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  • Geoff_01.qxd 8/1/04 12:29 PM Page 1 1 Principles and practices OBJECTIVES By the end of this chapter you will be able to: G Understand what is meant by ‘financial accounting’. G Contrast financial accounting with management accounting. G Identify the ‘user groups’ of accounting information. G Understand the underlying principles and concepts of financial accounting. G Appreciate the role of standard setting in a national and international context. G Consider the application of principles and policies to published annual reports. 1.1 Introduction It is rare for accountancy to be worldwide news, talked about nightly on TV discussion shows and written about by editors of both serious and tabloid newspapers. Accountancy and scandal are words which are rarely seen in the same sentence—but in recent years, jour- nalists throughout the world have been writing articles on what they perceived to be a meltdown in accounting procedures and reliability. The collapse of a major US energy supply group, Enron Corporation, was blamed on dubious accounting rules, whilst in the UK many employees were finding that their pension benefits were being downgraded by companies citing as justification a new ‘accounting standard’. In the courts, previously well-respected company directors were being charged with ‘false accounting’, and govern- ments of several countries decided to order inquiries into the role of the accountancy profession. New accounting rules in the USA were cited as being responsible for the writing off of $60bn of assets by two telecoms groups, whilst the body responsible for devising global accounting rules was itself accused of being part funded by the same companies it was trying to regulate. Accountants would claim that their role is not to portray a financial picture which is unique in its perfection, honesty, and reliability. What they do attempt is to present often highly complex data that can be relied upon as a reasonably truthful and fair summary of financial events. There has, historically, been considerable scope for different interpretation
  • Geoff_01.qxd 8/1/04 12:29 PM Page 2 2 PRINCIPLES AND PRACTICES of similar transactions according to the discretion of company directors. Over time, various restraints have been imposed and sanctions applied to try and ensure uniformity of treat- ment, a process which is continuing and evolving. In calling this book Applied Financial Accounting and Reporting, the intention is to link theory with practice and give readers the opportunity to consider how specific accounting procedures relate to actual companies, and to consider the legal and professional restraints imposed on corporate reporting. For this purpose, the annual report of Domino’s Pizza UK & IRL plc, a pizza delivery company listed on the London Stock Market, is reproduced on pp. 000–0, and many topics referred to within chapters are linked to that company’s financial statements. If you want your own copy of the Domino’s Pizza annual report, go to www.dominos. co.uk, click on ‘The Business’ then ‘Investor relations’. You will be able to download it in a ‘read-only’ format. You will see the symbol to prompt you to look at a particular section of the report. Domino’s Pizza has been chosen for a number of reasons, including: G it is a well-known high street brand; G it is an expanding and profitable company (sales and profit more than doubling in four years); G it publishes a clearly set-out annual report complying with best practice; G it is not a complex multinational with highly intricate and specialized financial aspects which may confuse rather than enlighten. As well as Domino’s Pizza plc, extracts from many other companies will be used to show the variety of ways in which information might be presented. Look for the following symbol . These companies are listed in the Acknowledgements on p. 6. There is a significant degree of change happening regarding the scope, quality, and content of accountancy’s procedures, rules, and regulations (known as GAAP—Generally Accepted Accounting Principles, or ‘regulatory framework’). In particular, a move from national to international rules, a process which has been gaining pace for several years, is accelerating. This means that countries which previously set their own rules for financial reporting are rapidly harmonizing them with their international equivalents. However, new legislation— national and international—is regularly introduced or updated, with new standards issued or old ones rewritten. This book is based on the regulations existing in mid-2003. 1.2 The background to accounting 1.2.1 What is accounting? There have been numerous attempts to develop an all-embracing definition of accounting. One which is often quoted was published by the American Accounting Association in 1966: [Accounting is] The process of identifying, measuring and communicating economic informa- tion about an organisation or other entity, in order to permit informed judgements by users of the information.
