Chapter 1: Introduction to Accounting PDF

# Chapter 1: Introduction to accounting ## Introduction - Learning outcomes - Specify why an entity maintains financial records and prepares financial statements. - Specify the ethical considerations for preparers of financial statements. - Record and account for transactions and event...

# Chapter 1: Introduction to accounting ## Introduction - Learning outcomes - Specify why an entity maintains financial records and prepares financial statements. - Specify the ethical considerations for preparers of financial statements. - Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements. - Specify the key aspects of the accrual basis of accounting and the cash basis of accounting. - Syllabus links - The material in this chapter will be developed as you progress through the Accounting modules, and later in Professional Level Financial Accounting and Reporting. - Examination context - Questions on topics in this chapter will be knowledge-type multiple choice, multi-part multiple choice or multiple-response questions. In the exam you may be required to: - Identify capital as opposed to revenue expenditure - Specify the distinctions between the different qualitative characteristics. - Identify the principles that relate to each qualitative characteristic. - Identify the different interests of stakeholders. ## Learning topics 1. The purpose of accounting information 2. The regulation of accounting 3. Sustainability standards 4. The main financial statements 5. Capital and revenue items 6. Qualitative characteristics of useful accounting information 7. Accounting concepts and conventions 8. Ethical considerations ## Summary - Further question practice - Technical references - Self-test questions - Answers to Interactive questions - Answers to Self-test questions ## 1 The purpose of accounting information ### Section overview - Accounting is a way of recording, analysing and summarising the transactions of an entity. - The three main types of business entity are sole traders, partnerships and companies. - Stakeholders who need financial information include: managers, owners, customers, suppliers, lenders, employees, trade unions, Tax and VAT authority, financial analysts and advisers, government agencies and the public. - Existing and potential investors, lenders and other creditors are the primary users of general purpose financial statements. - The primary users of financial statements use the financial information of a company to make decisions about providing resources to the entity and to assess managers' stewardship of the company's economic resources. ### 1.1 What is accounting? - Accounting is a way of recording, analysing and summarising the transactions of an entity (a term we shall use to describe any business organisation). - We will assume that entities use computerised accounting systems to record, process and summarise their transactions. - Computerised accounting systems and the recording of transactions are covered in Chapter 3. - The aggregation and analysis of transactions in the accounting system is covered in Chapter 4. - Finally, the summary of the transactions in the financial statements is covered in Chapter 5. - One of the roles of an accountant is to measure the revenue and expenditure of an entity and, if it is a business, its profit. This is not as straightforward as it may seem and in later chapters, we will look at some theoretical and practical difficulties. ### 1.2 Types of business entity - There are three main types of profit-focused business entity: - Sole traders - Partnerships - Limited liability companies - **Sole traders:** people who work for themselves. Examples include a local shopkeeper, plumber or hair dresser. The term sole trader refers to the ownership of the business; sole traders can have employees. - **Partnerships:** occur when two or more people decide to share the risks and rewards of a business together. Examples include an accountancy, medical or legal practice. A partnership can take one of two forms: a general partnership (like two or more sole traders) or a Limited Liability Partnership LLP (more like a company.) - **Limited liability companies:** are incorporated to take advantage of 'limited liability' for their owners (shareholders). This means that, while sole traders (always) and partners (usually) are personally responsible for the amounts owed by their businesses, the owners (shareholders) of a limited liability company are only responsible for the amount to be paid for their shares. ### 1.3 The objective of financial statements - According to the IFRS Foundation's Conceptual Framework for Financial Reporting (which we will cover in more detail later in the chapter), the objective of financial reporting is to 'provide information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity'. - Existing and potential investors, lenders and other creditors are known as the primary users of the financial statements. When making decisions, the primary users need to assess: - The economic resources of an entity (eg, its cash and other assets), claims against the entity (eg. its liabilities) and changes in those resources and claims. - How efficiently and effectively the entity's management have discharged their responsibilities relating to the management of the entity's resources. (Conceptual Framework: para. 1.4) - Cash is important to businesses. An entity needs to be able to use its resources to generate cash and use that cash to settle its claims. The timing and certainty of cash flows determines whether the business can: - Pay its employees and suppliers. - Meet interest payments. - Repay loans. - Pay something to its owners. - Large businesses are of interest to a wider range of stakeholders and so we will consider the case of a large public company, whose shares can be purchased and sold on a stock exchange. ### 1.4 Users of financial information and their information needs - The following stakeholders