1 Introduction to accounting

1.0 Learning outcomes

On completing this section, you should be able to:
Define the term `accounting`
Explain the purpose of accounting
Identify the users of accounting information
Explain the information needs of the various accounting information users
1.1 Defining accounting
The term `accounting` is generally defined as:
The process of identifying, measuring and communicating economic information to permit
informed judgements and decisions by users of that information
!ccounting therefore consists of the follo"ing activities:
#a$ collecting and recording economic data relating to a business enterprise
#b$ processing this data to produce useful economic information
#c$ communicating or reporting this accounting information to interested parties and, if
necessary, interpreting it for their benefit
The economic data referred to above is data "hich relates to the business activities of the
enterprise and "hich can be measured in %uantitative, usually monetary terms Typically, this
"ill consists of data about goods bought and sold, payments made, money received and so
forth
1.2 The purpose of accounting
The purpose of accounting is to assist the users of accounting information to ma&e better
economic decisions There "ould be no point in spending time and ma&e money on the
production, communication and interpretation of accounting information if the people for
"hom it "as produced then did nothing "ith the information "hen they received it To
understand the purpose of accounting more fully, therefore, ans"ers to the follo"ing
%uestions are needed:
#a$ 'ho are the users of accounting information(
#b$ 'hat accounting information do these users need(
#c$ 'hat economic decisions do they have to ma&e from this accounting information(
1.3 Accounting as an information system
)rom the definition and purpose given above, it "ill be noticed that accounting is an
information system *i&e all other information systems, the accounting information system
contains an input stage, a processing stage and an output stage In a given accounting period,
the accounting function can provide the follo"ing information:
Incomes and expenses for the period
+eceipts and payments for the period
!ssets and liabilities of the organi,ation
-rofit or loss for the period
1.4 Users of accounting information
The users of accounting information can be classified into a number of categories or groups
Each group has different types of economic decisions to ma&e and, as such, each group has
different information needs The principal users of accounting information include the
follo"ing:
O"ners and investors
.anagement
/an&s and other lenders
0uppliers
1ustomers
Employees
1ompetitors
The government
The general public
1.5 Information needs of arious users
!"ners and Inestors
The o"ner of a business is faced "ith a number of economic decisions These might include:
#a$ deciding "hether to &eep the business, sell it or close it do"n completely
#b$ deciding "hether to invest more money in the business
#c$ deciding ho" much money can safely be "ithdra"n from the business, "ithout
damaging its financial stability
0imilarly, people "ho do not o"n a business outright but "ho have invested their money in
one #eg the shareholders of a limited company$ must decide "hether to maintain, increase or
reduce the si,e of their investment O"ners and Investors "ho have delegated the day2to2day
running of the business to managers acting on their behalf "ill also need to decide "hether
the managers should remain in office This decision "ill usually depend upon ho" "ell the
business has performed under the ste"ardship of the manager#s$ concerned 'hen ma&ing all
of these decisions, o"ners and investors "ill probably find the follo"ing information useful:
#a$ information about the recent financial performance of the business, sho"ing ho"
"ell or badly the business has done
#b$ information about the current financial position of the business, sho"ing its assets
#the things that it o"ns$ and its liabilities #the amounts of money that it o"es$
)orecasts relating to the future financial performance and position of the business "ould also
have to be made not only by o"ners and investors, but also by potential o"ners3investors and
by the investment analysts "ho advise them
#anagement
The managers of a business are responsible for its day2to2day operations Their main role is to
ma&e plans for the business and then to ensure that these plans are carried out This planning
and control "or& involves a great many decisions These might include:
#a$ deciding "hat goods or services should be offered for sale by the business and
determining selling prices
#b$ deciding on sales targets and action to be ta&en if these targets are not met
#c$ deciding on planned levels of income and expenditure #ie establishing a budget$
