FINANCIAL ACCOUNTING

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1 FINANCIAL ACCOUNTING

2

3 Part 1 A conceptua framework: setting the scene 1 Who needs accounting? 2 A systematic approach to financia reporting: the accounting equation 3 Financia statements from the accounting equation 4 Ensuring the quaity of financia statements

4 Chapter 1 Who needs accounting? REAL WORLD CASE Meeting users needs Extracts from annua report 2008 (pp. 1 and 26) Key resuts (p. 1) m m Gross saes incuding VAT Up 15% 10,435 9,075 and trave agency saes Revenue before premiums Up 13% 9,399 8,289 ceded to reinsurers Operating profit before Up 11% significant items Operating profit after Up 60% significant items Profit before payments to Up 11% and on behaf of members Payments to and on behaf Up 122% of members Members funds Up 4% 3,933 3,797 Directors responsibiities (extract) Directors are expected to exercise their judgement when making decisions in the best interests of the Society as a whoe, mindfu of their responsibiities to members and other stakehoders. (p. 26) What is a co-operative? (from the website) Unike ots of other businesses, a co-operative doesn t have tradeabe shares ike a pc whose vaues can fuctuate. A co-operative, however, is owned equay and fairy by its members peope ike you! We d far rather give our profits back to our members and the community than to faceess sharehoding institutions. You know that twice-yeary payment you get from us? That s actuay a share of our profits! And the more you spend with us, the more of a profit you get back! How neat is that? Your dividend is inked to how much profit we make. Not many businesses give back that sort of money to their customers. Vaues in action (from the website) Our famiy of businesses has a set of socia goas which underpin everything we do, caed our vaues and principes. We have asked members what is important to them and they have tod us. By exercising their democratic rights, members make sure that we have ong standing agreements with Fairtrade producers, that we do not dea with arms traders, that we can offset the carbon that

5 Chapter 1 Who needs accounting? 5 is produced when we fy, and that we do give back to the communities in which we trade. That is pretty specia. Source: The Cooperative Group, December en/corporate/corporatepubications/annua-report-and-accounts/annua-report-archive/ Discussion points 1 Who might be incuded in the stakehoders to whom the directors are responsibe? 2 To what extent do the key resuts meet the needs of users of financia statements? Contents 1.1 Introduction The deveopment of a conceptua framework Framework for the preparation and presentation of financia statements Types of business entity Soe trader Partnership Limited iabiity company Users and their information needs Management Owners as investors Empoyees Lenders Suppiers and other trade creditors Customers Governments and their agencies Pubic interest Genera purpose or specific purpose financia statements? Stewards and agents Who needs financia statements? Summary 19 Suppement: introduction to the terminoogy of business transactions 24 Learning outcomes After studying this chapter you shoud be abe to: Define, and expain the definition of, accounting. Expain what is meant by a conceptua framework. Expain the distinguishing features of a soe trader, a partnership and a imited company. List the main users of financia information and their particuar needs. Discuss the usefuness of financia statements to the main users. Additionay, for those who choose to study the suppement: Define the basic terminoogy of business transactions.

6 6 Part 1 A conceptua framework: setting the scene 1.1 Introduction Activity 1.1 Before starting to read this section, write down one paragraph stating what you think the word accounting means. Then read this section and compare it with your paragraph. There is no singe officia definition of accounting, but for the purposes of this text the foowing wording wi be used: Definition Accounting is the process of identifying, measuring and communicating financia information about an entity to permit informed judgements and decisions by users of the information. 1 This definition may appear short but it has been widey quoted over a number of years and is sufficient to specify the entire contents of this introductory textbook. Taking the definition word by word, it eads to the foowing questions: 1 What is the process? 2 How is financia information identified? 3 How is financia information measured? 4 How is financia information communicated? 5 What is an entity? 6 Who are the users of financia information about an entity? 7 What types of judgements and decisions do these users make? Writing the questions in this order is sighty dangerous because it starts by emphasising the process and waits unti the fina question to ask about the use of the information. The danger is that accountants may design the process first and then hope to show that it is suitabe to aow judgements and decisions by users. This is what has often happened over many years of deveoping the process by accountants. In order to earn about, and understand, accounting by taking a critica approach to the usefuness of the current processes and seeing its imitations and the potentia for improvement, it is preferabe to reverse the order of the questions and start by specifying the users of financia information and the judgements and decisions they make. Once the users and their needs have been identified, the most effective forms of communication may be determined and ony then may the technica detais of measurement and identification be deat with in a satisfactory manner. Reversing the order of the questions arising from the definition of accounting is the approach used in this book, because it is the one which has been taken by those seeking to deveop a conceptua framework of accounting. This chapter outines the meaning of the words conceptua framework and in particuar the Framework for the Preparation and Presentation of Financia Statements which has been deveoped for internationa use in accounting practice. The chapter expains the nature of three common types of business entity and concudes by drawing on various views reating to the users of accounting information and their information needs. Because the understanding of users needs is essentia throughout the entire text, the chapter introduces David Wison, a fund manager working for a arge insurance company. In order to baance the demands of users with the restrictions and constraints on preparers of financia information, the chapter aso introduces Leona Rees who works as an audit manager with an accountancy firm. Both of them wi offer comments and expanations as you progress through the text.

