Unit 1: The Purpose and Context of Financial Accounting and Reporting

B291 Financial accounting
Unit 1
The purpose and context of nancial accounting and reporting
Written by Jane Frecknall-Hughes
Module Team Dr Devendra Kodwani, B291 Chair & Author Dr Carien van Mourik, Author Professor Jane Frecknall-Hughes, Professional Certicate in Accounting Chair & Author Catherine Gowthorpe, Author Kelly Dobbs, Curriculum Assistant Elizabeth Porter, Regional Manager Sam Cooper, Programme Coordinator Emir Forken, Qualications Manager Dr Lesley Messer, Programme Manager Funmi Mapelujo, Curriculum Manager External Assessor Professor Stuart Turley, Manchester Business School Critical Readers Professor Judy Day, Manchester Business School
Elizabeth Porter
Professor Peter Walton
Developmental Testers Dr Teodora Burnand Sam Cooper Vimal Goricha Vani Shri Goswami Dudley Hughes Production Team Martin Brazier, Graphic Designer Anne Brown, Media Assistant Sarah Cross, Print Buyer Beccy Dresden, Media Project Manager Vicky Eves, Graphic Artist Paul Hoffman, Editor Diane Hopwood, Rights Assistant Kelvin Street, Library
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The Module Team wishes to acknowledge use of some material from B680 The Certicate in Accounting.
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1.1
Contents
Introduction Learning aims and outcomes of Unit 1 Session 1 The purpose of accounting Introduction 1.1 Denitions of bookkeeping, accounting and
reporting 1.2 Reasons for and objectives of accounting 1.3 Management and nancial accounting 1.4 The main elements of accounting information 1.5 The main nancial statements Summary Session 2 The context of accounting Introduction 2.1 Business and its objectives 2.2 Classifying business organisations 2.3 Functions of accounting in different types of
organisations 2.4 Users and stakeholders needs Summary Session 3 Environmental inuences and constraints on
business and accounting Introduction 3.1 The history and development of accounting
and nance in business 3.2 Environmental inuences 3.3 Financial and capital markets and
institutions 3.4 Organisation of the accounting profession 3.5 The general need for a regulatory framework 3.6 Development of a regulatory framework in the
UK 3.7 International Financial Reporting Standards
and the International Accounting Standards
Board Summary 5
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Session 4 Accounting conceptual frameworks,

principles and conventions Introduction 4.1 The need for accounting theory 4.2 Conceptual frameworks: the IASB
Framework for the Preparation and
Presentation of Financial Statements
(= IASB Framework) 4.3 Conceptual frameworks: the ASB Statement
of Principles for Financial Reporting
(= Statement of Principles) 4.4 Other conceptual frameworks Summary Unit summary Self-assessed Questions References Acknowledgements
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Introduction
Introduction
Welcome to the rst unit of B291 Financial accounting. Unit 1 serves as an introduction to B291. It establishes the framework within which accounting now resides and presents a view of likely future developments. It sets the context for the remaining units in the module and, given its introductory nature, you will nd that it covers many concepts quite quickly and briey. This does not mean that they are unimportant. You will be returning to them in more detail in later units, so make sure that you understand thoroughly the material in this unit before going on to the rest of the module. Unit 1 consists of four sessions. Session 1 introduces the basic terminology, purpose and different types of accounting. Session 2 details the organisational context of nancial accounting and what accounting information is used for and by whom. Session 3 tells you about the environmental inuences and constraints on business and accounting and introduces regulatory frameworks and structures. Session 4 discusses the conceptual frameworks, concepts and principles underlying accounting and nancial reporting information. By the end of Unit 1, you should have a clear understanding of how accountants act as processors and purveyors of information for decision making, of the needs of those who use accounting information, and of the role performed by accountants as well as being aware of relevant regulatory and conceptual frameworks. Accounting does not exist for its own sake or in a vacuum: there must be a reason why accounting is being done. Unit 1 should also enable you to understand the relevance of the remainder of the module to your own career, if you are thinking about becoming a professionally qualied accountant.
Learning aims and outcomes of Unit 1

Upon completion of Unit 1 you are expected to be able to understand and explain: 1 2 3 4 the purposes of bookkeeping and accounting the context in which accounting information fulls its various functions the main environmental inuences and constraints on business and accounting conceptual frameworks, such as the International Accounting Standards Board (IASB) Framework for the Preparation and Presentation of Financial Statements and the Accounting Standards Board (ASB) Statement of Principles for Financial Reporting, the qualitative characteristics of accounting information and the concepts and principles of accounting.
Session 1 The purpose of accounting
SESSION
1 0The purpose of accounting

Introduction
Upon completion of Session 1 you are expected to be able to:
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dene bookkeeping and accounting explain the general purposes and functions of accounting explain the differences between management and nancial accounting describe the main elements of nancial accounting information assets, liabilities, revenue and expenses identify the main nancial statements and their purposes.
In Session 1 you will learn about what accounting is, the purposes for which accounting information is used, how to distinguish between management and nancial accounting, the components of accounting information, and the main nancial reports in which this information is presented to its users.
1.1 Denitions of bookkeeping, accounting and reporting

First of all, you need to be aware of some of the basic terminology in this subject area. There are several different terms in common use under the general umbrella of accounting and they are often used by people interchangeably without distinguishing the meanings of these terms. Some of the most important are considered below, namely bookkeeping, accounting and reporting.
1.1.1
Bookkeeping
Bookkeeping is the process of recording transactions in the nancial records of a business entity. Unit 2 looks in more detail at what a transaction is, but for now we shall consider it as any sort of occurrence that has a nancial effect. Before transactions are recorded, they need to be classied according to their type so that similar items can be recorded in the same record or account. For example, a business entity will keep records of sales and purchases of goods or services, each classied according to their nature. Originally records detailing similar types of transactions were kept together in a book or ledger, with one or more pages dedicated to a particular kind of transaction, for example, sales of specic goods. Therefore, records often are collectively referred to as the books of a business. Bookkeeping goes back many hundreds, even thousands, of years. It began because people needed to record business transactions as a means of keeping track of who owed them money and to whom they owed money, and of knowing whether businesses were nancially successful or not. For many years, bookkeeping was based on common sense businesses recorded the data they considered necessary in order to obtain the information they required. Bookkeeping as a term is used to denote not only recording transactions in the way
Unit 1 The purpose and context of nancial accounting and reporting
described here, but also frequently as an abbreviation for doubleentry bookkeeping, a particular system of recording transactions devised about 500 years ago, and rst written about by an Italian monk called Luca Pacioli. Today, double-entry bookkeeping remains the most widespread method of bookkeeping and it will be discussed further in Units 2 and 3 of this module.
Portrait of Luca Pacioli (c.1445c.1514) Mathematician and Friend of Leonardo da Vinci, 1495 by Jacopo deBarbari (1440/50a.1515) Museo e Gallerie Nazionale di Capodimonte, Naples, Italy/Bridgeman Art Library.
Portrait of Luca Pacioli
It is the job of the bookkeeper to maintain the books of a business and keep them up to date. This is done by ensuring that transactions are recorded in a timely and logical manner, either chronologically, as they occur, or by dealing with like items in batches, for example, recording all sales of a particular good in a dened period of time (day, week or month, according to the needs of a business). Recording may be done manually using paper and pen, but it is now more commonly done by using a computerised bookkeeping or accounting program. Recording items in individual accounts (see above) is also referred to as posting, and a computer program can ensure that all necessary records are completed quickly and accurately (provided that data have been entered correctly, of course!).
Link between accounting and writing
Arguably the need felt by the Sumerian civilisation in Mesopotamia to keep account of livestock was also the origin of writing, as this account was recorded. The concept of wealth is much older than that of money. Livestock was often regarded as an indication of wealth which is still the case in some developing countries. Anyone who has read Alexander McCall Smiths The No. 1 Ladies Detective Agency, set in Botswana in recent years, will recall that Mma Ramotse was bequeathed a herd of 180 prime cattle by her father, who had regarded them as an investment.
As a result of posting transaction details to individual accounts in this way, each account will show a history or list of transactions that have occurred, so the management of a business can keep track of
them individually. It can also track movements (increases and decreases in the volume of transactions recorded) over a period of time, for example, to monitor how well a new product might be selling. Businesses also need to know how well they are faring in all aspects, and the existence of accounts enables them to draw up a formal report to show this. The list of monetary transactions in an individual account can be totalled so, for example, the total sales of a good in a particular period can be determined. This totalling of individual accounts is referred to as balancing or balancing off. The individual account totals or balances for all accounts are then listed in a separate document, which is known as a trial balance. The process of balancing off individual accounts and drawing up a trial balance is an important part of determining whether a business has made a prot or loss overall. The mechanics of this process will be covered in Units 2 and 3 of this module. Activity 1.1
(Note: you should never look at the answer that follows before attempting an activity.) Imagine a business recorded what it had sold, to whom, the date it was sold, the price at which it was sold, and the date it received payment from the customer, along with similar data concerning the purchases made by the business. What information do you think that the business could produce from these data? Take ten minutes or so to write down your answer.
Feedback
These data would enable the business to know how much it had sold and how much it had purchased, how much cash it had received and paid, how much was owing to it and how much was owed by it (both in respect of any individual customer or supplier and in respect of the overall business transactions), and whether it was making a prot or a loss over a particular time period. It might also be possible to compare how much had been sold to the customer and purchased from the supplier with amounts sold and purchased previously.
1.1.2
Accounting and reporting
Accounting is a process which identies, organises, classies, records, summarises and communicates information about economic events, usually, but not exclusively, in monetary terms. While accounting is often considered as including bookkeeping as well, it is much wider than bookkeeping. It may also be regarded as a transformative process in that it turns the raw data recorded in bookkeeping into useful information. Data lack meaning until they have been processed into meaningful information. What good is it to know that a book cost a bookshop 10? Those data will only become information when they are combined with something else that enables you to assess them within a relevant context, such as how much the book would have cost had the bookshop bought it from a different supplier or how much prot the bookshop made when it sold the book to a customer. The communication aspect of accounting involves the reporting of information about a business to interested parties, such as owners and managers. Results of all transactions over a period of time need
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to be summarised, presented and interpreted in order to assess a businesss performance and its nancial position at a given date. The period of time for which results are calculated is referred to as an accounting period or period of account. An accounting period can be any length of time, and the length may be determined by the reason for which a set of results is required, for example, to provide management with information, to support an application for a bank loan, etc. Commonly, however, an accounting period is of a years duration, and however often businesses produce sets of results, they will always produce an annual set of results, as these are required for specic purposes, such as for taxation or, in the case of companies, ling with a regulatory authority. Only in certain well dened circumstances will sets of results for periods other than a year be accepted for these specic purposes. For example, the rst accounting period for companies in the UK must be more than six months, but no more than 18 months. The date on which an annual accounting period ends is referred to as the businesss accounting reference date or closing date. For UK business entities, this date can be any date in the year and does not have to coincide with a calendar year, though this is not necessarily the case elsewhere. The form in which results are presented is usually twofold: a calculation of the businesss overall prot or loss for its accounting period, referred to as an income statement or prot and loss statement/account; and a statement of nancial position as at the end of the accounting period, also called a balance sheet. In this module we will use the terms income statement and balance sheet. The income statement and balance sheet together are often referred to as the nancial statements or set of accounts.
Different accounting terminology
The different names for the different parts of nancial statements have arisen as a result of different customs, rules and regulations over the years, which are considered in more detail later in this unit, when we look especially at the impact of the International Accounting Standards Board (IASB) and the introduction of International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs). Prot and loss account was for many years a common term, but it was felt to be less than precise, particularly when, for example, it was used by entities which did not have a prot motive, such as charities. IAS 1, the international accounting standard which deals with the presentation of nancial statements, therefore, introduced the term income statement, which can be more universally applied. At the same time, it suggested the replacement of another, much older term, balance sheet, by the term statement of nancial position. IAS 1, however, did not make adoption of the new terms mandatory. Income statement has been widely adopted, but not statement of nancial position. While many professional accounting training manuals use the latter, it is not yet widely used by businesses, which still continue to use the term balance sheet. In this module, we therefore use the terms income statement and balance sheet. In addition to widespread use, the term balance sheet is also useful when learning accounting as it helps remind you that a balance sheet itself should balance, that is, both halves/sides should add up to the same gure, and that certain individual account balances will be included there. You will learn more about this when you get to grips with the mechanics of double-entry bookkeeping in Units 2 and 3 of this module.
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Although businesses produce formal income statements and balance sheets for, and at the end of, accounting periods, they can do so at any time, and often produce them more regularly to help managers monitor and control business activities and make decisions, as mentioned above. This adds further dimensions to accounting, as it helps look to the future, rather than focusing on transactions that have already occurred, and in this sense accounting has a management function, as a part or sub-set of the wider management information system (MIS) of a business. In this context, accounting is sometimes referred to as an accounting information system (AIS) or in short, accounting system. Activity 1.2
Earlier it was mentioned that it might not be very useful to know only that a book cost a bookshop 10. What other data do you think could be used in order to convert the data about the cost of the book into information? Take ten minutes or so to think about this and write down your answer.
Feedback
You may have suggested any of the following:
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the selling price of the book the amount the bookshop could have purchased the book for elsewhere the time it took to receive the book from the publisher after the bookshop ordered it the condition of the book when it arrived in the bookshop the length of time before payment was effected.
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These are all good answers, and there are probably many others. In each case, they provide the means of assessing something:
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the prot that will be made if the book is sold whether the bookshop paid a good price for the book how far in advance the bookshop should order the book if it wants it to be available for customers on a particular date whether the supplier packages books appropriately possibly, whether the business is likely to be given credit by the supplier in future.
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Information is data processed for a purpose. Once data have been converted into information, you can then use that information to help you make a decision, which will require the exercise of judgement. You cannot take meaningful decisions with data. This process can be expressed as follows: Decision = Purpose + Information + Judgement Note that while the bookkeeper will record data, it is the accountant who (as the denition of accounting suggests) will convert data into information which serves a purpose, that is, is useful. To be useful, information must be timely, relevant, complete and of good quality. It can only possess these qualities if the underlying data have been recorded properly.
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1.2 Reasons for and objectives of accounting

The main purpose of accounting is to provide nancial information to managers and owners of businesses (as we have already seen) and a variety of other interested parties (as you will learn in Session 2). This nancial information fulls different objectives, namely stewardship, accountability, planning and decision making and control, as discussed below.
1.2.1
Stewardship
Persons who run or manage businesses are not always those who have invested money and/or resources in the business. They manage money and/or resources which are owned by others, and act as stewards (or agents) on behalf of owners (sometimes called principals). The concept of stewardship places an obligation on stewards to provide nancial information relating to the resources which they control, but do not own (see Figure 1 below).
Owners/Principals Managers/Agents
Business Entity
Figure 1
Stewardship
1.2.2
Accountability
Accountability is connected to the idea of stewardship (though it is a wider concept as it may extend to other stakeholders or society in general). Stewards are obliged to give to owners of businesses an account of how they have managed resources. This may be discharged in part by the provision of nancial information, such as an income statement and balance sheet. However, the idea of accountability also carries with it the notion of acting responsibly and being able to justify ones actions and, therefore, prepared to suffer the consequences of irresponsible and unjustiable actions. The issues relating to accountability will be discussed in detail in Unit 6.
1.2.3
Planning and decision making
Business managers need to have nancial information to enable them to make plans for future business activities and operations. For example, if a business plans to sell 120,000 units of a good it manufactures in the next year, it will need to know the quantity and price of raw materials required to make 120,000 units, the number of staff required and the hours each staff member can work and their rate of pay, the type and number of machines required, etc. There will, of course, be other costs associated with production. Such information is typically derived from on-going business activities and experience and reported nancial information, combined with knowledge of future price increases for raw materials, wages and other known costs. Planning of this kind can be very difcult in
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practice if a business is aiming to increase or decrease production of an existing good, and becomes even more difcult in the case of producing any good which the business has not produced before.
1.2.4
Control
Accounting information can also be used for the purposes of control. Business managers need to monitor activities and operations to see whether they are proceeding according to plan. In the example in Section 1.2.3 of planning to manufacture and sell 120,000 units of a good, a business may have planned to sell the units evenly over a year, that is, 10,000 units per calendar month. Therefore, the business will need accounting information on a monthly basis to see whether this target is being achieved. If it is not, then the business will need to nd out why, and take corrective action if possible. The type of corrective action will depend on the problem that has been identied. Different problems can have the same overall effect. For example, if sales were down in any given month, it might be the case that trade was more seasonal than anticipated and there might be compensating higher sales in other months. It might also have been the case that a sales representative for a particular area had been away on sick leave, which would also result in lower sales. Equally, a production problem could have prevented sufcient goods being manufactured for sale perhaps being caused by machines breaking down or suppliers inability to deliver raw materials when needed. It is also possible that sales in a given month might be up on what was forecast which could also cause problems if it continued in the longer term, as the business may have resources that are inadequate to meet an unanticipated higher demand. Regular provision of accounting information (in this example, for sales and production) is essential for control purposes. Planning, decision making and control are aspects of accounting which will be covered in B292 Management accounting. Activity 1.3
How do you think a shareholder in a company can be assured that the nancial statements give a true and fair view of how the directors have been running the company? Take ten minutes or so to write down your answer.
Feedback
The shareholder would primarily look at the externally audited nancial statements for the accounting period ended most recently. You might have been thinking along the lines of the shareholder asking someone to undertake an independent investigation into the nancial statements and (by implication) into the directors management activities. You would have been right, because this is what external auditing involves. An external auditor is an independent, external person or rm appointed formally by the shareholders to write a report to them on the externally reported nancial results of a company (as shown in its nancial statements) and on its management. You will learn more about the role of the auditor in Unit 6. There are also internal auditors, who might do a similar job, but report to internal committees within a rm. (See Section 2.4, which looks at shareholders as one of the key stakeholders who have an interest in nancial statements.)
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1.3 Management and nancial accounting

From Section 1.2, it is clear that accounting information has a number of different purposes, governed by the needs of those using it. This brings us to consider different types of accounting, namely nancial accounting and management accounting, as the purposes fullled by accounting information generally fall under one or the other heading. It is important to note that this does not mean that any different types of books or records need to be kept. It is just that the information produced from the books and records organises, classies, summarises and communicates information according to the perspectives and needs of the users, as Table 1 below shows.
Table 1 Differences between nancial and management accounting Financial accounting Chief purpose Production of summarised income statements and balance sheets by managers as a formal report on the stewardship of resources entrusted to them but should also, in the case of public companies (see Session 2), help interested parties (such as investors) make decisions. Depending on the type of the business entity, documents may be publicly available. Management accounting Production of detailed and up to date information used by managers to plan activities and control them. This information is not publicly available, but is internal to the entity producing it.
When information is prepared
Annually, at the end of an accounting period, but, depending on the type of business entity, may be every three or six months as well.
Normally prepared on a monthly basis.
Governed by
Legal requirements and often mandatory accounting regulations* and/ or conventions which may also dictate a required format (though this depends on the legal form of an entity).
Management needs only with no legal requirement to produce anything in any format, or anything at all. Information is produced in the format management deems most useful, e.g., by operating unit or product line, to record and monitor sales (by product, region, etc.), costs of production methods or products.
Perspective
Gives information about past performance, and might in practice be outdated by the time summarised documents are produced.
Comparative and up to date. While a given months results are provided, these are usually accompanied by a total for all months to date and comparative gures for a prior year (as well as for planned activities in the month and period to date).
* In order to facilitate comparison between similar business entities, income statements, balance sheets and other summarised accounting documents are prepared using accepted conventions and standards. This is covered in Session 4.
B291 focuses on nancial accounting, while management accounting forms the focus of B292.
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Activity 1.4
Which of the following statements is untrue? 1 2 3 4 Financial statements are usually produced annually and management accounts are usually produced monthly. Financial statements are more accurate than management accounts. Financial statements may be audited by an external auditor and management accounts are not audited. Financial statements are intended primarily for external users and management accounts for internal purposes.
Take ten minutes or so to write down your answer.
Feedback
All statements are true, though in the case of Statement 2, it does depend on the extent to which nancial or management accounts may contain estimated gures, which are appropriate in certain circumstances, as you will learn later. Remember that all accounting information is produced from the same records but at different times and for different purposes. It should all be of similar quality. Note that, in respect of Statement 3, while management accounts are not audited, not all nancial statements are either, hence the subtle use of the phrase may be audited in respect of nancial statements. The requirement for audit is determined by the type of organisation and its size. Again, you will learn more about this in Unit 6.
1.4 The main elements of accounting information