  • Geoff_01.qxd 8/1/04 12:29 PM Page 3 PRINCIPLES AND PRACTICES 3 The key aspects of accounting are, it suggests, identifying, measuring, and communicating: G identifying the key financial components of an organization, such as assets, liabilities, capital, income, expenses, and cash flow; G measuring the monetary values of the key financial components in a way which represents a true and fair view of the organization; G communicating the financial information in a way that is useful to the users of that information. The systematic recording of financial data is universally based on double-entry bookkeeping principles (see pp. 000–0), which have been in use by businesses for many centuries. How- ever, there is no global agreement regarding the way in which accounting informa- tion should be summarized and communicated. Analysis and appraisal can be distorted by national differences in accounting procedures and there is a growing movement to harmo- nize the accounting treatment for specific areas of difficulty. Regulatory frameworks have been developed within national and international contexts to help ensure commonality of approach, and large organizations are expected or required to observe accounting stan- dards. These standards impose common procedures for coping with specific accounting difficulties with the aim of avoiding inconsistencies between companies and encouraging the improvement of the quality and usefulness of accounting statements. 1.2.2 Branches of accounting Accounting is split into two key areas: 1. Financial accounting, which is that part of accounting which records and summarizes financial transactions to satisfy the information needs of the various ‘user groups’ such as investors, lenders, creditors, and employees. It is sometimes referred to as meeting the external accounting needs of the organization. 2. Management accounting, which is sometimes referred to as meeting the internal accounting needs of the organization. It is designed to help managers with decision making, planning, and control. As such it often involves estimates and forecasts, and is not subject to the same regulatory framework as financial accounting. A leading professional body, the Chartered Institute of Management Accountants (CIMA), has defined manage- ment accounting as: An integral part of management concerned with identifying, presenting and interpreting informa- tion used for: G formulating strategy G planning and controlling activities G decision taking G optimising the use of resources G disclosure to shareholders and others external to the entity G disclosure to employees G safeguarding assets
  • Geoff_01.qxd 8/1/04 12:29 PM Page 4 4 PRINCIPLES AND PRACTICES The above involves participation in management to ensure that there is effective: G formulation of plans to meet objectives: (strategic planning) G formulation of short term operation plans: (budget/profit planning) G acquisition and use of finance (financial management) and recording of transactions (financial accounting and cost accounting) G communication of financial and operational information G corrective action to bring plans and results into line (financial control) G reviewing and reporting on systems and operations (internal audit, management audit).1 The CIMA definition is deliberately all embracing, and there are some obvious infringe- ments on what financial accountants might see as their ‘territory’. It reinforces the notion that there are overlaps between financial and management accounting, particularly in the recording, interpreting, and communicating aspects. However, if you look at most (if not all) textbooks devoted to management accounting, there are unlikely to be any references to ‘disclosure to shareholders and others external to the entity’, and in practice this is usually seen as a financial accounting function. 1.3 A statement of principles In the United Kingdom, an Accounting Standards Board (ASB) was set up in 1990 with the aim of improving standards of financial accounting and reporting. In 1999 the ASB pro- duced a statement of principles2 which sets out certain fundamental principles for the preparation and presentation of financial statements. The Statement of Principles also identifies the following seven groups of users of financial information, together with the information which they need from the financial statements: User group Information needs Investors Investors need to assess the financial performance of the organization they have invested in to consider the risk inherent in, and return provided by, their investments. For example, they would want to know if the company made a profit and what part of that profit was being paid to shareholders as a dividend. Other areas of interest would be to find out if the company had more assets than liabilities, and if its cash inflow was greater than its outflow. ‘Earnings per share’ is a key indicator of performance. For example, see Domino’s Pizza’s earnings per share shown at the foot of p. 000. Lenders Lenders need to be aware of the ability of the organization to repay loans and interest. Potential lenders need to decide whether to lend, and on what terms. For example, to what extent is the company’s profit before interest payments greater than those interest payments? Suppliers and other trade Suppliers need to take commercial decisions as to whether or not they should sell to the creditors organization and, if they do, whether they will be paid. They will be interested in such aspects as how well the company is funded and how quickly it pays its creditors’ bills. For example, see Domino’s Pizza’s creditor payment policy on p. 000. (Continued) 1 Management Accounting: Official Terminology (CIMA, London, 2000). 2 Accounting Standards Board, Statement of Principles for Financial Reporting (London, 1999).
  • Geoff_01.qxd 8/1/04 12:30 PM Page 5 PRINCIPLES AND PRACTICES 5 Employees People will be interested in their employer’s stability and profitability, in particular that part of the organization (such as a branch) in which they work. They will also be interested in the ability of their employer to pay their wages and pensions. Customers Customers who are dependent on a particular supplier or are considering placing a long-term contract will need to know if the organization is likely to continue in business for the foreseeable future. Do the directors consider that the company is a ‘going concern’? For example, see Domino’s Pizza’s director’s report on p. 000—the fourth bullet point under the heading ‘Corporate Governance’. Government and their Reliable financial data helps governments to assemble national economic statistics which agencies are used for a variety of purposes in controlling the economy. Specific financial information from an organization also enables tax to be assessed. The public Financial statements often include information relevant to local communities and pressure groups such as attitudes to environmental matters, plans to expand or shut down factories, policies on employment of disabled persons, etc. For example, see Domino’s Pizza’s policy on the employment of disabled people on p. 000. We could also add an eighth group—the management of the organization—as they are the ‘stewards’ of the business and need to have reliable financial information on which to base their decisions. 1.3.1 Concepts, principles, and policies As well as identifying the user groups, the Statement of Principles sets out the concepts that underlie the preparation of financial statements for external users. The Statement will be referred to several times within this text as it contains important guidance on such matters as definitions of key elements found within financial statements and how they should be recognized, measured, and presented. Overall, the Statement contains eight chapters, but the first three are worthy of consideration at this early stage. The objective of financial statements (chapter 1) The objective of financial statements is to provide information about the financial perform- ance and financial position of an enterprise that is useful to a wide range of users for assessing the stewardship of management and for making economic decisions. That objec- tive can usually be met by focusing exclusively on the information needs of present and potential investors, the defining class of user. Present and potential investors need information about financial performance and position that is useful to them in evaluating the entity’s ability to generate cash (including the timing and certainty of generation) and in assessing the entity’s financial adaptability. The reporting entity (chapter 2) This sets out the conditions that determine the principle whether companies should prepare general purpose financial statements, both as individual companies or within groups of companies. It also focuses on situations where one business ‘controls’ another or where there is a significant investment in another company but not ‘control’. This is con- sidered in more detail on pp. 000–0. In essence, a business should prepare and publish financial statements if there is a legitimate demand for the information that its financial statements would provide.