and deciding "hat to do if actual results differ from the budget
#d$ deciding bet"een investment opportunities
#e$ deciding ho" much money the business needs to borro" and "here to borro"ed it
from
The managers ma&ing these decisions "ill re%uire fre%uent, detailed accounting information
relating to the past and present activities of the business, together "ith projections or
forecasts for the future
$an%s and other &enders
The main concern of a ban& #or other lender$ "hen deciding "hether or not to lend money to
a business is the ability of the business to &eep up interest payments during the course of the
loan and to repay the loan at the end of its term In the case of short term loans, the re%uired
accounting information "ill relate to the current financial position of the business and its
expected financial position in the near future In this regard, current assets and current
liabilities "ill be of much interest to this group of users in determining the credit "orthiness
of the business )or loans over a longer period, attention "ould be directed to the fixed assets
that could possibly be used as collateral security, existing long2term loans 4 their security and
repayment arrangements The re%uired information "ill probably extend to a more general
analysis of the financial prospects of the business in the long term
'upp&iers
0uppliers of goods or services on credit terms are in a similar position to lenders They have
to decide "hether or not to offer credit to a business and, if so, ho" much credit to offer
Information about current assets and current liabilities of the business "ill help them to
determine its credit "orthiness and ability to generate cash in order to pay for goods and
services provided
(ustomers
! customer needing a secure source of supply may re%uire accounting information from
potential suppliers before deciding "here to place a long term contract )or example, a motor
manufacturer "ill need to be sure that its supplier of gear boxes is financially stable and is
not li&ely to cease trading in the foreseeable future
)mp&oyees
!n employee5s main re%uirements from an employer are job security and fair pay
Information about the employer5s financial performance and financial position helps
employees #or trade unions acting on their behalf$ to decide "hether the employer is li&ely to
continue in business and "hether the remuneration offered is fair !lso better "or&ing
conditions and prospects of a bonus or loans to buy fixed assets from the company
(ompetitors
1ompeting businesses may study the accounting information produced by their rivals in the
hope of finding "ays of improving their o"n financial performance )or this reason,
businesses are usually &een to &eep their accounting information as private as possible
6o"ever, if a business operates as a public limited company, it is obliged by la" to ma&e
certain information public
*oernment
One obvious purpose for "hich the 7overnment uses accounting information is the
assessment of taxes This is the "or& of the Taxes Department Other purposes for "hich the
government re%uires accounting information include the regulation of business, the
determination of gross domestic product, national economic planning and the production of
national economic statistics such as employment rates and economic gro"th rates
*enera& pu+&ic
The activities of some businesses #especially big, po"erful businesses$ are of interest to the
general public )or example, a large company "hich has a monopoly over the supply of a
certain product may be suspected of charging excessive prices for that product The study of
the accounting information published by the company may help the public to decide "hether
or not this suspicion is "ell2founded The public are also interested in these financial
statements because some companies offer certain scholarships
1., The -ua&itatie characteristics of financia& information
If financial information is going to be useful to the people for "hom it is produced, it must
possess a number of %ualities or %ualitative characteristics The !ccounting 0tandards /oard
#a body "hich see&s to improve the %uality of financial accounting in the 89$ has suggested
that the follo"ing characteristics are especially important:
#a$ .e&eance. )inancial information cannot be useful unless it is relevant to the
needs of the users and helps them to ma&e economic decisions Information "hich
has predictive relevance helps users to ma&e decisions about the future, "hile
information "ith confirmatory relevance helps users to evaluate their past
decisions
#b$ .e&ia+i&ity. Information is reliable if users can depend upon it to be complete and
free from error and bias +eliable information is prepared and presented in a
