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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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Businesses exist to make a profit. They do this by producing goods and services and selling those goods and services at a price that covers their cost. Conducting business involves a number of business events such as buying equipment, purchasing goods and services, paying expenses, making sales, distributing goods and services etc. In accounting terms, each of these business events is a transaction. A transaction is the financial description of each business event.

It is important to recognize that transactions are a financial representation of the business event, measured in monetary terms. This is only one perspective on business events, albeit the one considered most important for accounting purposes. A broader view is that business events can also be recorded in nonnancial terms, such as measures of product/service quality, speed of delivery, customer satisfaction etc. These non-financial performance measures (which are described in detail in Chapter 4) are important elements of business events that are not captured by financial transactions. This is a limitation of accounting as a tool of business decision-making.

Each transaction is recorded on a source document that forms the basis for recording in a business’s accounting system. Examples of source documents are invoices and cheques. The accounting system, typically computer based (except for very small businesses), comprises a set of accounts that summarize the transactions that have been recorded on source documents and entered into the accounting


system. Accounts can be considered as ‘buckets’ within the accounting system containing similar transactions.

There are four types of accounts:

ž Assets: things the business owns.

ž Liabilities: debts the business owes.

ž Income: the revenue generated from the sale of goods or services.

ž Expenses: the costs incurred in producing the goods and services.

The main difference between these categories is that business profit is calculated as

–  –  –

Financial reports – the Profit and Loss account and Balance Sheet (see Chapter 6) – are produced from the information in the accounts in the accounting system. Figure 3.1 shows the process of recording and reporting transactions in an accounting system.

–  –  –

The double entry: recording transactions Businesses use a system of accounting called double entry, which derives from the late fifteenth-century Italian city-states (see Chapter 1). The double entry means that every business transaction affects two accounts. Those accounts may increase or decrease. Accountants record the increases or decreases as debits or credits, but it is not necessary for non-accountants to understand this distinction.

Transactions may take place in one of two forms:

ž Cash: If the business sells goods/services for cash, the double entry is an increase in income and an increase in the bank account (an asset). If the business buys goods/services for cash, either an asset or an expense will increase (depending on what is bought) and the bank account will decrease.

ž Credit: If the business sells goods/services on credit, the double entry is an increase in debts owed to the business (called debtors, an asset) and an increase in income. If the business buys goods/services on credit, either an asset or an expense will increase (depending on what is bought) and the debts owed by the business will increase (called creditors, a liability).

When goods are bought, they become an asset called inventory (or stock). When

the same goods are sold, there are two transactions:

1 The sale, either by cash or credit, as described above; and 2 The transfer of the cost of those goods, now sold, from inventory to an expense, called cost of sales.

In this way, the profit is the difference between the price at which the goods were sold (1 above) and the purchase cost of the same goods (2 above). Importantly, the purchase of goods into inventory does not affect profit until the goods are sold.

To record transactions, we need to decide:

ž what type of account is affected (asset, liability, income or expense); and ž whether the transaction increases or decreases that account.

Some examples of business transactions and how the double entry affects the accounting system are shown in Table 3.1.

The accounts are all contained within a ledger, which is simply a collection of all the different accounts for the business. The ledger would summarize the transactions for each account, as shown in Table 3.2.

In the example in Table 3.2 there would be a separate account for each type of expense (wages, cost of sales, advertising), but for ease of presentation these accounts have been placed in a single column. The ledger is the source of the financial reports that present the performance of the business. However, the ledger would also contain the balance of each account brought forward from the previous period. In our simple example, assume that the business commenced with £50,000 in the bank account that had been contributed by the owner (the owner’s capital). Table 3.3 shows the effect of the opening balances.

Table 3.1 Business transactions and the double entry

–  –  –

The Balance Sheet lists the assets and liabilities of the business, as shown in Table 3.4.

The Balance Sheet must balance, i.e. assets are equal to liabilities. Although shown separately, capital is a type of liability as it is owed by the business to its owners. The double-entry system records the profit earned by the business as an

addition to the owner’s investment in the business:

–  –  –


The accounting equation can therefore be restated as:

capital (£51,000) = assets (£57,000) − liabilities (£6,000)

–  –  –

2 Profit is not the same as cash flow. Although there has been a profit of £1,000, the bank balance has reduced by £34,000 (from £50,000 to £16,000).

3 Most of the cash has gone into the new equipment (£25,000), but some has gone into working capital (again, this is covered in Chapter 6). Working capital is the investment in assets (less liabilities) that continually revolve in and out of the bank, comprising debtors, inventory, creditors and the bank balance itself (in this case £32,000 less £6,000 = £26,000).

The distinction between profit, cash flow and capital investment – the purchase of assets – is a crucial one for accounting. Whether a payment is treated as an expense (which affects profit) or as a Balance Sheet item (called capitalizing the expense, and therefore not affecting profit) is important, as it can have a significant impact on profit, which is one of the main measures of business performance.

