriously advocate that the typical business should produce no accounting information.At the same time, no one would advocate that every item of information that could be seen as possessing one or more of the key characteristics should be produced, regardless of the cost of producing it. The characteristics that in? uence the usefulness of accounting information and which have been discussed in this section and the preceding section are set out in Figure 1. 3. 9 10 CHAPTER 1 INTRODUCTION TO ACCOUNTING Figure 1. 3 The characteristics that influence the usefulness of accounting information There are four main qualitative characteristics that influence th e usefulness of accounting information.In addition, however, accounting information should be material and the benefits of providing the information should outweigh the costs. Accounting as an information system ? We have already seen that accounting can be seen as the provision of a service to clients. Another way of viewing accounting is as a part of the businesss total information system. Users, both inside and outside the business, have to make decisions concerning the parceling of scarce economic resources. To ensure that these resources are ef? ciently allocated, users need economic information on which to base decisions.It is the role of the accounting system to provide that information and this will involve information gathering and communication. The accounting information system should have certain features that are common to all valid information systems within a business. These are ? identifying and capturing relevant information (in this case ? nancial information) ? recording the information amass in a systematic manner ? analysing and interpreting the information collected ? account the information in a manner that suits the needs of users. The relationship between these features is set out in Figure 1. . ACCOUNTING AS AN INFORMATION SYSTEM Figure 1. 4 The accounting information system There are four sequential stages of an accounting information system. The first two stages are concerned with preparation, whereas the last two stages are concerned with using the information collected. Given the decision-making emphasis of this book, we shall be concerned primarily with the ? nal two elements of the process the analysis and reporting of accounting information. We shall consider the way in which information is used by, and is useful to, users earlier than the way in which it is identi? ed and recorded. Ef? ient accounting systems are an essential fraction of an ef? cient business. When the accounting systems fail, the results can be disastr ous. certain World 1. 1 provides an example of a systems failure when two businesses combined and then attempted to desegregate their respective systems. Real World 1. 1 Blaming the system FT When Sir visual sense Morrison bought Safeway for ? 3. 35bn in March 2004, he almost doubled the size of his supermarket twine overnight and went from being a regional actor to a case force. His plan was simple enough. He had to sell off some Safeway stores Morrison has to date sold off 184 stores for an estimated ? . 3bn and convert the remaining 230 Safeway stores into Morrisons. Sir Ken has about another 50 to sell. But, nearly fifteen months on, and the integration process is proving harder in practice than it looked on paper. Morrison, once known for its robust performance, has issued four profit archetypes in the past ten months. Each time the retailer has blamed Safeway. coating July, it was because of a faster-thanexpected sales decline in Safeway stores. In March there were t wo warnings that month it was the fault of Safeways accounting systems, which left Morrison with lower supplier incomes.This months warning was put down to higher-than-expected costs from course parallel store systems. At the time of the first warning last July, Simon Procter, of the stockbrokers Charles Stanley, noted that the news has blown all profit forecasts out of the water and visibility is very poor from here on out. But if it was difficult then to predict where Morrisons profits were heading, it is unacceptable now. Morrison itself cannot give guidance. No one envisaged this, says Mr Procter. When I made that comment about visibility last July, I was thinking on a twelve-month time frame, not a two-year one. Morrison says the complexity of the Safeway deal has put a significant strain on its ability to cope with managing national accounts. This is impacting the ability of the senesce to forecast likely trends in profitability and the directors are therefore not current ly in a position to provide reliable guidance on the level of profitability as a whole, admits the retailer. witness Morrison in uphill battle to integrate Safeway, Elizabeth Rigby, financial Times, 26 may 2005. As a footnote to Real World 1. 1, though Morrison had its problems, these were speedily overcome and the Safeway takeover has proved to be a success. 1 12 CHAPTER 1 INTRODUCTION TO ACCOUNTING centering accounting and financial accounting Accounting is usually seen as having two distinct strands. These are ? ? ? management accounting, which seeks to meet the accounting needs of managers and ? financial accounting, which seeks to meet the accounting needs of all of the other users identi? ed earlier in the chapter (see Figure 1. 