Accounting Concepts

Introduction to accounting
Introduction
It is not easy to provide a concise definition of accounting since the word has a broad application within businesses and applications.
The American Accounting Association define accounting as follows:
"the process of identifying, measuring and communicating economic information to permit informed judgement s and decisions by users of the information!.
This definition is a good place to start. Let's look at the key words in the above definition:
It suggests that accounting is bout providing information to others. Accounting information is economic information. It relates to the financial or economic activities of the business or organization.
Accounting information needs to be identified and measured. This is done by way of a "set of accounts" based on a system of accounting known as double entry bookkeeping. The accounting system identifies and records "accounting transactions".
The measurement of accounting information is not a straight forward process. It involves making judgments about the value of assets owned by a business or liabilities owed by a business. It is also about accurately measuring how much profit or loss has been made by a business in a particular period. As we will see the measurement of accounting information often requires subjective judgment to come to a conclusion.
The definition identifies the need for accounting information to be communicated. The way in which this communication is achieved may vary. There are several forms of accounting communication each of which seve a slightly different purpose. The communication need is about understanding who needs the accounting information and what they need to know!
Accounting information is communicated using "financial statements"

What is the purpose of financial statements?
There are two main purposes of financial statements:
(1) To report on the financial position of an entity (e.g. a business, an organization);
(2) To show how the entity has performed (financially) over a particularly period of time (an accounting period)
The most common measurement of "performance" is profit.
It is important to understand that financial statements can be historical or relate to the future.
Accountability
Accounting is about Accountability
Most organizations are externally accountable in some way for their actions and activities. They will produce reports on their activities that will reflect their objectives and the people to whom they are accountable.
The table below provides examples of different types of organizations and how accountability is linked to their differing organizational objectives:
Organization Objectives Accountable to (examples)
Private or public company -Making of profit - Shareholders
(e.g.BP, Tesco) -Creation of wealth - Other stakeholders(e.g.employees, customers, suppliers)

Charities
(e.g.save the children) -Achievement of charitable aims -Charity commissioners
- Maximise spending on activities - Donors

Local Authorities
(e.g. Leeds city council) - Provision of local services - Local electorate
- Optical allocation of spending budget - Government departments

Public Services - Provision of public service - Government ministers
(e.g.National Health Service, (often required by law) - Consumers
Prison Service - High quality and reliability of
services

Quasi Governmental agencies -Regulation or instigation of some
(e.g. Data Protection-Registrar, public action
Scottish Arts Council) - Coordination of public sector investments

All of the above organizations have a significant roles to play in society and have multiple stakeholders to whom that are accountable.
All require systems of financial management to enable them to produce accounting information.

How accounting information helps businesses be accountable
As we have said in our introductory definition, accounting is essentially an "information process" that serves several purposes:

- Provide a record of assets owned, amounts owed to others and monies invested;
- Providing reports showing the financial position of an organization and the profitability of its operations
- Helps management actual manage the organization
- Provides a way of measuring an organization's effectiveness (and that of its separate parts and management)
- Helps stakeholders monitor an organizations activities and performance
- Enables potential investors or funders to evaluate an organization and make decisions
There are many potential users of accounting information, including shareholders, lenders, customers, suppliers, government departments, employees and their organizations,and society at large. Anyone with an interest in the performance and activities of an organization is traditionally called a stakeholder.
For a business or organization is communicate its results and position to stakeholders,it need a language that is understood by all in common. Hence, accounting has come to be known as the "language of business"
There are broad types of accounting information:
(1) Financial Accounts: geared toward external users of accounting information
(2) Management Accounts: aimed more at internal users of accounting information
Although there is a difference in the type of information presented in financial and management accounts, the underlying objective is the same to satisfy the information needs of the user. These needs can be described in terms of the following overall information objectives:

Collection: Collection in money terms of information relating to transactions that have resulted from business operations
Recording and Classifying: Recording and classifying data into a permanent and logical form. This is usually referred to as "Book keeping"
Summarizing: Summarizing data to produce statements and reports that will be useful to the various users of accounting information both external and internal
Interpreting and communicating: Interpreting and communicating the performance of the business to the management and its owners
Forecasting and Planning: Forecasting and planning for future operationof the business by providing management with evaluations of the viability of proposed operations. The key forecasting and planning tool is the "Budget"

The process by which accounting information is collected, reported, interpreted and actioned is called "Financial Management". Taking a commercial business as the most common organizational structure, the key objectives of financial management would be to:
(1) Create wealth for the business
(2) Generate cash, and
(3) Provide an adequate return on investment bearing in mind the risks the business is taking and the resources invested.

