Financial Acounting

Introduction to Accounting

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Introduction to accounting

Introduction

It is not easy to provide a concise definition of accounting since the word has a broad application within businesses and applications.

The American Accounting Association define accounting as follows:

"the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information!.

This definition is a good place to start. Let's look at the key words in the above definition:

- It suggests that accounting is about providing information to others. Accounting information is economic information - it relates to the financial or economic activities of the business or organisation.

- Accounting information needs to be identified and measured. This is done by way of a "set of accounts", based on a system of accounting known as double-entry bookkeeping. The accounting system identifies and records "accounting transactions".

- The "measurement" of accounting information is not a straight-forward process. it involves making judgements about the value of assets owned by a business or liabilities owed by a business. it is also about accurately measuring how much profit or loss has been made by a business in a particular period. As we will see, the measurement of accounting information often requires subjective judgement to come to a conclusion

- The definition identifies the need for accounting information to be communicated. The way in which this communication is achieved may vary. There are several forms of accounting communication (e.g. annual report and accounts, management accounting reports) each of which serve a slightly different purpose. The communication need is about understanding who needs the accounting information, and what they need to know!

Accounting information is communicated using "financial statements"

What is the purpose of financial statements?

There are two main purposes of financial statements:

(1) To report on the financial position of an entity (e.g. a business, an organisation);

(2) To show how the entity has performed (financially) over a particularly period of time (an "accounting period").

The most common measurement of "performance" is profit.

It is important to understand that financial statements can be historical or relate to the future.

Accountability

Accounting is about ACCOUNTABILTY

Most organisations are externally accountable in some way for their actions and activities. They will produce reports on their activities that will reflect their objectives and the people to whom they are accountable.

The table below provides examples of different types of organisations and how accountability is linked to their differing organisational objectives:

Organisation	Objectives	Accountable to (examples)
Private or public company (e.g. BP, Tesco)	- Making of profit - Creation of wealth	- Shareholders - Other stakeholders (e.g. employees, customers, suppliers)
Charities (e.g. Save the Children)	- Achievement of charitable aims - Maximise spending on activities	- Charity commissioners - Donors
Local Authorities (e.g.  Leeds City Council)	- Provision of local services - Optimal allocation of spending budget	- Local electorate - Government departments
Public services (e.g. transport, health) (e.g. National Health Service, Prison Service)	- Provision of public service (often required by law) - High quality and reliability of services	- Government ministers - Consumers
Quasi-governmental agencies (e.g. Data Protection Registrar, Scottish Arts Council)	- Regulation or instigation of some public action - Coordination of public sector investments	- Government ministers - Consumers

All of the above organisations have a significant roles to play in society and have multiple stakeholders to whom they are accountable.

All require systems of financial management to enable them to produce accounting information.

How accounting information helps businesses be accountable

As we have said in our introductory definition, accounting is essentially an "information process" that serves several purposes:

- Providing a record of assets owned, amounts owed to others and monies invested;

- Providing reports showing the financial position of an organisation and the profitability of its operations

- Helps management actually manage the organisation

- Provides a way of measuring an organisation's effectiveness (and that of its separate parts and management)

- Helps stakeholders monitor an organisations activities and performance

- Enables potential investors or funders to evaluate an organisation and make decisions

There are many potential users of accounting Information, including shareholders, lenders, customers, suppliers, government departments (e.g. Inland Revenue), employees and their organisations, and society at large. Anyone with an interest in the performance and activities of an organisation is traditionally called a stakeholder.

For a business or organisation to communicate its results and position to stakeholders, it needs a language that is understood by all in common. Hence, accounting has come to be known as the "language of business"

There are two broad types of accounting information:

(1) Financial Accounts: geared toward external users of accounting information
(2) Management Accounts: aimed more at internal users of accounting information

Although there is a difference in the type of information presented in financial and management accounts, the underlying objective is the same - to satisfy the information needs of the user. These needs can be described in terms of the following overall information objectives:

Collection	Collection in money terms of information relating to transactions that have resulted from business operations
Recording and Classifying	Recording and classifying data into a permanent and logical form. This is usually referred to as "Book-keeping"
Summarising	Summarising data to produce statements and reports that will be useful to the various users of accounting information - both external and internal
Interpreting and Communicating	Interpreting and communicating the performance of the business to the management and its owners
Forecasting and Planning	Forecasting and planning for future operation of the business by providing management with evaluations of the viability of proposed operations. The key forecasting and planning tool is the "Budget"

The process by which accounting information is collected, reported, interpreted and actioned is called "Financial Management". Taking a commercial business as the most common organisational structure, the key objectives of financial management would be to:

(1) Create wealth for the business
(2) Generate cash, and
(3) Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested

In preparing accounting information, care should be taken to ensure that the information presents an accurate and true view of the business performance and position. To impose some order on what is a subjective task, accounting has adopted certain conventions and concepts which should be applied in preparing accounts.