1). The difference in their targeted user groups has led to each strand of accounting developing along different lines. The main areas of difference are as follows. ? nature of the reports produced.Financial accounting reports tend to be command - ? ? ? ? ? purpose, that is, they contain ? nancial information that will be useful for a broad commit of users and decisions or else than being speci? cally intentional for the needs of a particular group or set of decisions. centering accounting reports, on the other hand, are often speci? c-purpose reports. They are designed with a particular decision in mind and/or for a particular manager. Level of position. Financial accounting reports provide users with a broad overview of the performance and position of the business for a end.As a result, information is aggregate and exposit is often lost. Management accounting reports, however, often provide managers with considerable detail to help them with a particular operational decision. Regulations. Financial accounting reports, for many businesses, are subject to accounting regulations that try to ensure they are produced with standard content and in a standard format. The law of nature and accounting manage makers impos e these regulations. As management accounting reports are for internal use only, there are no regulations from out-of-door sources concerning the form and content of the reports.They can be designed to meet the needs of particular managers. reportage interval. For most businesses, ? nancial accounting reports are produced on an annual basis, though some large businesses produce half-yearly reports and a few produce quarterly ones. Management accounting reports may be produced as frequently as required by managers. In many businesses, managers are provided with certain reports on a daily, weekly or monthly basis, which allows them to check progress frequently. In addition, special-purpose reports will be prepared when required (for example, to evaluate a intent to purchase a piece of equipment).Time orientation. Financial accounting reports re? ect the performance and position of the business for the past period. In essence, they are feebleminded looking. Management accounting rep orts, on the other hand, often provide information concerning future performance as well as past performance. It is an oversimpli? cation, however, to suggest that ? nancial accounting reports never incorporate expectations concerning the future. Occasionally, businesses will release projected information to other users in an attempt to put together capital or to ? ght off unwanted takeover bids. Even preparation of the routine ? ancial accounting reports typically requires making some judgements about the future, as we shall see in Chapter 3. race and quality of information. Financial accounting reports concentrate on information that can be quanti? ed in monetary terms. Management accounting also produces such reports, but is also more likely to produce reports that contain information of a non-? nancial nature, such as physical volume of inventories, number of sales orders received, number of new products launched, physical output per employee and so on. Financial accounting pl aces greater emphasis on the use of objective, veri? ble evidence when preparing reports. Management accounting reports may use information that is less objective and veri? able, but nevertheless provide managers with the information they need. SCOPE OF THIS BOOK We can see from this that management accounting is less constrained than ? nancial accounting. It may draw from a variety of sources and use information that has varying degrees of reliability. The only real test to be applied when assessing the value of the information produced for managers is whether or not it improves the quality of the decisions made.The billets between management and ? nancial accounting suggest that there are differences between the information needs of managers and those of other users. While differences undoubtedly exist, there is also a good deal of overlap between these needs. Activity 1. 7 Can you think of any areas of overlap between the information needs of managers and those of other users? W e thought of two points ? ? Managers will, at times, be interested in receiving a historical overview of business operations of the sort provided to other users.Other users would be interested in receiving information relating to the future, such as the planned level of profits and non-financial information such as the state of the sales order book and the extent of product innovations. The distinction between the two areas of accounting re? ects, to some extent, the differences in access to ? nancial information. Managers have much more control over the form and content of information they receive. Other users have to rely on what managers are prepared to provide or what the ? nancial reporting regulations require to be provided. Though the scope of ? ancial accounting reports has increased over time, fears concerning loss of competitive advantage and user ignorance concerning the reliability of forecast entropy have led businesses to resist providing other users with the same det ailed and big information available to managers. In the past, it has been argued that accounting systems are far too geared to meeting the regulatory requirements of ? nancial accounting to be able to provide the information most helpful to managers. This is to say that ? nancial accounting requirements have been the main priority and management accounting has suffered as a result.Recent survey evidence suggests, however, that this argument has lost its force. Modern management accounting systems tend to provide managers with information that is relevant to their needs rather than what is determined by external reporting requirements. Financial reporting