In preparing accounting information, care should be taken to ensure taht the information presents an accurate tnd true view of the business performance and position. To impose some order on what is a subjective task, accounting has adopted certain conventions and concepts which should be applied in prearing accounts.
For financial accounts, the regulation or control of what kind of information is prepared and presented goes much further. UK and international companies are required to comply with a wide range of ASccounting Standards which define the way in which business transactions are disclosed and reported. These are applied by business through their Accounting Policies.

The main financial accounting statements
The purpose of financial accounting statements is mainly to show the financial position of a business at a particular point in time and to show how that business has performed over a specific period.
(1) The profit and loss account for the reporting period
(2) A balance sheet for the business at the end of the reporting period.
(3) A cash flow statement for the reporting period

A balance sheet shows at a particular point in time what resources are owned by a business and what it owes to other parties. It also shows how much has been invested in the business and what the sources of that investment finance were.

It is often helpful to think of a balance sheet as a "snap-shot" of the business a picute of the financial position of the business at a specific point. Whilst this is a useful picture to have, every time an accounting transaction takes place, the snap-shot picture will have changed.
By contrast, the profit and loss account provides a perspective on a longer time-period. If the balance sheet is a "digital snap-shot" of the business, then think of the profit and loss account as the "DVD" of the business' activities. The story of that financial transactions took place in a particular period- and (most importantly_ what the overall result of those transaction was.

Not surprisingly, the profit and loss account measures"profits".
What is profit?
Profit is the amount by which sales revenue( also known as "turnover" or "income") exceeds "expenses" for the period being measured.

Accounting concept and conventions
Ind drawing up accounting statements, whether they are external "financial accounts" or internally focused "management accounts", a clear objective has to be that the accounts fairly reflect the true "substance" of the business and the results of its operation.
The theory of accounting has, therefore, developed the concept of a "true and fair view". The true and fair view is applied in ensuring and assessing whethre accounts do indeed portray accurately the business activities.
To support the application of the " true and fair view", accounting has adopted certain concepts and conventions which help to ensure that accounting information is presented accurately and consistently.
Accounting Conventions
The most commonly encountered convention is the "historical cost convention". This requires transactions to be recorded at the price ruling at the time, and for assets to be valued at their original cost.
Undue the "historical cost convention", therefore, no account is taken of changing prices in the economy.
The other conventions you will encounter in a set of accounts can eb summarized as follows:
Monetary Measurement: Accountants do not account for items unless they can be quantified in monetary terms. Items that are not accounted for (unless someone is prepared to pay something for them) include things like workforce skill, morale, market leadership, brand recognition, quality of management etc.
Separate Entity: This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that relate to the business.
Rweaisation: With this convention, accounts recognize transactions ( and any profits arising from them) at the point of sale or transfer of legal ownership- rather than just when cash actually changes hands. For example, a company that makes a sale to a customer can recognise that sale when the trnasaction is legal- at the point of contract. The acual payment due drom the customer may not arise until several weeks later- if the customer has been granted some credit terms.
Materiality: An important convention. As we can see from the application of accounting stadards and accounting policies, the preparationof accounts involves a high degree od judgement. Where decisions are required about the appropriateness of a particular accounting judgement, the "mateialiity" convention suggests that this should only be an issue if the judgement is "significant" or "material" to a user of the accounts. The concept of "materiality" is an important issue for auditors of financial accounts.

Acccounting Concepts
Four important accounting concepts underpin the preparation of any set of accounts:
Going Concern: Accounts assume, unless ther is evidence to the contrary, that a company is not going broke. This has important implications for the valuation of assets and liabilities.
Consistency: Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meanigful comparisons of financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change.

Prudence: Profits are not recognised until a slae has been completed. In addition, a cuatious view is taken for future problems and costs of the businesss(the are "provided for" in the accounts" as soon as their is a reasonable chance that such costs will be incurred in the future.
Matching "Accruals": Income should be properly "matched" with the expenses of a given accounting period.