For financial accounts, the regulation or control of what kind of information is prepared and presented goes much further. UK and international companies are required to comply with a wide range of Accounting Standards which define the way in which business transactions are disclosed and reported. These are applied by businesses through their Accounting Policies.

The main financial accounting statements

The purpose of financial accounting statements is mainly to show the financial position of a business at a particular point in time and to show how that business has performed over a specific period.

The three main financial accounting statements that help achieve this aim are:

(1) The profit and loss account (or income statement) for the reporting period

(2) A balance sheet for the business at the end of the reporting period

(3) A cash flow statement for the reporting period

A balance sheet shows at a particular point in time what resources are owned by a business ("assets") and what it owes to other parties ("liabilities"). It also shows how much has been invested in the business and what the sources of that investment finance were.

It is often helpful to think of a balance sheet as a "snap-shot" of the business - a picture of the financial position of the business at a specific point. Whilst this is a useful picture to have, every time an accounting transaction takes place, the "snap-shot" picture will have changed.

By contrast, the profit and loss account provides a perspective on a longer time-period. If the balance sheet is a "digital snap-shot" of the business, then think of the profit and loss account as the "DVD" of the business' activities. The story of what financial transactions took place in a particular period - and (most importantly) what the overall result of those transactions was.

Not surprisingly, the profit and loss account measures "profit".

What is profit?

Profit is the amount by which sales revenue (also known as "turnover" or "income") exceeds "expenses" (or "costs") for the period being measured.

Accounting - Users of Accounts

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Users of accounts

The financial accounts provide a wealth of information that is useful to various users of financial information, as summarised below:

User	Interest in / Use of Accounting Information
Investors	Investors are concerned about risk and return in relation to their investments. They require information to decide whether they should continue to invest in a business. They also need to be able to assess whether a business will be able to pay dividends, and to measure the performance of the business' management overall
Lenders	Banks and other financial institutions who lend money to a business require information that helps them determined whether loans and interest will be paid when due
Creditors	Suppliers and trade creditors require information that helps them understand and assess the short-term liquidity of a business. Is the business able to pay short-term debt when it falls due?
Customers & Debtors	Customers and trade debtors require information about the ability of the business to survive and prosper. As customers of the company's products, they have a long-term interest in the company's range of products and services. They may even be dependent on the business for certain products or services
Employees	Employees (and organisations that represent them - e.g. trade unions) require information about the stability and continuing profitability of the business. They are crucially interested in information about employment prospects and the maintenance of pension funding and retirement benefits. They are also likely to interested in the pay and benefits obtained by senior management!
Government	There are many government agencies and departments that are interested in accounting information. For example, the IR&CE needs information on business profitability in order to levy and collect Corporation Tax. Various regulatory agencies (e.g. the Competition Commission and the Environment Agency) need information to support decisions about takeovers and grants, for example.
Analysts	Investment analysts are an important user group - specifically for companies quoted on a stock exchange. They require very detailed financial and other information in order to analyse the competitive performance of a business and its sector. Much of this is provided by the detailed accounting disclosures that are required by the London Stock Exchange. However, additional accounting information is usually provided to analysts via formal company briefings and interviews.
General public	Interest groups, formed by various groups of individuals who have a specific interest in the activities and performance of businesses, will also require accounting information.

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Accounting Concepts and Conventions

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Accounting concepts and conventions

In drawing up accounting statements, whether they are external "financial accounts" or internally-focused "management accounts", a clear objective has to be that the accounts fairly reflect the true "substance" of the business and the results of its operation.

The theory of accounting has, therefore, developed the concept of a "true and fair view". The true and fair view is applied in ensuring and assessing whether accounts do indeed portray accurately the business' activities.

To support the application of the "true and fair view", accounting has adopted certain concepts and conventions which help to ensure that accounting information is presented accurately and consistently.

Accounting Conventions

The most commonly encountered convention is the "historical cost convention". This requires transactions to be recorded at the price ruling at the time, and for assets to be valued at their original cost.

Under the "historical cost convention", therefore, no account is taken of changing prices in the economy.