7 Chapter 1 Who needs accounting? 7 Activity 1.2 How does this section compare with your initia notions of what accounting means? If they are simiar, then it is ikey that the rest of this book wi meet your expectations. If they are different, then it may be that you are hoping for more than this book can achieve. If that is the case, this may be a usefu point at which to consut your ecturer, tutor or some other expert in the subject to be sure that you are satisfied that this book wi meet your persona earning outcomes. 1.2 The deveopment of a conceptua framework A conceptua framework for accounting is a statement of principes which provides generay accepted guidance for the deveopment of new reporting practices and for chaenging and evauating the existing practices. Conceptua frameworks have been deveoped in severa countries around the word, with the UK arriving a itte ate on the scene. However, arriving ate does give the advantage of earning from what has gone before. It is possibe to see a pattern emerging in the various approaches to deveoping a conceptua framework. The conceptua frameworks deveoped for practica use by the accountancy profession in various countries a start with the common assumption that financia statements must be usefu. The structure of most conceptua frameworks is aong the foowing ines: Who are the users of financia statements? What are the information needs of users? What types of financia statements wi best satisfy their needs? What are the characteristics of financia statements which meet these needs? What are the principes for defining and recognising items in financia statements? What are the principes for measuring items in financia statements? The most widey appicabe conceptua framework is the Framework for the Preparation and Presentation of Financia Statements produced by the Internationa Accounting Standards Board (IASB). This Framework was issued in 1989 and either refects, or is refected in, nationa conceptua frameworks of the USA, Canada, Austraia and the UK. Since 2006 the Framework has been under review for updating but it seems unikey that a revised version wi be issued unti after some chaenging accounting issues have been addressed. The thinking in a those documents can be traced to two discussion papers of the 1970s in the UK and the USA. In the UK, The Corporate Report 2 was a sim but highy infuentia document setting out the needs of users and how these might be met. Two years earier the Truebood Report 3 in the USA had taken a simiar approach of identifying the needs of users, athough perhaps coming out more strongy in support of the needs of sharehoders and creditors than of other user groups. In the UK, various documents on the needs of users have been prepared by individuas invited to hep the process 4 or those who took it on themseves to propose radica new ideas. 5 Since January 2005, a isted companies in member states of the European Union (EU) have been required by an accounting reguation caed the IAS reguation 6 to use a system of internationa financia reporting standards set by the Internationa Accounting Standards Board. The UK ASB has been infuentia in the deveopment of these internationa reporting standards and, over a period of years, has been moving UK accounting practice cosey into ine with the internationa standards. For unisted companies and other organisations not covered by the IAS reguation of the EU, the UK ASB has a conceptua framework of its own, caed the Statement of Principes. 7 This document has many simiarities to the IASB s Framework.

8 8 Part 1 A conceptua framework: setting the scene Activity 1.3 Most conceptua frameworks start with the question: Who are the users of financia statements? Write down a ist of the persons or organisations you think woud be interested in making use of financia statements, and their possibe reasons for being interested. Have you incuded yoursef in that ist? Keep your ist avaiabe for comparing with a ater section of this chapter. 1.3 Framework for the preparation and presentation of financia statements The IASB s Framework has seven main sections. 1 Introduction purpose of the Framework, users and their information needs. 2 The objective of financia statements. 3 Underying assumptions. 4 Quaitative characteristics of financia statements. 5 The eements of financia statements. 6 Recognition of the eements of financia statements. 7 Measurement of the eements of financia statements. Sections 1 and 2 of the Framework are written at a genera eve and a reader woud find no difficuty in reviewing these at an eary stage of study, to gain a favour of what is expected of financia statements. The remaining sections are a mixture of genera principes, which are appropriate to first-eve study of the subject, and some quite specific principes which dea with more advanced probems. Some of those probems need an understanding of accounting which is beyond a first eve of study. This book wi refer to aspects of the various sections of the Framework, as appropriate, when particuar issues are deat with. You shoud be aware, however, that this book concentrates on the basic aspects of the Framework and does not expore every compexity. A conceptua framework is particuary important when practices are being deveoped for reporting to those who are not part of the day-to-day running of the business. This is caed externa reporting or financia accounting and is the focus of the Financia Accounting haf of this book. For those who are managing the business on a day-to-day basis, specia techniques have been deveoped and are referred to generay as interna reporting or management accounting. That is the focus of the management accounting haf of this book. Before continuing with the theme of the conceptua framework, it is usefu to pause and consider the types of business for which accounting information may be required. Activity 1.4 Visit the website of the Internationa Accounting Standards Board at and find the ink to the IASB Framework. (You may have to foow the ink to standards athough the Framework is not a forma standard.) What does the IASB say about the purpose of the Framework? How was it deveoped? What are the simiarities and differences between the ASB and IASB in the way each describes its conceptua framework? Visit the website of the Accounting Standards Board at and find the ink to the Statement of Principes. What does the ASB say about the purpose of the Statement of Principes? How was it deveoped? web activity