  • Geoff_01.qxd 8/1/04 12:30 PM Page 6 6 PRINCIPLES AND PRACTICES The qualitative characteristics of financial information (chapter 3) For financial information to have value, it must first be material. It is material if its mis- statement or omission might reasonably be expected to influence the economic decisions of users. Materiality is considered a ‘threshold quality’, i.e. without it the information is insignificant. Assuming that the information is material, it must have: G Content which is relevant. It is relevant if it has the ability to influence the economic decisions of users and is provided in time to influence those decisions. G Content which is reliable. It is reliable if it can be depended upon by users to represent faithfully what it either purports to represent or could reasonably be expected to rep- resent and therefore reflects the substance of transactions and other events that have taken place; it is free from deliberate or systematic bias and material error and is complete; and if prepared under conditions of uncertainty, a degree of caution has been applied in exercising the necessary judgements. G Comparability. It has comparability if users can discern and evaluate similarities or differences over time and between different companies. G Understandability. It has understandability if its significance can be perceived by users who have a reasonable knowledge of business and economic activities and accounting and a willingness to study with reasonable diligence the information provided. The Statement contains a diagrammatic representation of its chapter 3, which is shown in Figure 1.1. 1.3.2 Accounting policies Accounting policies determine which facts about a business are to be presented in the financial statements, and how those facts are to be presented. Policies should be adopted that enable a business’s financial statements to show a true and fair view. Indeed, one of the responsibilities of a company’s auditors is to report on whether the financial statements give a true and fair view. Look at Domino’s Pizza’s audit report (p. 000). What does the ‘Opinion’ say about the report’s truth and fairness? A UK accounting standard, FRS 18, was published in December 2000 which requires busi- nesses to adopt accounting policies which are ‘most appropriate’ to their particular circumstances for giving a true and fair view. The policies must be reviewed regularly and changed if others are more appropriate. Sufficient information must be disclosed in finan- cial statements to enable users to understand the policies adopted and how they have been implemented. Two concepts, going concern and accruals, are considered to have a pervasive role in selecting policies. Both are referred to in the UK’s 1985 Companies Act as ‘fundamental principles’.
  • Geoff_01.qxd 8/1/04 12:30 PM Page 7 PRINCIPLES AND PRACTICES 7 What makes financial information useful? Giving information that Threshold is not material may Materiality quality impair the usefulness of the other information given. Relevance Reliability Comparability Understandability Information that is Information that Similarities and The significance of a complete and has the ability to differences can be the information can faithful influence decisions evaluated be perceived representation Confirmatory Faithful Users’ Consistency value representation abilities Predictive Aggregation and Neutral Disclosure value classification Free from material error Complete Prudence Figure 1.1 The qualitative characteristics of financial information Source: Reproduced by kind permission of the Accounting Standards Board. Going concern concept Financial statements are drawn up on the basis that the business can continue in opera- tional existence for the foreseeable future. In other words, the business is assumed to be a ‘going concern’ (i.e. it can ‘keep going’) unless there is information to the contrary. This is extremely important, as investors, lenders, and suppliers may otherwise consider the company a suitable business to invest in, to lend money to, or provide goods and services to. If the business is not a going concern, the value of its assets (e.g. commercial premises, machinery, and stock) may need to be revalued to a much lower level than if the business was a viable, healthy organization.
