The Accounting Scene - Elsevier...the monetary projection of future activities arising from the alternative planned courses of action. Note the three aspects considered in this deﬁ

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The Accounting Scene

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1 LEARNING OUTCOMES When you have completed this chapter, you should be able to:

� identify the various user groups who need accounting information and the qualitative characteristics of fi nancial statements;

� explain the function of, and differences between, fi nancial and management accounting systems.

1.1 Introduction This chapter provides an introduction to the accounting framework and introduces the function of accounting systems. Much of the chapter relates to the fi rst syllabus area ‘ con-ceptual and regulatory framework ’ , which is also continued in Chapter 10. This chapter covers the objectives of accounting, an essential feature of which is a discussion of who uses accounts. This raises the question of how we can measure the usefulness of accounting information to those who use accounts.

1.2 What is accounting? Accounting can be described as being concerned with measurement and management . Measurement is largely concerned with the recording of past data, and management with the use of that data in order to make decisions that will benefi t the organisation.

The measurement process is not always easy. One of the most common problems is that of when to recognise a transaction. For example, if we are to obtain goods from a supplier with payment to be due 60 days after the goods are received, when should the transaction be recorded?

The following possibilities may be considered:

● when we place the order; ● when we take delivery of the goods;

The Accounting Scene


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E ● when we receive the invoice from the supplier; or ● when we pay the supplier for the goods.

Accounting, therefore, involves the exercising of judgement by the person responsible for converting data into meaningful information. It is this that distinguishes accounting from bookkeeping.

Accounting may be defi ned as:

● the classifi cation and recording of monetary transactions; ● the presentation and interpretation of the results of those transactions in order to assess

performance over a period and the fi nancial position at a given date; ● the monetary projection of future activities arising from the alternative planned courses

of action.

Note the three aspects considered in this defi nition: recording, reporting and forecasting:

1. Accounting is partly a matter of record-keeping. The monetary transactions entered into by a business need to be controlled and monitored, and for this a permanent record is essential. For an effi cient system of record-keeping, the transactions must fi rst be classifi ed into categories appropriate to the enterprise concerned.

2. At appropriate intervals, the individual transactions must be summarised in order to give an overall picture.

3. Finally, accounting information can be the basis for planning and decision-making.

An alternative explanation is that accounting is part of the management information sys-tem (MIS) of an organisation. In this context, the accounting element is referred to as an accounting information system (AIS).

Accounting can thus be said to be a method of providing information to management (and other users) relating to the activities of an organisation. In order to do this it relies on the accurate collection of data from sources both internal and external to the organisation. The recording of this data is often referred to as bookkeeping.

1.2.1 The objectives of accounting The objectives of accounting are to provide fi nancial information to the managers, owners and other parties interested in an organisation. This is done by the production of fi nancial statements. You will see in Chapter 10 that the International Accounting Standards Board (IASB) in their Framework for the Preparation and Presentation of Financial Statements ( Framework ) state that

If these objectives are to be achieved, then the information provided by the accounting sys-tem must be reliable and easily understood, and prepared consistently not only from one accounting period to the next but also between similar organisations so that meaningful comparisons may be made. This need for consistency has led to a number of accounting rules being devised. Some of these rules are contained in legislation – these rules apply par-ticularly to companies: some are included in accounting standards; some are included in documents such as the IASB’s Framework ; and others simply represent generally accepted

Providing useful information to investors is the main objective of fi nancial reporting.


5 FUNDAMENTALS OF FINANCIAL ACCOUNTING

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accounting practice (GAAP). These rules are used by accountants to determine the treatment to be adopted in respect of certain fi nancial transactions and the preparation of fi nancial statements.

1.3 Who uses financial statements? Accounting information is used by many people, both by individuals and in organisations. To get a feel for the purpose of accounts it is useful to classify these users into groups, and to look at the reasons why they use accounts and what they hope to get from them.

Any classifi cation of this sort is somewhat arbitrary, and many users fall into more than one classifi cation. However, the following groups are commonly recognised as having par-ticular needs for accounting information:

(a) The investor group. This group includes both existing and potential owners of shares in companies. They require information concerning the performance of the company measured in terms of its profi tability and the extent to which those profi ts are to be distributed to shareholders. They are also interested in the social/economic policies of the company so that they may decide if they wish to be associated with such an organisation.

(b) The lender group. This group includes both existing and potential providers of secured or unsecured, long- or short-term loan fi nance. They require information concern-ing the ability of the organisation to repay the interest on such loans as they fall due; and the longer-term growth and stability of the organisation to ensure that it is capable of repaying the loan at the agreed time. In addition, if the loan is secured, the value of the appropriate secured assets is important as a means of recovering the amount due.

