nature and purpose of accounting

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  • 1. Investors are interested in accounting information that will tell them about the financial health of the business. In a small, owner-managed business, the owner usually has a lot of tacit knowledge about how well the business is doing, but he or she will still want precise and accurate financial information. In a large business, the owners are the shareholders who appoint directors to manage the business on their behalf. Shareholders need information for making share trading decisions and for assessing how well the directors are managing the business for them. Because shareholders do not have access to the day-to-day records of the business, they can be classified as external users of the financial statements. 2. Lenders such as banks and venture capitalists will be interested in assessing the risk when deciding whether to lend to the business as well as monitoring the financial performance of the business in connection with its ability to make the repayments and pay the interest on the loan. Lenders are also interested in seeing whether there is sufficient collateral to repay the loan should the business fail. 3. Suppliers and other trade creditors are interested in whether the business can pay for the current and future supply of goods and services they have provided. 4. Employees will be interested in the security of their jobs and the possibility of an increase in salary, and any bonus that they get if there is a profit sharing scheme or if part of their pay is based on the performance of the business. They may also be shareholders if there is an employee shareholding scheme. 5. Customers will be interested in whether the supply goods and services on which they may depend will continue As well as overlapping with the needs of the other groups, the government , needs information to estimate the effects of its policies. The main government agencies that use the accounting information are the Dept of Trade & Industry, The Central Statistics Office, Companies House, the Inland Revenue and HM Customs & Excise. 6. The public may want information on the organisation as an employer, its effect on the community and the environment, any contributions it makes to political and charitable groups.
  • nature and purpose of accounting