9 Chapter 1 Who needs accounting? Types of business entity The word entity means something that exists independenty. A business entity is a business that exists independenty of those who own the business. There are three main categories of business which wi be found in a countries, athough with different tites in different ones. This chapter uses the terminoogy common to the UK. The three main categories are: soe trader, partnership and imited iabiity company. This ist is by no means exhaustive but provides sufficient variety to aow expanation of the usefuness of most accounting practices and their appication. Activity 1.5 Before reading the next sections, take out a newspaper with business advertisements or a business teephone directory, or take a wak down your oca high street or drive round the trading estate. Write down the names of five businesses, shops or other organisations. Then read the sections and attempt to match your ist against the information provided in each Soe trader An individua may enter into business aone, either seing goods or providing a service. Such a person is described as a soe trader. The business may be started because the soe trader has a good idea which appears ikey to make a profit, and has some cash to buy the equipment and other resources to start the business. If cash is not avaiabe, the soe trader may borrow from a bank to enabe the business to start up. Athough this is the form in which many businesses have started, it is one which is difficut to expand because the soe trader wi find it difficut to arrange additiona finance for expansion. If the business is not successfu and the soe trader is unabe to meet obigations to pay money to others, then those persons may ask a court of aw to authorise the sae of the persona possessions, and even the famiy home, of the soe trader. Being a soe trader can be a risky matter and the cost of bank borrowing may be at a reativey unfavourabe rate of interest because the bank fears osing its money. From this description it wi be seen that the soe trader s business is very much intertwined with the soe trader s persona ife. However, for accounting purposes, the business is regarded as a separate economic entity, of which the soe trader is the owner who takes the risk of the bad times and the benefit of the good times. Take as an exampe the person who decides to start working as an eectrician and advertises their services in a newspaper. The eectrician traves to jobs from home and has no business premises. Toos are stored in the oft at home and the business records are in a cupboard in the kitchen. Teephone cas from customers are received on the domestic phone and there are no ceary defined working hours. The work is inextricaby intertwined with famiy ife. For accounting purposes that person is seen as the owner of a business which provides eectrica services and the business is seen as being separate from the person s other interests and private ife. The owner may hardy fee any great need for accounting information because they know the business very cosey, but accounting information wi be needed by other persons or entities, mainy the government (in the form of HM Revenue and Customs) for tax coecting purposes. It may aso be required by a bank for the purposes of ending money to the business or by another soe trader who is intending to buy the business when the existing owner retires Partnership One method by which the business of a soe trader may expand is to enter into partnership with one or more peope. This may permit a pooing of skis to aow more efficient working, or may aow one person with ideas to work with another who has the

10 10 Part 1 A conceptua framework: setting the scene money to provide the resources needed to turn the ideas into a profit. There is thus more potentia for being successfu. If the business is unsuccessfu, then the consequences are simiar to those for the soe trader. Persons to whom money is owed by the business may ask a court of aw to authorise the sae of the persona property of the partners in order to meet the obigation. Even more seriousy, one partner may be required to meet a the obigations of the partnership if the other partner does not have sufficient persona property, possessions and cash. This is described in aw as joint and severa iabiity and the risks have to be considered very carefuy by those entering into partnership. Partnership may be estabished as a matter of fact by two persons starting to work together with the intention of making a profit and sharing it between them. More often there is a ega agreement, caed a partnership deed, which sets out the rights and duties of each partner and specifies how they wi share the profits. There is aso partnership aw, which governs the basic reationships between partners and which they may use to resove their disputes in a court of aw if there is no partnership deed, or if the partnership deed has not covered some aspect of the partnership. For accounting purposes the partnership is seen as a separate economic entity, owned by the partners. The owners may have the same intimate knowedge of the business as does the soe trader and may therefore fee that accounting information is not very important for them. On the other hand, each partner may wish to be sure that they are receiving a fair share of the partnership profits. There wi aso be other persons requesting accounting information, such as HM Revenue and Customs, banks who provide finance and individuas who may be invited to join the partnership so that it can expand even further Limited iabiity company The main risk attached to either a soe trader or a partnership is that of osing persona property and possessions, incuding the famiy home, if the business fais. That risk woud inhibit many persons from starting or expanding a business. Historicay, as the UK changed from a predominanty agricutura to a predominanty industria economy in the nineteenth century, it became apparent that owners needed the protection of imited iabiity. This meant that if the business faied, the owners might ose a the money they had put into the business but their persona weath woud be safe. There are two forms of imited iabiity company. The private imited company has the word Limited (abbreviated to Ltd ) in its tite. The pubic imited company has the abbreviation pc in its tite. The private imited company is prohibited by aw from offering its shares to the pubic, so it is a form of imited iabiity appropriate to a famiy-controed business. The pubic imited company is permitted to offer its shares to the pubic. In return it has to satisfy more onerous reguations. Where the shares of a pubic imited company are bought and sod on a stock exchange, the pubic imited company is caed a isted company because the shares of the company are on a ist of share prices. In either type of company, the owners are caed sharehoders because they share the ownership and share the profits of the good times and the osses of the bad times (to the defined imit of iabiity). Once they have paid in fu for their shares, the owners face no further risk of being asked to contribute to meeting any obigations of the business. Hopefuy, the business wi prosper and the owners may be abe to receive a share of that prosperity in the form of a cash dividend. A cash dividend returns to the owners, on a reguar basis and in the form of cash, a part of the profit created by the business. If the company is very sma, the owners may run the business themseves. If it is arger, then they may prefer to pay someone ese to run the business. In either case, the persons running the business on a day-to-day basis are caed the directors. Because imited iabiity is a great priviege for the owners, the company must meet reguations set out by Pariament in the form of a Companies Act. At present the reevant aw is the Companies Act 2006.

