Chapter 1

Introduction to accounting

Go online to discover the extra features for this chapter at www.wiley.com/college/jones

Introduction

The key to understanding business is to understand accounting. Accounting is central to the operation of modern business. Accounting enables businesses to keep track of their money. If businesses cannot make enough profit or generate enough cash they will go bankrupt. Often accounting is called the ‘language of business’. It provides a means of effective and understandable business communication. If you understand the language you will, therefore, understand business. However, like many languages, accounting needs to be learnt. The aim of this book is to teach the language of accounting.

Nature of Accounting

At its simplest, accounting is all about recording, preparing and interpreting business transactions. Accounting provides a key source of information about a business to those who need it, such as managers or owners. This information allows managers to monitor, plan and control the activities of a business. This enables managers to answer key questions such as:

• How much profit have we made?
• Have we enough cash to pay our employees’ wages?
• What level of dividends can we pay to our shareholders?
• Should we expand our product range?

In small businesses, managers and owners will often be the same people. However, in larger businesses, such as public limited companies, managers and owners will not be the same. Managers will run the companies on behalf of the owners. In such cases, accounting information serves a particularly useful role. Managers supply the owners with financial information in the form of an income statement, a statement of financial position and a statement of cash flows. This enables the owners to see how well the business is performing. In companies, the owners of a business are called the shareholders.

Essentially, therefore, accounting is all about providing financial information to managers and owners so that they can make business decisions (see Definition 1.1). The formal definition (given below), although dating from 1966, has stood the test well as a comprehensive definition of accounting.

Importance of Accounting

Accounting is essential to the running of any business or organisation. Organisations as diverse as Microsoft, Barclays Bank, General Electric Company, Volkswagen, The Royal Society for the Protection of Birds (RSPB) and Manchester United football club all need to keep a close check on their finances.

At its simplest, money makes the world go round and accounting keeps track of the money. Businesses depend on cash and profit. If businesses do not make enough cash or earn enough profit, they will get into financial difficulties, perhaps even go bankrupt. Accounting provides the framework by which cash and profit can be monitored, planned and controlled.

Unless you can understand accounting, you will never understand business. This does not mean everybody has to be an expert accountant. However, it is necessary to know the language of accounting and to be able to interpret accounting numbers. In some respects, there is a similarity between learning to drive a car and learning about accounting. When you are learning to drive a car you do not need to be a car mechanic. However, you have to understand the car's instruments, such as a speedometer or fuel gauge. Similarly, with accounting, you do not have to be a professional accountant. However, you do need to understand the basic terminology such as income, expenses, profit, assets, liabilities, equity and cash flow.

Financial Accounting and Management Accounting

There is a basic distinction between financial accounting and management accounting. Financial accounting is concerned with information on a business's performance and is targeted primarily at those outside the business (such as shareholders). However, it is also used internally by managers. By contrast, management accounting is internal to a business and used solely by managers. A brief overview is provided in Figure 1.1.

Financial Accounting

Financial accounting is the provision of financial information on a business's recent financial performance targeted at external users, such as shareholders. However, internal users, such as management, may also find it useful. It is required by law. Essentially, it is backward-looking, dealing with past events. Transactions are initially recorded using double-entry bookkeeping (see Chapter 3). Three major financial statements can then be prepared: the income statement, the statement of financial position and the statement of cash flows (see Chapters 4–8). In this book, I primarily use these three terms. They are the terms used by the International Accounting Standards Board (IASB) in International Financial Reporting Standards (IFRS). IFRS are widely used worldwide, for example, by listed companies in Europe (see Chapter 14 for more details). However, there are also often national reporting rules. In the UK, for example, Generally Accepted Accounting Principles (GAAP) are often used by UK non-listed companies. Alternative terminology is used as follows: income statement (alternative profit and loss account), statement of financial position (alternative balance sheet) and statement of cash flows (alternative cash flow statement). These standards are then interpreted using ratios (see Chapter 9) by users such as shareholders and analysts.

Management Accounting

By contrast, management accounting primarily serves the internal needs of organisations. Management accounting can be divided into cost accounting and decision making. In turn, cost accounting can be split into costing (Chapter 16) and planning, control and performance: budgeting (Chapter 17) and standard costing (Chapter 18). Decision making is divided into short-term decisions (Chapter 19) and long-term decision making (Chapters 20–21). In Chapter 22 both short-term and long-term sources of finance are considered.