  • Geoff_01.qxd 8/1/04 12:30 PM Page 8 8 PRINCIPLES AND PRACTICES Look at Domino’s Pizza’s ‘Corporate Governance’ Statement (p. 000). Has the ‘going concern concept’ been adopted? Look at the following extract from the annual report of Scoot.com plc: Going concern Scoot.com plc is in the development stage of its business and its strategy to develop a branded infomediary service. In the 15 month period to 31 December 2000, the Group incurred operating losses before excep- tional items and goodwill amortisation of £37.5m (1999: £16.4m loss); the net cash outflow from operat- ing activities was £37.3m (1999: £15.6m outflow). In order to trade profitably with positive cash flow from operations, the Group must continue to identify new subscribers to achieve the critical mass customer base necessary to generate sales levels that meet its operating costs. The directors are pleased with the progress that has been made in developing a profitable business. To achieve this fully, the Group intends to increase the focus on operating efficiencies and raise additional lines of finance where necessary. The directors have prepared detailed forecasts for at least a year from the date of this statement that reflect their plans, including aggressive marketing campaigns, close management of individual businesses and benefits expected from the continued integration of Loot in the UK. They expect Scoot (UK) to become cash flow positive in the fourth quarter of 2001 and they expect the current operations of the Group as a whole, including its Benelux and France joint ventures, to become cash flow positive in the fourth quarter of 2002. In the meantime, Scoot’s continuation as a going concern is dependent upon its ability to generate sufficient cash flows from other sources to meet its obligations as they fall due in the foreseeable future. As the Group’s businesses continue to develop rapidly, this makes their future cash flows more difficult to predict than that of a more mature business. As a result, the directors will need to raise funds of potentially up to £20m from non-operating sources. To this end, an additional facility has already been secured in the form of an equity line of credit (the facility enables the directors to issue up to 60m ordinary shares). This facility is subject to shareholder approval. If required, the directors intend to draw upon this facility at key points during the implementation of the Group’s plan . . . The directors have a range of other funding options under consideration including the disposal of non-core assets and additional debt or equity fundraising from either existing or new investors, The directors expect that the final funding arrangements will comprise a combination of these alternative sources. On the basis of the combination of potential fund raising options above, the directors are confident that they can secure adequate resources to fund the development of the business. Accordingly, they consider that it is appropriate to prepare these financial statements on a going concern basis, therefore no adjust- ments that would otherwise be required have been made. Comment Unlike Domino’s Pizza, this loss-making company has had to justify in considerable detail its use of the going concern. Note particularly the last sentence, ‘therefore no adjustments that would otherwise be required have been made’. This refers to the fact that if the going concern concept was not applicable, various values contained within the financial statements would have to be reassessed, par- ticularly those of assets such as cars, computers, equipment, and stocks. If the business were to fail, the amounts realized on such assets would often be a tiny fraction of their ‘going concern’ valuation.
  • Geoff_01.qxd 8/1/04 12:30 PM Page 9 PRINCIPLES AND PRACTICES 9 Accruals concept With the exception of cash flow information (see pp. 000–0), financial statements should be prepared on the accrual basis of accounting. This requires the non-cash effects of trans- actions and other events to be reflected, as far as possible, in the financial statements for the accounting period in which they occur, and not, for example, in the period in which any cash involved is received or paid. Revenue and profits dealt with when calculating profits or losses are matched with associated costs incurred in earning them, so when calculating profit, all income and expenditure, whether or not ‘paid for’, must be included. The accru- als concept is sometimes referred to as the ‘matching’ concept. In basic terms, the concept means that if you are told that a company made a profit of £10m in the year ended 31 December 2004, this has not been calculated by simply adding all the cash received in the year, and then deducting the cash paid! Every relevant transac- tion, regardless of whether cash is paid or received in the period, must be included when arriving at the profit figure. Numerical examples of this are shown in Chapter 3. Look at n. 15 on p. 000 of Domino’s Pizza’s annual report. Identify ‘Accruals and deferred income’. This represents unpaid, not yet invoiced liabilities. 1.4 Published accounts Large corporations will publish financial information, usually as a requirement of a specific stock exchange or due to national legislation. For example, in the UK, Acts of Parliament require that all of the approximately one million limited companies must publish financial statements. Although there is no equivalent in the USA of the UK’s Companies Acts, major US companies will be registered with the Securities and Exchange Commission (SEC), which sets out detailed requirements for audit and the rules of financial reporting. For smaller UK companies, only a brief summary of their finances is required, but for the largest companies, including all plc’s (public limited companies), an ‘annual report’ must be prepared which is sent (either physically or electronically) to all shareholders and Companies House, which is the UK government’s ‘storehouse’ of company information. The public has a right of access to the information, for example by using the website www.companies-house.gov.uk. UK companies whose shares are listed on the stock exchange will also publish an abbrevi- ated interim statement showing their results for the first six months of the financial period. To save printing and distribution costs, companies are permitted to provide an electronic version on their website. Many organizations regard their annual report as an opportunity to show off the best of their company, in effect treating it as a public relations exercise. The glossy photographs of the company’s products and exotic locations of major contracts can give some reports the style of a travel brochure. A key feature of UK and other EU published profit and loss accounts and balance sheets is that they have to follow specific formats of presentation. These formats were devised to
  • Geoff_01.qxd 8/1/04 12:30 PM Page 10 10 PRINCIPLES AND PRACTICES ensure a degree of uniformity across the European Community, as they apply to all member countries. Although there is a small amount of flexibility allowed (for example a company can produce statements in either a ‘vertical’ or ‘horizontal’ format), virtually all UK compa- nies follow the ‘vertical’ style format. Look at pp. 000–0 of the Domino’s Pizza annual report. Notice how the information flows from top to bottom on each page—hence the ‘vertical’ format. It is sometimes also referred to as a ‘columnar’ format. Many large mainland European companies not only produce corporate reports in their ‘home’ language but also produce English-language versions for wider circulation. An example can be found at www.bmw.com (follow links to ‘Investor Relations’ and then click on ‘Annual Report’). 1.5 Diversity of international accounting practice The method of recording day-to-day financial transactions is common throughout the world, being based on the double-entry system (see pp. 000–0). However, there are signifi- cant differences in approach when summarizing information for inclusion in published annual reports. In many countries, the accounting profession has been relatively weak, and financial reporting practices have tended to be set by formal government legislation rather than by relatively informal professional rules. A number of distinct country groupings have evolved in this respect, the principal ones being: G United States and United Kingdom and countries historically influenced by them, e.g. Commonwealth countries such as Australia, India, and Malaysia; G Mainland European countries, such as France and Germany—though Holland has tended towards the US/UK approach. The reasons for the disparity of accounting procedures include: G the relative strength of the accounting profession in the countries, G the nature of the country’s legal system, G the main types of business organization, and G the relationship between taxation requirements and financial reporting requirements. The key industrialized nations have developed their own specific accounting regulations. This rarely has a major impact when applied to domestic companies within those coun- tries, but may have dramatic implications when international investment decisions have to be made. See p. 000 for details of how accounting standards within the EU for listed companies are changing from 2005.