11 Chapter 1 Who needs accounting? 11 For accounting purposes the company is an entity with an existence separate from the owners. In the very smaest companies the owners may not fee a great need for accounting information, but in medium- or arge-sized companies, accounting information wi be very important for the sharehoders as it forms a report on how we the directors have run the company. As with other forms of business accounting information must be suppied to HM Revenue and Customs for tax-coecting purposes. The ist of other users wi expand consideraby because there wi be a greater variety of sources of finance, the company may be seeking to attract more investors, empoyees wi be concerned about the we-being of the business and even the customers and suppiers may want to know more about the financia strength of the company. Athough the aw provides the protection of imited iabiity, this has itte practica meaning for many sma famiy-controed companies because a bank ending money to the business wi ask for persona guarantees from the sharehoder directors. Those persona guarantees coud invove a mortgage over the famiy home, or an interest in ife assurance poicies. The potentia consequences of such persona guarantees, when a company fais, are such that the owners may suffer as much as the soe trader whose business fais. Tabe 1.1 summarises the differences between a partnership and a imited iabiity company that are reevant for accounting purposes. Tabe 1.1 Differences between a partnership and a imited iabiity company Formation Running the business Accounting information Meeting obigations Powers to carry out activities Status in aw Partnership Formed by two or more persons, usuay with written agreement but not necessariy in writing. A partners are entited to share in the running of the business. Partnerships are not obiged to make accounting information avaiabe to the wider pubic. A members of a genera partnership are jointy and severay iabe for money owed by the firm. Partnerships may carry out any ega business activities agreed by the partners. The partnership is not a separate ega entity (under Engish aw), the partnership property being owned by the partners. (Under Scots aw the partnership is a separate ega entity.) Limited iabiity company Formed by a number of persons registering the company under the Companies Act, foowing ega formaities. In particuar there must be a written memorandum and artices of association setting out the powers aowed to the company. Sharehoders must appoint directors to run the business (athough sharehoders may appoint themseves as directors). Companies must make accounting information avaiabe to the pubic through the Registrar of Companies. The persona iabiity of the owners is imited to the amount they have agreed to pay for shares. The company may ony carry out the activities set out in its memorandum and artices of association. The company is seen in aw as a separate person, distinct from its members. This means that the company can own property, make contracts and take ega action or be the subject of ega action.

12 12 Part 1 A conceptua framework: setting the scene Tabe 1.2 identifies the differences between the pubic imited company and the private imited company that are reevant for accounting purposes. Tabe 1.2 Brief comparison of private and pubic companies Running the business Ownership Accounting information Pubic company Minimum of two directors. Must have a company secretary who hods a reevant quaification (responsibe for ensuring the company compies with the requirements of company aw). Shares may be offered to the pubic, inviting subscription. Minimum share capita 50,000. Extensive information required on transactions between directors and the company. Private company Minimum of one director. The soe director may aso act as the company secretary and is not required to have a forma quaification. Shares must not be offered to the pubic. May ony be sod by private arrangements. No minimum share capita. Less need for discosure of transactions between directors and the company. Information must be made pubic through the Registrar of Companies. Provision of financia information to the pubic is determined by size of company, more information being required of medium- and argesized companies. Accounting information must be sent to a sharehoders. Activity 1.6 Look at the ist of five organisations which you prepared before reading this section. Did the ist match what you have just read? If not, there are severa possibe expanations. One is that you have written down organisations which are not covered by this book. That woud appy if you have written down museum, town ha or coege. These are exampes of pubic sector bodies that require speciaised financia statements not covered by this text. Another is that you did not discover the name of the business enterprise. Perhaps you wrote down Northern Hote but did not find the name of the company owning the hote. If your ist does not match the section, ask for hep from your ecturer, tutor or other expert in the subject so that you are satisfied that this book wi continue to meet your persona earning outcomes. 1.5 Users and their information needs Who are the users of the information provided by these reporting entities? This section shows that there is one group, namey the management of an organisation, whose information needs are so speciaised that a separate type of accounting has evoved caed management accounting. However, there are other groups, each of which may beieve it has a reasonabe right to obtain information about an organisation, that do not enjoy unrestricted access to the business and so have to rey on management to suppy suitabe information. These groups incude the owners, where the owners are not aso the managers, but extend further to empoyees, enders, suppiers, customers,