cycles, however, retain some in? uence over management accounting and managers are aware of expectations of external users (see the reference at the end of the chapter). Scope of this book This book is concerned with ? nancial accounting rather than management accounting. In Chapter 2 we begin by introducing the trey principal ? a ncial statements ? the statement of ? nancial position (sometimes known as the balance sheet) ? the income statement (also called the pro? t and loss account) and ? the statement of money ? ows. 13 14 CHAPTER 1 ? INTRODUCTION TO ACCOUNTING These statements are brie? y reviewed before we go on to consider the statement of ? nancial position in more detail. We shall see that the statement of ? nancial position provides information concerning the wealth held by a business at a particular point in time and the claims against this wealth. Included in our consideration of the statement of ? ancial position will be an introduction to the conventions of accounting. Conventions are the generally accepted rules that accountants tend to follow when preparing ? nancial statements. Chapter 3 introduces the second of the major ? nancial statements, the income statement. This provides information concerning the wealth created by a business during a period. In this chapter we shall be looking at s uch issues as how pro? t is measured, the point in time at which we recognise that a pro? t has been made and the accounting conventions that apply to this particular statement.In the UK and throughout much of the industrialised humans, the confine confederacy is the major form of business unit. In Chapter 4 we consider the accounting aspects of express companies. Although there is nothing of essence that makes the accounting aspects of companies different from other types of private-sector business, there are some points of detail that we need to consider. In Chapter 5 we continue our examination of moderate companies and, in particular, consider the framework of rules that must be adhered to when presenting accounting reports to owners and external users.Chapter 6 deals with the last of the three principal ? nancial statements, the statement of cash ? ows. This ? nancial statement is important in identifying the ? nancing and investing activities of the business over a period . It sets out how cash was generated and how cash was used during a period. Reading the three statements will provide information about the performance and position of a business. It is possible, however, to gain even more helpful insights about the business by analysing the statements using ? nancial ratios and other techniques. Combining two ? ures in the ? nancial statements in a ratio and canvas this with a similar ratio for, say, another business, can often sound out us much more than just reading the ? gures themselves. Chapters 7 and 8 are concerned with techniques for analysing ? nancial statements. The typical large business in the UK is a group of companies rather than just a single troupe. A group of companies will exist where one smart set controls one or more other companies. In Chapter 9 we shall see why groups exist and consider the accounting issues raised by the combination of companies into groups.The scope of ? nancial reporting has tended to alter over the yea rs. In Chapter 10 we shall consider where ? nancial reporting has come from and how it seems to be developing. Finally, in Chapter 11, we shall consider the way in which larger businesses are managed and how directors and other senior managers are accountable to the owners and to other groups with an interest in the business. Has accounting create too interesting? In recent years, accounting has become front-page news and has been a major talking point among those machine-accessible with the world of business.Unfortunately, the attention that accounting has attracted has been for all the wrong reasons. We have seen that investors rely on ? nancial reports to help to keep an eye both on their investment and on the performance of the managers. What, though, if the managers provide misleading ? nancial reports to investors? Recent revelations suggest that the managers of some large businesses have been doing just this. HAS ACCOUNTING BECOME TOO INTERESTING? devil of the most notorio us cases have been those of ? Enron, an energy-trading business based in Texas, which was charge of entering into complicated ? ancial arrangements in an attempt to obscure losses and to in? ate pro? ts and ? WorldCom, a major long-distance telephone operator in the US, which was charge of reclassifying $3. 9 billion of expenses so as to incorrectly in? ate the pro? t ? gures that the business reported to its owners (shareholders) and to others. In the wake of these scandals, there was much closer scrutiny by investment analysts and investors of the ? nancial reports that businesses produce. This led to further businesses, in both the US and Europe, being accused of using dubious accounting practices to bolster reported pro? ts.Accounting scandals can have a profound effect on all those connected with the business. The Enron scandal, for example, ultimately led to the collapse of the company, which, in turn, resulted in lost jobs and large ? nancial losses for lenders, suppliers a nd investors. Con? dence in the world of business can be crowingly shaken by such events and this can pose problems for hostel as a whole. Not surprisingly, therefore, the relevant authorities tend to be severe on those who perpetrate such scandals. In the US, Bernie Ebbers, the former antique executive director of WorldCom, received 25 years in prison for his part in the fraud. motley reasons have been put forward to explain this spate of scandals. Some may have been caused by the air pressures on managers to meet unrealistic expectations of investors for continually rising pro? ts, others by the greed of unscrupulous executives whose pay is coupled to ? nancial performance. However, they may all re? ect a particular economic environment. Real World 1. 