Section 1.1.2 told you that results of all business transactions over a period of time need to be summarised, presented and interpreted in order to assess a businesss performance and its nancial position at a given date, in the form of an income statement and balance sheet. It was emphasised in Section 1.3 that the presentation of nancial accounting information is governed by a combination of legal requirements and accounting regulations and conventions. Different types of business entities are governed by different requirements, and this is dealt with in Session 2. However, one of the rationales underlying the preparation of income statements and balance sheets is to turn raw nancial data into useful information, and this is achieved in part by organising, classifying and presenting data in particular ways to make them meaningful. Here we shall look at some conventional ways of doing this.
1.4.1
Income and expenses
An income statement is a summarised nancial statement which shows how well or badly a business is faring. An example of an income statement is shown in Figure 2. This is an income statement for a hypothetical sole trader (here called Mr Schmidt), a type of business entity you will learn about later in Session 2.
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Mr Schmidt Income statement for the year ended 31 March 2010 Sales Less: Cost of goods sold Opening inventory Purchases Less: Closing inventory Gross prot Less: Expenses Rent Lighting and heating expenses General expenses Net prot 3,000
2,800
800
(6,600) 9,400 14,000 22,000 36,000 (12,000) (24,000) 16,000 40,000
Figure 2
Example of an income statement
As its name suggests, an income statement includes all the income generated by a business in its accounting period. This is usually derived from the sales of its products and services, which are rst listed from individual accounts on to the trial balance and then added up together. Income derived from sales may be referred to by a number of different terms, such as turnover or sales (sometimes sales turnover), sales revenue or just revenue. However, income may be derived from other sources, and the source may be denoted in the terminology used to describe it. If a business derives income from a bank account in the form of bank interest, for example, this too will be included in the income statement. It will be shown separately from income arising from sales and will be called bank interest receivable or something similar. However, perhaps rather unhelpfully for persons learning about accounting for the rst time, revenue can also be used as a general term to mean any sort of income, and if so used, could include bank interest as well. There is no hard and fast rule about how the terms income or revenue are used. They are both very common terms, and you will see both used in this module. In acquiring or making products for sale, or delivering services to customers, however, a business will have laid out some of its own resources (most commonly, money). For example, if a business makes a product, it will need to buy in raw materials, pay wages to employees making the product, and pay for electricity (for example) used in the manufacturing process. Likewise all such items are listed from individual accounts on to the trial balance and then added up together, with like items grouped together. For example, raw materials will be added together, as will energy items, wages, etc. The term costs or expenses is often used here to denote these types of items. Some accounting textbooks differentiate between these terms, but you will nd them used interchangeably without distinction of meaning, and we do not differentiate between them in this module. Often terms used in accounting are also used in every day life with no reference to
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their nancial meanings and this contributes to the overall lack of precision. For example, it is common to speak of someone paying the price for something, such as committing a misdemeanour. An income statement shows the total costs subtracted/deducted from total income. If there is an excess of total income over total costs, this is referred to as a prot (sometimes called a surplus, if the entity, like a charity, does not have a prot motive). If total costs exceed total income, then a loss or decit (the latter is often used by non-prot-making entities) is said to arise hence the alternative name for an income statement of prot and loss account. By organising, classifying and presenting income and expenses in this way, the income statement makes them into meaningful information because by calculating a prot or loss it becomes possible to determine how well or poorly a business is performing. You will see that Mr Schmidt has separated his costs into those that relate to items that he has sold and the rest, and it shows two different kinds of prot. You will learn all about this later in this module, so do not worry if there are things here that you do not understand. Note also that the accounting convention used here puts gures to be deducted in round brackets. This is widely used, especially in the UK, but you should be aware that not every country uses it.
1.4.2
Assets and liabilities
As the income statement groups together like items of income and deducts like items of costs to show a prot or loss for an accounting period, the balance sheet also groups together like items to show the nancial position of an entity at the end of its accounting period. It is rather like a snapshot of the entity at that moment in time. Determining a nancial position is something that individual people frequently do as well, and involves sorting out what, as a person, you own and what is of value to you, often in terms of money and things like houses, cars, jewellery, furniture, etc. These types of things are called assets and the term means much the same in an accounting context as well. Determining a nancial position also involves sorting out what, as a person, you might owe to other people by way of things like mortgages, loans, credit card bills, unpaid bills for utilities, etc. These are called liabilities. If the value of your assets exceeds your liabilities, you could (in theory, at least) sell your assets, realise cash and settle your liabilities.
Assets and liabilities have been carefully dened by the International Accounting Standards Board (IASB) (see Session 4 for more on this). Assets are resources controlled by a business as a result of past events and from which future economic benets are expected to ow to the business. They might be things the business owns, like machinery.
Businesses try to establish a nancial position in a similar way at the end of an accounting period. They may have various assets, such as land and buildings, plant and machinery and vehicles, which they use to carry out business, manufacture goods and deliver them, and which they intend to keep for a long time. These are referred to as non current assets or xed assets. Fixed here does not necessarily imply that assets are immovably xed in one place (though many kinds of these assets often are); rather, it implies lasting. Many non-current assets, such as land and buildings, plant and machinery and vehicles, etc., are also referred to as tangible assets in that they have a physical form and can be touched (the basic meaning of the word tangible). It follows that there are also intangible assets which are things that cannot be touched, such as patents, copyrights, trademarks, etc., though their existence may be conrmed by some
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kind of documentation. Businesses may also have items which they have bought to use in manufacturing, such as raw materials, but have not yet used. These will be used up in the course of manufacturing, and are often referred to as inventory or stock. They form one of another category of assets known as current assets, which either stay with a business entity for only a short time, or change over time. They perform a different role in the business from non-current assets. A business will not have exactly the same type or amount of raw materials in stock at the end of every accounting period, but will keep buying in materials as and when required, as it continues to manufacture and sell goods, so from one accounting period end to another, these items will not be the same. Businesses may also have stocks of nished items, which have not yet been sold, or stocks of items which are only partly nished (work in progress). Other types of current assets are cash and amounts due from customers who have not paid for goods sold to them, referred to as trade receivables (receivables for short and sometimes also referred to as trade debtors). Businesses also have liabilities in a similar way to individuals. They buy from suppliers, and may not pay for goods immediately, so at the end of an accounting period may owe money for such goods, referred to as trade payables (payables for short and also sometimes referred to as trade creditors) or for utilities such as gas, electricity or telephone charges. Businesses also borrow money from banks or other lenders to start or continue business. Also, owners of businesses invest their own money in business, most often when business commences. Money, resources or assets put into a business by owners are referred to as owners interest, equity or, commonly, as capital, though this latter word can be used to mean other things as well. As money, resources and assets will eventually be repayable to a businesss owners, this may also be regarded as a type of liability. Generally, liability items are classied by reference to when they need to be paid. Those due more than a year after the end of the accounting period are referred to as non-current liabilities (or long-term liabilities). Those due within a year or less are called current liabilities. Amounts due in respect of trade payables will be current liabilities as such amounts are often due within three months or less, whereas loans may not be repayable for several years. At the end of an accounting period, all assets and liabilities are listed from individual accounts on to the trial balance and then added up together, with like items grouped together. There are two ways of showing assets and liabilities on a balance sheet using either a horizontal format or a vertical format. A horizontal format lists all the assets on the left-hand side and all the liabilities on the right. As a result of the manner in which transactions are recorded using double-entry bookkeeping (this is discussed further in Units 2 and 3), the total of assets always equals the total of liabilities. This is why a statement of nancial position is commonly called a balance sheet, that is, both sides (or halves) add up to the same amount. A vertical format often shows capital in the bottom half, and in the top half shows assets with liabilities deducted from them (current liabilities, for example, are deducted from current assets to show net current assets or liabilities). This is often referred to as the net assets approach. It is
Liabilities are present obligations of a business arising from past events, the settlement of which is expected to result in an outow from the business of resources embodying economic benets. They might be sums of money owed to lenders, for example, who have loaned money to a business, and who will need to be repaid in due course.
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also possible to show all assets in the top half and all liability (or credit) balances in the bottom half (which is now possible under the international accounting approach: different formats for nancial statements will be covered in detail in Units 4 and 5). Any entity could, in theory, produce a balance sheet in either format, as it is just a matter of presentation. The vertical balance sheet (i.e., using the net assets approach) is common in the UK, but different countries have different rules. It would not, for example, be permitted in France, although other countries with specic regulations may require it for certain types of entities. Examples of a horizontal and vertical balance sheet are shown in Figures 3 and 4 below again for Mr Schmidt, the hypothetical sole trader whose income statement you looked at previously, in Figure 2.
Mr Schmidt
Balance sheet as at 31 March 2010
Non-current assets Fixtures and ttings Current assets Inventory Trade receivables Cash at bank and in hand Drawings 12,000 5,800 Current liabilities 2,300 15,500 53,600 Figure 3 Example of a horizontal balance sheet Mr Schmidt Balance sheet as at 31 March 2010 Non-current assets Fixtures and ttings Current assets Inventory Trade receivables Cash at bank and in hand Current liabilities Trade payables Net current assets Net assets Capital Cash introduced Retained earnings Add: Net prot for the year Less: Drawings 25,000 11,000 36,000 9,400 45,400 (15,500) 29,900 Figure 4 Example of a vertical balance sheet, following the net assets approach (8,200) 11,900 29,900 12,000 5,800 2,300 20,100 18,000 53,600 Trade payables 8,200 18,000 Capital Cash introduced Retained earnings Net prot for the year 25,000 11,000 9,400
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Again, do not worry if there are things here that you do not understand, such as drawings or why these are included in the horizontal balance sheet with assets, as these will be explained later (though drawings are simply a withdrawal of capital by the owner(s)). You will see in the above balance sheets that both show the prot of 9,400, as per the income statement in Figure 2, included with the capital elements. Activity 1.5
Classify the following list of items as income, a cost/expense or an asset/liability: 1 2 3 4 5 6 7 8 a machine for manufacturing widgets air conditioning used in a factory sales of 1,000 widgets for cash to Mr Mohammad, a customer 3,000 borrowed from the bank a heap of metal on the yard, to be used for manufacturing widgets 4,000 owed to Pyron Ltd for the metal in item 5 a Toyota Lexus car, used by an employee, but owned by his/her employer, Yen Ltd
10,000 of personal savings used by someone starting up a business.

Take ten minutes or so to write down your answer.
Feedback
1 2 This is a tangible non-current asset used for carrying out business and likely to be kept for a long time. This is a cost/expense utility needed to keep machinery and employees at an appropriate temperature while they work. If the actual air conditioning plant itself is implied by the words air conditioning (rather than what the plant actually does) then this would be a tangible non-current asset, likely to be used and kept for a long time. This is a sale to a customer, generating sales revenue (income). This is a loan, which will have to be paid back. It is a liability, and whether it is classied as current or long-term will depend on the date of repayment. This is raw material to be used in manufacturing so is inventory, hence it is a current asset. This is money owed for material to be used in the business, so it represents a trade payable, and would be a current liability. This is a non-current asset, as it is used in the business for transporting the employees (it may be what is called a pool car, that is, it is available to a variety of employees). It is important to note that the car is owned by the employees company, not the employee. Therefore, the car would be one of the companys non-current assets. This is money introduced to do business therefore, it is capital which may be regarded as a particular type of liability, in that it will eventually be repayable to the owner.
3 4
5 6 7
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1.5 The main nancial statements

To summarise from the previous discussions, the nancial statements comprise:
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The income statement or prot and loss statement, which shows income, less costs/expenses for an accounting period. Where income exceeds expenses, a prot or surplus arises. Where costs/ expenses exceed income, a loss or decit arises. The balance sheet, which is a snapshot of assets and liabilities at a moment in time the end of the accounting period. The end of the accounting period is also often referred to as the accounting reference date, balance sheet date or closing date. The cash ow statement. There is a requirement for certain business entities, namely companies, to provide a cash ow statement to show movements in cash over the period covered by the income statement. This cash ow statement is considered by entities required to provide it as a third nancial statement in addition to the income statement and balance sheet. The cash ow statement will be discussed later in this module when you learn about company nancial statements, and examples will be given there.
To the above, we must also add:

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If you look at any income statement and/or balance sheet for an entity, you will nd that they are generally accompanied by a set of notes to the nancial statements which provide further information, explanation or analyses, which are more conveniently shown separately from the main statements. As you will come to learn in Session 4 and subsequent units of this module, prot and cash are not the same thing, although prot commonly becomes cash in time. It is important for a business to generate both prot to stay in business in the longer term and cash to be able to pay bills and liabilities as they fall due.
Summary
This session has provided an introduction to some of the basics of accounting. You have learned the basic terminology of bookkeeping and accounting, the general purposes and functions of accounting and the differences between the two sorts of accounting (nancial accounting and management accounting). You should also now be able to describe the different elements of nancial information, such as income/revenue, costs/expenses, assets and liabilities, as well as identify the main nancial statements (income statement, balance sheet and cash ow statement) and their purposes. In Session 2 you will learn about the different organisational forms that exist for doing business and how accounting fulls different functions in accordance with the primary goals of these organisations. Depending on their legal status, size, and whether they have shares which are sold on a stock exchange, business organisations have to follow more or less extensive accounting regulations and reporting requirements. Reporting regulations and requirements exist to protect the informational needs of a whole range of stakeholders.
Session 2 The context of accounting
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SESSION
2 0The context of accounting

Introduction
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identify and dene different types of business entity and not-for prot organisation sole trader, partnership, private and public limited liability company, charity, governmental and non governmental organisations explain the objectives of various business and other organisations identify and discuss the role of accounting in business and other organisations explain the functions of accounting in business organisations identify the main stakeholders in business and other organisations and discuss their information needs explain the need for recording transactions and the legal requirements for preparing nancial statements for different organisations.
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In Session 2 you will look at what the concept of business means and the different objectives that business organisations may have. You will go on to learn about the different types of business organisation and will look at different ways of classifying them by their primary activity, their legal form, by reference to their prot aims and to ownership or control. Different forms of business organisations are governed by different regulations, which affect the format in which they are required to present their nancial statements. You will also learn about the functions of accounting in different types of organisation and the different types of entities and people who use and are interested in nancial statements and why.
2.1 Business and its objectives

2.1.1 Dening business
The word business is often used very generally, and encompasses a variety of ideas. It can be used in the same way as other, rather general words, like rm or enterprise, simply to mean an entity designed to provide goods and/or services to consumers. It can also be used more widely to apply to a particular market sector, such as the car industry, or it can be very broad in meaning and encompass all activity undertaken by the whole community of suppliers of goods and services.
2.1.2
Business objectives
In capitalist economies, businesses are mostly privately owned and exist to earn prots for owners, though there is also a signicant body of non-prot business in the form of non-government organisations (NGOs), charities, cooperatives and state owned enterprises, etc. Forms of business ownership vary, but there are several common forms, which will be considered in Section 2.2.
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In socialist economies, business is generally owned and run by the state or state agencies. However, most, if not all, economies are mixed, that is, they contain both privately owned and state owned businesses, though there is no single denition for what mixed means or implies, as economies as different as those of the USA and Cuba have been termed mixed.
2.2 Classifying business organisations