13 Chapter 1 Who needs accounting? 13 government and its branches and the pubic interest. Those in the wider interest groups are sometimes referred to as stakehoders. Definition Stakehoder A genera term to indicate a those who might have a egitimate interest in receiving financia information about a business because they have a stake in it Management Many woud argue that the foremost users of accounting information about an organisation must be those who manage the business on a day-to-day basis. This group is referred to in broad terms as management, which is a coective term for a those persons who have responsibiities for making judgements and decisions within an organisation. Because they have cose invovement with the business, they have access to a wide range of information (much of which may be confidentia within the organisation) and wi seek those aspects of the information which are most reevant to their particuar judgements and decisions. Because this group of users is so broad, and because of the vast amount of information potentiay avaiabe, a speciaist branch of accounting has deveoped, caed management accounting, to serve the particuar needs of management. It is management s responsibiity to empoy the resources of the business in an efficient way and to meet the objectives of the business. The information needed by management to carry out this responsibiity ought to be of high quaity and in an understandabe form so far as the management is concerned. If that is the case, it woud not be unreasonabe to think that a simiar quaity (athough not necessariy quantity) of information shoud be made avaiabe more widey to those stakehoders who do not have the access avaiabe to management. 8 Such an idea woud be regarded as somewhat revoutionary in nature by some of those who manage companies, but more and more are beginning to reaise that sharing information with investors and other stakehoders adds to the genera atmosphere of confidence in the enterprise Owners as investors Where the owners are the managers, as is the case for a soe trader or a partnership, they have no probem in gaining access to information and wi seect information appropriate to their own needs. They may be asked to provide information for other users, such as HM Revenue and Customs or a bank which has been approached to provide finance, but that information wi be designed to meet the needs of those particuar users rather than the owners. Where the ownership is separate from the management of the business, as is the case with a imited iabiity company, the owners are more appropriatey viewed as investors who entrust their money to the company and expect something in return, usuay a dividend and a growth in the vaue of their investment as the company prospers. Providing money to fund a business is a risky act and investors are concerned with the risk inherent in, and return provided by, their investments. They need information to hep them decide whether they shoud buy, hod or se. 9 They are aso interested in information on the entity s financia performance and financia position that heps them to assess both its cash-generation abiities and the stewardship of management. 10 Much of the investment in shares through the Stock Exchange in the UK is carried out by institutiona investors, such as pension funds, insurance companies, unit trusts and investment trusts. The day-to-day business of buying and seing shares is carried out by a fund manager empoyed by the institutiona investor. Private investors are in the minority as a group of investors in the UK. They wi often take the advice of an

14 14 Part 1 A conceptua framework: setting the scene equities anayst who investigates and reports on share investment. The fund managers and the equities anaysts are aso regarded as users of accounting information. The kinds of judgements and decisions made by investors coud incude any or a of the foowing: (a) Evauating the performance of the entity. (b) Assessing the effectiveness of the entity in achieving objectives (incuding compiance with stewardship obigations) estabished previousy by its management, its members or owners. (c) Evauating manageria performance, efficiency and objectives, incuding investment and dividend distribution pans. (d) Ascertaining the experience and background of company directors and officias incuding detais of other directorships or officia positions hed. (e) Ascertaining the economic stabiity and vunerabiity of the reporting entity. (f) Assessing the iquidity of the entity, its present or future requirements for additiona working capita, and its abiity to raise ong-term and short-term finance. (g) Assessing the capacity of the entity to make future reaocations of its resources for economic purposes. (h) Estimating the future prospects of the entity, incuding its capacity to pay dividends, and predicting future eves of investment. (i) Making economic comparisons, either for the given entity over a period of time or with other entities at one point in time. ( j) Estimating the vaue of present or prospective interests in or caims on the entity. (k) Ascertaining the ownership and contro of the entity. 11 That ist was prepared in 1975 and, whie it is a vaid representation of the needs of investors, carries an undertone which impies that the investors have to do quite a ot of the work themseves in making estimates of the prospects of the entity. Today there is a stronger view that the management of a business shoud share more of its thinking and panning with the investors. The ist may therefore be expanded by suggesting that it woud be hepfu for investors (and a externa users) to know: (a) the entity s actua performance for the most recent accounting period and how this compares with its previous pan for that period; (b) management s expanations of any significant variances between the two; and (c) management s financia pan for the current and forward accounting periods, and expanations of the major assumptions used in preparing it. 12 If you ook through some annua reports of major isted companies you wi see that this is more a wish ist than a statement of current practice, but it is indicative of the need for a more progressive approach. In the annua reports of arge companies you wi find a section caed the Operating and financia review (or simiar tite). This is where the more progressive companies wi incude forward-ooking statements which stop short of making a forecast but give hep in understanding which of the trends observed in the past are ikey to continue into the future Empoyees Empoyees and their representatives are interested in information about the stabiity and profitabiity of their empoyers. They are aso interested in information that heps them to assess the abiity of the entity to provide remuneration, retirement benefits and empoyment opportunities. 13 Empoyees continue to be interested in their empoyer after they have retired from work because in many cases the empoyer provides a pension fund. The matters which are ikey to be of interest to past, present and prospective empoyees incude: the abiity of the empoyer to meet wage agreements; management s