2 gives some comments suggesting that when all appears to be expiration well with a business, people can be kinda a fleeceable and over-trusting. Real World 1. 2 The thoughts of Warren BuffettWarren Buffett is one of the wo rlds shrewdest and most successful investors. He believes that the accounting scandals mentioned above were perpetrated during the new economy boom of the late 1990s when confidence was high and exaggerated predictions were being made concerning the future. He states that during that period You had an erosion of accounting standards. You had an erosion, to some extent, of executive behaviour. But during a period when everybody believes, people who are inclined to take advantage of other people can get away with a lot.He believes that the worst is now over and that the dirty laundry created during this heady period is being washed away and that the washing machine is now in the rinse cycle. Source The Times, Business Section, 26 September 2002, p. 25. nisyndication. com. whatsoever the causes, the result of these accounting scandals has been to undermine the credibility of ? nancial statements and to introduce much stricter regulations concerning the quality of ? nancial information . We shall return to this issue in later chapters when we consider the ? nancial statements. 15 16 CHAPTER 1INTRODUCTION TO ACCOUNTING The changing face of accounting Over the past 25 years, the environment within which businesses operate has become increasely turbulent and competitive. Various reasons have been identi? ed to explain these changes, including ? the increasing sophistication of customers ? the development of a global economy where national frontiers become less important ? speedy changes in technology ? the deregulation of domestic markets (for example, electricity, water and gas) ? increasing pressure from owners (shareholders) for competitive economic returns ? he increasing volatility of ? nancial markets. This new, more complex, environment has brought new challenges for managers and other users of accounting information. Their needs have changed and both ? nancial accounting and management accounting have had to respond. To meet the changing needs of users there has been a radical review of the kind of information to be reported. The changing business environment has given added impetus to the search for a clear framework and principles upon which to base ? nancial accounting reports. Various attempts have been made to shed light on the purpose of ? ancial accounting reports and to provide a more solid rear end for the development of accounting rules. The frameworks and principles that have been developed try to address fundamental questions such as ? Who are the users of ? nancial accounting information? ? What kinds of ? nancial accounting reports should be prepared and what should they contain? ? How should items (such as pro? t and asset values) be measured? In response to criticisms that the ? nancial reports of some businesses are not clear enough to users, accounting rule makers have tried to improve reporting rules to ensure that the accounting policies of businesses are ore comparable and more transparent, and that they portray economic reality more faithfully. While this has had a generally bene? cial effect, the recent accounting scandals have highlighted the limitations of accounting rules in protecting investors and others. The internationalisation of businesses has created a need for accounting rules to have an international reach. It can no longer be assumed that users of accounting information relating to a particular business are based in the country in which the business operates or are familiar with the accounting rules of that country.Thus, there has been increasing harmonisation of accounting rules across national frontiers. A more detailed review of these developments is included in Chapter 5. Management accounting has also changed by becoming more superficial looking in its digest. In the past, information provided to managers has been largely restricted to that collected within the business. However, the attitude and behaviour of customers and rival businesses have now become the object o f much information gathering. Increasingly, successful businesses are those that are able to secure and maintain competitive advantage over their rivals.To obtain this advantage, businesses have become more customer driven (that is, concerned with satisfying customer needs). This has led to management accounting information that provides details of customers and the market, such as customer evaluation of services provided and market share. In addition, information about the costs and pro? ts of rival businesses, which can be used as benchmarks by which to gauge competitiveness, is gathered and reported. WHAT KINDS OF BUSINESS OWNERSHIP EXIST? To compete successfully, businesses must also ? d ways of managing costs. The cost base of innovative businesses is under continual review and this, in turn, has led to the development of more sophisticated methods of measuring and controlling costs. What kinds of business willpower exist? The particular form of business ownership has importa