Users of Accounts

The IASB now takes a relatively narrow view of the users of accounts identifying only investors, lenders and other creditors in its 2010 conceptual framework. However, there are in fact many more. The users of accounting information may broadly be divided into insiders and outsiders (see Figure 1.2). The insiders are the management and the employees. However, employees are also outsiders in the sense that they often do not have direct access to the financial information. The primary user groups are management and shareholders. Shareholders or investors are often advised by professional financial analysts who work for stockbrokers or big city investment houses. These financial analysts help to determine the share prices of companies quoted on the stock exchange. However, sometimes, they are viewed with mistrust (see Real-World View 1.1).

The influence of other users (or stakeholders) is growing in importance. Suppliers, customers and lenders have a closer relationship to the company than the government and tax authorities, or the public. These users all need accounting information to help them make business decisions. Usually, the main information requirements concern a company's profits, cash flow, assets and debt (see Figure 1.3).

Shareholders, for example, require information so that they can decide whether to buy, hold or sell their shares. The information needs of each group differ slightly and, indeed may conflict (see Pause for Thought 1.3).

Accounting Context

It is important to realise that accounting is more than just a mere technical subject. Although it is true that at the heart of accounting there are many techniques. For example, as we will see in Chapter 3, double-entry bookkeeping is essential when preparing financial statements. However, accounting is also determined by the context in which it operates. Accounting changes as society changes. Accounting in medieval England and accounting today, for example, are very different. Similarly, there are major differences between accounting in Germany and in the United Kingdom. We can see the importance of context if we look briefly at the effect of history, country, technology and organisation (see Figure 1.4).

History

Accounting is an integral part of human society. Early societies had accounting systems which, although appearing primitive to us today, served their needs adequately. The Incas in South America, for example, used knotted ropes, called quipus, for accounting. In medieval England notched sticks called tally sticks were used to record transactions.

Gradually, over time, human society became more sophisticated. A form of accounting called double-entry bookkeeping (every transaction is recorded twice) arose. Emerging from Italy in the fifteenth century, at the same time that Columbus discovered America, double-entry bookkeeping is now the standard way by which accounting transactions are recorded throughout the world.

International Accounting

Double-entry bookkeeping, the income statement (the profit and loss account) and the statement of financial position (balance sheet) are now routine in most major countries. The International Accounting Standards Board (IASB) is also making great efforts to harmonise the disclosure and measurement practices of listed companies worldwide and publishes International Financial Reporting Standards (IFRS). However, there is still great diversity in the broader context in which accounting is carried out. These differences are explained more fully in Chapter 14.

Accounting in the UK, for example, is very different from accounting in France despite the fact that both countries are members of the European Union. Listed companies in both France and the UK, however, do have to follow IFRS. However, for non-listed companies and other enterprises, the situation is very different. The UK traditionally has been proud of a flexible and self-regulated accounting system largely free of government control. By contrast, the French system has traditionally been very standardised and largely governmentally controlled. In general, as Soundbite 1.2 shows, accounting plays an important role globally.

There are also clear differences between the UK and the US. For example, in the UK, there are Companies Acts, which apply to all UK companies whereas in the US only companies quoted on the stock exchange (i.e., listed companies) are subject to detailed and comprehensive Federal regulations. Also, US listed companies, unlike those in the UK, do not have to comply with IFRS. Unlisted companies are subject only to state regulations, which vary from state to state.

Technology

A rapid change which has affected accounting is computerisation. Up until the advent of computers, accounting was done manually. This was labour-intensive work. Each transaction was entered into the books twice using double-entry bookkeeping. The accounts were then prepared by hand. Similarly, costing, budgeting and decision making were all carried out manually.

Today, almost all businesses use computers. However, they must be used with caution. For the computer, GIGO rules. If you put garbage in, you get garbage out. To avoid GIGO, one needs to understand accounting. In fact, computerisation probably makes it more, rather than less, important to understand the basics.

Organisations

The nature of accounting will vary from business to business. It will depend on the structure of the business and the nature of the business activity.

Structure

If we take the accounts of the three types of business enterprise with which this book deals; a sole trader's accounts will normally be a lot simpler than those of either a partnership or a company. Sole traders generally run smaller, less complicated businesses (for example, a small butcher's shop). Partnerships are multi-owned businesses typically larger in size than sole traders. The sole traders’ and partnerships’ accounts will normally be less complicated than company accounts as they are prepared for the benefit of active owner-managers rather than for owners who do not actually run the business.

Nature of the Business

Every organisation is different. Consequently, every organisation's accounts will differ in certain respects. For example, property companies will own predominantly more land and buildings than non-property companies. Manufacturing companies will have more inventory than non-manufacturing companies.

It is clear from Figure 1.5 that the nature of revenue or sales varies from business to business. In some businesses, a service is provided (e.g., bank, football club, insurance company and plumber).

Company Snapshot 1.1 shows the sales revenue (sometimes termed turnover) of Manchester United plc, mainly gate receipts, television and merchandising, which are generated by entertaining its customers.