    1. 1. Chapter 1: Nature and purpose of accounting  After studying this topic you should be able to  Explain the purpose of accounting in a business context  Distinguish between financial and management accounting  Compare different types of business entity  Explain the importance of financial information to management  Identify the main users of published financial statements  Independent study  Study Chapter 1  Progress test and practice question(s) as set Business Accounting 1
    2. 2. Exercise 1Let’s talk about accounting  Business is about money - and managers, owners and other interested parties need to keep track of  Where the money came from  Where it is now  Where it will be in the future  Butthat doesn’t tell us what accounting is  Required a) What is accounting? b) Why do you need to learn about the world of accounting? Business Accounting 2
    3. 3. Solution 1Let’s talk about accounting  Accounting is ‘the process of identifying, measuring, recording and communicating economic transactions’ (Collis and Hussey, 2007, p. 5)  Identifying economic transactions of the business and not the personal affairs of the owners or managers  Measuring the economic transactions in monetary terms  Recording them in the accounting system  Communicating them to users by producing financial statements that summarise the information  Accountants can be generalists or specialists … Business Accounting 3
    4. 4. Two main branches of accounting  Financial accounting is ‘a branch of accounting concerned with ‘classifying, measuring, and recording the economic transactions of an entity in accordance with established principles, legal requirements and accounting standards. It is primarily concerned with communicating a true and fair view of the financial performance and financial position of an entity to external parties’ (Collis and Hussey, 2007, p. 7)  True and fair view implies that the financial statements are a faithful representation of the entity’s economic activities Business Accounting 4
    5. 5. Two main branches of accounting (continued)  Management accounting is ‘a branch of accounting concerned with collecting, analysing and interpreting quantitative and financial information. It is primarily concerned with communicating information to management for planning, controlling and decision making’ (Collis and Hussey, 2007, p. 8)  So, whilst the focus of financial accounting is on meeting the needs of external users of financial information, the focus of management accounting is on meeting the needs of internal users of financial information Business Accounting 5
    6. 6. Financial objectives  Accounting information helps both large and small entities achieve their financial objectives  All organisations strive to ensure that the revenue earned and the costs incurred are at acceptable levels but what is an ‘acceptable level’ will vary according to the financial objectives of the organisation  In the public sector and the not-for-profit sector, the objective is to break even  In the business sector, the objective is to make a profit Business Accounting 6
    7. 7. Classifying enterprises by size  There are 4.3m enterprises in the UK (SBS, 2005)  Only 0.1% are large firms (with ≥ 250 employees) whilst 99.9% are small or medium-sized enterprises (SMEs) (with 0 – 249 employees)  Similar proportions in many other countries  Aswell as providing a living for their owners, SMEs make a significant contribution to the economy  In the UK they provide 59% of non-government employment and 51% of turnover  Businesses can also be classified by legal status… Business Accounting 7
    8. 8. Legal status of business enterprises in the UK Total number of business enterprises = 4.3m Partnerships 13% Companies & corporations Sole 24% proprietorships 63% (SBS, 2005, Table 2) Business Accounting 8
    9. 9. Overview of main types of business entity Entity Unincorporated Incorporated (unlimited liability) (limited liability) Sole Limited liability Limited liability Partnership proprietorship partnership (LLP) company Unlimited liability – owners have personal responsibility for the debts Private limited Public limited incurred by the business company company (Plc) Limited liability – owners’ responsibility is limited to the capital they agreed to invest Business Accounting 9
    10. 10. Sole proprietorship (unincorporated)  An unincorporated business owned by one person (the proprietor), such as  A sole trader (eg a newsagent, grocer or florist)  Someone providing services (eg a consultant, hairdresser or plumber)  Someone making goods (eg a tailor or cabinetmaker)  No legal formalities to set up  Capital is restricted to what owner can invest  Owner has sole liability  Must keep accounting records but no requirement to disclosure financial information Business Accounting 10
    11. 11. Partnership (unincorporated)  Minimum 2 partners to set up  Business Names Act 1985 requires the names of partners are shown on stationery, but no need to use them in the name of the business  In the absence of a partnership deed, the Partnership Act 1890 applies to profit sharing, interest on capital, interest on loans and partners’ salaries  Capital is restricted to what partners can invest  Partners have ‘joint and several’ liability  Must keep accounting records, but no requirement to disclose financial information Business Accounting 11
    12. 12. Limited liability entities (incorporated)  Many legal formalities under the Companies Act 1985 (CA85)  On formation, must register at Companies House (part of the DTI) and file  A memorandum of association (details about the constitution of the business and its objects)  And articles of association (details about internal regulation of the business eg voting rights of shareholders, conduct of shareholders’ meetings, powers of management, etc)  Two types of limited liability entity in the UK… Business Accounting 12
    13. 13. Limited liability partnership (LLP)  Introduced by Limited Liability Partnership Act 2000  7,396 LLPs on the register (DTI, 2004)  Has a legal identity separate from its owners (known as members), who have limited liability  Organised internally as a traditional partnership  Capital is raised by increasing the number of members  Must keep accounting records  Many requirements under CA85, including disclosure of financial information Business Accounting 13
    14. 14. Limited company  1.6m limited companies on the register (DTI, 2003)  A company has a separate legal identity from its owners (members)  Capital is raised by issuing shares to members  Shareholders have limited liability  Many requirements under CA85, including disclosure of financial information  Jargon alert!  A company is a particular type of entity  If you want a generic term, use business or firm Business Accounting 14
    15. 15. Private limited company A company that is not a public company (99.3% of companies on the register)  Name must end with ‘Limited’ or ‘Ltd’ (or the Welsh equivalent)  Shares can only be offered for sale privately  No minimum amount of share capital  Minimum 1 director  Company secretary need not have formal qualification  Extent of financial disclosure depends on size and public interest (concessions for qualifying small and medium- sized companies) Business Accounting 15
    16. 16. Public limited company (plc)  Only 0.7% of companies on the register  Most are converted from private companies under re- registration procedure in CA85  Name must end with ‘public limited company’ or ‘plc’  Minimum 2 directors  Must have a qualified company secretary  Minimum amount of authorised share capital is £50,000, of which at least £12,500 must be paid up share capital  Can offer shares to the public (via stock exchange listing)  Extensive financial disclosure due to public interest Business Accounting 16
    17. 17. CA85 main requirements – all limited liability entities  Must keep accounting records  Must prepare an annual report and accounts  Annual financial statements with supporting notes (concessions for most small and medium-sized entities)  Directors’ report  Auditors’ report on the truth and fairness of the view given by financial statements (exemption for most small entities)  The annual report and accounts must be  Filed at Companies House (on the public record)  Given to every shareholder Business Accounting 17
    18. 18. Users of financial statements  No public disclosure of financial information by unincorporated entities, so the main users are internal  Management (ie owner-managers and other senior managers) who use it for running the business, which may include passing it on to others at their discretion)  Limited liability entities are legally obliged to disclose financial information to the public, so the main users are external  Seven main user groups who use the information for economic decision making… Business Accounting 18
    19. 19. Users of the financial statements of limited liabilityentities 1. Present and potential investors – risk/return, stewardship 2. Employees – security, bargaining, opportunities, benefits 3. Lenders – assess/monitor lending risk (liquidity, collateral) 4. Suppliers and other trade creditors – credit risk 5. Customers - continuity, after sales service, warranties 6. Governments and their agencies – allocate resources, assess economic and fiscal policies, regulation, taxation, national statistics, etc 7. The public – impact on local economy, the community, the environment, etc. Business Accounting 19
    20. 20. Conclusions  Accounting is used in all types of business and can be divided into two main branches  Financial accounting is primarily concerned with communicating a true and fair view to the 7 groups of external users for making economic decisions  Management accounting is primarily concerned with communicating information to internal users to ensure the business meets its financial objectives  The legal status of the business affects the number of owners, their financial liability, legal formalities, how capital can be raised and financial disclosure Business Accounting 20

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