The Role of Accounting in Business. ACTY5200 Accounting for Business

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1 The Role of Accounting in Business ACTY5200 Accounting for Business

2 Chapter 1 Learning Outcome 1 Explore the role of accounting information in business When you have completed this Learning Outcome, you will be able to Outline the role of accounting in decision making by various users Explain the difference between financial accounting, management accounting and financial management Analyse the advantages and disadvantages of common types of business structures

3 Section 1 Explore the role of accounting information in business TOPICS 1. Outline the role of accounting in decision making by various users 1. What is Accounting 2. A Business Types of Businesses 4. Business Activities 2. Types of Business Ownership 1. Sole Proprietor 2. General Partnership 3. Company What is Accounting? ACCOUNTING IS WHAT ACCOUNTANTS DO just what is it that accountants do? There are many answers. Accountants are found wherever money measurements are needed, wherever money-related decisions must be made, wherever money-based reports must be prepared and assessed. In our modern society this is almost everywhere. Accounting is the language of business. Money measurements are the common denominator, which companies, nations, divisions, plants, regions and products use to combine their separate activities into measurements for the organisation as a whole. The accountant is also the principal user of the major information system in an organisation and, often, its manager. Accounting is the skill. Accountancy is the profession. (Hamilton, F. & Black, C. (2000). Accounting, a user/decision perspective (2nd Ed.). New Zealand: Pearson Education) The American Accounting Association (AAA) defines accounting as: The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by the users of the information. (AAA, 1996). 2

4 Financial Accounting provides statements to external users to enable them to understand the organisation. Management Accounting provides information to the internal users to enable them to understand the organisation. Financial Management is about obtaining and using cash in an organisation. A Business. A business is a task or activity undertaken by a commercial or industrial organisation. A business activity, or transaction, is an exchange of goods or services from one person or entity to another person or entity. The main purpose or prime objective of a business is to make a profit which creates wealth for the owners of the business. Therefore the business must survive (continuity). 1.1 Give examples of accounting information you use. 1.2 Give an example of how changes in society might influence accounting. Types of businesses Businesses exist to make a profit, but there are also many non-trading, non-profit making organisations such as churches, hospitals and clubs, which also require accounting records. A profit making business arises because of people s need for goods and services and can be divided into three broad groups. Businesses, which sell services These businesses do not sell anything that you can touch (tangible) but they still need to keep records of how time is spent and the income that they receive. Examples of this type of business are doctors, dentists, lawyers and accountants. All of the above require accounting records but the way in which the financial statements are presented will be different depending on the type of business. Businesses, which sell goods These businesses will buy goods from a manufacturer or a wholesaler and sell them on to their customers without changing the goods in any way. These goods are tangible you can touch and see them. Examples of this type of business are supermarkets, clothing stores and book-shops. Larger shops may have many branches and may manufacture their own products as well. Businesses, which make goods These businesses will use raw materials, apply processes to those raw materials and, turn them into a different product. A clothing factory and a restaurant are examples of this type of business, which make (manufacture) goods. 1.3 List some of the stakeholders for an accounting entity. 1.4 What could a business do with the profit it makes? 3

5 Business activities The business obtains finance to invest in assets, to use the assets to operate the business. Financing activities involve capital and loan funds borrowing. Investing activities involve assets. Operating activities are what the business does to create wealth. Types of business ownership The way in which the accounting information is reported will depend on the type of ownership. The main types of ownership are: ownership is common among lawyers and doctors, as the ethics of their professions require them to operate with unlimited liability. Company An important feature of a company is that it is a separate legal entity from its owners (shareholders). Because the company is a legal entity, it is responsible for its own debts and losses. This means that once the shareholders have paid the agreed purchase price for their shares, this is all that they contribute to the debts of the company. The shareholders have limited liability. The life of the company is not limited by the life of the shareholders. An existing shareholder may sell shares to another person who wishes to become a shareholder. When a shareholder dies, another person will receive or buy the shares. Sole proprietor This is one person in business on his or her own a sole owner or sole proprietor. The owner makes all the decisions but has no other owner of the business to consult if needed. The owner also keeps all the profits but, if the business should fail, the owner not only loses the business but all his or her personal possessions until the business debts are paid. A sole proprietor has unlimited liability. It is also more difficult to obtain finance for a sole proprietor business. Many businesses start under sole proprietor ownership. Partnership Under this type of ownership, two or more people decide to use their skills and resources and go into business together. A partnership, like a sole proprietorship, has unlimited liability. Partners are responsible individually or together for the debts of the business. One partner may get the partnership into debt but another partner may have to pay those debts out of their personal funds. Partnership 4