2.2.1 Overview of Section 2.2
In Section 2.2, we will look at how business organisations are classied. There are four different ways of classifying organisations, as outlined below: 1 by reference to their primary activity 2 by reference to their legal form (sole trader, partnership and company the latter two having several different kinds), unincorporated associations and trusts 3 by reference to their prot aims 4 by reference to ownership and control. We shall look at each of the above in turn. Knowing what a business does, the legal form it takes, whether it is prot-oriented and who owns and controls it, etc., provides a wider context for the nancial statements it produces, and their format, and may engender certain stakeholder interests in its nancial results. Although different legal organisational forms may be subject to different rules as to nancial statements and their format, if they keep accounting records, these will be kept using the same kind of bookkeeping as has already been described.
2.2.2
Classication by primary activity
There are many different types of business and organisations, and, consequently, they may be classied in different ways, for example, by reference to a businesss primary activity, such as manufacturing (where physical goods are made from raw materials and/or components), transportation (where goods are delivered or people transported), utilities (where services such as fuel, sewage treatment, etc., are provided), education (where teaching or other educational products/services are provided), and professional services (where legal, banking, accounting, auditing, taxation, investment and other nancial services are provided). Countries often have formal systems of classifying activities, most frequently for companies the shares of which are publicly traded on stock exchanges. This is frequently done by developing a code of numbers with a different number applicable to each industry sector, and may be done by various bodies, such as a stock exchange. The London Stock Exchange, for instance, uses the Standard Industrial Classication (SIC) to determine the main activity of a company, and will assign the same numerical code to all companies which provide the same goods/services. The use of such codes enables users of nancial statements to compare results of companies in the same
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industry. It enables governments to compare statistics of businesses in the home country with those of other countries and develop economic, industrial or even educational policies.
2.2.3
Classication by legal form
One of the commonest ways of classifying organisations is by reference to their legal form, and there are many different legal forms for doing business. Figure 5 below gives a number of forms differentiated by UK law, which are then discussed further. The difference in legal form between some of these relates to the way a particular form of business organisation raises nance, the nature of its activities, its size, how it pays tax and the type of legal and accounting regulations by which it must abide.
Business organisations
Sole traders
Partnerships
Companies
Unincorporated associations
Trusts
General
Limited liability partnerships
Limited partnerships
Chartered companies
Statutory companies
Registered companies
Companies limited by shares
Companies limited by guarantee
Unlimited companies
Public (plc)
Private
Private
Private
Figure 5 Different business organisations by reference to legal form
Sole traders (sole proprietors) These are entities owned by one person, and are the simplest form of business entity to deal with, as there are few formalities or constraints. A sole trader raises nance to do business by investing his/her own money (referred to as capital, equity, etc. see Section 1.4), borrowing money from friends or obtaining a loan, say, from a bank or possibly a combination of these things. A sole trader will be personally liable for any debts incurred by the business, so if the business does not generate enough cash to pay business bills as they fall due, the sole traders personal resources and assets will be used to pay them, and the sole trader may become bankrupt as a result. This is different from limited companies, for example, where the personal resources and assets of investors cannot normally be used to pay company bills. Businesses operated by sole traders tend to be small, because there are limited resources available to their owners. Some are quite literally one man operations, though they can, of course, have employees. Sole traders in general aim to be prot-making, as the business is their primary means of making a living. Sometimes you will see the term sole practitioner used. This term often just means that the person operating a business is offering
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a service, such as an accountant or a solicitor, rather than selling goods or making them, but is otherwise the same as a sole trader. The type and format of nancial statements are specied by regulations for many entities, but not for sole traders, at least in the UK. However, they would normally prepare rudimentary nancial statements to a level that is deemed adequate for taxation purposes, as well as for their own needs. Larger sole traders may choose to produce nancial statements in accordance with generally accepted accounting principles (GAAP), which will be referred to later in the unit. There is no legal requirement for a sole trader to have an audit. Partnerships General partnerships A partnership is a business entity owned by two or more persons who each invest resources (typically their own or borrowed money), again referred to as capital (see Section 1.4), and work together with the aim of making a prot. The greater number of owners means that, in comparison with a sole trader, more nance becomes available, and this is a common reason for forming a partnership, but partnership is also a means of sharing the risks of business and managing it. Prots are divided between the partners, often in accordance with the proportions in which they contributed capital to the business, though they can agree to divide prots in any way. Partners often draw up a partnership agreement as a formal written document, which sets out the rules by which the partnership is to be administered and includes things like how prot will be split (to prevent disagreement arising over this). However, there need not be a document there can also be an oral agreement. If an agreement is silent over prot-sharing arrangements, prots will usually be shared equally. (This is specically required in the UK by the provisions of the Partnership Act 1890.) The above description is that of a basic general partnership. It is a very old and very common form of doing business worldwide and, in the UK, is governed by one of the oldest pieces of business legislation still applicable: the Partnership Act 1890. The partners have authority to act on behalf of the business to bind all the other partners in legal contracts with third parties that are in the ordinary course of the partnerships business. Like sole traders, partners are personally liable for any debts incurred by the partnership, so there is no protection offered to partners personal assets if the partnership does not generate enough cash to pay bills as they fall due. The partners have a collective (joint) and individual (several) responsibility (or liability) for debts. A partnership will formally end if any partner dies, withdraws or becomes unable to act because of disability. Most partnership agreements will provide for these types of events, and the share of the departed partner is usually purchased by the remaining partners. All partners usually have an equal right to participate in the management and control of the partnership. Disagreements in the ordinary course of business are decided by a majority of the partners, but disagreements in respect of matters deemed extraordinary, and
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amendments to the partnership agreement, require that all partners consent to proposed solutions or amendments. In a partnership of any size, the partnership agreement will provide for day to day management of the partnership to be delegated to certain elected partners. Unless otherwise stated in the partnership agreement, no one can become a member of the partnership without the consent of all partners, though a partner is permitted to give (or assign) his/her share of the prots and losses to others. Limited liability partnerships (LLPs) Until relatively recently, the partnership form was the only form in which certain professionals who offered services, such as accountants, solicitors, etc., could do business. In addition to liability for partnership debts, as explained above, service professionals also face another threat to business, in that they can be sued by dissatised clients. Dissatisfaction can arise for many reasons, but becomes potentially actionable at law if a professional should act negligently, resulting in nancial loss for a client, which the client would seek to recover legally by taking the negligent professional to court and suing for damages. In the past, claims have been made for very large sums, far in excess of the amount of capital partners had contributed to businesses, and, indeed, in excess of their personal assets. If a dispute comes to court, it means delay in reaching agreement and uncertainty over the level of damages the court might award, hence cases have often been settled by agreement between the disputing parties outside the courts. This was regarded as very unsatisfactory by partnerships, especially the large accounting practices, and resulted in extensive lobbying of governments for a change of law so that the liability of partners could be restricted to the amount of capital they had invested, such that their personal assets were not at risk. This resulted in the Limited Liability Partnerships Act 2000 (in England, Wales and Scotland) and the Limited Liability Partnerships Act (Northern Ireland) 2002, which introduced these desired changes. The concept of limited liability for partners is now widespread around the world. LLPs are more complicated to set up and operate than general partnerships, as they must meet many of the same requirements as limited companies. (This is discussed further below). Limited partnerships A limited partnership is similar to a general partnership except that in addition to one or more general partners, there are one or more limited partners. It was an early attempt to limit the liability of partners in the way that LLPs now do. The general partners are, in all major respects, in the same legal position as partners in a general partnership, that is, they manage the business, and share the prots of the rm in (pre-dened) proportions, and have joint and several liability for the debts of the partnership. Limited partners, however, have limited liability, meaning they are only liable on debts incurred by the rm to the extent of their registered investment, and have no management authority. This latter was the price they paid for having limited liability. The general partners usually pay the limited partners a return on their investment, the nature and extent of which is usually dened in the partnership agreement. It is still theoretically possible to set up a limited partnership, but the form
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was not in any case found very frequently. It is unlikely that many limited partnerships will be formed now that the LLP is available. Regulations governing partnerships There are four Acts of Parliament in the UK governing partnerships, depending on the type of partnership in question. They are the Partnership Act 1890, the Limited Partnerships Act 1907, the Limited Liability Partnerships Act 2000 and the Limited Liability Partnerships Act (Northern Ireland) 2002. These regulations do not lay down specic requirements about nancial statements or audit. In general, partnerships will follow what is regarded as most acceptable accounting practice. Many large partnerships (such as the large LLP accounting rms like KPMG, PricewaterhouseCoopers, Ernst & Young and Deloitte) choose to be audited and make their nancial statements publicly available. Activity 2.1
Mr Jones has just opened a sh and chip shop, and he and his wife have both put in 5,000 to the business. What form of business is the shop likely to be? Take ten minutes or so to write down your answer.
Feedback
On the face of it, this looks like a partnership, as two persons (Mr and Mrs Jones) have both contributed capital and appear to be working together with a view to making prot. It could be a general partnership or even an LLP. However, this need not be the case. Mrs Jones may not be taking an active role in the business (the information is that Mr Jones has opened the shop), and the 5,000 she put into the business may be a loan to her husband. If this is the case, the business may then be a sole tradership operated by Mr Jones. The point of this is that you often need a great deal of information to decide what might be going on in a business and cannot make assumptions.
Companies Types of companies The word company or corporation is often used quite loosely to denote a body of people. In terms of business, the word company means a particular form of corporate body which has a specic legal meaning denoting people acting together in a particular way, usually to make a prot, but not exclusively. There are many different ways of setting up a company, which is also known as incorporating. Chartered companies Chartered companies in the UK are created by royal charter from the Crown and were frequently used in the seventeenth and eighteenth centuries for the purposes of overseas trading. Nowadays, charters are only granted to non-prot organisations and charitable and educational companies. The Law Society, the Institute of Chartered Accountants in England and Wales (ICAEW), the Association of Chartered Certied Accountants (ACCA) and the Chartered Institute of Management Accountants (CIMA), as well as The Open University, are examples of chartered companies.
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Statutory companies Statutory companies are companies established by a UK Act of Parliament for public purposes (such as the Historic Buildings and Monuments Commission for England). Registered companies Companies may also be incorporated in the UK by Parliament delegating authority to specic persons and by registration with a public ofcial, such as the Registrar of Companies, who has authority granted by Parliament to incorporate bodies on application to the Registrar, following certain specied steps. These are known as registered companies. Registration is now the commonest way of incorporating a company. There are several different types of registered companies, which are discussed below.
Company logos
Companies limited by shares This type of company may be set up (incorporated) under the relevant law of many different jurisdictions. In the UK, the relevant law governing all companies is now the Companies Act 2006. Individuals (shareholders) contribute capital in agreed units referred to as shares, which have a nominal (or par or paper) value, below which they cannot be issued, for example, 1, 5, etc. Certain countries (for example, the USA and some European countries, but not the UK) also permit companies to issue non-par value shares, whereby the amount to be raised is stated, but the value of individual shares is determined by the directors. Where shareholders pay more than the nominal value of a share, the excess over the nominal value is called the share premium and is recorded separately by the company. The amount of capital provided (or subscribed) by shareholders is referred to as share capital and is acknowledged formally by the company giving shareholders a share certicate, which shows the number and type of shares for which the shareholder has subscribed. (Companies may issue different types or classes of shares.) The concept of being limited by shares means that the liability of the shareholders to creditors of the company is limited to the capital shareholders invest, that is, the nominal value of the
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shares and any premium paid in return for the issue of the shares by the company. A shareholders personal assets are thereby protected if the company cannot generate enough cash to pay its bills and becomes insolvent, but money already invested in the company will be lost. A signicant characteristic of a company is that it is a legal person, which means it is separate in the eyes of the law from the people owning or running it (a sole trader is not). It can act in its own name and can make legally binding contracts. It is said thus to have legal personality. An LLP, despite being a partnership, also has legal personality. Although the personal assets of shareholders are protected, as described above, sometimes this is undermined. In many small companies, typically family-owned companies, the shareholders are also the directors. If such companies apply for loans, lenders commonly make it a condition of granting any loan that the directors personally guarantee that the loans will be repaid if the company itself fails to repay them. While this may be an incentive to the directors to do their best to ensure that the company is protable, it does mean that their personal assets will be at risk. A limited company may be private or public. A private limited company is not required by law to disclose as much about its activities and operations as a public company, and can only issue its shares privately. This is the major distinguishing feature between a private limited company and a public limited company, which can issue shares to the general public and trade them on a stock exchange, though it is not compelled to do the latter. Most companies, particularly small companies, are private. If they wish to sell or transfer shares, this will be by a private, not public, sale, and the procedures will be laid down in their Articles of Association. Some countries (e.g., the USA and Malaysia) do permit certain private companies to raise debt nance publicly. In such circumstances, companies in general must comply with the more stringent regulations which apply to public companies in this area. Private companies limited by shares are required to have the sufx Limited (often written Ltd or Ltd.) or Incorporated (Inc.) as part of their name, though the latter cannot be used in the UK or the Republic of Ireland. In the Republic of Ireland Teoranta (Teo.) may be used instead, though this is limited mainly to Gaeltacht companies (i.e., companies situated in an Irish-speaking region). Cyfyngedig (Cyf.) may be used by Welsh companies in a similar fashion. A public limited company must include the words public limited company or the abbreviation p.l.c. at the end of its name (Plc, plc and PLC being deemed equally acceptable). In the Republic of Ireland, the upper case initials CPT (Irish: cuideachta phoibl theoranta) may be used instead. In the UK, Welsh companies may use c.c.c. or CCC (Welsh: cwmni cyfyngedig cyhoeddus) in place of p.l.c. Certain public limited companies (mostly nationalised concerns), incorporated under special legislation, are exempted from bearing any of the identifying sufxes.
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Activity 2.2
Visit the website of the Chartered Institute of Taxation (CIOT), via the link on the B291 website. In the site search box, type in royal charter and navigate through to the CIOTs royal charter, which you will then be able to read. Take about ten minutes to do this.
Feedback
The CIOT was granted a royal charter in 1994, and is one of the most recent instances of this rare form of setting up a chartered company. You will see that the language of the charter is very old-fashioned and may be difcult to understand.
Activity 2.3
Visit the corporate website of Sainsburys (J Sainsbury plc, the UKbased supermarket) via the link on the B291 website and enter annual report into the search box. You should then nd a link to the most recent annual report. It is recommended that you download the annual report as a pdf. You will not need to print the document, but please make sure that you are able to read the pdf on screen. Find the note to the nancial statements headed Called up share capital and share premium account and read the details about share capital there (ignore the part of the note which refers to movements in the called up share capital and share premium account). Note down the things you do not understand. Spend no more than 20 minutes on this.
Feedback
This note looks extremely complicated, but it is not, really. First of all, this refers to the shares relevant to one company only, despite it saying group here. You will see that the company is allowed to issue two different sorts of shares ordinary and preference, with amounts specied. This is referred to as authorised share capital, and is the maximum the company can issue (in number of shares and value), though not all of it needs to be issued. Preference shares are ones on which a dividend has to be declared payable every year and before any dividend on ordinary shares, so they are regarded as a less risky type of investment. The next lines give called up share capital allotted and fully paid ordinary shares and this shows how much of the share capital has actually been issued to shareholders (= called up and allotted). No preference shares have been issued and not all of the ordinary share capital. Fully paid means what it says. Sometimes shareholders are asked to pay only a portion of the share value they agree to pay, but they can be asked for the extra at any time by the company. Share premium is the amount shareholders have paid over and above the nominal value of the shares (see above).
Companies limited by guarantee Under British, Irish and Australian law, a company limited by guarantee is an alternative type of corporation used primarily for non-prot organisations that require legal personality. A company limited by guarantee does not usually have a share capital, but instead has members who are guarantors instead of shareholders. The guarantors give an undertaking to contribute a nominal amount (typically very small) towards the winding up of the company in the event of there being inadequate funds upon cessation of business. A company limited by guarantee must include the sufx Limited in its name, and it is a form commonly used for clubs, membership organisations, including students unions, sports associations
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(for example, the Professional Golf Association (PGA)

European Tour), workers cooperatives, other social enterprises,
non-governmental organisations (NGOs) and charities.
It is often believed that such companies cannot distribute their prots
to their members but this is not actually true, though one which did
so would not be eligible for charitable status and could not put the
word Limited after its name.
Activity 2.4
Visit the website of Oxfam, via the link on the B291 website, and see if you can nd a statement of the organisations objectives and discover what type of organisation it is. Do not be afraid to explore the site. Often websites have a site map tab, which is a useful way of nding your way around if what you want to nd is not immediately obvious. Spend no more than 20 minutes on this.
Feedback
You should nd prominently displayed the following: Oxfam GB is a leading international NGO with a worldwide reputation for excellence in the delivery of aid and development work. Our purpose is to work with others to overcome poverty and suffering. You will also nd: Oxfam is a registered charity in England and Wales (no. 202918) and Scotland (SCO 039042) and a company limited by guarantee registered in England (no. 612172) at Oxfam House, John Smith Drive, Cowley, Oxford, OX4 2JY. Oxfam GB is a member of Oxfam International. There are further links to Oxfams annual review, accounts and strategic plan, which it will do no harm to browse. You will also nd the details about Oxfam being a charity given in the latest annual review.
You will note from the above that Oxfam is both a charity and a company limited by guarantee. People often think that a charity is a legal form in its own right, but it is not. Charity is the objective of the organisation, and has nothing to do with its legal form. A charity in theory can take almost any legal form. It is commonly a company of some sort, or sometimes a trust (see below for a discussion of trusts), and in the UK, will be subject to the Charities Act 2006. However, a charity cannot be a community interest company.
Community interest company
Community interest companies (CICs) are a new type of limited company designed specically for those wishing to operate for the benet of the community rather than for the benet of the owners of the company. This means that a CIC cannot be formed or used solely for the personal gain of a particular person, or group of people. CICs can be limited by shares, or by guarantee, and will have a statutory Asset Lock to prevent the assets and prots being distributed, except as permitted by legislation. This ensures the assets and prots are retained within the CIC for community purposes, or transferred to another assetlocked organisation, such as another CIC or charity. A CIC cannot be formed to support political activities and a company that is a charity cannot be a CIC, unless it has given up its charitable status. However, a charity may apply to register a CIC as a subsidiary company.
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CICs were established by the Companies (Audit, Investigations and Community Enterprise) Act 2004, which also established an independent Regulator to act in relation to them.
Source: Community Interest Companies website http://www.cicregulator.gov.uk [accessed 28 December 2009]
Unlimited companies An unlimited company does not offer shareholders the protection of limited liability and so conceptually it is very similar to a partnership, although it is a body incorporated under company law. It is only used in certain circumstances when there is a particular advantage in being an incorporated company and not having to make the disclosures that either a private or public limited company would have to make. There are only rare occasions when it will be preferred. Examples might be where the company will not trade (e.g., it will only be used to hold a title to property), is trading but in an area where limited liability is not permitted by, say, specic jurisdictions laws or where secrecy concerning nancial affairs is desired (an unlimited company can have fewer reporting obligations), and there is a low risk of insolvency. Regulations governing companies Most countries have some form of corporate law. In the UK, the current legislation is the Companies Act 2006. This was a substantial piece of new legislation for companies and replaced all previous Acts (chiey the Companies Acts 1985 and 1989). The Companies Act 2006 contains many provisions relevant to company nancial statements, such as their format, how much information they must disclose, whether they should be audited, and so on (some companies dened as small do not require an audit of nancial statements). There is also a considerable body of formal accounting regulations which apply to UK based companies, such as Financial Reporting Standards (FRSs) and/or International Financial Reporting Standards (IFRSs). You will learn more about the regulatory framework for company nancial statements in Session 3. Unincorporated associations The term unincorporated association is usually used to refer to an association of persons, who are not incorporated or a partnership. The distinction between an unincorporated association and a partnership is that partners carry on a business in common with a view to making prot, whereas unincorporated associations generally have no prot motive and are formed to look after particular interests of their members. These interests may be employmentrelated (e.g., trade unions, mutual societies, cooperatives) or may relate to leisure or social activities (e.g., golf clubs). Unincorporated associations raise money by levying joining and/or membership fees. They are not subject to any formal regulations governing the production of nancial statements.
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Trusts A trust is a formal arrangement set up usually by a document known as a trust deed, whereby assets or money are transferred by one person (the settlor) to one or more others (trustees) to hold, administer, make payments, etc., for the benet of one or more persons (beneciaries). Trusts in general are not active business entities, but you may frequently encounter them or hear them being mentioned. Many pension funds, for example, are set up as trusts. There are often specialised regulations governing trust nancial statements and we do not go into this topic in B291. Other types of organisational forms You may at this point be thinking about other types of organisational forms that you have heard about, such as branches, divisions or groups of companies. Branches and divisions are not separate legal entities, but are subsidiary parts of a larger entity, most often a company, and are usually dedicated to selling or manufacturing a particular product or range of products or delivering a particular service. The nancial results of branches and divisions are added in to the main nancial statements of the larger body. While it is possible to produce branch or divisional nancial statements (and this is often done, especially for management accounting purposes), these are not published externally as separate nancial statements, though large companies will disclose detailed information about branches or divisions in the notes to their nancial statements. Groups of companies exist when one company, referred to as a parent company, owns the shares of one or more other companies. You may often see the term holding company used instead of parent company in this context, as both are terms used to denote a company which owns shares in other companies. Typically accounting dictionaries do not differentiate between the two terms, but in practice there may be several differences. While a parent company will always be a holding company, by denition, a holding company may not always be a parent company, as it may just own shares in, say, a sub-group of companies which carry on similar types of business, and may be itself owned by a parent company. Often, too, a parent company may carry out business activities as well as owning shares, whereas a holding company is unlikely to do so: the latter is typically a more passive entity. Holding companies are often used for tax purposes, as, for example, they facilitate in a tax-effective manner the repatriation of income earned outside a groups home jurisdiction. Where the parent company controls another company (most obviously when it holds more than 50 per cent of the shares carrying voting rights of the other company), the owned companies are referred to as subsidiary companies. If a company is less than 50 per cent owned, the actual percentage and level of control determine whether the owned company will be considered as an associated company or simply as an investment. There are special ways of adding together
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the results of the parent company, subsidiaries and associates to produce group nancial statements (sometimes called consolidated nancial statements). We do not in this module teach you how to produce group nancial statements (though the process is just an extension of the double-entry bookkeeping you will learn in Units 2 and 3 of B291), but you will learn to understand and use them in Unit 5 (when you learn how to do nancial analysis), as most of the companies with shares traded on stock exchanges throughout the world are groups of companies. Some of these groups are very large and contain hundreds, if not thousands of companies, located in different parts of the world. They are often referred to as multinational companies (MNCs) or multinational enterprises (MNEs) (though the latter term is not specically conned to companies). However, private limited companies can also form groups. Activity 2.5
Look again at the pdf of the J Sainsbury plc latest annual report that you downloaded in Activity 2.3. This is an example of a set of group nancial statements. Take some time (about 20 minutes) to browse through these statements.
Feedback
You will no doubt be thinking that this is a long and very complicated document, and be wondering what you have let yourself in for on this module. Do not worry. This is just a taster. By the end of Unit 5, you will feel much more comfortable with published sets of nancial statements.
2.2.4
Classication by reference to prot aims
Sometimes organisations are classied in accordance with the principles underlying their chief activity namely, in accordance with whether they are seeking prots or not. Often non-prot organisations are subject to specialised requirements for the format and presentation of their nancial statements. For example, in the UK, charities must generally comply with the requirements of the Charities Act 2006, which has specic sections on nancial statements. Prot-seeking organisations are typically sole traders, partnerships and companies. These are discussed more fully in Section 2.2.3, under different legal forms. Prot-seeking organisations may have several different objectives. For a very long time, it was generally accepted that maximising the wealth of their owners and continuing in existence were the primary objectives of prot-seeking organisations. However, as organisations also aim, for example, to provide goods and services to customers and employment to employees, it is, perhaps, more reasonable to suggest that increasing, rather than maximising, the wealth of owners, is a more tting objective. All of the aforementioned objectives do require prot to be made in the longer term. Non-prot organisations, on the other hand, do not see wealth maximisation/increase as their main objective, but seek to satisfy the particular needs of their members or sectors of society. Such organisations are referred to as not-for-prot
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organisations (NFPs) or non-prot organisations (NPOs), and might include:

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government departments and agencies, for example, in the UK, HM Revenue & Customs (HMRC), the purpose of which will be to implement government policy schools, where the chief objective will be the provision of education hospitals, where the main aim will be to treat the sick charities, where the aim will be to provide relief or benet, the particular kind depending on the nature of the charity, such as relief of famine or hardship (Oxfam) or educational services (The Open University) clubs and societies, where the aim will be to foster the interests of members local councils, where the aim will be to provide services, for example, waste collection, street lighting, etc., to a community within a dened area mutual organisations (e.g., some building societies, trade unions, and working mens clubs), where services are provided from members subscriptions to those members.
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Activity 2.6
Refer back to Activity 2.4 and revisit the Oxfam website. Also look at HMRCs website, via the link on the B291 website, and nd out what they do. Take about ten minutes to do this.
Feedback
Please refer back to Activity 2.4 feedback for details about Oxfam. Note again that it said: Oxfam GB is a leading international NGO with a worldwide reputation for excellence in the delivery of aid and development work. Our purpose is to work with others to overcome poverty and suffering. Oxfams charitable status was also emphasised. For HMRC, you should nd: HM Revenue & Customs (HMRC) was formed on the 18 April 2005, following the merger of Inland Revenue and HM Customs and Excise Departments. Work is still continuing on our ofce restructuring programme. We are here to ensure the correct tax is paid at the right time, whether this relates to payment of taxes received by the department or entitlement to benets paid. (This relates to the UKs tax authority, but most countries have a website for their national tax authority see, for example, the USAs at www.irs.gov.) The HMRC page also refers to the following activities: l collection and administration of direct taxes (such as income tax and corporation tax) and of indirect taxes (such as petroleum revenue duty and Value Added Tax (VAT))
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payment and administration of child benet, child trust fund and tax credits protection of the citizen by enforcement and administration of border and frontier protection, environmental taxes, national minimum wage and recovery of student loans.
(Did you know that HMRC did all this?)
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2.2.5 Classication by reference to ownership/ control

A nal way of classifying organisations is by reference to whether they are in the public or private sector and who owns them. The public sector is concerned with providing government services and will be controlled by government organisations. Although what constitutes the public sector varies from country to country, in general the public sector will include services such as the police, military forces, public roads, etc. The private sector comprises organisations not controlled by government, so will include business, charities, etc., that are not under national ownership. Activity 2.7
Revisit Activity 2.4 (including feedback) and Activity 2.6 (including feedback) to see examples of what private and public sector organisations do. Spend about ten minutes doing this.
2.2.6
A nal word on organisational classication
The discussion in Section 2.2 about organisational classication applies commonly throughout capitalist economies, as ideas about legal forms in terms of sole traders, partnerships (including limited liability partnerships) and companies limited by shares are valid across different jurisdictions and cultures. While we have not gone into detail about the historical development of these ideas, they are all well established ideas, which have been in existence for a very long time. For example, the modern notion of limited partnership had its origins in the Qirad and Mudaraba institutions in mediaeval Islamic law, and accompanied the development of large scale international business operations. There will, however, be some variations, so one could not expect a limited liability partnership or company in the United States, for instance, to be exactly the same as in England, as under the US system such entities are governed by the laws of 50 states individually. Also, there may be additional, slightly different legal forms. For example, the USA has several different types of corporate entity with different degrees of limited liability that are subject to different tax regulations, which is a crucial difference between them. While different legal systems implement concepts differently, the underlying concepts, however, remain the same.
2.3 Functions of accounting in different types of organisations

In Section 1.1.2 you learned that accounting is a process which identies, organises, classies, records, summarises and communicates information about economic events, usually, but not exclusively, in monetary terms. The same kind of bookkeeping will be done by any kind of entity, but the functions of nancial accounting will vary between different types of organisation, and may be inuenced by their size and legal form.
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All organisations will need to know if they have made a prot/surplus or not. This is a very important function of accounting. For a non-prot-seeking organisation, like a charity, this will show if it has expended too little on its charitable objectives. For prot-seeking organisations (sole traders, partnerships and most types of companies) this will be the starting point for working out how much tax will be payable to the tax authorities. Knowing how much prot has been made is important in terms of how much a sole trader and partners may withdraw from their business hence, it can have a direct effect on their quality and style of living. Similarly, it is important for companies to decide how much prot can be paid out to shareholders by way of dividends. Branches and divisions will need to know if they, as part of a larger body, are making sufcient prots to ensure their survival. Financial accounting prot may be important for deciding branch or division management bonuses similarly for the larger body to which they belong. Prot that is not taken out of a sole tradership or partnership or paid out as dividends by a company will be retained by the business. This will help the business grow and invest in new assets or opportunities. Therefore, there is a balance to be struck between paying out or withdrawing prot and retaining it within the business. For companies, there are legal restrictions governing how much prot may be distributed as dividends, but no such restrictions apply to prots withdrawn by sole traders or partnerships. Formally drawing up a balance sheet shows the nancial position of a business at the end of an accounting period, and will show the value of assets and liabilities. If assets are included on the balance sheet, this is prima facie evidence of their existence and value. Existence and value are especially important if a business has bank or other formal loans, as loans might be secured on one or more of the assets. Formally drawing up a balance sheet will show whether or not such assets are still owned by the business, and their physical condition should be reected in their stated value. Banks which have loaned money to a business may routinely want to see its nancial statements to make sure that assets on which a loan is secured still exist, and have not been sold; to see that a loan is likely to be repaid; to ensure that enough prot is made to cover interest payments due; and to check generally that conditions under which a loan was made have not been breached. The existence of formal procedures to check on the existence and value of assets is also likely to discourage theft and embezzlement. Moreover, if a business is applying for a loan, a lender will want to see up to date nancial statements (as well as various types of management accounting information). Some business entities, most typically large public companies, the shares of which are traded on a stock exchange, produce nancial statements every three or six months, as well as annually. Such nancial statements are referred to as interim nancial statements and are often required as a result of the shares being publicly traded. Their purpose is to inform investors and nancial markets in general about what is happening in the company. Public companies are also required to issue prot warnings if their prots are not expected to be in line with forecasts.
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2.4 Users and stakeholders needs

One of the main functions of nancial accounting is to communicate information to interested parties. We look in this section at the specic needs of various users and stakeholders and examine how nancial accounting information, as shown in income statements, balance sheets and accompanying notes, can address those needs. Some users and stakeholders have a direct interest in an organisation because of a degree of personal involvement of some kind, that is, they run or work for the organisation (such as management and employees) or have invested personal money in it (such as shareholders in a company). Other stakeholders interests may be nancial, for example, an interest in the ability of the business to meet various nancial liabilities, or may be focused on the effect of the businesss activities on society and the environment. Depending on the nature of the stakeholder, the interest may still be quite personal in terms of effect on a particular person/ entity, or it may be more remote. Stakeholder theory is a term often given to such a wider attempt to consider the interests of all stakeholders in a business, rather than focusing on the narrower idea that a business is responsible only to its owners. You should also note that accounting information, as shown in published nancial statements of companies, for example, is heavily regulated, and some of that regulation is in place to ensure that certain user needs (e.g., those of shareholders) are met. Figure 6 below shows typical users and stakeholders with an interest in public company nancial accounting information. Their particular interests and the reasons for them are then discussed. (Stakeholders in private companies would also have similar interests, but the information to address them is not publicly available.)
Investors Special interest groups Customers
Management
Suppliers
Users
Employees
Lenders
The public Competitors
Government
Figure 6 Different users and stakeholders with an interest in public company nancial statements
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2.4.1
Investors
Usually, investors in this context mean the suppliers of risk capital, therefore, they are shareholders who invest money in a business and will be interested in the security of their investment, and also the returns they may receive from their investment. This is particularly the case of shareholders in public companies. They will thus be interested in prot levels, liquidity and cash ow, which will determine the level of dividends they receive, and in the nancial strength and solvency of the company as shown in the balance sheet. Past prots may also be a guide to how well the company will perform in the future, so the same information that is of interest to current shareholders will also be of interest to potential or future shareholders. The largest group of investors in publicly traded shares is institutional investors, such as pension funds and unit trusts, as they own signicantly more shares than any other shareholder.
2.4.2
Customers
Customers need to know whether a business will be able to continue supplying them with goods/services in the future, especially if they deal with a business regularly or signicant sums of money are involved. They will look to see that a business is regularly making a prot and for signs that it is solvent in the long term. This is especially important if the goods/services provided are specialised. Customers might, however, be concerned that goods sold to them have been overpriced if they perceive that prot levels are very high.
2.4.3
Suppliers
Suppliers will need to know that they will be paid what is owed to them, so they will be interested in a businesss nancial health, especially in terms of its solvency, so they will look to see that the balance sheets show healthy amounts of cash, and there are no overdrafts or large loans. New suppliers may seek assurances about such matters before agreeing to supply goods to a business, especially on credit terms.
2.4.4
Lenders
Lenders need to know if loans made will be repaid, and that interest due on loans will be paid when it falls due. There are different kinds of lenders. They range from banks (high street and merchant banks) through to individual and institutional investors in various kinds of complex loan instruments (these are discussed in detail in Section 3.3). Their interests will, however, be broadly similar, and focused on the protability and the solvency of a business. If assets have been used as security for loans, then they will also look to ensure that assets are retained (this is shown in a balance sheet). Potential lenders approached by businesses for new loans will examine the same nancial aspects. This has already been discussed in Section 2.3.
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2.4.5
Government
Various government agencies and departments will be interested in nancial results for different reasons. For example, HMRC will use the prot shown by income statements as a starting point to assess how much tax is payable; the Department for Business, Innovation and Skills may be interested in collecting data about certain aspects for statistical analysis; and the Department of Work and Pensions may be interested in numbers of jobs created or lost. Government should also be taken to include local government, which will be interested in things like jobs created and investment in its region.
2.4.6
Competitors
Competitors will wish to compare their own performance with that of their rivals, and will carry out various detailed analyses to evaluate strategic advantages, and so on.
2.4.7
The public
The general public will often wish to assess the effect of a business on the economy, the environment and communities, at local, national and international levels. Businesses may, for instance, contribute to a local economy by creating employment and obtaining goods from local suppliers, and may disclose this in nancial statements. Some businesses actively support particular communities by sponsoring local events, providing education, and so on. Media services might also be included under this heading as well, as they are typically interested in the same type of things as the general public, although often with a different perspective.
2.4.8
Employees
Employees (and also trade unions) will wish to know about the security of their jobs, pay rises, pension issues and potential redundancies. Therefore, they will be typically interested in the long-term survival of a business as indicated by continued protability and long-term solvency. They will also often be interested in directors salaries and benets.
2.4.9
Management
The management of a business will also be interested in nancial accounting information, especially prots, as bonuses may depend on them. They will also be interested in information for budgeting, planning, decision making and control purposes, but this is more typically management accounting information which is not made public in the same way as nancial accounting information.
2.4.10
Special interest groups
There may be special interest groups which are very interested in one or more aspects of a business. An example might be an environmental body interested in how a chemical company disposes of toxic waste or a rm of nancial analysts which gives investment advice to clients.
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Activity 2.8
In which category of users or stakeholders do you think the following t? 1 2 3 Greenpeace Ms Brown, the managing director of Zip Ltd Mr Jones, who is thinking about buying some shares in Sainsburys
4 Mr Smith, who is one of Zip Ltds sales representatives Spend about ten minutes on this.
Feedback
1 2 Special interest group Greenpeace is an environmental pressure group. The managing director is part of the management stakeholder group, but as managing director, if she is a competent and conscientious director, she will also be concerned about ensuring that other stakeholders needs are addressed. Mr Jones is a potential shareholder of Sainsburys, so he will fall into the shareholder group. Mr Smith is one of Zip Ltds employee stakeholders.
3 4
Summary
In this session you have learned about the context of accounting, with a focus on different organisations objectives and different ways of classifying organisations (by reference to primary activity, legal form, prot aims and ownership/control), and how this can be important for accounting purposes. You have also learned about various functions of accounting and different users and stakeholders perspectives and needs. In Session 3 we will go on to look at the wider, external context of accounting by helping you to understand how accounting has developed and the ways in which environmental factors inuence or place constraints on the development of business and accounting practices. We will thus consider political and legal factors; macroeconomic and scal policy; nancial and capital market issues; and social, demographic, technological, professional and regulatory inuences.
Session 3 Environmental inuences and constraints on business and accounting
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SESSION
3 0Environmental inuences and constraints on business and accounting

Introduction
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explain briey the history and development of accounting and nance in business indicate how environmental inuences (such as political, legal, economic, social, demographic and technological factors) impact on business and accounting relate the development of nancial and capital markets to the need for reliable and relevant accounting information and the development of nancial accounting standards describe the organisation of the accounting profession in the UK explain how regulatory frameworks and the organisation of the accounting profession inuence the development of accounting standards, rules and practices describe the accounting regulatory framework in the UK describe the international accounting regulatory structure and the International Accounting Standards Board (IASB).
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In Session 3 you will learn about the history and role of accounting in business and the various environmental inuences and constraints on business (such as political and legal factors, macroeconomic factors and social, demographic and technological inuences), as well as nancial and capital markets. These provide the wider context in which both organisations and accountants operate. In addition, you will learn about the further regulatory constraints governing the work of accountants within that wider context, including the organisation of the profession.
3.1 The history and development of accounting and nance in business

Accounting for private business dates back to the origins of capitalist organisations. History points to auditors and accountants developing together. The earliest records show that information was recorded using simple stone and wood devices (see Table 2). Then, in Ancient Egypt, the introduction of papyrus (paper) and ink made recording information quicker and easier.
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Table 2
A history of accounting
1650 1776 1789 British develop concept of Corporation. U.S. Declaration of Independence. Benjamin Workmans The American Accountant the earliest known U.S. accounting textbook. First income tax law in Great Britain. THE ADDING MACHINE. William Burroughs patented the first commercially successful calculating machine. U.S. Income Tax Act. THE PEGBOARD. Pegboard system based on write-it once principle. Securities and Exchange Commission created. THE COMPUTER. First commercially successful computer, UNIVAC 1, containing 5,500 vacuum tubes. THE POCKET CALCULATOR. Originally sold for $100. THE PERSONAL COMPUTER. First commercially successful PC, the Micral, French, preceded the IBM PC by 8 years. VISICALC. First computer spreadsheet program. Ushered in widespread use of Personal Computers. LOTUS 1-2-3. Created in 1982. Lotus takes VisiCalcs place as most popular spreadsheet program. QUINCENTENNIAL. 500th anniversary of modern accounting.
A PERIPATETIC HISTORY OF ACCOUNTING 4000 BC THE PAINTED PEBBLE. A form of accounting by painting dot-dash patterns on pebbles. THE CLAY TABLET. Babylonians recorded business transactions on clay tablets. THE ABACUS. First appeared in Babylonia. THE COIN. Earliest coins have been traced back to Lydia, now the northwest corner of Turkey. Earliest known Partnership records. THE TALLY STICK. Used to keep tax records in London. Leonardo Pisano demonstrates the superiority of Hindu-Arabic numerals over Roman numerals and the arrangement of accounts in regular columns. Accounting added to curriculum at Oxford University. First printed books. Birth of Leonardo da Vinci. Columbus arrived in America with Bernal de Pisa, his chief accountant. THE TEXTBOOK. Fra. Luca Pacioli published first accounting textbook.
3500 BC
1799 1892
1700 BC 700 BC
1913 1920
1157 1200 1202
1934 1951
1249 1446 1452 1492 1494
1971 1973
1978
1983 1509 1564 1640 Henry VIII becomes King of England. Birth of Shakespeare. Pascal designs a machine to process tax data. 1994
(Note that the above table is somewhat selective about the items it includes!)
It appears to be some sort of tax cut promise.
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Forensic scientists have now determined that the fall of the Roman Empire was due to an accounting error.
Maintaining sums and totals grew to such importance during Roman times that ofcials known as quaestors were responsible for examining the accounts of provincial governments on behalf of Emperor Augustus. These quaestors were, perhaps, the rst auditors. During the Renaissance in the fourteenth and fteenth centuries a small elite of public accountants in northern Italian cities (e.g., Venice, Florence and Siena) fought for written records of transactions to be kept. Alongside this, there was a need for nancial records to be examined and veried. As the practices of auditing and accounting developed, they began to respond to the needs of private
Detail of fruit and grain merchants, from 'De Sphaera' c.1470 by De Predis, Cristoforo (1440/4586) (attributed to) Biblioteca Estense, Modena, Italy/Giraudon/ The Bridgeman Art Library
Fruit and grain merchants in the marketplace
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investors and entrepreneurs. For example, Italian merchants engaging in trade with the Middle East and Far East needed to know the nancial state of affairs of people who came to them for loans or funding. It was the need to control nancial relationships between these merchants and their creditors and investors that led to the development of banking and double-entry records and reports. Much later, during the Industrial Revolution (in the eighteenth and nineteenth centuries in England), a tendency developed to employ accountants, sometimes known as public accountants, to perform various nancial functions, including installing bookkeeping systems for new enterprises as well as winding up failed companies, that is, sorting out the affairs of companies which had become insolvent and were unable to pay their bills. The concept of auditing became important towards the end of the nineteenth century, as shareholders who did not participate in day to day management of companies needed assurance that investee companies were being properly run. The rst person in Western Europe considered to have practised auditing on a full time basis was a Scotsman named George A. Watson, who was born in 1645 in Edinburgh. As the need for common criteria for accounting practice became more important, public accounting grew to be regulated by professional institutes, societies and associations. By the end of the nineteenth century, accounting bodies had emerged. Their role was to establish, design and manage written examinations and quantitative grading as a way of regulating the entry of new people to the profession of public accountant, and assuring the provision of high quality accounting services therefore, allowing accounting rms to develop good reputations.
More on the history of accounting and accountants This discussion of the history of accounting and accountants is necessarily brief. Further relevant material can be found at http://www.acaus.org where the paper by John R. Alexander, entitled The History of Accounting, may be freely downloaded. A link to this paper will also be provided on the B291 website.
The professionalisation of accounting and auditing reected developments that were taking place in the management of enterprises. Once reliant on the skills of the entrepreneur, management moved towards a scientic approach that could be learned and taught. Today, the accounting profession is itself an international industry which gives clients advice on a wide range of different issues, some of which derive from the nature of the business they do, while others arise from the need to deal with and account for the external inuences and constraints of the environments in which they operate. Sections 3.23.5 consider these environmental inuences and constraints.
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3.2 Environmental inuences