  • Geoff_01.qxd 8/1/04 12:30 PM Page 11 PRINCIPLES AND PRACTICES 11 There are many reasons why countries developed dissimilar procedures, including: The legal system Some countries (e.g. France and Germany) have all-embracing sets of rules and regulations which apply to businesses, whereas countries such as the UK and the USA have more general statute laws backed up by case law, allowing more flexibility for individual companies. For example, in the USA, individual companies decide the rates at which assets depreciate, but in Germany the government decides what are appropriate. Types of ownership patterns Countries with wide share ownership (e.g. UK, USA) have developed strong independent professional accountancy associations to provide reliable financial data to shareholders. Those countries with predominantly small, family-run businesses (e.g. France) or with banks owning most shares of large companies (e.g. Germany), have had less need for providers of independent financial information. The accounting profession Strong independent professional associations of accountants developed in those countries (e.g. UK, USA) with the most liberal company laws and widest share ownership. Countries with restricted patterns of business ownership and rigid company legislation (e.g. France, Germany) had weak groupings of accountants, and sometimes the governments themselves controlled the profession. Conservatism Financial statements produced by independent accountants should ideally show a ‘true and fair view’. This is open to many interpretations, not least being the problem of asset valuation. Should assets be valued at original cost, what they might be sold at today, what it would cost to replace them, or a depreciated value based on usage, wear and tear, etc.? G US practice is conservative—don’t revalue, depreciate on a reasonable basis over the asset’s lifetime. G German practice is also conservative—don’t revalue, but depreciate on a basis decreed by the government. G UK practice is liberal—allowing companies either to revalue at intervals or show assets at cost, and depreciate on a reasonable basis. 1.5.1 International accounting standards In 1973, an International Accounting Standards Committee (IASC) was formed with the aim of harmonizing accounting practices throughout the world. Now renamed as the International Accounting Standards Committee Foundation (IASCF), its objectives are: G to develop, in the public interest, a single set of high-quality, understandable, and enforceable global accounting standards that require high-quality, transparent, and comparable information in financial statements and other financial reporting to help participants in the world’s capital markets and other users make economic decisions; G to promote the use and rigorous application of those standards; and
  • Geoff_01.qxd 8/1/04 12:30 PM Page 12 12 PRINCIPLES AND PRACTICES G to bring about convergence of national accounting standards and International Accounting Standards3 to high-quality solutions. Since April 2001, the standards-setting work has been undertaken by a subsidiary of the IASCF, the International Accounting Standards Board (IASB). The IASB’s responsibilities include: G responsibility for all IASCF technical matters including the preparation and issuing of International Accounting Standards; G publishing an ‘Exposure Draft’ (a preliminary version of the proposals, made available for public debate and feedback) on all projects and normally will publish a Draft Statement of Principles or other discussion document for public comment on major projects; G full discretion over the technical agenda of the IASCF and over project assignments on technical matters; in organizing the conduct of its work, the Board may outsource detailed research or other work to national standard setters or other organizations; G working to identify and review all the issues related to a topic and study other national accounting standards and practice; G the possible holding of public hearings to discuss proposed standards, although there is no requirement to hold public hearings for every project; G undertaking field tests (both in developed countries and in emerging markets) to ensure that proposed standards are practical and workable in all environments, although there is no requirement to undertake field tests for every project. The status of International Accounting Standards (IASs) was given a significant boost in 2001 when the European Commission proposed that from 2005 listed companies through- out the EU should be obliged to follow IASs rather than national standards. The other key driver in their growing acceptance may follow the accounting scandals in the USA (princi- pally related to Enron and World Com), where the perception of weak US standards may lead to a much greater role for their international equivalent. In the UK, all new standards contain an explanation of the extent to which they are in accordance with IASs. In most respects they are closely aligned, but occasionally there are significant differences due to perceived ‘national’ requirements. One example is the area of deferred taxation (see pp. 000–0), where a UK standard issued in 2000 has key differences from the IAS, also issued in that year. As the ex-chairman of the UK Accounting Standards Board, Sir David Tweedie, was subsequently appointed chairman of the IASB, it would not be unexpected if the inter- national standards develop in line with the UK’s position rather than vice versa. 1.6 Chapter summary G Accounting is defined as ‘The process of identifying, measuring and communicating economic information about an organisation or other entity, in order to permit informed judgements by users of the information’. 3 Standards ‘inherited’ from the old IASC. New standards will in fact be referred to as International Financial Reporting Standards (IFRSs).