are likely to be interested in financial information about a large company with listed shares: - **Managers/directors:** appointed by the company's owners to supervise the day-to-day activities of the company. They need information about the company's present and future financial situation. This enables them to manage the business efficiently (exercising the stewardship function) and to make effective decisions about matters such as pricing, output, employment and financing. - **Owners of the company (shareholders):** want to assess management performance. They are the providers of capital for the company, so they are interested in the risk to their capital, and the return they will get for taking that risk. They need information to help them determine whether they should buy, hold or sell shares. They want to know how profitable and sustainable the company's operations are and how much profit is available for distribution to the shareholders through a dividend. - **Lenders:** include banks which allow the company to operate an overdraft or, provide longer term loan finance secured on the company's assets. A bank wants to ensure that the company is able to keep up loan payments. - **Other creditors,** such as suppliers who provide goods and services on credit and customers who purchase goods or services. Suppliers want to know about the company's ability to pay its debts. Trade creditors are likely to be interested in an entity over a shorter period than lenders, unless they are dependent upon the continuation of the entity as a major customer. Suppliers are also interested in the company's corporate values such as its fair trade policies, how it treats its employees and its environmental practices. - **Trade contacts,** which includes suppliers as above, and customers need to know that the company is a secure source of supply, so that repeat purchases and after-sales care will be available. - **Income Tax Authority-Commissioner of Taxes:** wants to know about business profits in order to assess the company's tax liabilities. - **Employees and their representative groups:** need information about the stability and profitability of their employers, so they can assess the entity's ability to provide remuneration, retirement benefits and employment opportunities. - **Financial analysts and advisers:** need information for their clients or audience. For example, stockbrokers need information to advise investors; credit agencies want information to advise potential suppliers of goods to the company; and journalists need information for their reading public. - **Government agencies:** are interested in the efficient allocation of resources and therefore in the activities of enterprises. They also require information in order to provide a basis for national statistics. - **The public:** are affected by business entities in a variety of ways. For example, they may make a substantial contribution to a local economy by providing employment and using local suppliers. Another important factor is the effect of an entity on the natural environment, for example as regards the levels of pollution generated by the entity. - **Regulatory bodies,** such as the Financial Reporting Council (FRC) which regulates the financial services industry, require information to ensure compliance with regulations and the law. - The financial statements are intended to provide useful information to the primary users, however that information is also likely to be useful to the other stakeholders. Some of the stakeholders may have conflicting needs or information needs that are not satisfied by the financial statements. This 'information gap' is likely to be greater in large companies. - **Managers of a business:** need financial information to help them make planning and control decisions. They do not, however, rely on the financial statements as they have access to internal business information. Managers can obtain extra information through the cost and management accounting system. - Therefore, instead of being thought of as users of the financial statements, management are primarily responsible for the preparation and presentation of the financial statements. ### 1.4.1 Interactive question 1: Accounting information - It is easy to see how 'internal' stakeholders access accounting information. A manager, for example, can just go along to the accounts department and ask the staff there to prepare whatever accounting statements she needs, but external users of accounts cannot do this. - **Requirement:** How, in practice, can a business contact or a financial analyst access accounting information about a company? - **See Answer at the end of this chapter.** - In addition to the financial statements, additional accounting information is often prepared for the benefit of other stakeholders to satisfy their specific information needs: - **Tax Authority-NBR:** will receive information to make tax assessments. - **A bank:** might demand a cash flow forecast as a pre-condition of granting an overdraft. - **The IASB:** is responsible for issuing International Accounting Standards and International Financial Reporting Standards (IASs and IFRSs). ICAB as a member of IASB adopts those standards in Bangladesh. These require companies to publish certain additional information. Accountants, as member so of professional bodies, are placed under an obligation to ensure that company financial statements conform to the requirements of IAS/IFRS, where relevant. - **It is not only businesses that need to prepare financial statements. Charities and clubs, for example, prepare financial statements every year. Financial statements also need to be prepared for government (public sector) organisations.** ### 1.4.2 Ethical considerations - **Ethical considerations should underpin the work of all professional accountants, including those in business who prepare financial statements and those who set the rules and regulations of financial reporting.**