In other businesses, the sale is more tangible as goods change hands (for example, manufacturing companies and shops).

Overall, within the UK economy, services are becoming relatively more important and manufacturing industry is declining. In particular, there is an increase in information technology and knowledge-based industries. This trend is set to continue.

Types of Accountancy

We need to distinguish between the types of accountancy and the types of accountant. Accountancy refers to the process, while accountant refers to the person. In other words, accountancy is what accountants do! In this book, we primarily focus on bookkeeping, financial accounting and management accounting. However, accountants perform other roles such as auditing, financial management, insolvency, fraud detection, taxation and management consultancy. All of these are briefly covered below. Auditors charge management audit and consultancy fees. For example, KPMG, a firm of auditors, charged HSBC Holdings £24.5 million in 2008 for auditing and £17.2 million for consultancy services. Audit fees are shown for the banking system in the UK in 2008 in Real-World View 1.2.

Auditing

Auditing is carried out by teams of staff headed by qualified accountants who are independent of the business. Essentially, auditors check that the financial statements, prepared by management, give a true and fair view of the accounts. Auditing is normally associated with company accounts. However, the tax authorities or the bank may request an audit of the accounts of sole traders or partnerships. For companies, auditors issue an auditor's report annually to shareholders. Company Snapshot 1.2 provides an auditors’ report for J. Sainsbury plc. This is issued after a thorough examination by the auditors of the accounting records and systems of the company.

Bookkeeping

Bookkeeping is the preparation of the basic accounts (bookkeeping is dealt with in more depth in Chapter 3). It involves entering monetary transactions into the books of account. A trial balance is then extracted, and an income statement and statement of financial position are prepared. Nowadays, most companies use computer packages for the basic bookkeeping function which is often performed by non-qualified accountants.

Financial Accounting

Financial accounting is a wider term than bookkeeping. It deals not only with the mechanistic bookkeeping process, but the preparation and interpretation of the financial accounts. For companies, financial accounting also includes the preparation of the annual report (a document sent annually to shareholders, comprising both financial and non-financial information). In orientation, financial accounting is primarily outward-looking and aimed at providing information for external users. However, monthly financial accounts are often prepared and used internally within a business. Within a company, financial accounting is usually carried out by a company's employees. Smaller businesses, such as sole traders, may use professionally qualified independent accountants.

Financial Management

An area of growing importance for accountants is financial management. Some aspects of financial management fall under the general heading of management accounting. Financial management, as its name suggests, is about managing the sources of finance of an organisation. It may, therefore, involve managing the working capital (i.e., short-term assets and liabilities) of a company or finding the cheapest form of borrowing. These topics are briefly examined in Chapter 22. There is often a separate department of a company called the financial management or treasury department.

Insolvency

One of the main reasons for the rise to prominence of professional accountants in the UK was to wind up failed businesses. This is still part of a professional accountant's role. Professional accounting firms are often called in to manage the affairs of failed businesses, in particular to pay creditors (trade payables or banks) who are owed money by the business.

Management Accounting

Management accounting covers the internal accounting of an organisation. There are several different areas of management accounting: costing (see Chapter 16), budgeting (see Chapter 17), standard costing (see Chapter 18), short-term decision making (see Chapter 19), strategic management accounting (see Chapter 20), capital investment appraisal (see Chapter 21) and management of working capital and sources of finance (see Chapter 22). Essentially, these activities aim to monitor, control and plan the financial activities of organisations. Management uses such information for decisions such as determining a product's selling price or setting the sales budget.

Fraud Detection

Accountants who detect fraud are often called forensic accountants. The frauds they investigate may be personal or corporate and often involve large amounts of money. Real-World View 1.3 shows an interesting example.

Taxation

Taxation is a complicated area. Professional accountants advise businesses on a whole range of tax issues. Much of this involves tax planning (i.e., minimising the amount of tax that organisations have to pay by taking full advantage of the often complex tax regulations). Thus, for example, Lisa O’Carroll (Guardian, 14 October 2011) commented that it had been calculated that over a three year period Google had ‘saved $3.1 bn in tax revenues using a subsidiary located in Bermuda where the corporate tax rate is zero’. A Google spokesperson told the Guardian ‘we have an obligation to our shareholders to set up a tax-efficient structure, and our present structure is compliant with the tax rules in all the countries where we operate.’ This tax avoidance which operates within the law should be distinguished from tax evasion which is illegal. Professional accountants may also help individuals with a scourge of modern life, the preparation of their annual income tax assessment.