Key Characteristics of Accounting Information
There is general agreement that, before it can be regarded as useful in satisfying the needs of various user groups, accounting information should satisfy the following criteria:
Criteria: What it means for the preparation of accounting information
Understandability: This implies the expression, with clarity, of accounting information in such a way it will be understandable to users- who are generally assumed to have a reasonable knowledge of business and economic activities.
Relevance
This implies that, to be useful, accounting information must assist a user to form, confirm or may be revise a view- usually in the context of making a decision (e.g.should I invest, should I lend money to this busienss? Should I wokr for this business?)
Consistency
This implies consistent treatment of similar items and application of accounting policies.
Comparability
This implies the ability for usrs to compare similar companies in the same industry group and to make comparisons of performance over time. Much of the work that goes into setting accounting standards is based around the need for comparability.
Reliability
This implies that the accounting information that is presented is trustful, accurate, complete (nothing significant missed out) and capable of being verified(e.g. by a potential investor).
Objectivity
This implies that accounting information is prepared and reported in a "neutral" way. In other words, it is not biased towards a particular use group or vested interest

Business stakeholders
In terms of understanding the objectives of a business or other organisation, there are two traditional views:
(1) The Shareholder Concept
(2) The Stakeholder Concept
Shareholder Concept- Maximising Shareholder Wealth
In the theory of accounting and finance, it is assumed that the objective of the business is to maximise the value of a company. Put simply, this means that the mangers of a business should create as much wealth as possible for the shareholders. Given this objevtive, any financing or investment decision that is expected to improve the value of the shareholder's stake in the business is acceptable. In short, the objective for managers running a business should be profit maximisation. Bothe in the short and long term.

Stakeholder Concept- A wider Range of Objectives
In recent years, a wider variety of goals have been suggested for a business. These include the traditional objevtive of profit maximisation ( in other words- the shareholder concept has not been abandoned). However, they also include goals relating to earnings per share, total sales, numhers employed, measures of employee welfare, manager satisfaction, environmental protection and many others.
A major reason for increasing adoption of a Stakeholder Concept in setting business objectives is the recognisition that businesses are affecte by the "environment" in which they operate. Businesses come into regular contact with customers, suppliers, government agenecies, families of employees, special interest groups. Decisions made by a business are likely to affect one or more of these "stakehilder groups". Some examples are given below

Business Decision
Relocation of Head office from London to Wales

Stakeholders Affected
-Employees in London: potential redundancies; concerns about family; housing; change in "living standards"
- New employees in Wales: job oppurtunities; training
- Customers: IMPACE ON SUPPLY OF PRODUCE OR SERVICE;
- Suppliers: impace on supply of costs; loss of trade for London-based suppliers
- Governement agencies: regional development agencies; agencies providing other grants; employment traning agencies
- Other groups: environmental impace in Wales
The stakeholder concept suggests that the mangers of a busienss should take into account their responsibilities to other groups- not just the shareholder group- when making decisions. The concept suggests taht businesses can benefit significantly from cooperating with stakeholder groups, incorporating their needs in the decision making process.
Examples of Stated Business Objectives that Incorporate the Stakeholder Concept
British Telecom
We aim to be at the heart of the information society- a communication rish world in which everyone, irrespective of nationality, culture, ethnicity, class, creed or education, has access to the benefits of information and communication technology.
In practical terms, that means we are committed to doing business in a way that:
- maximise's the benefits of ICT for individuals
- contributes to the communities in which we operate
- minimizes any adverse imopact that we might have on the environment.
- It means doing business in a way that will persuade customers to buy from us, investors to back us, the best people towkr for us and communities to have us around.
If we had to say waht we believe in a single sentence, it would be this: better communications help create a better world.
Marks and Spencer
Our commitment to society is nothing new. We've always known that as well as providing the right products, a sustainable retail business needs the support the healthy communities and a high quality environment. Since the 1930s, Marks & Spencer has been actively involved in improving the quality of life for a wide range of comminities. We's ve always tried to make an active contribution to the needs of our stakeholders, whether as customers, employees, investors, suppliers, partners and neighbours.
Entering the 21st century our commitment remains as strong as ever, but the world is changing. Business is becoming global, society more diverse and our environment is uder greater threat than at any time before. Comapnies are having to consider how their actions impace on an increasingly connected st of issues.
We aim to be the most trusted reailer wherever we trade by demonstratingg a clear sense of social responsibility and consistency in our decision making and behaviur.
GlaxoSmithkline: GlaxoSmithline is one of the world;s leading pahrmaceutical companies. Its gloabal quest is to improve the quality of human life byenabling people to do more, feel better and live longer. GSK's strategic intent is to become the indisputable leader in its industry- not simply in terms of size, but in how it uses that size to achieve its mission. Through its Global Community Partnerships function and Corporate Donations Committee, GSK partners with and supports organisations whose and objectives refelct its mission of improving the quality of human life.