nt implications for accounting purposes and so it is useful to be clear about the main forms of ownership that can arise. There are basically three arrangements ? sole proprietorship ? coalition and ? throttle company. Each of these is considered below. Sole proprietorship ?Sole proprietorship, as the bring in suggests, is where an psyche is the sole owner of a business. This type of business is often quite small in terms of size (as measured, for example, by sales revenue generated or number of staff employed) however, the number of such businesses is very large indeed. Examples of sole-proprietor businesses can be found in most industrial sectors but particularly within the service sector. Hence, services such as galvanic repairs, picture framing, photography, driving instruction, retail shops and hotels have a large rest of sole-proprietor businesses.The sole-proprietor business is easy to set up. No formal procedures are required and operations can often commence immediate ly (unless special authorization is required because of the nature of the trade or service, such as running licensed premises). The owner can decide the way in which the business is to be conducted and has the ? exibility to restructure or dissolve the business whenever it suits. The law does not recognise the sole-proprietor business as being separate from the owner, so the business will cease on the death of the owner.Although the owner must produce accounting information to satisfy the taxation authorities, there is no legal requirement to produce accounting information relating to the business for other user groups. However, some user groups may demand accounting information about the business and may be in a position to have their demands met (for example, a bank requiring accounting information on a regular basis as a condition of a loan). The sole proprietor will have unlimited liability which means that no distinction will be made between the proprietors personal wealth and that of the business if there are business debts that must be paid. component league ? A partnership exists where at least two individuals carry on a business together with the intention of making a pro? t. Partnerships have much in common with sole-proprietor businesses. They are usually quite small in size (although some, such as partnerships of accountants and solicitors, can be large). Partnerships are also easy to set up as no formal procedures are required (and it is not even necessary to have a written agreement between the partners). The partners can agree whatever arrangements suit them concerning the ? nancial and management aspects of the business.Similarly, the partnership can be restructured or dissolve by agreement between the partners. 17 18 CHAPTER 1 INTRODUCTION TO ACCOUNTING Partnerships are not recognised in law as separate entities and so contracts with third parties must be entered into in the name of individual partners. The partners of a business usually hav e unlimited liability. Activity 1. 8 What are the main advantages and disadvantages that should be considered when deciding between a sole proprietorship and a partnership? The main advantages of a partnership over a sole-proprietor business are ? ? ? sharing the burden of ownership he fortune to specialise rather than cover the whole range of services (for example, in a solicitors practice each partner may specialise in a different aspect of the law) the ability to raise capital where this is beyond the capacity of a single individual. The main disadvantages of a partnership compared with a sole proprietorship are ? ? the risks of sharing ownership of a business with unsuitable individuals the limits placed on individual decision making that a partnership will impose. circumscribed company ? Limited companies can range in size from quite small to very large.The number of individuals who subscribe capital and become the owners may be unlimited, which provides the opportunity to cr eate a very large-scale business. The liability of owners, however, is limited (hence limited company), which means that those individuals subscribing capital to the company are liable only for debts incurred by the company up to the amount that they have agreed to invest. This cap on the liability of the owners is designed to limit risk and to produce greater con? dence to invest. Without such limits on owner liability, it is dif? cult to see how a ripe capitalist economy could operate.In many cases, the owners of a limited company are not involved in the day-to-day running of the business and will, therefore, invest in a business only if there is a clear limit set on the level of investment risk. The bene? t of limited liability, however, imposes certain obligations on such companies. To start up a limited company, documents of incorporation must be prepared that set out, among other things, the objectives of the business. Furthermore, a framework of regulations exists that place s obligations on limited companies concerning the way in which they conduct their affairs. Part of this regulatory framework requires annual ? ancial reports to be made available to owners and lenders and usually an annual general meeting of the owners has to be held to approve the reports. In addition, a copy of the annual ? nancial reports must be lodged with the Registrar of Companies for public inspection. In this way, the ? nancial affairs of a limited company enter the public domain. With the exception of small companies, there is also a requirement for the annual ? nancial reports to be subject to an audit. This involves an independent ? rm of accountants examining the annual reports and underlying records to see whether the reports provide a true and fair view of the ? ancial health of the company and whether they comply with the relevant accounting rules established by law and by accounting rule makers. All of the large household-name UK businesses (Marks and Spencer, Tesco , Shell, BSkyB, BA, BT, easyJet and so on) are limited companies. Limited companies are considered in more detail in Chapters 4 and 5. HOW ARE BUSINESSES organise? Activity 1. 