The other conventions you will encounter in a set of accounts can be summarised as follows:

Monetary measurement	Accountants do not account for items unless they can be quantified in monetary terms. Items that are not accounted for (unless someone is prepared to pay something for them) include things like workforce skill, morale, market leadership, brand recognition, quality of management etc.
Separate Entity	This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that relate to the business.
Realisation	With this convention, accounts recognise transactions (and any profits arising from them) at the point of sale or transfer of legal ownership - rather than just when cash actually changes hands. For example, a company that makes a sale to a customer can recognise that sale when the transaction is legal - at the point of contract. The actual payment due from the customer may not arise until several weeks (or months) later - if the customer has been granted some credit terms.
Materiality	An important convention. As we can see from the application of accounting standards and accounting policies, the preparation of accounts involves a high degree of judgement. Where decisions are required about the appropriateness of a particular accounting judgement, the "materiality" convention suggests that this should only be an issue if the judgement is "significant" or "material" to a user of the accounts. The concept of "materiality" is an important issue for auditors of financial accounts.

Accounting Concepts

Four important accounting concepts underpin the preparation of any set of accounts:

Going Concern	Accountants assume, unless there is evidence to the contrary, that a company is not going broke. This has important implications for the valuation of assets and liabilities.
Consistency	Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change.
Prudence	Profits are not recognised until a sale has been completed. In addition, a cautious view is taken for future problems and costs of the business (the are "provided for" in the accounts" as soon as their is a reasonable chance that such costs will be incurred in the future.
Matching (or "Accruals")	Income should be properly "matched" with the expenses of a given accounting period.

Key Characteristics of Accounting Information

There is general agreement that, before it can be regarded as useful in satisfying the needs of various user groups, accounting information should satisfy the following criteria:

Criteria	What it means for the preparation of accounting information
Understandability	This implies the expression, with clarity, of accounting information in such a way that it will be understandable to users - who are generally assumed to have a reasonable knowledge of business and economic activities
Relevance	This implies that, to be useful, accounting information must assist a user to form, confirm or maybe revise a view - usually in the context of making a decision (e.g. should I invest, should I lend money to this business? Should I work for this business?)
Consistency	This implies consistent treatment of similar items and application of accounting policies
Comparability	This implies the ability for users to be able to compare similar companies in the same industry group and to make comparisons of performance over time. Much of the work that goes into setting accounting standards is based around the need for comparability.
Reliability	This implies that the accounting information that is presented is truthful, accurate, complete (nothing significant missed out) and capable of being verified (e.g. by a potential investor).
Objectivity	This implies that accounting information is prepared and reported in a "neutral" way. In other words, it is not biased towards a particular user group or vested interest

 

Accounting - Introduction to Stakeholders

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Introduction to stakeholders

Let’s start with a definition of stakeholders, which are:

Groups / individuals that are affected by and/or have an interest in the operations and objectives of the business

Most businesses have a variety of stakeholder groups which can be broadly categorised as follows:

Stakeholder groups vary both in terms of their interest in the business activities and also their power to influence business decisions.  Here is a useful summary:

Stakeholder	Main Interests	Power and influence
Shareholders	Profit growth, Share price growth, dividends	Election of directors
Banks & other Lenders	Interest and principal to be repaid, maintain credit rating	Can enforce loan covenants Can withdraw banking facilities
Directors and managers	Salary ,share options, job satisfaction, status	Make decisions, have detailed information
Employees	Salaries & wages, job security, job satisfaction & motivation	Staff turnover, industrial action, service quality
Suppliers	Long term contracts, prompt payment, growth of purchasing	Pricing, quality, product availability
Customers	Reliable quality, value for money, product availability, customer service	Revenue / repeat business Word of mouth recommendation
Community	Environment, local jobs, local impact	Indirect via local planning and opinion leaders
Government	Operate legally, tax receipts, jobs	Regulation, subsidies, taxation, planning

Accounting information - characteristics

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Key characteristics of accounting information

There is general agreement that, before it can be regarded as useful in satisfying the needs of various user groups, accounting information should satisfy the following criteria:

Understandability

This implies the expression, with clarity, of accounting information in such a way that it will be understandable to users - who are generally assumed to have a reasonable knowledge of business and economic activities

Relevance

This implies that, to be useful, accounting information must assist a user to form, confirm or maybe revise a view - usually in the context of making a decision (e.g. should I invest, should I lend money to this business? Should I work for this business?)

Consistency

This implies consistent treatment of similar items and application of accounting policies

Comparability

This implies the ability for users to be able to compare similar companies in the same industry group and to make comparisons of performance over time. Much of the work that goes into setting accounting standards is based around the need for comparability.