Management Consultancy

Management consultancy is a lucrative source of income for accountants (see Real-World View 1.4). However, as Soundbite 1.3 shows, management consultants are often viewed cynically. Management consultancy embraces a whole range of activities such as special efficiency audits, feasibility studies and tax advice. Many professional accounting firms now make more money from management consultancy than from auditing. Examples of management consultancy are investigating the feasibility of a new football stadium or the costing of a local authority's school meals proposals.

Types of Accountant

There are several types of accountant. In the UK, for example, the most high-profile are those belonging to the six professionally qualified bodies. In addition to these accountancy bodies, there are other accounting associations in the UK, the most important of which is probably the Association of Accounting Technicians. The web addresses for these institutes are listed at the end of the chapter.

Professionally Qualified Accountants

Chartered Accountants

Six institutions of professionally qualified accountants currently operate in the UK (see Figure 1.6). All jealously guard their independence and the many attempts to merge have all failed (see Real-World View 1.5). ‘It's like proposing that Manchester United and Manchester City merge, suggests one indignant ICAEW member, illustrating the strength of feeling’ (Michelle Perry, Accountancy Age, 22 July 2004, p. 6).

There are three institutes of chartered accountants: the Institute of Chartered Accountants in England and Wales (ICAEW), the Chartered Accountants Ireland (CAI) and the Institute of Chartered Accountants of Scotland (ICAS). The largest of these three is the ICAEW. Its members were once mainly financial accountants and auditors, but now take part in a whole range of activities. Many leave the professional partnerships with which they train to join business organisations. In fact, qualifying as a chartered accountant is often seen as a route into a business career.

Association of Chartered Certified Accountants (ACCA)

The ACCA's members are not so easy to pigeonhole as the other professionally qualified accountants. They work both in public practice as auditors and as financial accountants. They also have an enormous number of overseas students. Many certified accountants train for their qualification in industry and never work in public practice. The ACCA qualification is very popular overseas.

Chartered Institute of Management Accountants (CIMA)

This is an important body whose members generally train and work in industry. They are found in almost every industry, ranging, for example, from coal mining to computing. They mainly perform the management accounting function.

Chartered Institute of Public Finance and Accountancy (CIPFA)

This institute is smaller than the ICAEW, ACCA or CIMA. It is also much more specialised with its members typically working in the public sector or the newly privatised industries, such as Railtrack. CIPFA members perform a wide range of financial activities within these organisations, such as budgeting in local government.

Second-Tier Bodies

The main second-tier body in the UK is the Association of Accounting Technicians. This body was set up by the major professional accountancy bodies. Accounting technicians help professional accountants, often doing the more routine bookkeeping and costing activities. Many accounting technicians go on to qualify as professional accountants. The different accountancy bodies, therefore, all perform different functions. Some work in companies, some in professional accountancy practices, some in the public sector. This diversity is high-lighted in an original way in Real-World View 1.6.

Limitations of Accounting

Accounting, therefore, measures business transactions in numerical terms. It thus provides useful information for managers and other users of accounts. It is, however, important to appreciate certain limitations of accounting. First, accounting tends to measure the cost of past expenditures rather than the current value of assets. There have been attempts to introduce ‘fair value’ or ‘market prices’ in some cases. However, this then brings in a great deal of subjectivity into accounting. This is dealt with in more detail in Chapter 11. Second, traditional accounting does not capture non-financial aspects of business. Thus, if an industry pollutes the air or the water this is not recorded in the conventional accounts. Nor does traditional accounting measure the human resources of a business or its knowledge and skills base. The accounts can, thus, only give a partial picture of a business's activities.

Conclusion

Accounting is a key business activity. It provides information about a business so that managers or owners (for example, shareholders) can make business decisions. Accounting provides the framework by which cash and profit can be monitored and controlled. A basic distinction is between financial accounting (accounting targeted primarily at those outside the business, but also useful to managers) and management accounting (providing information solely to managers).

Accounting changes as society changes. In particular, it is contingent upon history, country, technology and the nature and type of the organisation. There are at least eight groups which use accounting information, the main ones being managers and shareholders. These user groups require information about, amongst other things, profits, cash flow, assets and debts. There are several types of accountancy and accountant. The types of accountancy include auditing, bookkeeping, financial accounting, financial management, insolvency, management accounting, taxation and management consultancy. The six UK professional accountancy bodies are the Association of Chartered Certified Accountants, the Chartered Institute of Management Accountants, the Chartered Institute of Public Finance and Accountancy, and the Institute of Chartered Accountants in England and Wales, the Institute of Chartered Accountants in Ireland and the Institute of Chartered Accountants of Scotland. Although very useful, accounting has certain limitations, for example, its historic nature and its failure to measure non-financial transactions.

Go online to discover the extra features for this chapter at www.wiley.com/college/jones