(c) The employee group. This group includes existing, potential and past employees. They require information concerning the ability of the organisation to pay wages and pen-sions today. In addition, they are interested in the future of the organisation because this will affect their job security and future prospects within the organisation.

(d) The analyst/adviser group. This group includes a range of advisers to investors, employ-ees and the general public. The needs of these users will be similar to those of their cli-ents. The difference is, perhaps, that in some instances, the members of this group will be more technically qualifi ed to understand accounting reports.

(e) The business contact group. This group includes customers and suppliers of the organi-sation. Customers will be concerned to ensure that the organisation has the ability to provide the goods/services requested and to continue to provide similar services in the future. Suppliers will wish to ensure that the organisation will be capable of paying for the goods/services supplied when payment becomes due.

(f ) The government. This group includes taxation authorities, and other government agen-cies and departments. The taxation authorities will calculate the organisation’s taxation liability based upon the accounting reports it submits to them. Other departments require statistical information to measure the state of the economy.

(g ) The public. This group includes taxpayers, consumers and other community and spe-cial interest groups. They require information concerning the policies of the organisa-tion and how those policies affect the community. The public is increasingly interested in environmental issues.


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E (h) Internal users. The management of the company require information to assist them in the performance of their duties. Three different levels of management can be identifi ed: ● Strategic. This is the level of management found at the top of organisations. In a

commercial organisation it is referred to as the board of directors. These people require information to assist them in decisions affecting the long-term future of the organisation.

● Tactical. This is often referred to as middle management. These people require infor-mation to assist them in monitoring performance and making decisions to enable the organisation to achieve its short- to medium-term targets.

● Operational. This is the level of management responsible for decisions concern-ing the day-to-day activities of the organisation. It is common for the information provided to them to be quantifi ed in non-monetary units, such as hours worked, number of components produced, and so on.

1.4 The qualitative characteristics of financial statements

All of the above user groups, both internal and external to the organisation, require the information provided to be useful. In this context, information should:

(a) enable its recipient to make effective decisions; (b) be adequate for taking effective action to control the organisation or provide valuable

details relating to its environment; (c) be compatible with the responsibilities and needs of its recipient; (d) be produced at optimum cost; (e) be easily understood by its recipient; (f ) be timely; (g) be suffi ciently accurate and precise for the purpose of its provision.

The IASB’s Framework also suggests that fi nancial statements should have certain quali-tative characteristics, including relevance, reliability, completeness, comparability, under-standability and timeliness.

For decisions to be made, the information must be relevant to the decision and be clearly presented, stating any assumptions upon which the information is based, so that the user may exercise judgement as appropriate.

Often, better information may be provided at additional cost or after an additional time delay. The adequacy of information is important, and factors such as the cost of the infor-mation and the speed with which it is available may be more important than it being 100 per cent accurate.

The information provided must be communicated to the person responsible for taking any action in respect of the information provided. In this regard it is better to distinguish information between that which relates to controllable aspects of the business and that which relates to non-controllable aspects. The controllable aspects may then be further divided into those that are signifi cant and an exception reporting approach applied.

Exception reporting is the technique of reducing the size of management reports by including only those items that should be drawn to the manager’s attention, rather than including all items.



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Most organisations will set targets against which actual performance can be compared. You will learn more about the setting of such targets in your studies of management accounting. Their use enables exception reports to be produced to highlight the differ-ences between the actual and target results. The use of exception reporting avoids wasting unnecessary management time reading reports that merely advise the management that no action is required and concentrates on those issues that do require management action.

In conclusion, therefore, internal information will be much more detailed than external information, and will be prepared on a more regular basis.

1.5 Terminology 1.5.1 Bookkeeping Bookkeeping can be described as the recording of monetary transactions, appropriately clas-sifi ed, in the fi nancial records of an entity, by either manual means or otherwise.

Bookkeeping involves maintaining a detailed ‘ history ’ of transactions as they occur. Every sale, purchase or other transaction will be classifi ed according to its type and, depending on the information needs of the organisation, will be recorded in a logical man-ner in the ‘ books ’ . The ‘ books ’ will contain a record or account of each item showing the transactions that have occurred, thus enabling management to track the individual move-ments on each record, that is, the increases and decreases.

Periodically a list of the results of the transactions is produced. This is done by listing each account and its fi nal position or balance . The list is known as a trial balance and is an important step prior to the next stage of providing fi nancial statements.

1.5.2 Financial accounting Financial accounting can be described as the classifi cation and recording of monetary transactions of an entity in accordance with established concepts, principles, accounting standards and legal requirements, and their presentation, by means of various fi nancial statements, during and at the end of an accounting period.

Two points in particular are worth noting about this description:

1. Financial statements must comply with accounting rules published by the various advisory and regulatory bodies. In other words, an organisation does not have a completely free hand. The reason for this is that the end product of the fi nancial accounting process – a set of fi nancial statements – is primarily intended for the use of people outside the organi-sation. Without access to the more detailed information available to insiders, these people may be misled unless fi nancial statements are prepared on uniform principles.

2. Financial accounting is partly concerned with summarising the transactions of a period and presenting the summary in a coherent form. This again is because fi nancial statements are intended for outside consumption. The outsiders who have a need for and a right to infor-mation are entitled to receive it at defi ned intervals, and not at the whim of management.

1.5.3 Management accounting Management accounting can be described as the process of identifi cation, measurement, accu-mulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of


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E and accountability for its resources. Management accounting also comprises the preparation of fi nancial reports for non-management groups such as shareholders, lenders, regulatory agencies and tax authorities.

Although the needs of external users of accounts are addressed in this defi nition, it can be seen that the emphasis of management accounting is on providing information to help managers in running the business. The kind of information produced, and the way in which it is presented, are at the discretion of the managers concerned; they will request whatever information, in whatever format, they believe to be appropriate to their needs.

1.6 The differences between external and internal information

External information is usually produced annually, though in organisations listed (or quoted) on a stock exchange, information may be produced more frequently, for example quarterly. External information is provided mainly by limited companies, in accordance with the rel-evant company legislation. These may prescribe the layouts to be used and the information that is to be disclosed either on the face of the fi nancial statements or in the notes that accom-pany them. For other organisations that are not regulated by such legislation, accounts may have to be provided for other interested parties such as those dealing with taxation and lenders. For these organisations, the requirements of legislation are not mandatory and may not be appropriate. However, these requirements are often considered to be good accounting practice.

External information is often available publicly and is therefore available to the com-petitors of the organisation as well as its owners and employees. Of necessity, therefore, it is important that the information provided does not allow the organisation’s competitors to obtain detailed information concerning the working of the organisation. Thus external information is summarised in order to protect the organisation from losing any competi-tive edge that it may possess.

Internal information is produced on a regular basis in order for management to com-pare the organisation’s performance with its targets and to make decisions concerning the future. Accounting information is usually produced on a monthly basis, although other non-fi nancial performance measures may be produced more regularly. Whereas external information is almost exclusively measured in monetary terms, internal information will most likely involve reporting fi nancial and non-fi nancial measures together. There is a very good reason for this: many managers, particularly those in control of operational matters, will not feel competent to understand accounting reports. They will understand differences in output levels and in usage of materials and labour much more readily than they will understand the implications of these same differences upon profi t.

1.7 What is a business organisation? A business is an organisation that regularly enters into transactions that are expected to provide a reward measurable in monetary terms. It is thus obvious from everyday life that many business organisations exist; what is less obvious is that their organisational (legal) structure and therefore their accounting requirements may differ.



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There are two main reasons for the different organisational structures that exist – the nature of their activities and their size .

1.7.1 Profit-making organisations Some organisations are formed with the intent of making profi ts from their activities for their owners:

(a) Sole traders ( sole proprietors ). These are organisations that are owned by one person. They tend to be small because they are constrained by the limited fi nancial resources of their owner.

(b) Partnerships. These are organisations owned by two or more persons working in com-mon with a view to making a profi t. The greater number of owners compared with a sole trader increases the availability of fi nance and this is often the reason for forming such a structure.

(c) Limited companies. These are organisations recognised in law as ‘ persons ’ in their own right. Thus a company may own assets and incur liabilities in its own name.

The accounting of these organisations must meet certain minimum obligations imposed by legislation, for example, via company law and other regulations. Some of these require-ments constitute recommended accounting practice for other types of organisation.

Two types of limited companies can be identifi ed: private limited companies; and public limited companies.

Public limited companies can be further divided according to their size, and whether they are ‘ listed ’ on a stock exchange. These distinctions can be important when consider-ing the accounting requirements. A common feature of private limited companies is that their owners are actively involved in running the business. In this way they are similar to sole traders and partnerships. This is rarely true of public companies, where the owners may not become involved in the day-to-day activities of the business. Listed companies may have many thousands of owners (shareholders) who are even further removed from the running of the business.

1.7.2 Non-profit-making organisations Other organisations are formed with the intent of providing services, without intending to be profi table in the long term:

(a) Clubs and societies. These organisations exist to provide facilities and entertainments for their members. They are often sports and/or social clubs and most of their revenue is derived from the members who benefi t from the club’s facilities. They may carry out some activities that are regarded as ‘ trading ’ activities, in which profi ts are made, but these are not seen as the main purpose of the organisation.

(b) Charities. These exist to provide services to particular groups, for example people with special needs and to protect the environment. Although they are regarded as non-profi t-making, they too often carry out trading activities, such as running shops.

(c) Local and central government. Government departments are fi nanced by members of society (including limited companies). Their fi nances are used to provide the infra-structure in which we live, and to redistribute wealth to other members of society. You will not look at the accounts of government bodies in this Learning System.


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E 1.8 Summary In this chapter you have learnt:

● that ‘ accounting ’ involves recording, summarising and forecasting, to meet the informa-tion needs of different user groups;

● the qualitative characteristics of fi nancial statements; ● the distinction between ‘ bookkeeping ’ , ‘ fi nancial accounting ’ and ‘ management accounting ’ ; ● the differences between internal and external information; the different types of business

organisation.


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Question 1 Multiple choice 1.1 The main aim of accounting is to:

(A) maintain ledger accounts for every transaction. (B) provide fi nancial information to users of such information. (C) produce a trial balance. (D) record every fi nancial transaction individually.

1.2 The main aim of fi nancial accounting is to:

(A) record all transactions in the books of account. (B) provide management with detailed analyses of costs. (C) present the fi nancial results of the organisation by means of recognised

statements. (D) calculate profi t.

1.3 Financial statements differ from management accounts in that they:

(A) are prepared monthly for internal control purposes. (B) contain details of costs incurred in manufacturing. (C) are summarised and prepared mainly for external users of accounting

information. (D) provide information to enable the trial balance to be prepared.

1.4 Which one of the following does not apply to the preparation of fi nancial statements?

(A) They are prepared annually. (B) They provide a summary of the outcome of fi nancial transactions. (C) They are prepared mainly for external users of accounting information. (D) They are prepared to show the detailed costs of manufacturing and trading.

1.5 Which of the following statements gives the best defi nition of the objective of accounting?

(A) To provide useful information to users. (B) To record, categorise and summarise fi nancial transactions. (C) To calculate the taxation due to the government. (D) To calculate the amount of dividend to pay to shareholders.

Revision Questions 1


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REVISION QUESTIONS C212

1.6 Which one of the following sentences does not explain the distinction between fi nancial statements and management accounts?

(A) Financial statements are primarily for external users and management accounts are primarily for internal users.

(B) Financial statements are normally produced annually, and management accounts are normally produced monthly.

(C) Financial statements are more accurate than management accounts. (D) Financial statements are audited by an external auditor and management

accounts do not normally have an external audit.

Question 2 Match the following users with their information requirements.

1. Investors A Firm’s ability to provide goods now and in future and pay debts

2. Lenders B Performance, profi tability and dividends 3. Employees C Profi t levels, tax liability and statistics 4. Business contacts D Firm’s ability to pay interest and repay loans, the

value of secured assets 5. Government departments E Firm’s ability to pay wages, cash resources, future

prospects, pay pensions

Question 3 State six characteristics of useful accounting information?

(A) R … … … (B) R … … … (C) C … … … (D) C … … … (E) U … … … (F) T … … …


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Solution 1 1.1 Answer: (B)

Maintaining ledger accounts, producing a trial balance and recording transactions are all part of the bookkeeping system.

1.2 Answer: (C)

Recording transactions is part of the bookkeeping function. This should be capable of providing management with internal information, but this is part of the manage-ment accounting function. The calculation of profi t also results from the bookkeep-ing system and contributes towards the presentation of the fi nancial results.

1.3 Answer: (C)

Management accounts are prepared monthly (or more frequently) for internal con-trol purposes; they also contain detailed information such as costing fi gures. The trial balance is prepared from the bookkeeping system and is used as a basis for the prepa-ration of fi nancial statements.

1.4 Answer: (D)

Management accounts would provide detailed costs and other information regarding manufacturing and trading.

1.5 Answer: (A)

1.6 Answer: (C)

Solution 2 1. Answer: (B) 2. Answer: (D) 3. Answer: (E) 4. Answer: (A) 5. Answer: (C)

1Solutions to RevisionQuestions


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SOLUTIONS TO REVISION QUESTIONS C214

Solution 3 (A) Relevant (B) Reliable (C) Comparable (D) Complete (E) Understandable (F) Timely.


The Accounting Scene - Elsevier...the monetary projection of future activities arising from the alternative planned courses of action. Note the three aspects considered in this deﬁ

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