15 Chapter 1 Who needs accounting? 15 intentions regarding empoyment eves, ocations and working conditions; the pay, conditions and terms of empoyment of various groups of empoyees; job security; and the contribution made by empoyees in other divisions of the organisation. Much of this is quite speciaised and detaied information. It may be preferabe to suppy this to empoyees by means of specia purpose reports on a frequent basis rather than waiting for the annua report, which is sow to arrive and more genera in nature. However, empoyees may ook to financia statements to confirm information provided previousy in other forms Lenders Lenders are interested in information that enabes them to determine whether their oans, and the reated interest, wi be paid when due. 14 Loan creditors provide finance on a onger-term basis. They wi wish to assess the economic stabiity and vunerabiity of the borrower. They are particuary concerned with the risk of defaut and its consequences. They may impose conditions (caed oan covenants) which require the business to keep its overa borrowing within acceptabe imits. The financia statements may provide evidence that the oan covenant conditions are being met. Some enders wi ask for specia reports as we as the genera financia statements. Banks in particuar wi ask for cash fow projections showing how the business pans to repay, with interest, the money borrowed Suppiers and other trade creditors Suppiers of goods and services (aso caed trade creditors) are interested in information that enabes them to decide whether to se to the entity and to determine whether amounts owing to them wi be paid when due. Suppiers (trade creditors) are ikey to be interested in an entity over a shorter period than enders uness they are dependent upon the continuation of the entity as a major customer. 15 The amount due to be paid to the suppier is caed a trade payabe or an account payabe. Trade creditors suppy goods and services to an entity and have very itte protection if the entity fais because there are insufficient assets to meet a iabiities. They are usuay cassed as unsecured creditors, which means they are a ong way down the queue for payment. So they have to exercise caution in finding out whether the business is abe to pay and how much risk of non-payment exists. This information need not necessariy come from accounting statements; it coud be obtained by reading the oca press and trade journas, joining the Chamber of Trade, and generay istening in to the stories and gossip circuating in the geographic area or the industry. However, the financia statements of an entity may confirm the stories gained from other sources. In recent years there has been a move for companies to work more cosey with their suppiers and to estabish partnership arrangements where the operationa and financia pans of both may be dovetaied by specifying the amount and the timing of goods and services required. Such arrangements depend heaviy on confidence, which in turn may be derived party from the strength of financia statements Customers Customers have an interest in information about the continuance of an entity, especiay when they have a ong-term invovement with, or are dependent upon, its prosperity. 16 In particuar, customers need information concerning the current and future suppy of goods and services offered, price and other product detais, and conditions of sae. Much of this information may be obtained from saes iterature or from saes staff of the enterprise, or from trade and consumer journas. 17

16 16 Part 1 A conceptua framework: setting the scene The financia statements provide usefu confirmation of the reiabiity of the enterprise itsef as a continuing source of suppy, especiay when the customer is making payments in advance. They aso confirm the capacity of the entity in terms of noncurrent assets (aso caed fixed assets) and working capita and give some indication of the strength of the entity to meet any obigations under guarantees or warranties Governments and their agencies Governments and their agencies are interested in the aocation of resources and, therefore, in the activities of entities. They aso require information in order to reguate the activities of entities, assess taxation and provide a basis for nationa income and economic statistics. 19 Acting on behaf of the UK government s Treasury Department, HM Revenue and Customs coects taxes from businesses based on profit cacuated according to commercia accounting practices (athough there are some specific rues in the taxation egisation which modify the norma accounting practices). HM Revenue and Customs has the power to demand more information than appears in pubished financia statements, but wi take these as a starting point. Other agencies incude the reguators of the various utiity companies. Exampes are Ofcom 20 (the Office of Communications) and Ofgem 21 (the Office of Gas and Eectricity Markets). They use accounting information as part of the package by which they monitor the prices charged by these organisations to consumers of their services. They aso demand additiona information designed especiay to meet their needs Pubic interest Enterprises affect members of the pubic in a variety of ways. For exampe, enterprises may make a substantia contribution to the oca economy by providing empoyment and using oca suppiers. Financia statements may assist the pubic by providing information about the trends and recent deveopments in the prosperity of the entity and the range of its activities. 22 A strong eement of pubic interest has been aroused in recent years by environmenta issues and the impact of companies on the environment. There are costs imposed on others when a company poutes a river or discharges harmfu gases into the air. It may be perceived that a company is cutting corners to prune its own reported costs at the expense of other peope. Furthermore, there are activities of companies today which wi impose costs in the future. Where an oi company has instaed a driing rig in the North Sea, it wi be expected one day to remove and destroy the rig safey. There is a question as to whether the company wi be abe to meet that cost. These costs and future iabiities may be difficut to identify and quantify, but that does not mean that companies shoud not attempt to do so. More companies are now incuding descriptions of environmenta poicy in their annua reports, but reguar accounting procedures for incuding environmenta costs and obigations in the financia statements have not yet been deveoped. Activity 1.7 Look back to the ist of users of financia statements which you prepared earier in this chapter. How cosey does your ist compare with the users described in this section? Did you have any in your ist which are not incuded here? Have you used names which differ from those used in the chapter? Are there users in the chapter which are not in your ist? If your ist does not match the section, ask for hep from your ecturer, tutor or other expert in the subject so that you are satisfied that this book wi continue to meet your persona earning outcomes.