9 What are the main advantages and disadvantages that should be considered when deciding between a partnership business and a limited liability company?The main advantages of a partnership over a limited company are ? ? ? ? the ease of setting up the business the degree of tractableness concerning the way in which the business is conducted the degree of flexibility concerning restructuring and dissolution of the business freedom from administrative burdens imposed by law (for example, the annual general meeting and the need for an independent audit). The main disadvantage of a partnership compared with a limited company is the fact that it is not possible to limit the liability of all of the partners.This book concentrates on the accounting aspects of limited liability companies because this type of business is by far the most important in economic terms. The early chapters will introduce accounting concepts through examples that do not draw a distinction between the different types of business. at once we have dealt with the basic accounting principles, which are the same for all three types of business, we can then go on to see how they are applied to limited companies. It must be emphasised that there are no differences in the way that these three forms of business keep their day-to-day accounting records.In preparing their periodic ? nancial statements, there are certain differences that need to be considered. These differences are not ones of principle, however, but of detail. How are businesses organised? As we have just seen, nearly all businesses that involve more than a few owners and/or employees are set up as limited companies. This means that the ? cigarette will come from the owners (shareholders) both in the form of a direct cash investment to buy shares (in the ownersh ip of the business) and through the owners allowing past pro? s, which belong to them, to be reinvested in the business. Finance will also come from lenders (banks, for example), who earn interest on their loans and from suppliers of goods and services being prepared to supply on credit, with payment occurring a month or so after the date of supply, usually on an interest-free basis. In larger limited companies, the owners (shareholders) are not involved in the daily running of the business or else they appoint a board of directors to manage the business on their behalf. The board is charged with three major tasks ? etting the overall direction and strategy for the business ? monitoring and controlling its activities and ? communicating with owners and others connected with the business. Each board has a chairman, elected by the directors, who is responsible for running the board in an ef? cient manner. In addition, each board has a chief executive of? cer ( chief executive officer ), or managing director, who is responsible for running the business on a dayto-day basis. Occasionally, the roles of chairman and CEO are combined, although it is usually considered to be a good idea to eparate them in order to prevent a single individual having excessive power. We shall come back to consider the relationship between directors and shareholders in more detail in Chapter 4. 19 20 CHAPTER 1 INTRODUCTION TO ACCOUNTING The board of directors represents the most senior level of management. Below this level, managers are employed, with each manager given responsibility for a particular part of the businesss operations. What is the financial objective of a business? A business is created to enhance the wealth of its owners.Throughout this book we shall assume that this is its main objective. This may come as a surprise, as there are other objectives that a business may pursue that are related to the needs of others associated with the business. For example, a business may seek to provide good working conditions for its employees, or it may seek to conserve the environment for the local community. While a business may pursue these objectives, it is normally set up with a view to increasing the wealth of its owners. In practice, the behaviour of businesses over time appears to be consistent with this objective.Real World 1. 3 reveals how one well-known business has changed its focus in order to improve pro? tability. Real World 1. 3 Profiting from change It speaks volumes for the work done by Kate Swann in turning some W H metalworker that when she became chief executive five years ago, the company was being spoken of in similar tems to Woolworths. Comments such as You wouldnt invent it if you were starting out today and What is it actually for these days? were typical among analysts, as they were with Woolies.Indeed, many thought that W H Smith was beyond help and argued that the supermarkets were eating away at sales. Ms Swann has defied the scepti cs, achieving an imposing turnaround. The companys magazine and newspaper distribution division was hived off as a separate entity and new outlets were opened at airports and railroad track stations so much so that sales by W H Smiths travel unit now jeopardize to overtake those of its traditional high path stores. Lower-profit-margin lines, such as CDs and DVDs, have been cleared from the shelves to make way for higher-margin items, such as stationery.The last fatten up of the strategy was in evidence again in yesterdays update, in which Ms Swann reported that sales in the nine weeks to January 17 were down by 7 per cent in the high street stores and by 2 per cent in the travel stores, partly because W H Smith is continuing to reduce its exposure to the entertainment category. That was the bad news. The good news was that, although sales overall were down, the reduced focus on entertainment was good for profits. W H Smith made an superfluous 2p of profit in every ? 