Reliability

This implies that the accounting information that is presented is truthful, accurate, complete (nothing significant missed out) and capable of being verified (e.g. by a potential investor).

Objectivity

This implies that accounting information is prepared and reported in a "neutral" way. In other words, it is not biased towards a particular user group or vested interest

Non-financial objectives of a business

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Introduction

A business may have important non-financial objectives which will limit the achievement of financial objectives. Examples of these are summarised below:

Welfare of employees

The provision of employee welfare is an important objective; this relates to issues such as wages & salaries; comfortable and safe working conditions, training and development; pensions etc. The value of many businesses is critically-dependent on attracting and retaining high quality employees – which makes managing the welfare of such people even more important.

Serving customers

As all marketers understand, a critical activity of business is to understand and meet the needs and wants of customers. In the long-term, this objective is the foundation for a financially successful business. Non-financial objectives under this heading would include meeting defined delivery standards, product quality, reliability and after-sales service levels.

Welfare of management

Management can, and do set objectives which are essentially about their own welfare. These include objectives in relation to pay and conditions.

Relationships with Suppliers

Responsibilities to suppliers are expressed mainly in terms of trading relationships. Large businesses often have considerable buying power over their suppliers – which should be used with care. Supplier objectives would include those relating to the timing of payment and other terms of trade.

Responsibilities to Society

Businesses increasingly aware of their overall responsibility to society at large. The term that is often used is Corporate Social Responsibility. This includes a business complying with relevant laws and regulations (e.g. health and safety), minimising harmful externalities (such as pollution).

Maximising the value of a business

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Introduction

If an important financial objective of a business is to maximise the value of the business, how can this be achieved? The answer lies in the different approaches to valuing a business.

There are two broad approaches to valuing a business:

(1) Break-up Basis: this method of valuing a business is only of interest when the business is threatened with liquidation, or when management are considering selling off individual assets to raise cash;

(2) Market Value Basis: The market value of a business is the price at which buyers and sellers will trade shareholdings in a company. This method of valuation is most relevant to the financial objectives of a business.

When shares are traded on a recognised stock market, such as the Stock Exchange, the market value of a business can be measured by the share price.

When shares are held in a private company, and are not traded on any stock market, there is no easy way to measure value. It becomes a subjective judgement on behalf of both the buyer and seller about factors such as:

• Future profits and cash flows that the buyer can expect the business to deliver;

• The “intangible” quality of the business, including the quality of management, products etc.

• The strategic position of the business – e.g. is it a market leader?

Nevertheless, the objective remains for management – to maximise the wealth of their ordinary shareholders.

The wealth of shareholders in a company comes from:

• Dividends received:

• Market value of the shares

A shareholders’ return on investment is obtained from:

• Dividends received;

• Capital gains from increases in the market value of his or her shares

If shares in a business are traded on a stock market, the wealth of shareholders is increased when the share price goes up. The share price will go up when the business makes additional profits (or is expected by the market to do so) which it pays out as dividends or re-invests in the business to achieve future profit growth. However, to increase the share price, the business should try to increase profits without taking business and financial risks which worry shareholders (thereby increasing their required rate of return).

Business Objectives - Alternatives to Profit Maximisation

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Introduction

In much of economic theory, it is assumed that a business aims to maximise profits.

In reality, most businesses which are run for “commercial gain” do have profit maximisation as an important objective – since the shareholders have taken a risk investing in the business and require a return (profit) to compensate them for their risk.

There are, however, many other potential financial objectives of a business. The table below summarises three alternative models of business objectives that have attracted popular support:

Sales Maximisation Model (Baumol)

This model argues that businesses try to maximise sales or revenues rather than profits. There are several possible motives for such an objective:

• Grow or sustain market share
• Ensure survival
• Discourage competitors (particularly new entrants to a market)
• Build the prestige of the senior management – who like to be seen running a large rather than a particularly profitable business
• Achieve bonuses – if these are based on revenues rather than profits

Management Discretion Model (Williamson)

In this model, Williamson argues that management act to further their own interests – in other words to achieve personal utility rather than to meet the interests of outside investors. Businesses run with this kind of objectives tend to deliver high levels of remuneration to management rather than the highest possible profits.

Consensus Model (Cyert & March)

The consensus model presents a slightly more complicated model of business objectives. In this case, it is argued that a business is an organisational coalition of shareholders, managers, employees and customers – each with different objectives. Management therefore try to reach a consensus with these different groups – each of which must settle for less than they would otherwise want. Shareholders, therefore have to settle for profits that are less than the theoretical maximum, perhaps to ensure that employees do better.