6 Comparison of Ownership Sole Proprietor Partnership Company Ownership One owner Two or more One or more Capital Legal Status of Business Entity Profit Sharing Provided by owner Not a separate legal entity All to the owner as drawings Partners contribute according to partnership agreement Not a separate legal entity Shared as drawings according to partnership agreement or Partnership Act 1908 Contribute as shares Separate legal entity Dividends declared by directors Management Owner Each partner Appointed by shareholders Liability for debts Risk of Ownership Duration of Life Transfer of Ownership Sources of Finance Unlimited Unlimited Limited to amount outstanding on share capital Owner s personal assets at risk Ends by owner s choice or death of owner If proprietor sells his interest, the business is reformed under new ownership Owner s funds and borrowings Owner s personal assets at risk Ends by choice or withdrawal of partner Partnership share cannot be sold without agreement of other partners: new partnership formed. Partners funds borrowings Limited liability Continues even when shareholders change. Shareholders can choose to end the company. Usually transferable Shares and borrowings Review 1.1 Try these Questions Question 1 of 6 Accounting is the process of: A. identifying, measuring and communicating economic information; B. analysing, recording and reporting financial information; C. inputting, processing and outputting economic information; D. planning, implementing and monitoring economic activity. Check Answer 5

7 Section 2 The process of Accounting TOPICS 1. The process of Accounting 2. Four main financial statements 3. The characteristics of Accounting information 4. Accounting conventions and rules The process of Accounting Identify and capture relevant economic information Record the information collected in a systematic manner Analyse and interpret the information collected Report the information in a manner that suits the needs of users Try this You Tube video 6

8 There are four main financial statements: The statement of cash flows (shows the sources and uses of cash for a period) The statement of comprehensive income (commonly referred to as the income statement, sometimes called the profit and loss statement; measures and reports how much profit has been generated in a period) The statement of changes in equity (sometimes referred to as the statement of changes in owners equity; shows all changes in owners interest in the net assets from transactions during the period) The statement of financial position (commonly referred to as the balance sheet; shows the assets of a business and the claims on those assets) Illustrative Example With this example you are required to draw up the four financial statements as they would exist at the end of each trading day. How much did wealth increase as a result of the first day s trading? The increase or decrease in wealth is measured as the difference between sales made and the cost of goods sold sales were $110 less cost of goods sold $75 = profit of $35 Note that only the cost of the paper sold is measured against the sales to find profit, not the total cost of the wrapping paper purchased. What is the financial position at the end of the first day? At the end of the first day, a balance sheet is drawn up, showing the resources held by the business: Cash (closing balance) = $110 Inventory (stock available for resale) = $25 Interactive 1.1 Total business wealth at end of day = $135 Paul starts a wrapping paper sales business with $100. On the first day, he uses the $100 to purchase wrapping paper ( inventory ). On the same day he sells 75% of that inventory for $110 in total. Note that the profit of $35 has led to an increase in wealth of $35. What cash movements took place in the first day of trading? Closing cash balance for the day is $110 (opening balance $100 $100 stock purchase + $110 sales = $110) On the second day of trading, Paul purchased more wrapping paper for $50 cash. He managed to sell all of the new wrapping paper and half of the earlier inventory for a total of $90. 7