neutral "ay, not in a "ay "hich see&s to influence the decisions "hich "ill be
made by users
Total reliability is usually difficult to achieve since #as mentioned earlier$ the
preparation of financial information nearly al"ays involves the exercise of
judgment 6o"ever, as far as possible, financial information should possess the
%uality of objectivity, consisting of definite facts rather than subjective opinions
#c$ (ompara+i&ity. 8sers may need to compare the financial information produced
by a business "ith:
/ information produced by the same business in previous years, or
/ information produced by other businesses
0uch comparisons "ill be valid only if all the information has been prepared and presented in
a consistent manner, so that similar transactions and events are dealt "ith in a similar "ay
:ou should no" have some idea of "hat accounting is: it is a process "hich has three basic
stages: identifying and recording accounting information, classifying and measuring it and
communicating and explaining it to those parties "hich need to &no" so that they can ma&e
the right &ind of decisions in the business
Figure 1.1 Accounting Information Users And Their Information Needs
0ractice -uestions1
Accounting


information

*enera& pu+&ic
*oernment
)mp&oyees (ustomers
'upp&iers
(ompetitors Inestors2shareho&ders
#anagers
;; Explain the type of information accounting "ants to identify and record(
;< Describe the &inds of information needed by each user group
;= Explain the desirable %ualities that should be possessed by accounting information
2. BRANCHES OF ACCOUNTING
2.0 Learning !utcomes1
2.1 Introduction
The term >accounting3 refers to a speciali,ed information system The purpose of !ccounting
is to provide economic information concerning the past, current or expected future activities
of an organi,ation to such diverse groups as managers, investors, creditors, tax authorities,
regulatory agencies, labour unions and the general public This chapter focuses on the
branches of accounting and their relationships !ccounting provides information for three
major purposes:
Routine internal reporting for decisions of managers
Non-routine internal reporting for decisions of managers
External reporting to investors, government authorities, and other outside parties on
the organisation5s financial position, operations and related activities
2.2 $ranches of Accounting
!ccounting is divided into )inancial !ccounting, .anagement !ccounting and 1ost
!ccounting
2.2.1 4inancia& Accounting
Is concerned "ith the development of general purpose financial statements, #such as
the statement of financial position, income statement etc$ that are intended for the
primary use by persons external to the organi,ation
!n comp&etion of this chapter5 you shou&d +e a+&e to1
Explain ho" accounting provides decision support information to
management
Explain the relationships of cost accounting to management accounting and to
financial accounting
8nderstand the standards of ethical conduct for management and financial
accountants

-ublic limited companies are re%uired by the la" to issue financial statements #to the
general public$ that disclose the organi,ation5s current financial condition and report
on management5s handling of the affairs of the organi,ation in the past
)inancial statements are highly aggregated to provide a broad overvie" of the
organi,ation
These statements are created in accordance "ith external standards imposed by the
1ompanies !ct and the !ccounting -rofession in the form of 7enerally !ccepted
!ccounting -ractice #7!!-$
! significant feature of extremely imposed standards is the emphasis of objectivity
7eneral2purpose financial statements are based on objective, verifiable economic
transactions that t"o trained accountants "ould interpret in a similar manner
)inancial accounting emphasi,es on the historical, custodial, and ste"ardship aspects
of accounting
2.2.2 #anagement Accounting

Is the application of accounting techni%ues to the provision of information designed
to assist all levels of management in planning and controlling of the activities of the
firm, and in decision2ma&ing
It involves producing and interpreting accounting and statistical information in
order to assist management in its function of maximi,ing efficiency, and achieving of
corporate goals
It is concerned "ith the provision of special2purpose financial statements and reports
to managers and other persons in the organi,ation #Internal +eporting$
.anagement accounting reports are not re%uired by la" and so are prepared only
"hen deemed useful to management /ecause internal decision2ma&ers are primarily
concerned "ith the impact of their decisions on the future performance of the
organi,ation, management accounting reports are future2oriented
.anagement accounting reports may be %uite subjective since there are no