  • Geoff_01.qxd 8/1/04 12:30 PM Page 13 PRINCIPLES AND PRACTICES 13 G There are two main branches: financial accounting and management accounting. Financial accounting concentrates more on the recording and summarizing of financial information and compliance with GAAP and relevant legislation. Management accounting tends to concentrate on decision making, planning, and control. G There is a ‘Statement of Principles’ for the preparation and presentation of financial statements. G There are seven user groups defined in the Statement: investors; lenders; suppliers and other trade creditors; employees; customers; government and their agencies; the public. G Qualitative characteristics of financial information are that it should be: material; relevant; reliable; comparable; understandable. G Policies are needed which enable a true and fair view to be shown. G Going concern and accruals concepts have a ‘pervasive role’ in selecting policies. G Published accounts in the EU must follow defined formats. G International accounting practices vary but there is great impetus towards harmonization. G US accounting scandals have boosted the influence of international standards. I GLOSSARY accounting The process of identifying, measuring, and communicating economic information about an organization or other entity, in order to permit informed judgements by users of the information accounting policies Principles, bases, conventions, rules, and practices applied by an entity that specify how the effects of transactions and other events are to be reflected in its financial statements through recognizing, selecting measurement bases for, and presenting assets, liabilities, gains, losses, and changes to shareholders’ funds accounting standards Rules to be followed by accountants when preparing financial information Accounting Standards The body which sets accounting standards within the UK Board accrual concept The non-cash effects of transactions and other events should be reflected, as far as possible, in the financial statements for the accounting period in which they occur, and not, for example, in the period in which any cash involved is received or paid double-entry A logical system which allows a record to be made of all bookkeeping the financial aspects of an entity exposure draft A preliminary version of an accounting standard, circulated for public debate and comment
  • Geoff_01.qxd 8/1/04 12:30 PM Page 14 14 PRINCIPLES AND PRACTICES financial accounting The day-to-day recording of an organization’s financial transactions and the summarizing of those transactions to satisfy the information needs of various user groups in accordance with the regulatory framework formats Standard layouts required by the European Union which ensure consistency of presentation of published financial information by companies in member states going concern Financial statements are drawn up on the basis that the business can concept continue in operational existence for the foreseeable future International Accounting standards developed by the International Accounting Accounting Standards Board and its predecessor to harmonize and improve Standards global financial reporting practices management The internal accounting needs of an organization, involving planning, accounting forecasting, and budgeting for decision-making purposes materiality A ‘threshold quality’ of financial information. To be material, its misstatement or omission might reasonably be expected to influence the economic decisions of users published accounts Financial information required to be disclosed by entities as a result of legislation, accounting standards, or stock exchange requirements regulatory framework The rules and regulations followed by financial accountants, imposed (in the UK) mainly by company legislation and the Accounting Standards Board true and fair view An accounting concept requiring financial summaries to reflect a reasonable and objective approach in their representation of the organization’s affairs user groups Key groups who have a need for financial information I MULTIPLE CHOICE QUESTIONS 1. Financial data is recorded by means of a system known as: a Management accounting b Auditing c Double-entry bookkeeping d Generally Accepted Accounting Principles 2. Which one of the following is not specifically identified as a ‘user group’ by the UK’s ‘Statement of Principles’: a Management b Customers c Lenders d Investors
  • Geoff_01.qxd 8/1/04 12:30 PM Page 15 PRINCIPLES AND PRACTICES 15 3. Which of the following is a key indicator of performance for investors? a Number of shares issued by a company b Number of directors c Ratio of customers to suppliers d Earnings per share 4. According to the ‘Statement of Principles’, for financial information to have value it must first be: a Material b Relevant c Reliable d Comparable 5. Once an accounting policy is adopted by a company, it: a Must never be changed b Must be changed on an annual basis c Can be changed if another policy is more appropriate d Can only be changed with the government’s approval 6. If a company is said to be a ‘going concern’, which one of the following statements is certain about that company? a It is about to go out of business b It is assumed to be able to continue in business for the foreseeable future c It is a company that people are concerned about d It is profitable and has more assets than liabilities 7. The ‘accruals’ concept means that, when calculating a company’s profit or loss: a All relevant transactions, whether or not cash transfers are involved, are included b Any money owed by customers at the end of the period is ignored c Any invoices received but not paid in the period are ignored d Only cash paid and received in a period is included 8. The summary of company information which UK companies have to send to Companies House is called the: a Profit sheet b Annual report c Cash summary d Tax return 9. ‘Formats’ are followed by EU companies when presenting published company financial information. The most common format used in the UK is the: a Vertical format b Horizontal format c Circular format d Diagonal format 10. ‘Harmonization’ of international accounting practice refers to: a International accounting standards being replaced by national standards b US standards being replaced by European standards