9 On The third day of the business venture, Paul purchased more inventory for $100 cash. However, it was raining hard and sales were slow. After Paul had sold half of the total inventory for $65, he decided to stop trading until the following day. Note also that the increase in cash of $10 is not the same as the increase in wealth because wealth does not exist only in the form of cash (see inventory). Atril, P., McLaney, E., Harvey, D., Jenner, M., Weil, S. (2011). Accounting an introduction (pp ). Auckland, New Zealand: Pearson. Materiality. All significant items must be reported in accounting reports. This allows for immaterial amounts to be omitted. The test of whether items are material is whether or not their omission would influence financial decisionmaking. For example, materiality leads to the omission of cents in accounting reports as they have an insignificant effect on the users of accounting information. Comparability. Accounting reports are used to track changes in a firm s performance over consecutive accounting periods. Users of reports must be able to compare results from different years. In order to do this, the same methods must be applied consistently from one accounting period to the next. (ACS Distance Education. Accounting conventions and standards.) Accounting conventions and rules The characteristics of accounting information Accounting is influenced by several underlying qualitative characteristics. Relevance. Accounting information needs to relevant to the entity under examination. Only events relevant to the business entity are recorded and reported. Reliability. Because a wide range of financial decisions are made/influenced by accounting reports, there is a high expectation that such reports contain reliable information. Understandability. This refers to the extent to which information can be understood by a suitably qualified user. Accounting information should be able to be understood. Accounting conventions (or assumptions) are the basic rules of accounting which have become acceptable procedures over time. They are the basic rules of accounting. Accounting standards are laws for members of the professional bodies to follow. Together they form a set of rules which allow accounting records and reports to be prepared in a similar fashion, regardless of the type of business or the form of ownership. The more important conventions are as follows: The accounting entity convention is the basic principle that the personal transactions of the owner(s) should be kept separate from those of the business. The business is always viewed as a separate entity, regardless of whether the firm is a sole trader, a partnership or a company. The historical cost convention is a rule which states that all transactions are recorded at their original value, and adjustments are not made for inflation. This means that assets are not valued at what they could be sold for at the present 8

10 time. All items stay in the accounting records at their historical or original price. This method is quite objective, as it relies on document evidence such as invoices and receipts. There are some exceptions to this rule, for example with land. Unlike most assets which lose value over time, land normally appreciates in value and may be revalued in some circumstances. better to err on the safe side. There is a tendency to allow for all possible losses and to recognise gains if reasonably certain that they will occur. The going concern assumption conceives that a business will continue as a going concern for an indefinite period. By following this rule, accountants can report long-term assets in a balance sheet. Otherwise they would all have to be written off as costs in their year of purchase. The going concern rule also allows accountants to cater for transactions which overlap over two consecutive years, as is the case with many credit transactions. The accounting period convention endeavours to address the problem which arises once it is assumed that a business will go on forever. People are interested in how a business is performing in terms of profit, but do not want to wait until the business ceases to see how successful it was. Therefore, the continuous life of a business is divided into equal periods of time for the purpose of calculating profit or loss. These arbitrary periods are known as accounting periods. The length of an accounting period may be a week, a month, a quarter, or a full year, but must not be any longer due to taxation requirements. The consistency principle requires that the accounting methods used are applied consistently from one accounting period to the next. By applying the same accounting techniques, comparisons of performance can be made over time. Verifiability is the concept that evidence should be available whenever possible to verify or check the details of financial transactions. Business documents such as invoices, receipts and cheque butts are the tools of verifiability. Accounting Standards Review 1.2 Try these questions Question 1 of 5 Which of the following is not a main qualitative characteristic of accounting information A. Comparability B. Understandability C. Relevance D. Confidentiality Conservatism (prudence). Accounting, in some cases, involves a degree of estimation. It is generally accepted that when trying to predict the future, it is Check Answer 9

11 As economies grew, companies became bigger and more complex. The need arose for a set of commonly applied and accepted standards which could be followed by accountants. Standards were established in many countries over the 20th century and as time moves forward, many countries move to align increasingly with each other through adoption of international standards. There may still be some variance from country to country. (ACS Distance Education. Accounting conventions and standards.) Interactive 1.2 References ACS Distance Education. Accounting conventions and standards. Retrieved from Atril, P., McLaney, E., Harvey, D., Jenner, M., Weil, S. (2011). Accounting an introduction (pp ). Auckland, New Zealand: Pearson. 10