Non financial objectives of a business
Introduction
A business may have important non-financial objectives which will limit the achievement of financial objectives. Examples of these are summarised below:
Welfare of employees
The provision of employee welfare is an important objective; this relates io issues such as wages & salaries; comfortable and safe working conditions, training and development; pensions etc. The value of many businesses is critically dependent on attacting and retaining hich quality employees- which makes managing the welfare of such people even more imporatant.
Serving Customers
As all marketers understand, a critical activity of business is to understand and meet the needs and wants of customers. In the long-term, this objective is the foundation for a financially successful business. Non-financial activities objectives under this heading would incluse meeting defined delivery standards, product quality, reliability and after-sales service levels.
Welfare of management
Management can, and do set objectives which are essentially about their own welfare. These include objectives in relation to pay and conditions.
Relationships with Suppliers
Responsibilities to suppliers are expressed mainly in terms of trading relationships. Large businesses often have considerable buying power over their suppliers- which should be used with care. Supplier objectives would include those relting to the timing of pyment and other terms of trade.
Responsibility to Society
Business increasingly aware of their overall responsibility to society at large. The term that is often use is Corporate Social Responsibility. This inclises a business complying with relevant laws and regulations, minimising harmful externalities.
http://www.vernimmen.com/html/glossary/gl_f.html
Maximising the value of a business
Introduction
If an important financial objective of a business is to maximise the value of the business, how can this be ahchieved? The answer lies in the different approaches to valuing a business.
There are two broad approaches to valuing a business:
(1) Break up basis: this method of valuing a business is only of interest when the business is treatened with liquidation, or when management are considering selling off individual assets to raise cash;
(2) Market Value Basis: The market vaue of a business is the price at which buyers and sellers will trade shareholdings ina company. Thsi method valusation is most relevant to the financial objectives of a bsuienss.
When sahres are traded on a recognised stock market, such as teh Stock Exhange, the market value of a business can be measured by the share price.

When shares are held in a private company, and are not traded on any stock market, there is no easy way to measure value. It becomes a subjective judgement on behald of both the buyer and seller about factors such as:
-Future profits and cash flows that the buyer can expect the business to deliver;
- The "intangible" quality of the business, including the quality of managemnte, products etc.
- The stratagic position of the business- e.g. is it a market leader?
Nevertheless, the objective remains for management- to maximise the wealth of their ordinary shareholders.
The wealth of shareholders in a company comes from:
- Dividends received:
- Market value of the shares

A shareholders' return on investment is obtained from:
- Dividends erceived;
- Capital gains from increases in the market value of his or her shares
If shares in a business are traded on a stock market, the wealth of shareholder is increased when the share price goes up. The share price will go up when the business makes additional profits (or is expected by market to do so) which it pas out as dividens or re-invests in the busines to achieve future profit growth. However, to increase the share price, the business should try to increase profits without taking business anf financial risk which worry shareholders(thereby increasing their requried rate of return).

Comparison of financial and management accounting
There aer two broad types of accounting information:
- Financial Acccounts: geared toward extenal users of accounting information
- Management Accounts: aimed more at intenal users of accounting information

Although there is a difference in the type of information presented in financial and management accounts, the underlying objective is the same - to satisfy the information needs of the user.
Financial Accounts
Financial accounts describe the performance of a business over a specific period and state of affiars at the end of that perid, The specific period is often referred to as the "Trading Period" and is usually one year long. The period-end date as the "Balance sheet date".
Companies that are incorporated under the Companies Act 1989 are required by law to prepare and publish financial accounts. The level of detaial required in these accounts refelcts the size of the business with smaller companies being required to prepare only brief accounts.
The format of published financial accounts is determined by seveal different regulartory elements:
- Company Law
- Accounting Standards
- Stock Exchange
Financial accounts concentrate on the business as a whole rather than analysing the component parts of the business. For example, sales are aggregated to provide a figure for total sales rather than publish a detaieled analysis of sales by product, market etc.
Most financial accounting information is of a monetay nature
By definition, financial accounts present a historic perspective on the financial performance of the business

Management Accounts
Manangement accounts are used to help management record, plan and control the activities of a business and to assist in the decision making process. They can be prepared for any period( for exmaple, many retialers prepare daily management information on sales, margnins and stock levels).
There is no legal requirement to prepare management accounts, although few(if any) well run businesses can survice without them.
There is no pre-determined format for management accounts. They can be as detailed or brief as management wish.
Management accounts can focus on specific areas of a business'activities. For example, they can provide insights into performance of:
-Products
-Separate business locations (e.g.shops)
-Departments/divisions
Management accounts usually include a wide variety of non-financial information. For example, management accounts often include analysis of:
-Employees(number,costs,productivity etc.)
-Sales volumes(units sold etc.)
-Customer transactions(e.g.number of calls received into a call centre)
Management accounts largely focus on analysing histocal performance. However, they also usually include some forward-looking elements e.g a sales budget;cash-flow forecast.