17 Chapter 1 Who needs accounting? Genera purpose or specific purpose financia statements? Some experts who have anaysed the needs of users in the manner set out in the previous section have come to the concusion that no singe set of genera purpose financia statements coud meet a these needs. It has been expained in the previous section that some users aready turn to specia reports to meet specific needs. Other experts hod that there coud be a form of genera purpose financia statements which woud meet a the needs of some user groups and some of the needs of others. This book is written on the assumption that it is possibe to prepare a set of genera purpose financia statements which wi have some interest for a users. The existence of such reports is particuary important for those who cannot prescribe the information they woud ike to receive from an organisation. That is perhaps because they have no bargaining power, or because they are many in number but not significant in economic infuence. Preparers of genera purpose financia statements tend to regard the owners and ong-term enders as the primary users of the information provided. There is an expectation or hope that the interests of these groups wi overap to some extent with the interests of a wider user group and that any improvements in financia statements wi be sufficient that fewer needs wi be eft unmet. 23 The primary focus of the Framework is on genera purpose financia statements. 24 It takes the view that many users have to rey on the financia statements as their major source of financia information. Financia statements shoud be prepared with their needs in mind. The Framework assumes that if financia statements meet the needs of investors, they wi aso meet the needs of most other users Stewards and agents In an earier section, the needs of investors as users were isted and the word stewardship appeared. In the days before an industria society existed, stewards were the peope who ooked after the manor house and ands whie the ord of the manor enjoyed the profits earned. Traditionay, accounting has been regarded as having a particuar roe to pay in confirming that those who manage a business on behaf of the owner take good care of the resources entrusted to them and earn a satisfactory profit for the owner by using those resources. As the idea of a wider range of users emerged, this idea of the stewardship objective of accounting was mentioned ess often (athough its infuence remains strong in egisation governing accounting practice). In the academic iterature it has been reborn under a new heading that of agency. Theories have been deveoped about the reationship between the owner, as principa, and the manager, as agent. A conscientious manager, acting as an agent, wi carry out their duties in the best interest of the owners, and is required by the aw of agency to do so. However, not a agents wi be perfect in carrying out this roe and some principas wi not trust the agent entirey. The principa wi incur costs in monitoring (enquiring into) the activities of the agent and may ose some weath if the interests of the agent and the interests of the principa diverge. The view taken in agency theory is that there is an inherent confict between the two parties and so they spend time agreeing contracts which wi minimise that confict. The contracts wi incude arrangements for the agent to suppy information on a reguar basis to the principa. Whie the study of agency theory in a its aspects coud occupy a book in itsef, the idea of conficts and the need for compromise in deaing with pressures of demand for,

18 18 Part 1 A conceptua framework: setting the scene and suppy of, accounting information may be hepfu in ater chapters in understanding why it takes so ong to find answers to some accounting issues. 1.8 Who needs financia statements? In order to keep the favour of debate on accounting issues running through this text, two peope wi give their comments from time to time. The first of these is David Wison, a fund manager of seven years experience working for an insurance company. He manages a UK equity portfoio (a coection of company shares) and part of his work requires him to be an equities anayst. At university he took a degree in history and has subsequenty passed examinations to quaify as a chartered financia anayst (CFA). 26 The second is Leona Rees, an audit manager with a major accountancy firm. She has five years experience as a quaified accountant and had previousy spent three years in training with the same firm. Her university degree is in accounting and economics and she has passed the examinations to quaify for membership of one of the major accountancy bodies. David and Leona had been at schoo together but then went to different universities. More recenty they have met again at workout sessions at a heath cub, reaxing afterwards at a nearby bar. David is very enthusiastic about his work, which demands ong hours and a fexibe attitude. He has absorbed a itte of the genera scepticism of audit which is expressed by some of his fund manager coeagues. Leona s main roe at present is in company audit and she is now sufficienty experienced to be working on the audit of one isted company as we as severa private companies of varying size. For two years she worked in the corporate recovery department of the accountancy firm, preparing information to hep companies find sources of finance to overcome difficut times. She fees that a great dea of accounting work is carried out behind the scenes and the carefu procedures are not aways appreciated by those who concentrate ony on the reativey few we-pubicised probems. We join them in the bar at the end of a hectic working week. DAVID: This week I ve made three visits to companies, attended four presentations of preiminary announcements of resuts, received copies of the projector sides used for five others that I coudn t attend, and coected around 20 annua reports. I have a sma mound of brokers reports, a of which say much the same thing but in different ways. I ve had to read a those whie preparing my monthy report to the head of Equities Section on the performance of my fund and setting out my strategy for three months ahead consistent with in-house poicy. I think I m suffering from information overoad and I have reservations about the reiabiity of any singe item of information I receive about a company. LEONA: If I had to give scores for reiabiity to the information crossing your desk, I woud give top marks to the 20 annua reports. They have been through a very rigorous process and they have been audited by reputabe audit firms using estabished standards of auditing practice. DAVID: That s a very we, but it takes so ong for annua reports to arrive after the financia year-end that they don t contain any new information. I need to get information at the first avaiabe opportunity if I m to keep up the vaue of the share portfoio I manage. The meetings that present the preiminary announcements are hed ess than two months after the accounting year-end. It can take another six weeks before the printed annua report appears. If I don t manage to get to the meeting I take a carefu ook at what the company sends me in the way of copies of projector sides used.