Both the Profit and Loss account and the Balance Sheet are described in more detail in Chapter 6. In financial reporting, as Chapter 6 will show, there are strict requirements for the content and presentation of these financial statements. One of these requirements is that the reports (produced from the ledger accounts) are based on line items. Line items are the generic types of assets, liabilities, income and expenses that are common to all businesses. This is an important requirement as all businesses are required to report their expenses using the same accounts, such as rent, salaries, advertising, vehicle running costs etc. While this may not appear to be significant, it does cause a problem when a business is trying to make decisions based on cost information, because cost information is needed for products and services, rather than for line items.

Principles and limitations of accounting There are some basic accounting principles that are generally accepted by the accounting profession as being essential for recording and reporting financial information. These are as follows.

Accounting entity Financial reports are produced for the business, independent of the owners – the business and its owners are separate entities. This is particularly important for owner-managed businesses where the personal finance of the owner must be separated from the business finances. The problem caused by the entity principle is that complex organizational structures are not always clearly identifiable as an ‘entity’. The treatment by Enron of joint-venture vehicles that were not part of the Enron group for financial reporting purposes enabled ‘off-Balance Sheet’ financing that was a cause of that company’s collapse.

Accounting period Financial information is produced for a financial year. The period is arbitrary and has no relationship with business cycles. Businesses typically end their financial


year at the end of a calendar or national fiscal year. The business cycle is more important than the financial year, which after all is nothing more than the time taken for the Earth to revolve around the Sun. If we consider the early history of accounting, merchant ships did not produce monthly accounting reports. They reported to the ships’ owners at the end of the business cycle, when the goods they had traded were all sold and profits could be calculated meaningfully.

Matching principle Closely related is the matching (or accruals) principle, in which income is recognized when it is earned and expenses when they are incurred, rather than on a cash basis. The accruals method of accounting provides a more meaningful picture of the financial performance of a business from year to year. However, the preparation of accounting reports requires certain assumptions to be made about the recognition of income and expenses. One of the criticisms made of many companies is that they attempt to ‘smooth’ their reported performance to satisfy the expectations of stock market analysts in order to maintain shareholder value. This practice has become known as ‘earnings management’. This has been particularly difficult in the telecoms industry, where income that should have been spread over several years has been taken up earlier, or where expenditure has been treated as an asset in order to improve reported profits. When this last practice was disclosed, it was a significant cause of the difficulties faced by WorldCom.

Monetary measurement Despite the importance of market, human, technological and environmental factors, accounting records transactions and reports information in financial terms.

This provides a limited though important perspective on business performance.

The criticism of accounting numbers is that they are lagging indicators of performance. In Chapter 4 we consider non-financial measures of performance that are more likely to present leading indicators of performance. An emphasis on financial numbers tends to overlook important issues of customer satisfaction, product/service quality, innovation and employee morale, which have a major impact on business performance.

Historic cost Accounting reports record transactions at their original cost less depreciation (which is explained in Chapter 6), not at market (realizable) value or at current (replacement) cost. The historic cost may be unrelated to market or replacement value. Under this principle, the Balance Sheet does not attempt to represent the value of the business and the owner’s capital is merely a calculated figure rather than a valuation of the business. The Balance Sheet excludes assets that have not been purchased by businesses but have been built up over time, such as customer goodwill, brand names etc. The market-to-book ratio (MBR) is the market value of the business divided by the original capital invested. Major service-based companies


such as Microsoft, which have enormous goodwill and intellectual property but a low asset base, have high MBRs because the stock market takes account of information that is not reflected in accounting reports.

Going concern The financial statements are prepared on the basis that the business will continue in operation. Many businesses have failed soon after their financial reports have been prepared on a going concern basis, making the asset values in the Balance Sheet impossible to realize. As asset values after the liquidation of a business are unlikely to equal historic cost, the continued operation of a business is an important assumption.

Conservatism Accounting is a prudent practice, in which the sometimes over-optimistic opinions of non-financial managers are discounted. A conservative approach tends to recognize the downside of events rather than the upside. However, as mentioned above, the pressure on listed companies from analysts to meet stock market expectations of profitability has resulted from time to time in ‘creative’ accounting practices (discussed in Chapter 7), such as those that led to problems at Enron and WorldCom.

Disclosure The accounting standards and principles that have been applied in the financial statements are described in the financial reports. In the UK, there is a substantial body of principles governing what information is to be disclosed in financial reports (see Chapter 6), although in the US the disclosure requirements are rule based rather than principle based. As a result, it has been argued that it is easier to find ways to get around rules that are set in explicit terms than principles that are more general. The interpretation of the disclosure rules is important in auditing and led to criminal charges against accounting firm Arthur Andersen in the United States.

Consistency The application of accounting standards and principles should be consistent from one year to the next. Where those principles vary, the effect on profits is separately reported under the disclosure principle. However, some businesses have tended to change their rules, even with disclosure, in order to improve their reported performance, explaining the change as a once-only event.

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