standards imposed on the information provided for internal users
The primary criterion in developing management accounting information is
relevance
-ast and current activities are reported to extent that such information helps
management plan for the future
.anagement accounting reports are only aggregated as management desires
/riefly, management accounting is the identification, measurement, accumulation, analysis,
preparation and communication of information that assist management in fulfilling
organi,ational objectives
2.2.3 (ost Accounting
Is the accumulation, assignment, and analysis of production and cost data to provide
information for external reporting, internal planning and control of ongoing
operations, and special decisions
It is concerned "ith providing information for financial accounting and management
accounting purposes That is, product cost data is needed for inventory valuation,
budgeting, control of operations and decisions #such as pricing$
1ost !ccounting therefore, provides the basis for .anagement !ccounting
1ost and .anagement !ccounting formulate a management information system "hich can
assist management in the tas& of planning controlling and decision2ma&ing
Exhibit ;; belo" summarises the differences bet"een )inancial !ccounting and
.anagement !ccounting "hile Exhibit ;< sho"s the type of information that 1ost
!ccounting may provide to both )inancial !ccounting .anagement !ccounting Exhibit ;=
on the other hand presents possible duties of the .anagement !ccountant, 1ost !ccountant
and )inancial !ccountant
2.3 'ummary of differences +et"een 4inancia& Accounting and
#anagement accounting1
)I?!?1I!* !11O8?TI?7 .!?!7E.E?T !11O8?TI?7
7eneral purpose financial statement 0pecial purpose statements and reports
External orientation Internal orientation
-repared %uarterly, half2yearly or annually -repared as deemed useful to
management
+eports on the past Is future oriented
6ighly aggregated #/road$ .ay be very specific #narro"$
.ust conform to external standards ?o need for external standards
Emphasis on objective data .ay be %uite subjective
.ust be audited ?o need for auditing
.ust be published Does not need publishing
)67I$IT 2.1
2.4 'ummary of Uses of (ost Accounting1

)I?!?1I!* !11O8?TI?7:2
-roduct costs for inventory control
-roduct costs for income
determination
1O0T
!11O8?TI?7
.!?!7E.E?T !11O8?TI?7:2
predicted cost data for budgeting
cost data for control
cost data for special decisions
2.5 !rganisation (hart for an Accounts Department
8of a typical manufacturing company$
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3. Types of organi;ations
3.0 Learning outcomes
On completing this section you should be able to:
0tate the different types of organi,ations
Describe the nature of each type of organi,ation
Explain the advantages and disadvantages of one type of organi,ation over the other
3.1 0riate )nterprises
-rivate enterprise firms conform to one of three legal forms:
#a$ 0ole trader
#b$ -artnership
#c$ *imited liability
#d$ ?on2trading entities
#e$ 1ooperatives
The choice of legal form "ill be influenced by the financial needs, considerations of the
o"ner5s liability and the degree of personal control sought by the founder of the business
3.2 'o&e trader +usinesses
In this form of business organi,ation one person provides the permanent finance and, in
return, retains full control of the business and enjoys all the profits It is possible and li&ely
that the sole proprietor "ill eventually employ others as "age earners but the distinctive
feature of this form of business is that there is a single o"ner 6o"ever, just as the sole
proprietor enjoys all the profits, he or she is personally liable to all the debts and all decisions
made
There are no legal formalities involved in setting up the business as a sole trader 6o"ever,
under the business ?ames !ct ;BCD a business #irrespective of legal form$ using a trade name
other than that of the o"ner must conform to three basic re%uirements:
#a$ the name of the o"ner must be displayed on all business documentsE
#b$ the o"ner must disclose all information relating to o"nership to anyone "ho has
dealings "ith the businessE
#c$ a notice concerning o"nership must be displayed in the business premises This act
displaced the previous obligation to register business names
There are no other business re%uirements "hen establishing a sole trader business except in a
minority of trades "hich have the potential for causing a nuisance to others The sale of
alcohol re%uires a license from local magistratesE other activities might re%uire a license from
a local authority 6o"ever these are exceptions rather than the rule
*egally the business and its sole proprietor are inseparable This means that the o"ner is
responsible for all debts, is taxed in the same "ay as an individual #ie through income tax$