1 of sale s, compared with the same period a year earlier, a stunning achievement given the deflation hitting the high street.Source Business big shot, Ian King, The Times, 27 January 2009, p. 39. nisyndication. com. Within a market economy there are strong competitive forces at work that ensure that failure to enhance owners wealth will not be tolerated for long. Competition for the funds provided by the owners and competition for managers jobs will normally mean that the owners interests will prevail. If the managers do not provide the expected increase in ownership wealth, the owners have the power to replace the existing management team with a new team that is more responsive to owners needs. WHAT IS THE FINANCIAL accusatory OF A BUSINESS?Does this mean that the needs of other groups associated with the business (employees, customers, suppliers, the community and so on) are not really important? The answer to this question is certainly no, if the business wishes to survive and prosper ov er the longer term. gratifying the needs of other groups will normally be consistent with increasing the wealth of the owners over the longer term. The importance of customers to a business cannot be overstated. Dissatis? ed customers will take their business to another supplier and this will, in turn, lead to a loss of wealth for the owners of the business losing the customers.Real World 1. 4 provides an illustration of the way in which one business acknowledges the link between customer satisfaction and creating wealth for its owners. Real World 1. 4 Checking out Sainsburys objectives J Sainsbury plc is a leading food retailer that recognises the importance of customers to increasing the wealth of the owners (shareholders) as follows Our objective is to serve customers well and thereby provide shareholders with good, sustainable financial returns. Source Investor FAQs, www. j-sainsbury. co. uk, 8 January 2009, p. 1. A dissatis? d workforce may result in low productivity, strikes and so forth, which will in turn have an adverse effect on owners wealth. Similarly, a business that upsets the local community by unacceptable behaviour, such as polluting the environment, may attract bad publicity, resulting in a loss of customers and heavy ? nes. Real World 1. 5 provides an example of how two businesses responded to potentially minus allegations. Real World 1. 5 The price of clothes FT US clothing and sportswear manufacturers crack cocaine and Nike have many of their clothes produced in Asia where labour tends to be cheap.However, some of the contractors that produce clothes on behalf of the two companies have been accused of unacceptable practices. Campaigners visited the factories and came up with damaging allegations. The factories were employing minors, they said, and managers were harassing female employees. Nike and Gap reacted by allowing independent inspectors into the factories. They promised to ensure their contractors obeyed minimum standards of empl oyment. Earlier this year, Nike took the extraordinary shade of publishing the names and addresses of all its contractors factories on the internet.The company said it could not be sure all the abuse had stopped. It said that if campaigners visited its contractors factories and found examples of act malpractice, it would take action. Nike and Gap said the approach made business sense. They needed societys approval if they were to prosper. Nike said it was concerned about the response of potential US recruits to the campaigners allegations. They would not want to work for a company that was constantly in the news because of the allegedly cruel treatment of those who made its products. Source Fair shares? , Michael Skapinker, Financial Times, 11 June 2005. 21 22 CHAPTER 1 INTRODUCTION TO ACCOUNTING It is important to recognise that generating wealth for the owners is not the same as seeking to maximise the current years pro? t. Wealth creation is a longer-term concept, which relate s not only to this years pro? t but to that of future years as well. In the short term, corners can be cut and risks taken that improve current pro? t at the expense of future pro? t. Real World 1. 6 gives some examples of how emphasis on short-term pro? t can be damaging. Real World 1. 6 short-term gains, long-term problemsFT Human beings are bad at learning and changing. It takes a good crisis to drive home what may have been staring us in the face. So what in particular are the lessons for all those concerned with saving, investment, borrowing and lending? For many years, under the guise of defending capitalism, we have been allowing ourselves to degrade it. We have been poisoning the well from which we have drawn wealth. We have misunderstood the importance of values to capitalism. We have surrendered to the idea that success is engage by making as much money as the law allowed without regard to how it was made.Thirty years ago, retailers would b