Wealth Maximisation Model

The theory of corporate finance suggests an alternative financial objective to profit maximisation that can provide a day-to-day focus for management. This theory assumes that management’s main job is to maximise the value or wealth of the business. Within this context, management seek to ensure that investments made by the business earn a return that is satisfactory to shareholders.

Accounting - financial & management accounting compared

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Comparison of financial and management accounting

There are two broad types of accounting information:

• Financial Accounts: geared toward external users of accounting information

• Management Accounts: aimed more at internal users of accounting information

Although there is a difference in the type of information presented in financial and management accounts, the underlying objective is the same - to satisfy the information needs of the user.

Financial Accounts	Management Accounts
Financial accounts describe the performance of a business over a specific period and the state of affairs at the end of that period.  The specific period is often referred to as the "Trading Period" and is usually one year long.  The period-end date as the "Balance Sheet Date"	Management accounts are used to help management record, plan and control the activities of a business and to assist in the decision-making process.  They can be prepared for any period (for example, many retailers prepare daily management information on sales, margins and stock levels).
Companies that are incorporated under the Companies Act 1989 are required by law to prepare and publish financial accounts.  The level of detail required in these accounts reflects the size of the business with smaller companies being required to prepare only brief accounts.	There is no legal requirement to prepare management accounts, although few (if any) well-run businesses can survive without them.
The format of published financial accounts is determined by several different regulatory elements: ·   Company Law ·   Accounting Standards ·   Stock Exchange	There is no pre-determined format for management accounts.  They can be as detailed or brief as management wish.
Financial accounts concentrate on the business as a whole rather than analysing the component parts of the business.  For example, sales are aggregated to provide a figure for total sales rather than publish a detailed analysis of sales by product, market etc.	Management accounts can focus on specific areas of a business' activities.  For example, they can provide insights into performance of: ·   Products ·   Separate business locations (e.g. shops) ·   Departments / divisions
Most financial accounting information is of a monetary nature	Management accounts usually include a wide variety of non-financial information.  For example, management accounts often include analysis of: - Employees (number, costs, productivity etc.) - Sales volumes (units sold etc.) - Customer transactions (e.g. number of calls received into a call centre)
By definition, financial accounts present a historic perspective on the financial performance of the business	Management accounts largely focus on analysing historical performance.  However, they also usually include some forward-looking elements - e.g. a sales budget; cash-flow forecast.

Financial Objectives - Overview

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Financial objectives - overview

From the first day of trading, a business should set itself financial objectives.

For a start-up, the relevant financial objective is likely to be focused initially on survival - i.e. not running out of cash. 

After a while (hopefully sooner rather than later) the business aims to breakeven and then start generating a profit. 

Even better would be to generate positive cash flows out of those profits.  Medium-term financial objectives for the start-up might then also include making a return for the investors and growing the capital value of the business.

Importantly, those early financial objectives of the start-up never really disappear completely.  The many well-established businesses that became insolvent in 2008-09 during the recession would certainly have given their all to have achieved survival and emerged intact from the economic downturn. The profit objective continues to be a vitally important aim for private sector businesses of all sizes.

However, as a business becomes well-established and its products and operations become more complex, the nature of its financial objectives changes.

Why set financial objectives?  It is quite simply because the performance of a business is traditionally measured in financial terms.

Internal and external influences on financial objectives

The main internal and external influences which are likely to affect the financial objectives include:

Internal Influences	External Influences
Business ownership The nature of business ownership has a significant impact on financial objectives.  A venture capital investor would have quite a different approach to a long-standing family ownership.	Economic conditions As demonstrated by the Credit Crunch.  The economic downturn forced many businesses to reappraise their financial objectives in favour of cost minimisation and maximising cash inflows and balances. Significant changes in interest rates and exchange rates also have the potential to threaten the achievement of financial targets like ROCE.
Size and status of the business E.g. start-ups and smaller businesses tend to focus on survival, breakeven and cash flow objectives.  Quoted multinational businesses are much more focused on growing shareholder value	Competitors Competitive environment directly affects the achievability of financial objectives.  E.g. cost minimisation may become essential if a competitor is able to grow market share because it is more efficient
Other functional objectives Almost every other functional objective in a business has a financial dimension – which often brings the finance department into conflict with other functions.	Social and political change Often an indirect impact.  E.g. legislation on environmental emissions or waste disposal may force an business to increase investment in some areas, and cut costs in others