and must pay ?ational Insurance as a self employed person The trader is re%uired to submit
accounts to the Inland +evenue #income tax$ and 1ustoms and Excise #expenditure taxes$ In
relation to expenditure taxes, all businesses have to register for @at purposes if sales revenue
exceeds FGH III per year It is li&ely that the tax liability of a ne" and small sole trader "ill
be lo"er #and he or she "ill have longer to pay$ then if the trader established a company
)urthermore, as a simple form of organi,ation, accountancy fees are li&ely to be lo"er than if
the business "as established as a company
The sole trader enjoys distinct advantages:
freedom and flexibilityE
personal satisfactionE
secrecy 4 there is no need to disclose business affairs, except to tax authorities and to
creditors "hen see&ing loansE
personal control "ith no re%uirement to consultE
personal contact "ith staff and customersE
enjoyment of all profitsE
absence of legal formalities "hen establishing the businessE
financial advantages in terms of lo" taxes, longer time to pay taxes and lo"er
accountancy feesE
!gainst these advantages there are major dra"bac&s:
limited sources of financeE
restricted gro"thE
limited scope for economies of scaleE
success depends on the o"ner5s energy and continuing fitnessE
the constraint of the lac& of time and speciali,ationE
full personal responsibility for decisions and for the debts of the businessE
3.3 0artnerships
To overcome some of the problems inherent in the sole trader form of business a partnership
might be formed The la" defines a partnership as >the relationship "hich subsists bet"een
persons carrying on a business in common "ith a vie" to profit5 ! partnership is an
association of individuals and is not a legal entity in its o"n right 1onse%uently it cannot sue
or be sued in its o"n name but instead each of the partners has to be named Each partner is
responsible for the debts of the partnerships .oreover, every partner, "hen acting on behalf
of the firm, acts as an agent of the partnership and thus binds his or her fello" partners In
simple language, the individual partner can be personally sued and held liable for all
decisions made, and all debts incurred, by other partners if these people "ere acting "ith the
authority of the partnership Therefore, one should choose business partners very carefully
and dra" up a legal agreement on the rights and responsibilities of each partner The
partnership agreement should deal "ith:
#a$ the nature of the business and date of commencement
#b$ the amount of the capital put into the business by each partner
#c$ the method by "hich profits # or losses $ are to be shared
#d$ voting rights
#e$ the role of each partner
#f$ the duration of the partnership and method of dissolving the partnership
#g$ arbitration procedure if partners cannot reach agreement
#h$ arrangement to cover absence retirement and the admission of ne" partners
#i$ arrangements concerning finances, boo&&eeping, ban&ing and insurance "here one of
the partners contributes a disproportionate amount of the finance it is doubly
important to dra" up a "ritten agreement This is because the ;CBI -artnership !ct
lays do"n that, except "here there is a specific agreement to the contrary:
#a$ all partners are entitled to an e%ual share of profits
#b$ each partner is entitled to participate in the management of the firm
#c$ decisions are settled on a majority basis, except for any change in the nature of the
business, "hich re%uires unanimous agreement
!s business form, partners enjoy certain advantages over the sole trader:
#a$ additional sources of finance
#b$ sharing of responsibilities
#c$ speciali,ation
#d$ sharing of losses
In addition, partners enjoy greater privacy and fe"er legal formalities compared "ith the
company form of organi,ation 6o"ever the attractiveness of the partnership form of
organi,ation is reduced "hen it is remembered that each partner is fully responsible for
decisions, and the ease "ith "hich companies can be formed has reduced the popularity of
the partnership form It is most commonly found in the professions, "here the rules of the
appropriate professional association #eg the *a" 0ociety$ preclude the translation of the
business of the company form Outside the professions, there is a preference for the joint
stoc& company form of organi,ation
3.4 Limited &ia+i&ity companies
1ompanies differ from partnerships in that the act of incorporation creates a ne" legal entity
distinct from the share holders "ho o"n the company This has important implications in the
separation of the affairs of the business from those of the people "ho o"n shares in it
1ompanies can ma&e contracts, and they can sue and be sued !ll action ta&en by the