  • Geoff_01.qxd 8/1/04 12:30 PM Page 16 16 PRINCIPLES AND PRACTICES c Non-US standards being replaced by US standards d National accounting standards being brought into line with international standards (Note: answers are shown in Appendix 2.) I DISCUSSION QUESTIONS To answer these, you should refer to the Domino’s Pizza annual report on pp. 000–0. 1. Read the auditors’ report (see p. 000) and comment on the extent to which you regard it as an objective opinion of the company’s financial statements. 2. Look at the Chairman’s report (see p. 000). See if you can identify any areas which give an indication as to the future strengths or weaknesses of the company. 3. Contrast the ‘profit for the financial year’ as shown in the profit and loss account (see p. 000) with the ‘increase or decrease in cash’ as shown in the cash flow statement (see p. 000). Are they the same? Can you think of reasons why they might be different? (Note: Suggested answers or discussion points are available on the companion website.) I LONGER QUESTIONS Questions marked W have suggested answers on the companion website. Other questions are answered in Appendix 3. 1. Look at the ‘cash flow statement’ of Manchester United plc for 2002 (with comparative figures given for 2001) shown in Fig. 1.2, then answer the questions below. a How did the overall cash flow differ between 2001 and 2002? b Which year saw more cash spent on the purchase of footballers? c Can you think why taxation paid in 2002 was greater than in 2001, even though the ‘net cash inflow from operating activities’ shown on the top line shows more in 2001 than in 2002? 2. Sandygate plc has summarized its key financial information for the past year, as follows: £ Total sales made in the year 560,000 Total cash received in the year from customers 490,000 Total expenses and goods bought for resale 160,000 Total cash paid in the year for expenses and goods bought for resale 170,000 a What was the total profit which Sandygate plc made during the year? b How can the ‘cash paid in the year for expenses and goods bought for resale’ be greater than the ‘total expenses and goods bought for resale’?
  • Geoff_01.qxd 8/1/04 12:30 PM Page 17 PRINCIPLES AND PRACTICES 17 Figure 1.2 Manchester United plc Source: Manchester United plc 2002 Annual Report. 3. Read the following extract and then answer the question that follows it. Monotub Industries in a spin as founder gets Titan for £1 Monotub Industries, maker of the Titan washing machine, yesterday passed into corporate history with very little ceremony and only a whimper of protest from minority shareholders. At an extraordinary meeting held in a basement room of the group’s West End headquarters, shareholders voted to put the company into voluntary liquidation and sell its assets and intellectual
  • Geoff_01.qxd 8/1/04 12:30 PM Page 18 18 PRINCIPLES AND PRACTICES property to founder Martin Myerscough for £1. The shares, which once reached 650p were duly suspended on Aim [author’s note: Aim is a stock market] at 3/4p. The only significant opposition came from Giuliano Gnagnatti, who along with other shareholders has seen his investment shrink faster than a wool twin-set on a boil wash. The not-so-proud owner of 100,000 Monotub shares, Mr Gnagnatti, the managing director of an online retailer, has referred the sale to the Department of Trade and Industry. Yesterday he described the sale of Monotub as a ‘free gift’ to Mr Myerscough. This assessment was denied by Ian Green, the chairman of Monotub, who said the closest the beleaguered company had come to a sale was an offer of £60,000 that gave no guarantees against liabilities which are thought to amount to £750,000. The quiet passing of the washing machine, eventually dubbed the Titanic, was in strong contrast to its performance in many kitchens. Originally touted as the ‘great white hope’ of the washing machine industry with its larger capacity and removeable drum, the Titan ran into problems when it kept stopping during the spin cycle, causing it to emit a loud bang and leap into the air. Summing up the demise of the Titan, Mr Green said; ‘Clearly, the machine had some revolutionary aspects, but you can’t get away from the fact that the machine was faulty and should not have been launched with those defects’. The usually vocal Mr Myerscough, who has promised to pump £250,000 into the company and give Monotub shareholders £4 for every machine sold, refused to comment on his plans for the Titan or reveal who his backers were. But eschewing another public listing, he did say that he intended to ‘take the Titan forward’. Lisa Urquhart, Financial Times, 23 Mar. 2003 For each of the seven ‘user groups’ identified in the Accounting Standards Board’s ‘Statement of Principles’, suggest key areas of information which they might need concerning Monotub Industries. 4W. A company has reported record profits and increased asset values, but has also disclosed that it is unable to be considered as a ‘going concern’. Suggest three reasons why a profitable company might be in imminent danger of financial collapse. 5W. ‘A limited company’s financial affairs should not be disclosed to anyone other than its directors and shareholders.’ Criticize this statement by reference to the ‘user groups’ identified in the Statement of Principles. 6W. Write a brief report distinguishing between the key aspects of ‘financial accounting’ as contrasted with ‘management accounting’. I MINI CASE STUDY Minnie’s ambitions Minnie von Mausen is about to set up a company that deals in exotic animals, selling them to zoos throughout the world. She is ambitious and realizes that her company could one day be the global leader in its field. She wants to make sure that she understands the financial implications of her enterprise, so has consulted an accountant, and asks the following questions: 1. How will I know if the company has made a profit? 2. What key accounting rules and regulations have to be considered?