19 Chapter 1 Who needs accounting? 19 LEONA: Where does accounting information fit in with the picture you want of a company? DAVID: It has some importance, but accounting information is backward-ooking and I invest in the future. We visit every company in the portfoio once a year and I m ooking for a confident management team, a cheerfu-ooking workforce and a genera feeing that things are moving ahead. I aso ask questions about prospects: how is the order book; which overseas markets are expanding; have prices been increased to match the increase in raw materias? LEONA: Isn t that cose to gaining insider information? DAVID: No I see it as carification of information which is aready pubished. Companies are very carefu not to give an advantage to one investor over another they woud be in troube with the Stock Exchange and perhaps with the Financia Services Authority if they did give price-sensitive information. There are times of the year (running up to the year-end and to the haf-yeary resuts) when they decare a cose season and won t even speak to an investor. LEONA: So are you teing me that I spend vast amounts of time auditing financia statements which no one bothers to read? DAVID: Some peope woud say that, but I woudn t. It s fairy cear that share prices are unmoved by the issue of the annua report, probaby because investors aready have that information from the preiminary announcement. Nevertheess, we ike to know that there is a reguated document behind the information we receive it aows us to check that we re not being ed astray. Aso I find the annua report very usefu when I want to find out about a company I don t know. For the companies I understand we, the annua report tes me itte that I don t aready know. LEONA: I take that as a very sma vote of confidence for now. If your offer to hep me redecorate the fat sti stands, I might try to persuade you over a few cans of emusion that you rey on audited accounts more than you reaise. Activity 1.8 As a fina activity for this chapter, go back to the start of the chapter and make a note of every word you have encountered for the first time. Look at the gossary at the end of the book for the definition of each technica word. If the word is not in the gossary it is probaby in sufficienty genera use to be found in a standard dictionary. 1.9 Summary This chapter has expained that accounting is intended to provide information that is usefu to a wide range of interested parties (stakehoders). Key points are: Accounting is the process of identifying, measuring and communicating financia information about an entity to permit informed judgements and decisions by users of the information. A conceptua framework for accounting is a statement of principes which provides generay accepted guidance for the deveopment of new reporting practices and for chaenging and evauating the existing practices. The Framework of the IASB provides broad principes that guide accounting practice in many countries.

20 20 Part 1 A conceptua framework: setting the scene The Statement of Principes of the UK ASB has many simiarities to the IASB s Framework. Since January 2005, a isted companies in member states of the EU have been required by an accounting reguation to use a system of internationa financia reporting standards (IFRS) set by the IASB. Business entities in the UK are either soe traders, partnerships or imited iabiity companies. Users of accounting information incude management, owners, empoyees, enders, suppiers, customers, governments and their agencies and the pubic interest. Stakehoders are a those who might have a egitimate interest in receiving financia information about a business because they have a stake in it. Genera purpose financia statements aim to meet the needs of a wide range of users. The reationship between the owner, as principa, and the manager, as agent is described in the theory of agency reationships. Accounting information heps to reduce the potentia conficts of interest between principa and agent. Further reading ASSC (1975), The Corporate Report, Accounting Standards Steering Committee. Beattie, V. (ed.) (1999), Business Reporting: The Inevitabe Change?, Research Committee of The Institute of Chartered Accountants of Scotand. IASB (1989), Framework for the Preparation and Presentation of Financia Statements, Internationa Accounting Standards Board. ICAS (1988), Making Corporate Reports Vauabe, discussion paper of the Research Committee of The Institute of Chartered Accountants of Scotand. Marston, C. (1999), Investor Reations Meetings: Views of Companies, Institutiona Investors and Anaysts, Research Committee of The Institute of Chartered Accountants of Scotand. Weetman, P. and Beattie, A. (eds) (1999), Corporate Communication: Views of Institutiona Investors and Lenders, Research Committee of The Institute of Chartered Accountants of Scotand. QUESTIONS The Questions section of each chapter has three types of question. Test your understanding questions to hep you review your reading are in the A series of questions. You wi find the answers to these by reading and thinking about the materia in the book. Appication questions to test your abiity to appy technica skis are in the B series of questions. Questions requiring you to show skis in probem soving and evauation are in the C series of questions. A etter [S] indicates that there is a soution at the end of the book. A Test your understanding A1.1 Define accounting and identify the separate questions raised by the definition. (Section 1.1) A1.2 The foowing technica terms appear for the first time in this chapter. Check that you know the meaning of each. (If you can t find them again in the text, there is a gossary at the end of the book.)

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