company, including the contracting of the debt, are action of the company rather than the
actions of the individual owners 8nli&e the business forms described above, the legal
position of the company is completely affected by the death #or retirement$ of one of the
shareholders 0hareholders enjoy the privilege of limited liability "hich means that they are
liable to meet the debts of the business only to the extent that they have invested in the
business 6ence, if the shares they o"n are fully paid up, no further claim can be made on the
shareholder *imited liability #seen by earlier @ictorians as an attempt to evade responsibility
for the debts of the business$ is regarded as essential in overcoming the reluctance of the
people to purchase shares in a business
There are t"o common misconceptions about limited liability )irst, it is often stated
#"rongly$ that companies enjoy limited liability The company is in fact fully liable to its
debtsE it is the shareholders "ho enjoy limited liability 4 they are liable only to a limited
extent 0econd, it is often stated #again "rongly$ that limited liability reduces the ris& of
business In fact limited liability transfers the ris& from the o"ners to creditors of the
business The greater ris& no" incurred by creditors provide the rationale for the greater
scrutiny of the companies and the re%uirement that the "ord >limited5 should appear in the
name, as a "arning to potential creditors /ecause of the limit to liability, creditors often
insist that shareholders in a small private company #or directors in large one$ accept some
personal responsibility for the debt This reduces the value of limited liability to people
establishing a business
1ompanies are established by registration under the 1ompanies !cts #currently the ;BCD
!ct$ The founders or promoters are re%uired to lodge a number of documents "ith the
+egistrar of 1ompany
3.5 (omparison of companies and partnerships
(ompany 0artnerships
o"ners are shareholders #members$ o"ners are partners
; or more shareholders in a private company <2<I partners #except in certain
< or more shareholders in a public company professions$
.aximum determined by number of shares
0eparate legal entity not separate entity
*imited liability liabilities of partners is not limited
#except in the case of limited
partnerships$
!mount of capital limited by authori,ed share capital determined in the partnership
capital stated in .emorandum of !ssociation agreement
profits distributed in the form of dividends profits distributed in accordance "ith
expressed in relation to shares partnership agreement E%ual distribution
if no agreement exists
shareholders are not entitled to ta&e part in normally all partners entitled to ta&e
management 4 directors appointed for this part in running the firm
purpose
activity limited by objects clause a firm can do anything la"ful
accounts generally open to public inspection accounts are private
perpetual succession 4 company not affected partnership ends "ith death of a
by death of member partner
"hen a company is "ound up no member all partners are liable for its debts
is liable for its debts
shares are transferable in accordance no transfer possible
"ith the articles
companies are not liable to pay operation no income tax on profits of
tax on their profits partnership but income tax is assessed
upon the partners on their
share of profits
3., Distinctions +et"een priate and pu+&ic companies
0u+&ic company 0riate company
?ame .ust end "ith public .ust end "ith limited #*td$
*imited company #-*1$
.emorandum of !ssociation .ust state that it is a -*1 2
.inimum membership < ;
.inimum authori,ed capital JDI III none
0hare issue The public is invited to 1annot advertise to invite
subscribe public to subscribe
!ccounts 0trict re%uirements about 0mall companies may submit
the format of accounts modified, simplified accounts
1ompany secretary .ust be %ualified Does not have to be %ualified
0i,e *arge 8sually small
3.< 4rom priate company to pu+&ic company and +ac% again
*oing pu+&ic *oing priate
+easons To raise additional finance To regain control of the business
in order to: To eliminate threat of ta&eover
develop ne" products To avoid administrative burden and
ac%uire ne" capital e%uipment costs associated "ith stoc& exchange
moderni,e listing
expand To pursue independent long2term
strategy "ithout "orrying about the
short2termism of investors
.ethod ; 0pecial resolution of shareholders ; 0pecial resolution of shareholders
meeting meeting
< 1hange .emorandum and !rticles < 1hange .emorandum and !rticles
of !ssociation of !ssociation
= 0ubmission and declaration to the = 0ubmission to +egistrar of
registrar of 1ompanies 1ompanies
G +e2registration G +e2registration
D ?e" certificate of incorporation D ?e" certificate of incorporation
a certificate of trading issued