3.2.1 Introduction
Organisations will carry out analyses of their external environment as part of their overall business planning to identify the constraints under which they must operate, to identify potential threats and opportunities, and often to determine whether they will need professional accounting or business advice to deal with them. Generally, the major environmental factors impacting on an organisation can be grouped under four headings: political/legal, economic, social/demographic and technological (reected in the acronym, PEST analysis). These factors will be considered in greater depth in Units 1 and 7 of B292, but the brief outline given here is adequate for the purposes of B291.
3.2.2
Political and legal factors
The political systems of countries in which organisations operate will impact on them in various ways. The prevailing political ideology of the government of a given sovereign state may mean that business can only operate in a certain way, such as being state owned under certain socialist regimes. Some governments might set up trade barriers to prevent goods being exported or imported and/or not allow businesses from overseas to operate within their jurisdictions. The laws and regulations which governments implement affect ways of doing business, for example, in terms of the law of tort, contract law or company law, which regulate different aspects of business behaviour, such as negligence, how deals are made, how nancial statements should be presented and what they should contain. Tax law, too, is important in that it determines how much tax a business will need to pay on its prots, but it can also be used to offer incentives to businesses to undertake certain activities in preference to others (e.g., set up an operation in a low employment area by giving various tax allowances or subsidies). Other areas of law that generally affect organisations are employment law, health and safety legislation, consumer protection legislation, environmental legislation and data protection legislation. The sources of law depend on whether a country operates under a system of common law or codied law. In a common law jurisdiction (such as the UK, USA, Australia, Canada and New Zealand), the sources of law are generally national Acts of Parliament, decisions of senior courts (e.g., the Supreme Court in the UK and the USA), and other major courts through the principles of case law and setting of legal precedents. Sometimes, too, there are regional sources of law (such as bye-laws issued by local councils in the UK or individual state laws in the USA). The decisions of courts and principles developed in case law are of particular importance in common law jurisdictions, as law develops incrementally in accordance with decisions made in certain courts, and is not all embodied in particular statutes. In the UK, for example, much of contract law is based on common law. In codied law systems, such as those in much of continental Europe, law is
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embodied in a series of codes (e.g., commercial, civil, scal and penal) and other sources of law are not so signicant. Additionally, these days, countries must often abide by legal rules set by international bodies with power superior even to their own parliaments, such as the European Parliament, the European Courts and the International Court of Justice. There are other supranational organisations, such as the United Nations and the World Trade Organisation (WTO) (which sets rules on trade between signatories), where members are bound by contractual force, though the organisations themselves cannot set legally binding regulations. The difference between common law and codied law systems is mirrored to a certain extent in accounting, too. In countries with codied law, setting accounting regulations was regarded as the domain of law. However, in common law countries, regulation was often left to the private sector as was the case with the accounting profession and various stock exchanges. In common law countries, regulations tended to be principles-based, rather than codied into a set of rules, and the issue of whether accounting regulation should be rules- or principles-based remains a topic of debate. The USA, despite being a common law jurisdiction, is inclined towards rules. The powerful political inuence of certain industries has also contributed to differences in accounting regulatory structures in attempts to protect particular interests.
3.2.3
Macroeconomic factors
Economics involves the study of how resources are created and allocated to various competing purposes. Resources are often in short supply, so there are never enough to go round and make or produce everything that everyone would want. Microeconomics focuses on the economic behaviour of individual organisations, industries and consumers, and macroeconomics focuses on the aggregate workings of the economy as a whole, such as the overall (or aggregate) demand for goods and services, the output of goods and services (national output/ product), the supply factors of production and total incomes earned by production factors (national income). Macroeconomics, therefore, determines the wider environment in which an organisation operates. Given that resources are scarce, there are always basic questions as to the amount and type of goods and services that should be produced and who should make/produce and receive them. This has many implications for individual rms, often in terms of their ability to make a prot or how they should account for use of resources. In a market economy, interaction between the market forces of supply (producers) and demand (individual consumers) determines the answers to these basic questions. In the purest form of market economy, there would be no government intervention (nor, indeed, any non-prot organisations or charities). However, in practice, most economies are a mix between free market economics and government intervention to provide public services, such as law and order, education, health care, social services, etc.
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In general, governments have four main macroeconomic objectives. These are as listed below. 1 control of economic growth 2 control of ination and deation 3 ensuring adequate levels of employment 4 controlling the balance of payments making sure that imports do not signicantly exceed exports (or vice versa). If signicantly more goods are imported than exported, a trade decit arises, which needs to be nanced.
Weve got a balance of payments decit
There is, perhaps, a common factor underlying the above four main objectives, namely that of ensuring national economic and political stability, such that a country remains a going concern at all levels and across all sectors of society. Macroeconomic policy choices There are various policies governments may pursue to keep an economy viable, or use in combination to address particularly issues of economic growth, unemployment, ination or the balance of payments, as discussed below. Fiscal policy This refers to a governments taxation and spending plans. However, some people use the term taxation policy to refer to the way a government raises income through taxation and use the term scal policy to refer just to government expenditure. Governments generally use scal policy to ensure that they have a balanced budget, that is, where government income is equalled by government expenditure. In practice this is difcult to achieve, and often expenditure exceeds income (a budget decit), though sometimes income exceeds expenditure (a budget surplus). Either effect may be achieved by changing costs (reducing/increasing public expenditure) or revenue (increasing/decreasing tax rates) or a mixture of both.
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Fiscal policy impacts on businesses in the form of the taxes they must pay, which they need to be able to calculate, for which they will need to put appropriate entries through their books and which, if appropriate, they may need to report in their nancial statements. Depending on their legal form, size, type of activity, etc., businesses may have to deal with a variety of taxes, for example, income tax, corporation tax, business rates, capital gains tax and Value Added Tax (VAT). They will also need to collect employment taxes from employees wages to pay to the tax authority in due course. (Unit 3 will look at VAT and taxes on wages in more detail.) Complying with tax legislation creates a burden for businesses in terms of administration, and often, additional costs if they need to obtain professional help from a tax adviser to ensure that all requirements are met, as these can be complex. Part of this complexity lies in the technical difculty associated with calculations, but much of it derives from the fact that individual taxes often have a long history, and the ways that they are applied, and to whom or to what, continually change.
The best way to boost the economy is to lower taxes. The best way to lower your taxes is to reduce your income. Paying you less is my patriotic duty!
Monetary policy Monetary policy refers to the management of the economys money supply, which is the total amount of money in the economy. There are many different ways of estimating this. Monetary policy involves measures either to increase the total supply of money in the economy (an expansionary policy) or to decrease it (a contractionary policy). There are several measures which can be used to different effect, namely changing interest rates, setting reserve requirements for banks, or trading in open and foreign exchange markets. Controlling the money supply in these ways is also referred to as monetarism or monetarist theory. Attempts to control the money supply have an impact on businesses in terms of the availability of money to borrow. If it is difcult to borrow money, either because lenders are unwilling to lend, or because interest rates are high (both contractionary effects), businesses may be unable to continue to operate. Lack of funds to borrow may also compel businesses to turn to other sources of funding, such as retained earnings. In general, harsh economic times
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may push businesses into trying to show their results in the best possible light and the use of creative accounting techniques to achieve this (see Section 3.6).
3.2.4
Social and demographic factors
Social factors relate to the impact of societal structure and changes on business. For example, the existence of different groups within society (as dened by income, education, profession, etc.) creates the potential for different customer groups with different demands (e.g., single parent families requiring low cost housing or child care for parents in work). Changes in peoples attitudes, values and lifestyles will also create different demands, for example, greater awareness of the food we eat and where it comes from in terms of animal well-being, also greater concern about environmental issues, such as greenhouse gases. A concern about environmental issues could translate into a changed attitude to the recycling of waste (to minimise use of landll for rubbish and use of plastic to provide packaging products, etc.). Changes in tastes and fashions can also have an adverse effect on organisations which do not anticipate changes or do not accept them. Clothes, cars and items such as mobile phones are examples of things subject to such changes, and organisations which make or supply them must be able to adapt to survive. Demographic factors relate to the population and groups within it. It is important for organisations to know about population size, and its composition and location. An increasing population size may, for example, indicate a growing market and availability of a workforce. Birth rates, death rates, immigration and emigration will determine population growth or decline, and these things vary across the world. Rates of birth and death also determine the age prole of a population. Some countries have noticeable imbalances, with, say, a relatively young population (making them attractive to rms needing a large workforce) or an older one (creating problems with availability of pensions). Where a population lives and how densely it is packed together are also signicant. There is an increasing proportion of the worlds population living in cities, which has various implications for the type of goods and services they might need and consequently for the organisations which might provide them. The amount of disposable income which people have, their level of education and their health also signicantly affect businesses in terms of the luxury goods they might buy, the skills present in the workforce, and, indeed, the availability of that workforce in the rst instance. For example, the incidence of HIV/AIDS in sub-Saharan African countries, notably South Africa, means a changed population structure with fewer people in middle age normally the most economically active group, and one which supports elderly and young people. In many Western countries, eating habits and obesity are a major concern, which has implications for the fast food industry. Health issues also create greater demands on the medical profession and healthcare providers generally.
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In terms of accounting, social and demographic factors have considerable impact. Organisations will need to adapt to changes in social and demographic trends to survive. There is an increasing expectation upon them to be good corporate citizens and account for their effect on the environment and ensure that they are seen to be accountable. They will be concerned to train/educate employees, if necessary, and negotiate wage, pension and possibly health costs, and account for them.
3.2.5
Technological factors
Technology, especially information technology (IT), has had an unprecedented effect on business. It has changed working patterns, by enabling people to work more exibly and from home (via secure internal networks). Some posts now do not require people as a computer program can do the job instead, or sometimes a robot or automated production line (which also reduces the need for as many supervisors). In general this has resulted in organisations employing fewer personnel (downsizing) but not necessarily reducing the work or output, and having fewer hierarchies within management (delayering). IT systems are also used for scheduling and monitoring of production, to eliminate bottlenecks, to produce lower inventory holdings and to generate better quality products at lower cost. Technological changes have also resulted in an increase in outsourcing. This means contracting out to specialist providers work which had hitherto been done within a business. Organisations have always had an option to do this, but often chose not to, so that they could retain greater control over production processes and could meet demand on time. However, technological advances, which allow suppliers access to internal computer networks, now permit outsourcing without the loss of control. Technological advances have also brought about changes in many products by making them smaller or more sophisticated (e.g., the mobile phone). Some business models have changed completely, such as banking and insurance, where removal of barriers has allowed supermarkets to enter the market, with either home- or overseasbased call centres providing customer care, instead of face to face operatives in a bricks and mortar structure. As well as affecting employment patterns and production processes, technology has affected all aspects of marketing within organisations. For example, price comparison sites, whereby supermarkets or insurers advertise their prices, rely on IT, as do promotions via websites and viral and banner advertisements, direct selling via the Internet to a wider range of possible customers and market research (via databases). In terms of accounting, technological developments have meant that accounting for changes in production methods and demand for products and services can be done very swiftly, accurately and efciently, particularly in terms of providing costing information; that information can be disseminated very swiftly; and that business statistics can be produced very quickly for analysis purposes.
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Computerised accounting programs (see Unit 2) have meant that double-entry bookkeeping can be done with great accuracy and reliability, and that vast volumes of transactions can be processed easily and speedily.
3.3 Financial and capital markets and institutions

3.3.1 Different types of markets
Before considering the impact and inuence of nancial and capital markets on business and accounting, it is necessary rst to explain the difference between the various kinds of markets. Financial market is a general term which refers to a market where nancial assets, including currencies, are traded. Depending on their precise nature, non-currency nancial assets may sometimes also be referred to as nancial contracts, nancial claims and nancial instruments, and would include things like shares (also called equities) and various types of debt nance instruments (e.g., bonds, debentures/loan stock). There are many different names for debt nance instruments, which can also be called securities. Securities is often an umbrella-type term used to refer generally to both shares and debt instruments. A capital market is more specically a market for trading in long-term nancial assets or contracts. Here long-term generally means that they last more than one year. Stock exchanges, where shares and bonds are traded, are capital markets. A money market is a market where currencies and short-term nancial contracts/assets are traded. Here short-term means lasting a year or less, and would include short-term loans, but also bills of exchange, trade bills and Treasury bills. The transactions take place mostly between nancial institutions, such as banks. The term currency market can also be used to describe a market on which currencies only are traded. Put simply, nancial market = capital market + money market. In Section 2.2 you learned that companies primarily raise equity and debt capital from investors by means of shares and debentures to commence business and also to enable expansion. This is referred to as direct nancing. They may also borrow money. Often they will borrow from banks or other nancial institutions. This kind of nancing is called indirect nancing (or intermediated nance), as the money comes from, for example, savers deposits, which the bank then lends out, acting as a nancial intermediary. Large companies frequently operate on an international basis in several different countries, and so may raise nance at an international level, which brings into consideration the above markets in more than one country. Accountants are often involved in the raising of nance as well as accounting for it as capital introduced. Capital needs to be accounted for in accordance with different regulations, which govern how it is classied for balance sheet purposes and disclosed in notes
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to nancial statements, so it is important for accountants to know and understand the nature of nancial and capital markets and institutions.
3.3.2
The nature and role of nancial markets
A nancial market, as the denition above implies, is a place where those who wish to borrow or raise capital can meet those who are willing to provide it. There are two main types of nancial market: 1 2 Primary markets. These deal in new issues of nance, such as issues of new shares or debentures. Secondary markets. These deal in trading of what might be termed second-hand or pre-owned nancial assets of various kinds, for example, securities, bonds, debentures/loan stock. They do not provide new funds, but allow holders of existing assets to sell them on to other investors. It is thought that a well developed secondary market should reduce price volatility of traded assets through regular trading activities.
A stock exchange is, by denition, a secondary market as it does not deal with the issue of new shares or debentures. Before shares or debentures can be traded on a stock exchange, they must rst be listed as a separate exercise by satisfying that exchanges listing requirements. Once listed, shares and debentures may be bought and sold. The London Stock Exchange in the UK, for example, deals in two major types of security company securities (shares and longterm loan stock/debentures) and public sector stocks. (We will look below in more detail at the role of a stock exchange and at the London Stock Exchange as an example of a stock exchange.) London is also a major market for international bonds (also called eurobonds). International bonds are issued to raise debt nance in different countries by governments, supranational organisations, banks and large companies. There is also a London money market, although there is no physical market place, as transactions are conducted by telephone, telex or electronically.
3.3.3
The role of a stock exchange
Most people have heard of the London Stock Exchange as it is one of the oldest and most famous in the world, and still one of the most important. The word stock is an old word for a number of different things and can mean commodities, business capital or money invested in a commercial enterprise, and also property held for public purposes by a nation, so it is not surprising to see it used in this way to refer to a nancial market. Stock is also a common term for US ordinary shares. It should not in this context be confused with the concept of trading stock, which we refer to in this module as inventory. Share is a term which reects the concept that capital can be divided. Most countries with well developed and internationally operative nancial systems have a stock exchange. A stock exchange, as we have seen, is essentially a market for trading in certain types of shares and debt securities the issued shares of public companies, government bonds, local authority and other publicly owned institution loans and some foreign company stocks. There may be
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more than one type of stock market in operation in any one country. In the UK, for example, there are three stock markets: 1 The London Stock Exchange (LSE). As mentioned above, this deals in two major types of security including the shares of large public companies. However, it is a complex and expensive process for a company to go public, that is, get its shares listed on a stock exchange. Therefore, there are two additional stock markets: 2 The Alternative Investment Market (AIM). This is another arm of the London Stock Exchange, but is a junior market for the shares of smaller companies unwilling or unready for a full listing on the main market. 3 The Over The Counter Market (OTC). This is a market in which nancial assets, including shares, are traded other than through a formal stock exchange (e.g., by telephone and e-mail) as there are no physical market premises. Most OTC trading is done by large institutional investors (like pension funds see below) between themselves. The worlds largest OTC market is the National Association of Securities Dealers Automated Quotations Systems (NASDAQ) in the USA. Few investors would be willing to risk buying shares or lending money if they could not easily sell such long-term investments. The saleability of such investments is an essential characteristic, which is why public companies cannot proceed with an issue of their shares unless they know that they are acceptable to the relevant stock exchange(s). A stock exchange thus plays a crucial role in the provision of capital to industry. If a company has a good reputation with investors, its shares tend to increase in value, and it usually nds it easy to raise capital through an issue of new shares, and thus grow. This is not the case for every company. Most UK public company shares which are listed on a stock exchange are now held by what are termed institutional investors, meaning pension funds, insurance companies (in life assurance funds) and open-ended investment companies (OEICs). The UK government has, however, tried to encourage wider private ownership of shares by privatising a number of government-owned organisations and encouraging employees and small investors to buy shares. One of the rst government organisations affected was the Post Ofce, when its telecommunications arm was separated out from mail services and subsequently privatised. The privatisation of many other utilities followed. The government also encourages private investment by enabling people to invest certain sums annually in shares with no tax consequences. An example is the stocks and shares Individual Savings Account (ISA), where dividend income and capital gains are free of tax. Such accounts are provided by a variety of nancial institutions. Sometimes share prices in a particular company or in general are affected by the activities of speculators. A speculator deals in shares with a view to making a quick prot from favourable price movements. This might seem a little like betting which assets will go up in price and which will go down.
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There are in general two types of speculative investor a bull, who believes that share prices will rise, and who will buy shares in the hope that he/she will be able to sell them at a prot and a bear, who will sell shares he/she does not at present own (referred to as short selling), in the hope of buying them back later at a lower price.
Some stock exchange terminology
The term bear to describe a speculator who sells shares he/she does not have, seems to have originated in the early eighteenth century and was common at the time of the South Sea Bubble, a famous share speculation scandal which came to light in 1720, involving the shares of the South Sea Company in England and which caused nancial ruin to many. Even the British government was involved. According to the Oxford English Dictionary, [t]he term bearskin jobber, then applied to the dealer now called the bear, makes it probable that the original phrase was sell the bearskin, and that it originated in the well known proverb, to sell the bears skin before one has caught the bear. The Oxford English Dictionary goes on to suggest that the associated term, bull, appeared later and was perhaps inuenced by this understanding of the word bear. The term stag is also used in the context of share speculation, and is used to describe a person who applies to buy shares in listed companies when there is a new issue, in the hope of then selling them at a prot once trading in the new shares begins. According to the Oxford English Dictionary, the earliest use of the word with this meaning was in 1845.
3.3.4
Security market efciency
The extent to which share prices reect new information that becomes available is a function of how well a securities market absorbs and processes that information. This is referred to as the Efcient Market Hypothesis (EMH). There are three versions of the EMH: 1 strong-form efciency, where not only all publicly held but also all privately held past and present information is reected in share prices semi-strong efciency, where all publicly held past and present information is reected in share prices weak-form efciency, where all past price history is reected in share prices.
2 3
The most usual form of market efciency assumed to exist is the semi-strong form, as private information is not usually disclosed outside companies. The EMH (in theory, in whatever form it exists) assumes that capital markets will be efcient if they use all the information at their disposal to determine share prices. Markets will then operate on a level playing eld, and investment is a fair game for everyone and helps prevent abuses such as insider dealing/ trading. The latter results from individuals acting on private information which they have (but the market does not) and is a potential hazard in the semi-strong form of efciency. It is severely punished by the law. Efciency is important in that it encourages individuals to invest. Investments are still risky but the risks are the same for all investors.
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Financial markets are heavily regulated. Regulation is needed to ensure that relevant and reliable information is available to investors in shares and other securities to facilitate their investment decisions. This concept of decision-usefulness links to the purposes also of nancial reporting (see Session 4), which aims to ensure that there is a dependable and transparent process for providing nancial information about companies the shares of which are traded. Efcient functioning of the nancial markets in terms of information provided helps reduce the consequences of information asymmetry between different types of investors. Activity 3.1
Go to the home page of the London Stock Exchange, via the link on
the B291 website.
See if you can nd when the Exchange began and where. Spend no
more than 15 minutes on this.
Feedback
You should nd that the London Stock Exchange started in 1698 in a coffee house in London in Jonathans coffee house when John Castaing began to issue a list of stock and commodity prices called The Course of the Exchange and other things. From this description it does seem that stock in the sense of goods had an important initial role. However, as stated above, stock as a word had other meanings as well at the same time. Note that most websites have tabs which you can click on with your mouse and which link to details of the history and development of the organisation that you are investigating. You should nd such tabs for the London Stock Exchange.
3.4 Organisation of the accounting profession

The accounting profession has a long and varied history, though as professions stand, it is a relative newcomer. In England, for instance, the accounting profession was rst recognised as a legitimate profession in 1831, when the Bankruptcy Court ordered that certain accountants be appointed as assignees to assist the court with nancial records. As you have learned earlier in Session 3, it was the need for common criteria for accounting practice, especially in public accounting, that led to the formation of professional institutes, societies and associations, which were formed at local and national levels during the 1800s. Increasingly, their role was to regulate the entry of new people into the profession by ensuring that they were appropriately qualied by the passing of stringent examinations, thus assuring provision of a uniform standard of accounting service and the promulgation of uniform accounting practices a function they still perform. As accounting institutes are self-regulating, they have the power to subject members to their internal disciplinary procedures if they fail to observe the requirements of their body, for example, not following accounting standards and acting unethically. The accountants societies (as they were called in the early years) initially represented particular types of accountancy, as the latter were considered different from each other, for example, works and costs accountants were considered different from nancial accountants. As a result of its historical development, the UK has several different accounting bodies (perhaps more than any other
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country), some of which still specialise in different kinds of accounting. Most countries now have at least one main accounting body or institute. The accounting bodies in the UK played a signicant role in the establishment of the Accounting Standards Committee (ASC) in the 1960s, the rst body set up to develop accounting standards. This has played an important role in UK accounting regulation. Since the establishment in the UK of the Financial Reporting Council (FRC) as an independent regulatory body in the 1990s (see Section 3.6), the Accounting Standards Board (the successor to the ASC) does not have such a prominent a role. However, it still has considerable input into and inuence on the setting of accounting standards and regulations at both national and international levels, through formal consultation of its members. The fact that four very large rms of (nancial) accountants (KPMG, Ernst & Young, PricewaterhouseCoopers and Deloitte) currently have corporate membership of certain accounting bodies, such as the ICAEW, and the fact that they are multinational enterprises, contribute towards to the inuence held by accounting bodies in general. Despite many attempts made over the years by the different UK institutes to merge into a smaller number of bodies, they remain primarily organised by the type of accounting practised or their location. Activity 3.2
How many UK professional accounting bodies can you name? Write them down, trying to group them according to the type of accounting in which they specialise. Spend no more than 15 minutes on this.
Feedback
How many did you manage to list? Did you know that there are six chartered accounting bodies? If you are interested in becoming an accountant, you may have already decided which one you hope to join. You will nd links to the websites of all the UK bodies at www.accountingeducation.com if you wish to have more information about them. So far as classifying them is concerned, you may have come up with a list like the following.
l
Financial accountants The Association of Chartered Certied Accountants (ACCA) [www.accaglobal.com and www.acca.org.uk for the UK site] The Institute of Chartered Accountants of Scotland (ICAS) [www.icas.org.uk] The Institute of Chartered Accountants in England and Wales (ICAEW) [www.icaew.com] Chartered Accountants Ireland (formerly the Institute of Chartered Accountants in Ireland (ICAI)), considered to be both a British and Irish professional body (it predates the Partition of Ireland in 1922) [www.charteredaccountants.ie]
Management accountants The Chartered Institute of Management Accountants (CIMA) [www.cimaglobal.com]
Note that members of the ACCA, ICAS and ICAEW also work as management accountants in commerce and industry, so these bodies should be included here as well (though they do not indicate this specialism in their names as CIMA does).
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Public sector accountants l The Chartered Institute of Public Finance and Accountancy (CIPFA) [www.cipfa.org.uk] There are ve main chartered accountancy bodies that specialise in the private sector and a sixth (CIPFA) that specialises in the public sector. There are also lower level accounting qualications, including: l The Association of Accounting Technicians (AAT) [www.aat.co.uk] and several additional bodies which accountants (and non-qualied accountants) can join, including: l The Chartered Institute of Taxation (CIOT) [www.tax.org.uk]
l
The Institute of Internal Auditors United Kingdom (IIAUK) [www.iia.org.uk] The Institute of Chartered Secretaries and Administrators (ICSA) [www.icsa.org.uk] (Note that the term Secretaries relates to Company Secretaries.)
You need to pass the examinations of the relevant institutes in order to join any specic bodies. The Professional Certicate in Accounting will enable you to gain exemptions from some of the examinations of some of these bodies. You will nd the latest information on the exemptions available to holders of the Professional Certicate in Accounting on The Open University website. You should note that not all countries have as many different accounting bodies as the UK, or draw distinctions between different accounting specialisms in the same way.
3.5 The general need for a regulatory framework

In Section 3.5, we shall be looking at the need for a regulatory framework in accounting and nancial reporting and how that has developed and the reasons underlying that development. We chiey concentrate here on companies as business entities most affected by this type of regulation. As mentioned in Session 2, sole traders and partnerships are not governed in the same way by accounting and nancial reporting regulations. You have already learned that different classes of user are interested in nancial statements, but do not have nancial statements that are put together especially for them, that is, copies of the same set of nancial statements are given to everyone. As a result, the banker, the customer, the prospective buyer of the business, the supplier, the owner, the employee, etc., all see the same income statement, balance sheet and cash ow statement. Financial statements must provide a basic minimum of information upon which everyone can rely. While this makes it easier for the accountant to prepare the nancial statements, it is not ideal as the interests of each user group are different and each needs different kinds of information from that wanted by the others. The nancial statements must, therefore, be something of a compromise and, at the very least, they must provide a basic minimum of information upon which each user group can rely. Activity 3.3
Spend a few minutes writing down why it is important that all the user groups (stakeholders) are able to rely on the nancial statements. Spend about 15 minutes on this.
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(Be sure to attempt this question before reading the comments below. This is a very important point that you need to understand.)
Feedback
If the nancial statements could not be relied upon, they would be worthless. If they could only be relied upon by some of the user groups, something else would need to be produced to provide reliable information for the others, and the nancial accountants would lose their chosen option to only produce one set of nancial statements.
Many people assume that accountants always produce nancial statements, therefore, that do not favour the interests of one user group above another, that is, nancial statements are accurate and unbiased and are based on an objective approach. While this may be true to a certain extent, one must not forget that company nancial statements are primarily required by law as a report to company shareholders, so it might be conceptually difcult to construct them (within these legal constraints) to serve the needs of wider user groups. However, companies quoted on a stock exchange are obliged to do this, as a result of needing to comply with listing regulations. Nevertheless, by being objective whenever possible, accountants try to ensure that there is an underlying reliability in the information presented in nancial statements. If statements are prepared on a foundation that is known and acceptable to users, they will all know what to expect. In particular, the accounting bodies, government and other regulators have attempted to achieve a degree of standardisation through regulation to govern accounting and nancial reporting. However, one of the problems with regulation is that it has had to allow differences in concepts, denitions, language, treatments, formats, presentation and disclosure in order to permit differences between companies to be dealt with equitably. Differences thus allow accountants to make a choice, and this leads to subjectivity. Also, irrespective of any regulation, a large number of gures in nancial statements may be based on personal judgement and interpretation of the evidence available to the accountant who prepared them, and, to this degree, are also subjective. We shall now consider how the UK has been affected by these issues.
3.6
Development of a regulatory framework in the UK
In the late 1960s, to reduce the possibility of very large variations in reported prots under different accounting methods, the accounting bodies in the UK formed an Accounting Standards Committee (ASC). During the subsequent 20 years, 25 Statements of Standard Accounting Practice (usually abbreviated to SSAPs or Accounting Standards) were issued. Accountants and auditors were expected to comply with the SSAPs, though non-compliance was allowed provided that there was a good reason for it (e.g., where strict compliance would result in a misleading entry in the nancial statements). The audit report had to explain why any standard was not observed.
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Activity 3.4
What do you think was likely to happen if accountants were allowed to ignore a rule in an accounting standard? Do you think it was wise of the professional accounting bodies to allow this? Spend about ten minutes writing down your answers to these two questions.
Feedback
The professional accounting bodies would have been justied in expecting that their members would observe the spirit of the rules. They were, after all, members of a highly respected profession and ethically bound to observe its rules. That they did not always do so was as much a result of the changing business environment and the power of company directors as of any desire by individual accountants to ignore the rules. You will learn more about these issues in Unit 6.
To make a long story short, the generally accepted accounting practices werent as generally accepted as I thought
It would probably have been difcult for the accounting standards to have been accepted and used if accountants were not allowed to use their expertise when they felt it made more sense than following the rules. In other words, without an option to ignore the rules, it is unlikely the accounting standards would have been nearly as readily applied by the accounting profession of that era. This is certainly the case in the UK. However, it is not the case elsewhere, especially in the USA and Europe, where disobeying the rules was not and is not permitted.
Consequently, the use of SSAPs did not necessarily mean that two identical businesses would show exactly the same prots year by year. It did, however, considerably reduce the possibilities of very large variations in such prot reporting. Reported prot can be seriously affected by the subjective view adopted when the nancial statements are prepared. The inherent problem that nancial statements cannot avoid some subjectivity may mean that they are open to manipulation and abuse, which was exacerbated by the choices permitted by regulations. In a book
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published some years ago called Accounting for Growth, Terry Smith, a stock market analyst, showed how widespread this problem had become. The book revealed just how great the effect upon prots could be if different subjective views were adopted when preparing the nancial statements. Activity 3.5
Read the introduction to the rst edition of Accounting for Growth (published in 1992), which is available via the B291 website. While you do this, take careful notes of each of the examples of the manipulation of nancial information that the author presents. Spend up to 30 minutes on this. You will possibly nd some of the language and terminology a bit complex. Do not worry too much about that. Skip over any terms about which you are unsure. You will still be able to follow enough of the reading to get the point he is making.
However, by using an alternate method of accounting...
Feedback
One of the noticeable things about Accounting for Growth is that it was published over 20 years after the professional accounting bodies began issuing accounting standards in the 1970s. What happened, in effect, was that as the rules were developed, so some accountants became skilled at nding loopholes and ways around them that allowed their companies to look better than they ought to in their nancial statements. In order to deal with this, the UK professional accounting bodies have issued over 50 different accounting standards, and virtually all the rst 25 have now been revised or replaced with more precise sets of rules.
In an effort to improve observation of accounting standards, company law was amended to require anyone preparing nancial statements for publication outside the business to observe the rules laid down in the accounting standards.
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In 1990, the accountancy bodies replaced the Accounting Standards Committee with the Accounting Standards Board (ASB). It took over the SSAPs that were still in use. Accounting standards developed by the ASB are called Financial Reporting Standards (usually abbreviated to FRSs or still referred to as Accounting Standards). The ASB may issue pronouncements other than FRSs, announcing as each one appears what authority, scope and application it will have. Activity 3.6
In keeping with the desire that nancial statements should be useful to all user groups, virtually all the SSAPs and FRSs were written to focus upon providing rules to regulate the nancial statements of the most complex businesses as, by default, that would ensure coverage of the least complex. Can you think of any problems this might have brought for smaller businesses? Spend about ten minutes writing down your views on this.
Feedback
Quite often, the accounting standards required quite detailed processes to be followed and complex calculations to be undertaken. For a large company, these were not likely to have very serious cost implications as their computer systems were often sophisticated enough to deal with any adjustments. However, for smaller businesses, many of which had no sophisticated computing facilities, the costs of complying with the regulations could be very much greater than the costs of not complying with them, yet the smaller companies had to comply, or nd a good excuse for not doing so. Partly to address this point, some of the clauses in standards and even some of the standards themselves, do not apply to smaller businesses. However, the conditions for exemption were usually arbitrary ones based on company size that may have been relevant when accounting was mainly a manual exercise, but are hardly relevant in a modern computerised accounting environment. Also, the users of small business accounting information are unlikely to be greatly concerned about the implications of complex account ing standards.
To correct the situation, the ASB has issued a third category of

standard the Financial Reporting Standard for Smaller
Entities (FRSSE). It contains a collection of some of the rules from
virtually all the other accounting standards. Small companies can
choose whether to apply it or, if they feel it appropriate to do so,
continue to apply all the other accounting standards.
SSAPs, FRSs and the FRSSE are known collectively as
Accounting Standards. Accounting standards must comply with
the laws of the UK and with the Directives of the European Union.
The UK Companies Act 2006 also applies to all UK companies.
At the same time the ASB was formed, a Review Panel was
established to monitor published nancial statements: the Financial
Reporting Review Panel (FRRP). It is empowered under civil law
to prosecute companies that fail to comply with the requirements of
an accounting standard or company law. No such monitoring process
exists for partnership and sole trader nancial statements. You can
see more about the ASB and the FRC at either www.asb.org.uk or
www.frc.org.uk (both URLs link to the same website).
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The organisational structure of which the ASB is part is shown in Figure 7 below. The ASB operates under the supervision of the FRC, the objectives of which are to:
l l l
guide the ASB on work programmes and issues of public concern ensure that work on accounting standards is properly nanced act proactively as a public inuence for securing good accounting practice.
There are several other bodies in Figure 7, which are likewise supervised by the FRC. These bodies are concerned with audit, actuarial matters (related to pensions), professional accounting practice (the Professional Oversight Board) and corporate governance. For accounting standards, while the ASB is responsible for developing, issuing and withdrawing standards, the Urgent Issues Task force (UITF) is responsible for issuing swift guidance where there are differing interpretations of SSAPs and FRSs and dealing with emerging issues on a temporary basis.
FRC
Accounting Standards Board Auditing Practices Board Board for Actuarial Standards
FRC Ltd Board
Professional Oversight Board
Financial Reporting Review Panel
Accountancy and Actuarial Discipline Board
Committee on Corporate Governance
Urgent Issues Task Force
Executive
Figure 7 Accounting regulation organisation chart
3.7 International Financial Reporting Standards and the International Accounting Standards Board
In 1973, the International Accounting Standards Committee (IASC) was founded. This committee consisted of representatives from about 15 accountancy bodies across the world, representing seven countries. Activity 3.7
Why do you think the IASC was formed? Spend about ten minutes writing down a list of possible reasons.
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Feedback
The IASC was formed in order to encourage standardisation in the methods applied when preparing accounting statements to: l make international investment decisions more compatible
l
reduce the costs of converting nancial statements made under one regime of accounting regulation to comply with those prepared under another (by multinational companies) encourage the growing number of national standard-making bodies to work in harmony provide accounting standards for countries that do not have their own standard-setting bodies.
The IASC was reorganised and its standard-setting arm became the International Accounting Standards Board (IASB) in 2001. You can nd more details of the IASB on its website at www.iasb. org. The operational structure of the IASB is illustrated in Figure 8 below.
Trustee Appointments Advisory Group appoints advises IASC Foundation appoints oversees funds advises SAC IASB creates
reports
reports interprets
appoints
IFRIC
IFRS high quality, enforceable and global
KEY: IASB IASC IFRIC IFRS SAC = = = = = International Accounting Standards Board International Accounting Standards Committee International Financial Reporting Interpretations Committee International Financial Reporting Standard Standards Advisory Council
Figure 8 Organisation of the IASB
While the IASB is an independent body, with overall responsibility for creating IFRSs, it is appointed and overseen by a geographically and professionally diverse group of trustees (IASC Foundation) who are accountable to the public interest. It is also supported by an external advisory council (SAC) and an interpretations committee (IFRIC) to offer guidance where divergence in practice occurs. The actual standard-setting process is outlined in Figure 9.
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Agenda Decision RESEARCH Discussion Paper (DP) (Optional) PROPOSALS PUBLIC CONSULTATION INPUT FROM: Advisory Council Working Group International groups: Analysts; Preparers; Audit technical partners Special interest groups Local standard-setters Regulators Political groups PROPOSALS
Exposure Draft (ED)
PUBLIC CONSULTATION
Published IFRS
Feedback Statement
Jurisdictional adoption process IASB two year post-implementation review
Figure 9
The IASB standard-setting process
As indicated above, IFRSs are prepared by the IASB. The terminology here can be confusing because the accounting standards produced by the predecessor to the IASB, the International Accounting Standards Committee, are known as International Accounting Standards (IASs) whereas those produced by the IASB are known as IFRSs. However, the IASB adopted the IASs produced by its predecessor. Therefore, for the purposes of this module, when we refer to the body of international accounting standards we will generally refer to them as IFRSs, but if we refer to individual standards we will give them their individual name. The move towards the use of IFRSs which have been approved by the European Union (EU) means that these accounting standards now automatically become part of company law because they have been adopted by the EU on the basis of a regulation. However, in the UK, IFRSs currently only apply to the nancial statements of groups of companies with either debt or equity securities listed on any regulated market of any Member State. It is likely that their use will eventually be extended to apply to the nancial statements of all companies.
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EU countries already have the option to require compliance with IFRSs by all companies. The UK has chosen not to do this yet, but has decided to permit companies the securities of which are publicly traded to also use IFRSs in their individual company accounts, not just their group accounts, and to permit other companies to use IFRSs in both their group and individual accounts if they wish. Therefore, many companies now have to choose between UK accounting standards and IFRSs they are not allowed to cherry pick from the more favourable aspects of both. It seems likely that where an individual company is part of a group of companies that reports using IFRSs, it will make sense for that individual company to use IFRSs too. Also, it is likely that private companies that want to list in due course on the London Stock Exchange will choose to follow IFRSs. The ASB, however, is heading towards making IFRSs compulsory for medium-sized companies and the FRSSE for smaller companies. Therefore, other private companies may adopt IFRSs in due course. Even though most UK companies do not have to comply with the requirements of IFRSs yet, UK accounting standards will change signicantly in the next few years. As the IASB improves existing international standards and publishes new ones, the UK Accounting Standards Board is bringing the provisions of UK standards substantially into line with IFRSs in a parallel consultation process and reform programme. UK company law has also been modied to incorporate some of the changes following the introduction of IFRSs so that companies, which are either required to adopt IFRSs or which choose to do so, will not be in contravention of the law as a result. For some years the IASB has not had an equivalent to the UK Accounting Standards Boards FRSSE, but in July 2009 the IASB issued an IFRS for small and medium-sized enterprises (SMEs), which it denes as entities that do not have public accountability and publish general purpose nancial statements for external users. The existence of FRSs and IFRSs creates a dilemma for the writers of accounting modules, such as B291, in terms of which to follow. While both provide a coherent framework to follow, there are sometimes differences between them in terms of concepts, denitions, language, treatments, formats, presentation and disclosure of accounting information. This module will primarily follow IFRSs and you have been introduced to some aspects already, in that we have used terms such as non-current assets (instead of xed assets), inventory (instead of stock), trade receivables (instead of debtors), trade payables (instead of creditors) and income statement (instead of prot and loss statement/account). However, we will continue to use balance sheet (instead of the IFRS term statement of nancial position the use of which is optional in any case), as we feel that this is a more useful term in that it both reminds you that a balance sheet shows nominal ledger balances of certain kinds and that it balances (i.e., the top and bottom halves add up to the same total). If there are signicant differences between FRSs and IFRSs, these will be considered, discussed and explained as this module progresses.
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Summary
In Session 3 you have learned about the history and role of accounting in business and the various environmental inuences and constraints on business (such as political and legal factors, macroeconomic factors and social, demographic and technological inuences) and nancial and capital markets. These provide the wider context in which both organisations and accountants operate. In addition, you have learned about the organisation of the accounting profession and the further regulatory constraints governing the work of accountants within that wider context. In Session 4 you will go on to learn about the fundamental principles underlying the regulatory constraints applying to accounting and accountants, and hence underlying also the preparation and presentation of nancial reports. Session 4 also introduces the ASBs Statement of Principles and IASBs Conceptual Framework.
Session 4 Accounting conceptual frameworks, principles and conventions
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SESSION
4 0Accounting conceptual frameworks, principles and conventions

Introduction
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describe the IASBs Framework for the Preparation and Presentation of Financial Statements and ASBs Statement of Principles for Financial Reporting and discuss the similarities and differences between them in the context of the above frameworks: m dene and understand the qualitative characteristics of nancial reporting information m dene, understand and apply accounting principles, concepts and conventions m understand and explain different concepts of prot measurement and recognition m identify and explain the main characteristics of alternative valuation bases for assets and liabilities.
In Session 4 you will learn about the conceptual frameworks for accounting and nancial reporting produced by the IASB and the ASB to develop accounting theory, and the differences and similarities between them. You will learn about the importance of the qualitative characteristics of nancial reporting information and to dene, understand and apply the conventions and concepts, especially the fundamental accounting principles, underlying the calculation of nancial information and preparation of nancial statements. You will come to see how different concepts of prot measurement and recognition, and the use of different valuation bases for assets and liabilities, can produce different calculations of the gures which can appear in a set of nancial statements.
4.1 The need for accounting theory

4.1.1 Background
In Sections 3.6 and 3.7 you learned that accounting bodies, such as the IASB and the ASB, have developed various standards designed to regulate nancial accounting and reporting. Regulations have often been implemented in reaction to events affecting accounting or the accounting profession, which have given rise to various perceived needs, for example:
l
to eliminate creative accounting arising from manipulation of denitions, language, treatments, formats, presentation and disclosure to set out best or most widely accepted practice on which both accountants and nancial statement users could rely (thus
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protecting accountants against claims of negligence by providing a set of uniform standards to which they could adhere)
l
to address particular nancial matters, by providing a response to a crisis in an ad hoc, pragmatic way, or to a longer-term issue, such as ination and changing prices.
Like the UK, many countries developed their own individual accounting standards. However, as the worlds economy has become more globalised, the need to deal with these issues on a global basis has grown, for example, accountants and users of a companys nancial statements respectively need to provide and receive a consistent view of results regardless of the home country of the company, accountant or user. IFRSs are one way in which these issues are being addressed, but their development has been accompanied by an interest in developing a wider conceptual or theoretical framework against which standards might evolve, by setting out general principles inherently capable of dealing with political, scal, economic and commercial changes and of eliminating conceptual inconsistencies between different countries. The process of developing standards one by one had hitherto not allowed for broader consideration of accounting theory, and it is only with the benet of hindsight that one can discern how accounting theory actually evolved.
4.1.2
Evolution of accounting theory
Elliott and Elliott, in their book Financial Accounting and Reporting,1 outline three stages in the evolution of accounting theory: 1 An empirical inductive approach. This approach existed prior to 1970, and examined accounting practices that were then in existence, and attempted to generalise and rationalise from them. This resulted in standards that tried to establish best current practice as normal practice, and resulted in, for example, general acceptance of the historical cost model and concepts such as matching and realisation, which will be covered later in Session 4. This approach has played a signicant part in the development of accounting/nancial reporting practice. However, after the 1970s an increasing rate of economic, political, scal and commercial change meant that practices to deal with such developments themselves also changed rapidly, so the process of generalisation from existing practice was no longer pragmatic. Also, there were theoretical issues about how accountants dened income under this approach, which was not the same as how others, such as economists, would dene it. Thus the approach was decient in addressing different user needs. 2 A deductive approach. This approach was followed in the 1970s. It resulted in standards which were based on principles deduced from assumptions, for example, that nancial statements adjusted for changing prices/ination would be more appropriate than if prepared on another basis. However, this approach was felt to be unrealistic as it produced gures (especially for income) that were not easily validated and not
1
Elliott, B. and Elliott, J. (2009) Financial Accounting and Reporting (13th edn), Harlow, Essex, Pearson Education Limited.
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easily understood by users, as there were several different methods that could be used to adjust for price changes. There was also a problem caused by the nature of the deductive principles being used, as these were basically derived from theoretical economics, and many practising accountants were unhappy about this. A conceptual framework based on decision-usefulness. This approach was promoted in the 1980s. According to Elliott and Elliott (2009, p. 160):
It was recognised that standards needed to be decision-useful, that they should satisfy cost/benet criteria and that their implementation could only be achieved by consensus. Consensus was generally only achievable where there was a clearly perceived rationale underpinning a standard and, even so, alternative treatments were required in order to gain support.
This decision-usefulness approach has also been used during the twenty-rst century, but it is a mandatory model where alternative treatments are not allowed. However, it must be stressed that it is only one of several conceptual frameworks that are possible. Others might be a distributional framework (focusing primarily on stakeholders) or a valuation framework (based on economic principles). The extant conceptual frameworks are considered below.
4.2 Conceptual frameworks: the IASB Framework for the Preparation and Presentation of Financial Statements (= IASB Framework)
4.2.1 Background
The IASB conceptual framework was developed by the (then) IASC in the 1980s, and adopted by the IASB in April 2001. (This conceptual framework is still a draft document, and references below are to the version current at the time of writing in December 2009, so further changes are possible.) It deals with: (a) the objective of nancial statements (b) the qualitative characteristics that determine the usefulness of information in nancial statements (c) the denition, recognition and measurement of the elements from which nancial statements are constructed (d) concepts of capital and capital maintenance.
Items (a) to (d) are considered below.
4.2.2
The objective of nancial statements
The objective of nancial statements is to provide information about the nancial position, performance and changes in nancial position of an entity that is useful to a wide range of users in making economic decisions. IASB Framework, paragraph 12
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The potential range of users is identied in paragraphs 911 of the document and includes present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies and the public. For the interests of such groups, please refer back to Section 2.4. To meet their objectives, the IASB Framework sets out the underlying assumptions on which nancial statements should be prepared, namely the accruals basis and the going concern basis. The accruals basis Under this basis:
the effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the nancial period to which they relate. IASB Framework, paragraph 22
If transactions/events were recognised when cash was paid, this would be referred to as the cash basis of accounting. The accruals basis, on the other hand, dictates the point at which transactions and other events should be recognised and included in nancial statements. It means that the concept of income/revenue and expenses replaces that of cash receipts and payments. In practice, this may be simpler than it looks. For example, assume that a company has an accounting period ending on 31 December 2012. On 30 June 2012 it pays its annual buildings insurance for the next year. This means that it will have paid a sum of money mid-accounting period that covers 12 months from 1 July 2012 to 30 June 2013. The period 1 July to 31 December 2012 falls into the accounting period ending on 31 December 2012, so 6/12 of the sum relates to 2012, but the other 6/12 relates to the rst six months of the next period, ending 31 December 2013. Accrual accounting would mean that a half of this payment should be treated as an insurance cost for each year. This arises, of course, because the insurance year does not coincide with the accounting year. The above example also demonstrates what is meant by period matching, that is, it shows how a cost is allocated to two different accounting periods that both benet (from insurance in this example). You will learn about accruals in this sense in Unit 3. However, this is not the only way of determining allocation (see Recognition of elements in Section 4.2.4). The going concern basis This means that when preparing nancial statements, values are based on the assumption that the business will continue into the foreseeable future without the intention or need to liquidate or curtail materially the scale of its operations (IASB Framework, paragraph 23). If such an intention exists, it means that the nancial statements may have to be prepared on a different basis (typically a liquidation/break-up basis) and if so, that basis will need to be disclosed.
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Activity 4.1
Jones Ltd has prepared its nancial statements for many years on a going concern basis, stating inventory at its cost. However, owing to innovations made by competitors which it cannot match, the company thinks it can only continue trading for another six to eight months at most and can only sell its inventory at much less than what it cost. Imagine that you are about to prepare the nancial statements for Jones Ltd. What do you think you should do, now that you are aware that it is unlikely to continue to operate for the foreseeable future? Spend about ten minutes writing down what you would do.
Feedback
Instead of valuing the inventory at cost, you would need to value it on the basis of what it could be sold for (less any costs associated with selling it), as this will be less. This is referred to as net realisable value and will be appropriate in these circumstances that is, where the business is likely to cease operating. The value of other assets, such as non-current assets, will also need to be considered. When a business ceases to operate, in general, assets need to be valued on a liquidation/break-up basis. Also, if the business is to close down, consideration will need to be given to providing for closure costs, such as redundancy payments to the workforce.
Activity 4.2
What valuation-related problems do you think a business cessation
may create for the accountant?
Spend about ten minutes writing down a list of the problems you can
envisage.
Feedback
A decision would need to be made about whether it is likely that the business could be sold intact to someone who would then continue to use all the assets to do what they are currently doing, all together or individually, or whether the assets would need to be sold for scrap. Buyers might not want, for example, specialised inventory or a 20 year old machine, say, unless it was going to be used to do what it has always done, nor would they want a custom-designed factory unless they were going to produce similar products within it. As a general rule, when checking whether the going concern assumption should hold, it should not hold if: 1 the business is going to close down in the near future 2 a shortage of cash makes it almost certain that the business will have to cease trading 3 a large part of the business will almost certainly have to be closed down because of a shortage of cash.
4.2.3 The qualitative characteristics that determine the usefulness of information in nancial statements
Qualitative characteristics are the attributes that make the information provided in nancial statements useful to users. The four principal qualitative characteristics are understandability, relevance, reliability and comparability. IASB Framework, paragraph 24
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These characteristics will be discussed below. Understandability Inevitably, some understanding of business and accounting is required to enable users to understand nancial statements, and the extent to which they do so will be a combination of their knowledge and abilities. However, users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence (IASB Framework, paragraph 25). Companies do differ in the amount of effort they put into analysing, aggregating and classifying nancial information to make it user-friendly, but information should not be excluded simply because it may be too complex for certain users to understand. Relevance Financial information is deemed to be relevant if it helps users make decisions. This means it should help them assess past, present or likely future events. It may conrm what they had predicted might happen or can correct an inaccurate evaluation, so is often said to be conrmatory or predictive. However, as mentioned previously in Section 3.5, nancial statements are prepared primarily for owners and/or shareholders, so some of the needs of other users are unlikely to be specically addressed. If other users were to be considered in detail, then it would mean preparing nancial statements for each individual user, which would take considerable time. A common criticism of published nancial statements is that they are in any case often too late and out of date to enable effective decision making, and considering explicitly the needs of other users by preparing separate nancial statements would compound this problem. Information, then, needs to be both relevant and provided in an acceptable time frame. The relevance of information may be affected by materiality. Information may be considered material if its omission from or misstatement in nancial statements would affect or distort the economic decisions of users. A lender, for instance, might choose not to make a loan to a company if it considered that the assets offered as security for the loan were incorrectly valued. If information would not make a difference, then it is regarded as immaterial. Information that is immaterial can be understandable, relevant, reliable and comparable, but if it does not make a difference in any way, these other characteristics do not matter and would be ignored. There are different ways of quantitatively measuring or assessing materiality, such as by reference to a certain percentage of prot (before tax is deducted) or of net asset value. Materiality is of great importance to auditors and whether an omission or misstatement is material or not will depend on its size in a particular context. It thus provides a cut off point in terms of overall usefulness. Relevance can also be affected by the nature of information, which in certain cases alone determines relevance. For example, there may be a legal requirement to disclose information. If information is required by law, as in the case of disclosing company directors emoluments (i.e., the salaries and other benets they receive), it will
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be material whatever the size or value of items involved as the legal requirement will make it so. Reliability If information is unreliable, it almost goes without saying that it is of limited use, and, indeed, may be quite useless. In general, to be reliable, information should be free from error and bias. Here, error means material error in line with comments made above about materiality. However, by their very nature, some items in nancial statements may be less reliable than others. For example, if a company were preparing its nancial statements just before it was due to go to court where a case against it would be heard (e.g., for an allegedly faulty product, which had injured its purchaser), it might not know whether it would win or lose the case. This would make the nancial effect on the company very difcult to gauge, and cause great uncertainty as to what the company should include in its nancial statements in terms of the likely need to pay damages and other costs. The company could only calculate the nancial effect in accordance with the best legal opinion available. Reliability can also thus be connected to timing and timeliness. If, in the example above, the nancial statements had been drawn up after the conclusion of the legal case (instead of when a decision was pending), this decided outcome would have removed any uncertainty related to the case. In general, the qualities which make information reliable faithful representation, substance over form, neutrality, prudence and completeness are discussed below. Faithful representation The effects of transactions and events must be faithfully recorded, measured and represented. They must be as accurate as possible. Risk to faithful representation may be caused by bias or inherent difculty in identifying transactions/events which need to be measured or in devising and applying appropriate measurement techniques. Consider again the difculties associated with the legal case involving an allegedly faulty product discussed above. Substance over form This means that the economic substance of a transaction or event should take precedence over its legal form if the two differ (so far as this is legally possible). A good example of this is a hire purchase (HP) transaction. The legal title to an asset does not pass to an owner until the last HP instalment has been paid, but the person or entity will have been using the asset from the day the HP agreement was signed, which might have been years before the nal instalment was paid. If the strict legal form were to be followed, such an asset would not appear on the users balance sheet until the nal instalment had been paid therefore, ignoring the fact that the asset was being used and generating income and/or benets for the user before then. Neutrality It is often necessary to exercise judgement to determine a gure which will be included in nancial statements and/or to decide how something ought to be disclosed. For example, an accountant might
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be counting an inventory of raw materials which had been kept outside either because this was usual for this type of stock or there was no indoor storage facility. However, if the stock had been damaged by weather because it had been mistakenly left outside and unused for too long, it might require an informed opinion from a production engineer, say, as to how much of the raw materials would still be usable thus impacting on the overall value the accountant would include in the nancial statements. Neutrality means that these kinds of judgement should be made honestly and without bias. Prudence Prudence means that caution must be used when preparing nancial statements and in estimating the likely outcome of uncertain events. In the example above of the court case (see Reliability), the most likely outcome should be reported. If the outcome is genuinely unassessable, then an estimate of a successful outcome and an unsuccessful outcome might both be provided in the interests of completeness. Caution does not mean that the most pessimistic interpretation should automatically be adopted. In the example above of the damaged raw materials (see Neutrality), it might have been overly pessimistic, for example, to assume that they all needed to be thrown away as useless. Neutrality and prudence might at rst glance seem to push an accountants judgement in different directions. However, a balance needs to be struck so that assets, income and gains are not overstated and liabilities, expenses and losses are not understated. Equally, the exercise of prudence does not permit the deliberate understatement of assets or the overstatement of liabilities. Completeness Completeness means that information given in nancial statements should be as full as possible, subject to the concept of materiality and, of course, the costs of obtaining it, which may also need to be considered. Comparability Comparability means that nancial statements should be comparable with the nancial statements of other, similar organisations and with the nancial statements of the same organisation for earlier accounting periods. Key elements of comparability are disclosing how any transaction/event is accounted for (referred to as an accounting policy), and applying accounting policies consistently (treating and disclosing like items in the same way, and from one accounting period to another). However, a company should not do this blindly, but change its accounting policies if more relevant or reliable ones are available. Companies are required to disclose their accounting policies, which helps users make allowance for the effect of different policies on company nancial statements. If a company changes its accounting policies, this must be disclosed, together with the effect of the change. Limiting factors In the above discussion, it is evident that some characteristics militate against others. Information that is more relevant may be less reliable, while the opposite may also be true. Timing and timeliness are also
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important in terms of reliability. It will often be a case of making the best possible compromise between timeliness and reliability. Furthermore, the benets and costs of providing information need to be considered. Unless there is a legal requirement to provide information, there is always a trade-off between the benets and costs: the latter should not exceed the former. It should also be noted that nancial statements are required to show a true and fair view of or present fairly (the precise words used are jurisdiction-specic) the nancial position, performance and changes in nancial position of an entity. It is an auditors job to report on this, and this will be considered further in Unit 6.
4.2.4 The denition, recognition and measurement of the elements from which nancial statements are constructed
Denition of elements In paragraph 47, the IASB Framework says that the nancial effects of transactions and other events should be grouped into broad classes and portrayed in nancial statements according to their economic characteristics. These broad classes form the elements from which the nancial statements are constructed. The balance sheet elements are assets, liability and equity. The income statement elements are income and expenses. Elements will usually be analysed into sub groups. For example, assets and liabilities may be classied by their nature or function. Paragraphs 49 and 70 of the Framework dene the elements as follows. Assets, liability and equity (paragraph 49): (a) An asset is a resource controlled by the entity as a result of past events and from which future economic benets are expected to ow to the entity. (b) A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outow from the entity of resources embodying economic benets. (c) Equity is the residual interest in the assets of the entity after deducting all its liabilities. The elements of income and expenses are dened as follows (paragraph 70): (a) Income is increases in economic benets during the accounting period in the form of inows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. (b) Expenses are decreases in economic benets during the accounting period in the form of outows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Recognition of elements Recognition means the process of incorporating into the balance sheet or income statement items which meet the denition of an element
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(as given above) and have a cost or value that can be measured reliably. For example, something would be incorporated into the balance sheet as an asset when it is probable that future economic benets will ow to the entity from it and it has a cost or value that can be measured reliably. Measurement of elements Measurement means the process of determining the monetary amount at which the elements of the nancial statements are to be included in the balance sheet and income statement. This involves the selection of a particular basis of measurement. Paragraph 100 of the IASB Framework includes the following bases of measurement. (a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. (b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently. (Note that discounting is a calculation done to allow for changes in the value of money, for instance, because of investment potential. For example, 1 received at a future date would not have the same value as 1 received now, as 1 received now could be invested to earn a return. Discounting will be discussed further in B292.) (c) Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values, that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. (d) Present value. Assets are carried at the present discounted value of the future net cash inows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outows that are expected to be required to settle the liabilities in the normal course of business. The IASB Framework goes on to comment that the measurement basis most commonly adopted is historical cost, but that this is usually combined with other measurement bases. For example, inventories are usually carried at the lower of cost and net realisable value (this will be covered in Unit 3), whereas marketable securities may be carried at market value and pension liabilities are carried at their present value. The current cost basis has been frequently used as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets.
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4.2.5
Concepts of capital and capital maintenance
You will remember from Section 1.4.2 that there are different ways of showing a nancial position (balance sheet), either in a horizontal or vertical format, and that capital may be regarded as a particular kind of liability. It is the amount invested by the owner, against which the owner may make drawings and which would be repayable in full to the owner as and if the business permanently ceased operations. As shown in Figures 3 and 4 (in Section 1.4.2), any prot generated by business operations is added in to capital and increases the overall value of the half of the balance sheet in which it is included. (You will nd out how this all works, when you learn in detail about doubleentry bookkeeping in Units 2 and 3.) In the vertical balance sheet format, you will see that the top half shows assets less liabilities, and the bottom half shows capital plus prots, and the two halves add up to the same gure. This gure is referred to as net assets or net worth. This is a measure of the wealth or well-offness of the business. The concept of capital maintenance is concerned with how a business denes the capital/wealth (investment in the business) which it wishes to maintain. Put simply, a business has maintained its capital if it has at least as much capital at the end of an accounting period as it had at the beginning. The IASB Framework (paragraphs 102110) suggests that there are two basic concepts of capital:
l
The nancial concept of capital. This refers to invested money or invested purchasing power, hence giving rise to the further concept of nancial (or money) capital maintenance. Under this concept, capital means net assets or equity. The physical concept of capital. This refers to the productive capability of a business thus giving rise to the further concept of physical capital maintenance.
These concepts are discussed further below. If a business has a net worth according to its nancial statements of 100,000 on 1 January 20X9, it must also have a value in its nancial statements of 100,000 at 31 December 20X9, to be as well off at the end of the period. Take the example of Mr Jones, a sole trader who has introduced no new capital and has not withdrawn any (via drawings). If he started with a value according to his nancial statements of 100,000 on 1 January 20X9 and nished with a value in his nancial statements of 170,000 on 31 December 20X9, he must have made a prot of 70,000. This idea of prot increasing net worth is known as nancial (or money) capital maintenance. It would be acceptable to everyone in a period when there is no change in price levels. However, most people would agree that it is not satisfactory when either prices in general, or specic prices affecting a business, are changing. In these two cases, to state that 70,000 prot has been made in 20X9 completely ignores the fact that the 100,000 at 1 January 20X9 and the 100,000 at 31 December 20X9 do not have the same value.
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The reason is that the purchasing power of 100,000 has changed between the two dates. Financial capital maintenance ignores ination and deation. Real capital maintenance is a form of capital maintenance which takes account of ination and deation. Under real capital maintenance, the concern is to maintain the general purchasing power of the owners. This takes into account changes in the purchasing power of money (i.e., ination) as measured by the Retail Price Index (RPI). Physical (or operating) capital maintenance is a further form of capital maintenance. It only recognises a prot if the assets held at the end of the period are able to maintain the same level of output in the next period as was maintained during this period. For example, a newspaper seller will recognise a prot if the revenue from the sale of newspapers is greater than the historical cost of the newspapers. Using the operating capital maintenance concept, the newspaper seller will only recognise a prot if the revenue from the sale is greater than the cost of buying the newspapers to replace the newspapers sold. Here a price index can be used to adjust price related to changes in the prices of specic goods in which a rm deals. As Table 3 below shows, the prot of a business will vary depending upon which of these three concepts is used.
Table 3 Comparison of the effects of different capital maintenance concepts
The value of a company (called its net asset or its net worth), according to its nancial statements on 1 January 20X9, was 200,000 and on 31 December 20X9 it was 280,000. There have been no issues or withdrawals of share capital during the year. The rate of ination, as measured by the Retail Price Index, was 10 per cent, whereas the specic rate of price increase for the type of goods in which the company deals was 15 per cent. The prots for the three measures were as follows. Financial capital maintenance Net assets as at 31 December 20X9 Less: what net assets would need to be, to be as well off as at 1 January 20X9 Prot 280,000 Real capital maintenance 280,000 Physical (or operating) capital maintenance 280,000
200,000
220,000 (= 200,000 + 10%)
230,000 (= 200,000 + 15%)
80,000
60,000
50,000
You can see how the two maintenance concepts other than nancial capital maintenance reduce the prot from 80,000. Real capital maintenance recognises that there has been a fall in the purchasing power of money and gives a prot of 60,000. Physical (or operating) capital maintenance takes into account that it would cost 230,000 for items that had a value at the start of the year of 200,000, and so reduces the conventional prot from 80,000 to 50,000. These concepts are difcult when examined for the rst time, but as you become more familiar with accounting and reporting, they will become clearer. Do not worry if you nd you are struggling with these ideas.
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The IASB Framework does not prescribe the adoption of any particular capital maintenance model, other than in exceptional circumstances, such as a hyperinationary economy.
4.3 Conceptual frameworks: the ASB Statement of Principles for Financial Reporting (= Statement of Principles)
4.3.1 Background
The IASB Framework encouraged the development of conceptual frameworks by national standard-setting bodies. The Statement of Principles produced in the UK in 1999 by the ASB was one of the earliest of the national conceptual frameworks, and developed and amplied the ideas contained in the IASB Framework. The Statement of Principles contained eight chapters and dealt with the following key issues: Chapter 1: The objectives of nancial statements Chapter 2: The reporting entity Chapter 3: The qualitative characteristics of nancial information Chapter 4: The elements of nancial statements Chapter 5: Recognition in nancial statements Chapter 6: Measurement in nancial statements Chapter 7: Presentation of nancial information Chapter 8: Accounting for interests in other entities The above structure shares much common ground with the IASB Framework, but there are signicant differences, which will be addressed below in a chapter by chapter discussion. Chapter 1: The objectives of nancial statements Chapter 1 follows the IASB Framework in identifying the same objectives of nancial statements for the same user groups who will have interests in nancial statements (see Section 4.2.2), but particularly identies the investor group as the primary group for whom nancial statements are prepared. As only one set of nancial statements is prepared and there are seven user groups, all user group needs cannot be addressed, hence, a decision needs to be taken as to whose needs take precedence. While other user groups are not ignored, information that is relevant to them (but not to the investor group) may not be disclosed. It is also possible for there to be a conict of interest between the needs of the investor group and other users (e.g., disclosure about a signicant reduction in company activities). Chapter 1 does not set out the underlying principles for nancial statement preparation (such as the accruals and going concern basis given by the IASB Framework), but it does go on to suggest that information is required in the four areas of nancial performance, nancial position, generation and use of cash, and nancial adaptability. These areas are discussed below.
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Financial performance This comprises the return obtained from the resources a business controls, and is available from the income statement (prot). It facilitates evaluation of past (and anticipated) management performance and management stewardship, assessment of capacity to generate cash, how effectively resources have been utilised and enables users to modify their expectations. An emphasis on stewardship here ties in with the focus on the investor group as the primary user group, which is not the focus adopted by the IASB Framework. Financial position This is usually provided by an examination of the balance sheet to show a businesss assets and liabilities, sources of nance, liquidity and solvency, and ability to adapt to changes. Generation and use of cash Such information will be available from a cash ow statement, which shows cash ows in and out of a business as a result of its operating, investment and nancing activities. Financial adaptability This refers to a businesss ability to alter the amount and timing of its cash ows so that it can respond to unexpected needs or opportunities, such as raising or repaying nance, disposing of assets and changing the cash ows from operations. Chapter 2: The reporting entity Chapter 2 focuses on identifying when an entity should report (e.g., when there is a legitimate demand for information and there is a cohesive economic unit) and the type of activities to include (e.g., activities under the units direct control and, in dened cases, indirect control). The chapter devotes considerable effort to dening terms, such as control. The IASB Framework originally did not contain a section on the reporting entity, but in March 2010 the IASB issued an exposure draft of a separate document, entitled Conceptual Framework for Financial Reporting: the Reporting Entity, as part of its on-going development of the IASB Framework. The exposure draft, which is a formal draft document inviting interested parties to comment on proposals made, considers in general the same issues as Chapter 2. Chapter 3: The qualitative characteristics of nancial information The ASB Statement contains the same four principal qualitative characteristics of information as the IASB Framework (see Section 4.2.3). However, slightly different focus and emphasis is laid on certain aspects, as is shown in Figure 10. Materiality here is treated as a separate characteristic and described as relating to both the nature and size of the item, whereas the IASB Framework treats it as a sub-category of reliability and describes it as a quantitative characteristic. As the two documents focus on including information if it will inuence the users of nancial
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THE QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION WHAT MAKES FINANCIAL INFORMATION USEFUL? Giving information that is not material may impair the usefulness of the other information given
Threshold quality
MATERIALITY
RELEVANCE Information that has the ability to influence decisions Predictive value
RELIABILITY
COMPARABILITY
UNDERSTANDABILITY
Information that is a complete and faithful representation
Similarities and differences can be discerned and evaluated
The significance of the information can be perceived
Confirmatory value
Consistency
Disclosure
Faithful representation
Neutral
Free from material error
Complete
Prudence
Users abilities
Aggregation and classification
Figure 10 What makes information useful
statements, there should be no difference in their effect. The concept of substance over form, which the IASB Framework includes under reliability, is not included here. The ASB Statement also includes an extensive discussion of how the different characteristics may militate against one another and of the possible trade-offs between them. However, while the IASB Framework considers true and fair view as a limiting factor, the ASB treats this very differently, that is, as an underlying concept at the foundation of the Statement, and discusses it not in the main chapters of the Statement, but much more prominently in a separate introduction to the Statement. Chapter 4: The elements of nancial statements These are the same as in the IASB Framework, though in addition the ASB uses the terms ownership interest, gains and losses as equivalent to equity, income and expenses in the IASB Framework. The ASB Statement also includes and denes:
l
contributions by the owners as increases in ownership interest resulting from transfers from owners in their capacity as owners distributions to the owners as decreases in ownership interest resulting from transfers to owners in their capacity as owners.
The IASB Framework treats the above two items as movements within equity. Chapter 5: Recognition in nancial statements In its approach to recognition of items in nancial statements, the ASB has adopted the recognition criteria set out in the IASB Framework. However, the ASB has also incorporated into its interpretation of recognition the IASBs denition of the accruals basis. In terms of assets and costs/expenses, for example, the
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Statement approach is to identify primarily the amount of expenditure which should be recognised as an asset, not to match costs to revenue. It considers primarily the point at which future economic benets ow to a business. If they arise over several accounting periods, the expenditure will constitute an asset and its use or wearing away will be treated as a cost to those periods. If the future economic benets are eliminated at a single point in time, expenditure will be treated as an expense/cost in the income statement. As Elliott and Elliott (2009, p. 169) say: the question is not How much expenditure should we match with the revenue reported in the prot and loss account? but rather Are there future economic benets arising from the expenditure to justify inclusion in the statement of nancial position? and if not, expenditure should be included as a cost in the income statement. The Statement adopts a balance sheet orientated position overall in its approach to recognition of nancial statement elements. The Statement recognises that there is often uncertainty as to when to recognise an element, and that to do so there must be sufcient evidence of existence and sufcient reliability in the measurement of the monetary amount. The concept of prudence dictates that evidence of assets and gains should be more persuasive than for liabilities and expenses, but there should not be deliberate understatements of assets or gains, or deliberate understatement of liabilities/expenses. The IASB Framework refers to the probability of future benet owing to or from a business, rather than evidence. Chapter 6: Measurement in nancial statements The Statement accepts, as does the IASB Framework, that companies often use a mixture of measurement bases, but the ASB and IASB generally adopt different approaches to the subject. As we have seen, the IASB Framework describes briey the possible measurement bases, but the ASB Statement has a preference in general for a gradual move towards use of current value, by which it means something different from the IASBs current cost. It discusses measurement bases extensively and adopts the value of assets to the business model (also referred to as the deprival value model), to provide a means of deciding between different measures of current value. This is illustrated in Figure 11.
Value to the business
= lower of
Replacement cost and Recoverable amount = higher of
Value in use
and
Net realisable value
Figure 11
Value to the business
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The value to the business is determined by considering whether the company would replace the asset. If the answer is yes, then use replacement cost; if the answer is no but the asset is worth keeping, then use value in use; and if no and the asset is not worth keeping, then use net realisable value. (Elliott and Elliott, 2009, p. 171)
The value in use is the discounted net present value of future cash ows and net realisable value means the sales proceeds less costs associated with the sale. It has been suggested that recent moves towards using fair (or market) values for assets might make the need to use current cost and deprival value redundant. However, not every asset will have a market value, so there must also be some method that acts as a proxy for fair value, or accepted valuation models or techniques. The ASB Statement also includes its comments on going concern (no different from the IASB Framework) under measurement issues. The ASB Statement includes also in Chapter 6 comments on capital and capital maintenance, commenting that most businesses adopt the nancial capital maintenance concept. While this is satisfactory when prices are stable, it is less so when prices are subject to general or specic change, and adjustments would need to be made which reect the impact of the changes on capital maintenance and prot. Chapter 7: Presentation of nancial information The objective of presentation in nancial statements is to communicate clearly, effectively, simply and straightforwardly relevant and reliable nancial information, as succinctly as possible but without compromising the value of the communication. Chapter 7 analyses the way in which nancial statements should aggregate, classify and present information to meet nancial statement objectives and users needs in a statement of nancial performance (income statement), statement of nancial position (balance sheet), cash ow statement and accompanying information (typically chairmans statement, directors reports, and so on). This is much more extensive than anything in the IASB Framework. Chapter 8: Accounting for interests in other entities The IASB Framework does not specically allude to how businesses should deal with their interests in other entities, for example, where one company owns shares in another, such that those owned shares confer, to varying degrees, control or inuence over that other entity. The ASB Statement states:
Financial statements need to reect the effect on the reporting entitys nancial performance and nancial position of its interest in other entities. This involves various measurement and presentation issues. Rather than being dealt with in the relevant chapters and therefore in isolation from each other, they are dealt with together in this chapter.
Chapter 8, therefore, deals with the way that results of entities are combined. This topic is not included in B291, so Session 4 will not discuss this further.
86
4.4 Other conceptual frameworks

The ASB Statement is one of several national conceptual frameworks. Documents produced by leading accounting standard setters, such as those in Australia, Canada, New Zealand and the USA, all utilise similar principles and explanations, though there are differences between them some more signicant than others. The US Financial Accounting Standards Board (FASB) pronouncements (a series of Concepts Statements) have been of particular importance in a worldwide context, given the USAs dominance in the global economy. However, the US approach is much more rules-based than that of other countries (other than, perhaps, continental Europe), which tend to be more principles-based. This has proven to be something of a stumbling block in moves towards developing a global convergence of accounting standards. However, the IASB and FASB are presently working on a Conceptual Framework Convergence Project, which may result in changes to the current FASB and IASB frameworks. The new exposure draft of the Conceptual Framework for Financial Reporting: the Reporting Entity (as mentioned in Section 4.3.1) is actually a result of this convergence project, as it is a document issued jointly by the IASB and FASB.
Summary
In Session 4, you have learned about the IASB Framework as a development to meet the need for an underlying theoretical basis for accounting and nancial reporting, and about the ASB Statement of Principles as the UKs attempt to implement that Framework. You have learned about the differences and similarities between these two documents in terms of dening and understanding the qualitative characteristics of nancial reporting information; dening, understanding and applying accounting principles, concepts and conventions; understanding and explaining different concepts of prot measurement and recognition; and identifying and explaining the main characteristics of alternative valuation bases for assets and liabilities. You will appreciate how differences in applications of concepts and principles can produce different calculations, treatments and presentations of the gures which can appear in a set of nancial statements.
Unit summary
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Unit summary
You have now come to the end of Unit 1, the rst unit of B291 Financial accounting. This unit has acted as an overall introduction to the module, by identifying a number of concepts and ideas, which will be explored and developed in greater depth in subsequent units. When you encounter these again, you will be aware that you need to get to grips with them as fundamental topics, as, for example, in the case of double-entry bookkeeping, which immediately follows in Units 24. Therefore, Unit 1 acts as an essential foundation for developing the specic subject matter addressed in subsequent units. Do not be afraid to refer back to Unit 1 when you encounter material in more depth in later units as it will help remind you of what you have learned already. In conjunction with all this, each session in Unit 1 introduced a number of subjects which are important in their own right. Session 1 introduced the main purposes and objectives of bookkeeping and accounting. Session 2 taught you about the context in which accounting fulls its various functions, especially in terms of organisations of different kinds and the needs of various users of accounting information. Session 3 examined the main environmental inuences and constraints on business, accounting and accountants and introduced you to regulatory frameworks. Session 4 considered the theoretical frameworks for accounting and nancial reporting, and their underlying concepts and principles, and the qualitative characteristics of accounting information. Before you move on to Unit 2, the following self-assessed questions provide you with the opportunity to check whether you have understood the material in this unit. Self-assessed Questions
Please note that in the suggested answers that follow each of these self-assessed questions (SAQs), the answers are only given briey in outline form, with a cross reference to the section of the main text where relevant material is provided. These self-assessed questions are representative of the type of questions that could be set in the end of course unseen examination. Full written answers are not provided, as writing styles, how people include content and discuss it, etc., can be different from individual to individual, and answers which may look very different can each be good, original, and even creative. There are several ways, for example, of writing an effective answer to address the critically discuss requirement as in the SAQs here. This does not mean describe or give a list: it means evaluating or assessing the merits or demerits of a particular set of facts, lines of reasoning, etc., to arrive at a reasoned conclusion. This requires practice and no two people will do it in the same way! You will need to develop your own style of producing written answers. Remember too that written answers need a proper introduction, and should be as full as the time allowed permits and should be written in good English with proper use of grammar, syntax and punctuation.
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(Note that you should work on a maximum of 4045 minutes being available to answer any question in an unseen examination situation.)
Question 1
What do you think are the main purposes of accounting? Critically discuss how accounting and nancial information full different objectives for different interested parties.
Suggested answer
It would be helpful rst, perhaps, to give a denition of accounting (see Section 1.1), before going on to consider the reasons for and objectives of accounting stewardship, accountability, planning and decision making (see Section 1.2). The different users, their perspectives and needs (see Section 2.4) could be discussed, and also the concept of decision-usefulness as operationalised in the IASB and ASB conceptual frameworks (see Session 4, especially Sections 4.1.2, 4.2.2, 4.2.3 and 4.3.1; also see Section 3.5).
Question 2
Critically discuss the role of accounting and reporting in different types of business organisation.
Suggested answer
First here the role of accounting in general might be discussed (see Section 3.1) before considering the different types of business organisation. Their legal form (see Section 2.2.3) may be a primary factor, as this determines which accounting and reporting rules apply. Most organisations which keep accounting books will use double-entry bookkeeping, so often it is the reporting requirements, as determined by various regulations, which result in different presentation of information for different purposes, some of which is governed by users needs (see the answer to Question 1 here too).
Question 3
How exactly do political, legal, macroeconomic, social, demographic and technological factors inuence business? