Chapter 1 revision notes
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Underlying principles – the building blocks

What is accounting, and its uses and purposes

The main branches of accounting within commercial and industrial organisations are financial accounting, management accounting, treasury management, financial management and corporate finance. The original, basic purposes of accounting were to classify and record monetary transactions and present the financial results of the activities of an entity, the scorecard that shows how the business is doing. There are three questions that are generally answered by accounting information:

• how are we doing, and are we doing well or badly?          

a scorecard (like scoring a game of cricket, for example)

• which problems should be looked at?                                 

attention directing

• which is the best alternative for doing a job?

problem solving

In order to be useful to the users of financial information, the accounting data from which it is prepared, together with its analysis and presentation must be:

• accurate – free from error of content or principle
• reliable – representing the information that users believe it represents
• timely – available in time to support decision-making
• relevant – applicable to the purpose required, for example a decision regarding a future event or to support an explanation of what has already happened
• consistent – the same methods and standards of measurement of data and presentation of information to allow like-for-like comparison
• clear – capable of being understood by those for whom the information has been prepared

 

The conceptual frameworks of accounting

The framework of accounting is bounded by concepts (or rules) and standards, covering which data should be included within an accounting system and how that data should be recorded. Many countries have sought to produce a ‘conceptual framework’. In the UK this has been titled a Statement of Principles (SOP). The key issues are:

• the definition of a conceptual framework
• the development of a conceptual framework.

 

The 1975 Corporate Report was the first UK attempt at a conceptual framework. The SOP is a basic structure for determining objectives, in which there is a thread from the theory to the practical application of accounting standards to transactions that are reported in published accounts. The SOP is not an accounting standard, but it is a statement of guidelines; it is, by virtue of the subject, constantly in need of revision.

The basic assumption for these conceptual frameworks is that financial statements must be useful. The general structure of conceptual frameworks deals with the following 6 questions:

• What is the purpose of financial statement reporting?
• Who are the main users of accounting and financial information?
• What type of financial statements will meet the needs of these users?
• What type of information should be included in financial statements to satisfy these needs?
• How should items included in financial statements be defined?
• How should items included in financial statements be recorded and measured?

 

The Statement of Principles

The SOP is a statement of guidelines, and comprises 8 chapters that deal with the following topics:

• The objectives of financial statements, which are fundamentally to provide information that is useful for the users of that information.
• Identification of the entities that are required to provide financial statement reporting by virtue of the demand for the information included in those statements.
• The qualitative characteristics required to make financial information useful to users, such as materiality, relevance, reliability, comparability comprehensibility.
• The main elements included in the financial statements – the ‘building blocks’ of accounting such as assets and liabilities.
• When transactions should be recognised in financial statements.
• How assets and liabilities should be measured.
• How financial statements should be presented for clear and effective communication.
• The accounting by an entity in its financial statements for interests in other entities.

 

UK accounting concepts

Accounting concepts are the principles underpinning the preparation of accounting information. Fundamental accounting concepts are the broad basic assumptions, which underlie the periodic financial accounts of business enterprises. The five most important concepts are as follows:

• the prudence concept
• the accruals concept
• the consistency concept
• the going concern concept
• the separate valuation concept
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Further fundamental accounting concepts are:

• the business entity concept
• the money measurement concept
• the historical cost concept
• the materiality concept
• the periodicity concept
• the realisation concept
• the substance over form concept
• dual aspect concept

 

True and fair view

The term true and fair view was introduced in the Companies Act 1947, requiring that companies’ reporting of their accounts should show a true and fair view. It was not defined in that Act and has not been defined since. Some writers have suggested that conceptually it is a dynamic concept but over the years it could be argued that it has failed, and various business scandals and collapses have occurred without users being alerted. The concept of true and fair was adopted by the European Community Council in its fourth directive, implemented by the UK in the Companies Act 1981, and subsequently in the implementation of the seventh directive in the 1989 Act (section 226 or 227). Conceptually the directives require additional information where individual provisions are insufficient.

In practice true and fair view relates to the extent to which the various principles, concepts, and standards of accounting have been applied. It may therefore be somewhat subjective and subject to change as new accounting rules are developed, old standards replaced and new standards introduced.

UK accounting and financial reporting standards

A number of bodies have been established to draft accounting policy, set accounting standards, and to monitor compliance with standards and the provisions of the Companies Act.

The Financial Reporting Council (FRC), whose chairman is appointed by the Department of Trade and Industry (DTI) and the Bank of England, develops accounting standards policy and gives guidance on issues of public concern. The ASB, which is comprised of members of the accountancy profession, and on which the Government has an observer status, has responsibility for development, issue, and withdrawal of accounting standards.

The accounting standards are called Financial Reporting Standards (FRSs). Up to 1990 the accounting standards were known as Statements of Standard Accounting Practice (SSAPs),

The ASB is supported by the Urgent Issues Task Force (UITF). Its main role is to assist the ASB in areas where an accounting standard or Companies Act provision exists, but where unsatisfactory or conflicting interpretations have developed or seem likely to develop. The UITF also deals with issues that need to be resolved quicker than through the issuing of an accounting standard.

The Financial Reporting Review Panel (FRRP) reviews comments and complaints from users of financial information. It enquires into the annual accounts of companies where it appears that the requirements of the Companies Act, including the requirement that annual accounts shall show a true and fair view, might have been breached.

Pressure groups, organisations and individuals may also have influence on the provisions of the Companies Act and FRSs (and SSAPs). These may include some Government departments (for example, Inland Revenue, HM Customs & Excise, Office of Fair Trading) in addition to the DTI and employer organisations such as the Confederation of British Industry (CBI), and professional bodies like the Law Society, Institute of Directors, and Chartered Management Institute.

Within the scope of current legislation, best practice and accounting standards, each company needs to develop its own specific accounting policies. Accounting policies are the specific accounting bases selected and consistently followed by an entity as being, in the opinion of the management, appropriate to its circumstances and best suited to present fairly its results and financial position.

The accounting standard, which deals with how a company chooses, applies and reports on its accounting policies is called FRS 18 Accounting Policies, and was issued in 2000 to replace SSAP 2 Disclosure of Accounting Policies. FRS 18 clarified when profits should be recognised (the realisation concept), and the requirement of  ‘neutrality’ in financial statements in neither overstating gains nor understating losses (the prudence concept).

The aims of FRS 18 are:

• to ensure that companies choose accounting policies that are most suitable for their individual circumstances, and incorporate the key characteristics stated in chapter 3 of the SOP
• to ensure that accounting policies are reviewed and replaced as necessary on a regular basis
• to ensure that companies report accounting policies, and any changes to them, in their annual reports and accounts so that users of that information are kept informed.

Whereas FRS 18 deals with the disclosure by companies of their accounting policies, FRS 3 Reporting Financial Transactions deals with the reporting by companies of their financial performance. Financial performance relates primarily to the profit and loss account, whereas financial position relates primarily to the balance sheet.

FRS3 aims to ensure that users of financial information get a good insight into the company’s performance during the period to which the accounts relate. This is in order that decisions made about the company may be made on an informed basis.

FRS 3 requires the following items to be included in company accounts

• analysis of turnover, cost of sales, operating expenses, and profit before interest
• exceptional items
• extraordinary items
• statement of recognised gains and losses (a separate financial statement along with the balance sheet, profit and loss account, and cash flow statement).

 

International accounting standards

The increase in international trade and globalisation has led to a need for convergence, or harmonisation of accounting rules and practices. The IASC was created in order to develop international accounting standards. The successor to the IASC, the IASB (International Accounting Standards Board) was set up in April 2001 to make financial statements more comparable on a worldwide basis. The IASB publishes its standards in a series of pronouncements called International Financial Reporting Standards (IFRSs). It has also adopted the body of standards issued by the IASC, which continue to designated IASs.

From 1 January 2005 there will be convergence in the mandatory application of the IFRSs by listed companies within each of the European Union member states.

A list of all FRSs , SSAPs, IASs, and IFRSs that are currently in force are included in Appendix 3, which may be found at the end of Business Accounting and Finance.

Financial accounting, management accounting, and financial management

The main branches of accounting that provide services to commercial and industrial organisations are auditing, corporate taxation, personal taxation, VAT, and consultancy.

Financial accounting
Financial accounting is the function responsible in general for the reporting of financial information to the owners of a business, and specifically for preparation of the periodic external reporting of financial information, statutorily required, for shareholders. It also provides such similar information as required for Government and other interested third parties, such as potential investors, employees, lenders, suppliers, customers, and financial analysts.

Financial accounting is concerned with the three key financial statements: the balance sheet; profit and loss account; cash flow statement. It assists in ensuring that financial statements are included in published reports and accounts in a way that provides ease of analysis and interpretation of company performance.

 

 

Management accounting
Management accounting is primarily concerned with the provision of information to managers within the organisation for product costing, planning and control, and decision-making, and to a lesser extent involved in providing information for external reporting.

 

Financial management
Financial management is broadly defined as the management of all the processes associated with the efficient acquisition and deployment of both short and long-term financial resources. Financial management assists an organisation’s operations management to reach its financial objectives. This may include responsibility, for example, for corporate finance, and treasury management, which is concerned with cash management, and the management of interest rate and foreign currency exchange rate risk.

Accounting and accountancy

Accounting is sometimes referred to as a process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information, and also to provide information, which is potentially useful for making economic and social decisions. The term ‘accounting’ may be defined as:

• the classification 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 financial position at a given date
• the monetary projection of future activities arising from alternative planned courses of action.

 

Accountancy is defined as the practice of accounting.

Types of business entity

The large variety of types of business entities includes profit and not-for-profit organisations, both privately and Government owned, involved in providing products and services.

Business entities are either involved in manufacturing (for example, food and automotive components) or in providing services (for example retailing, hospitals or television broadcasting).  Such entities include profit-making and not-for-profit organisations, and charities.

Sole traders and partnerships
A sole trader entity is owned and financed by one individual even though more than one person may work in the business. The individual has complete flexibility regarding:

• the type of (legal) activities in which the business may be engaged
• when to start up or cease the business
• the way in which business is conducted
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Unlike limited companies, sole traders are not required to file a formal report and accounts each year with the Registrar of Companies, but they must submit annual accounts for tax purposes to the Inland Revenue. Legally, a sole trader is not separate from the business, unlike the legal position of owners, or shareholders, of limited and unlimited companies who are recognised as separate legal entities from the businesses they own.

Partnerships are similar to sole traders except that the ownership of the business is in the hands of two or more persons. The main differences are in respect of how much each of the partners puts into the business, who is responsible for what, and how the profits are to be shared. These factors are normally set out in formal partnership agreements, and if the partnership agreement is not specific then the provisions of the Partnership Act 1890 apply. Apart from certain professions, the number of persons in a partnership is limited to twenty. A new type of legal entity was established in 2001, the limited liability partnership (LLP), which has a separate legal entity from the partners.

Limited companies
A limited company is a legal entity separate from the owners of the business. The owners limit their obligations to the amount of finance they have put into the company by way of the share of the company they have paid for. Normally, the maximum that may be claimed from shareholders is no more than they have paid for their shares, regardless of what happens to the company. Equally, there is no certainty that shareholders may recover their original investment if they wish to dispose of their shares or if the business is wound up, for whatever reason.

Public limited companies must have a minimum issued share capital of (currently) £50,000, and may offer their shares for sale to the public but private limited companies may not. Private limited companies tend to be family businesses and smaller business with the ownership split between a few shareholders, although there have been many examples of very large private limited companies. Accounting requirements are the same for private and public limited liability companies. Limited companies must produce annual accounts that are filed with the Registrar of Companies and are available to the public. Sole traders do not have to comply with any such requirement.

Accounting processes

Accounting processes follow a system of recording and classifying data, followed by a summarisation of financial information for subsequent interpretation and presentation.

Accounting is sometimes referred to as a process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information, and also, to provide information which is potentially useful for making economic and social decisions.

An accounting system is a series of tasks and records of an entity by which the transactions are processed as a means of maintaining financial records. Such systems identify, assemble, analyse, calculate, classify, record, summarise and report transactions.

An introduction to financial statements

The three main financial statements that appear with a business’s annual report and accounts, together with the chairman’s statement, directors’ report, and auditors’ report, are the balance sheet, profit and loss account and cash flow statement.

Companies are also obliged to provide similar financial statements at each year end to provide information for their shareholders, the Inland Revenue, and the Registrar of Companies. This information is frequently used by City analysts, investing institutions and the public in general. 

After each year end companies prepare their annual report and accounts for their shareholders. Copies of the annual report and accounts are filed with the Registrar of Companies and copies are available to other interested parties such as financial institutions, major suppliers and other investors. In addition to the profit and loss account and cash flow statement for the year and the balance sheet as at the year end date, the annual report and accounts includes Notes to the Accounts, and much more financial and non-financial information such as company policies, financial indicators, corporate governance compliance, directors’ remuneration, employee numbers, business analysis, and segmental analysis. The annual report also includes an Operating and Financial Review of the business, a report of the auditors of the company, and the chairman's statement.

 

 

Users of accounting and financial information

There is a wide range of users of financial information: external to the organisation for example potential investors, suppliers and financial analysts; internal to the organisation for example managers, shareholders, employees.

Financial information is important to a wide range of groups both internal and external to the organisation. Such information is required, for example, by individuals outside the organisation to make decisions about whether or not to invest in one company or another, or by potential suppliers who wish to assess the reliability and financial strength of the organisation. It is also required by managers within the organisation as an aid to decision-making.

Accountability and financial reporting

Accountability is maintained by the reporting on the financial performance and the financial position of the business to shareholders on both a yearly and an interim basis.

Ownership of a business is separated from its stewardship, or management, by the shareholders’ assignment to a board of directors the responsibility of running the company. The directors of the company are accountable to the shareholders, and both parties must play their part in making that accountability effective.

The reporting made in the form of the financial statements includes the balance sheet, profit and loss account, and cash flow statement. Because it is important that the credibility of financial statement reporting is maintained so that actual and potential investors are protected as far as possible against inappropriate accounting practices, these financial statements that are regulated by a range of national and international accounting standards and legislative requirements. Moreover, the auditors of companies must have some rules on which to base their true and fair view of financial position and financial performance, which they give to the shareholders and other users of the financial statements.

External auditors are appointed by, and report independently to, the shareholders. They are professionally qualified accountants who are required to provide objective verification to shareholders and other users that the financial statements have been prepared properly and in accordance with legislative and regulatory requirements; that they present the information truthfully and fairly and that they conform to the best accounting practice in their treatment of the various measurements and valuations.

The audit is defined by the Auditing Practices Board (APB) as ‘an independent examination of, and expression of an opinion on, the financial statements of the enterprise’. There is a requirement for all companies registered in the UK to have an annual audit, except for those companies, which (currently) have an annual turnover of less than £5.6m and a balance sheet total of less than £2.8m.