  • Geoff_01.qxd 8/1/04 12:30 PM Page 19 PRINCIPLES AND PRACTICES 19 3. What is the main objective of providing financial statements? What answers is the accountant likely to give to Minnie? (Suggested solutions can be found in Appendix 4.) I MAXI CASE STUDY Ahold Read the following extract then answer the questions that follow it: $500m accounts scandal engulfs Dutch retailer Europe was last night facing one of its biggest accounting scandals when the Dutch retailer Ahold disclosed ‘significant accounting irregularities’ and said its chief executive and finance director would resign. The announcement, just over a year since Enron shook corporate America, fuelled speculation that the world’s third-largest grocer may be broken up and fall victim to bids from rivals . . . The Dutch group, which expanded rapidly through a series of US acquisitions in the late 1990s, said income at US Foodservice, the second-largest US food distribution company, had been overstated by more than $500m (£314m). Some of its executives have been suspended and 2002 operating earnings will be reduced. Accountants are also investigating the ‘accounting and legality’ of transactions by Disco, an Argentine subsidiary, Ahold said. The news knocked share prices across the continent, which had hoped to avoid a US-style accounting debacle. Ahold fell nearly two-thirds to €3.59, barely a tenth of the price a year ago, leaving it with a market value of €3 bn. Analysts said Ahold might now have to sell assets even if the diminished valuation did not attract a bidder for the entire group . . . The irregularities had been discovered in the last two weeks, during the audit of the 2002 accounts. [The company chairman said] ‘We believe that there are other accounting issues, but we are determined to pursue the investigation as far as possible.’ Deloitte & Touche, Ahold’s auditor, insisted it had done its job properly. Ahold issued two profit warnings last year, related principally to Latin American subsidiaries and slow- ing organic growth. It said net profit would now be ‘significantly lower’ and it would restate earnings for 2001 and the first nine months of 2002. Adapted from Ian Bickerton and Susannah Voyle, Financial Times (London), 25 Feb. 2003. Questions: 1. The company disclosed ‘significant accounting irregularities’, with income overstated by $500m. Do you think that there could ever be an agreed system of rules and regulations that would be able to prevent similar problems from occurring in the future? 2. Although the auditor of Ahold ‘insisted it had done its job properly’, the ‘irregularities’ still occurred. What do you consider is the auditor’s role, if any, in preventing such ‘accounting scandals’? (Suggested answers and discussion areas are available on the companion website.)
  • Geoff_01.qxd 8/1/04 12:30 PM Page 20 20 PRINCIPLES AND PRACTICES I WEB LINKS American Accounting Association http://raw.rutgers.edu/raw/aaa/ Annual Report Service (to obtain copies of annual reports) http://ft.ar.wilink.com or: www.reportgallery.com/ Chartered Institute of Management Accountants www.cimaglobal.com/ Companies House (UK government’s official information registry) www.companieshouse.gov.uk/ Company Reporting (an independent business information research company which monitors company compliance with best financial reporting practice) www.companyreporting.com/home.htm The International Accounting Standards Board www.iasb.co.uk The UK’s Accounting Standards Board www.asb.org.uk Company websites (Companies referred to in this chapter) Ahold www.ahold.com BMW www.bmw.com Domino’s Pizza www.dominos.co.uk Enron Corporation www.enron.com Manchester United plc www.manutd.com/corporateinformation/corporate.sps Scoot (now part of British Telecommunications plc) www.scoot.com/ WorldCom Inc www.worldcom.com/global/about/facts/ I FURTHER READING Britton, A., and Waterston, C. (2003). Financial Accounting, 3rd edn. (Harlow: FT/Prentice Hall), chapter 1. Dyson, J. R. (2003). Accounting for Non-accounting Students, 5th edn. (Harlow: FT/Prentice Hall), chapters 1, 2, 13. Meek, G., and Gernon, H. (2001). Accounting: An International Perspective, 5th edn. (Maidenhead: McGraw-Hill), chapters 1–3. Weetman, P. (2003). Financial and Management Accounting: An Introduction, 3rd edn. (Harlow: FT/Prentice Hall), chapters 1, 16. Also: A regularly updated website for news relating to the accounting profession: www.accountingeducation.com I COMPANION WEBSITE MATERIALS AQ: Please update web Additional materials are available for students and lecturers on the companion website, at address www.????????.co.uk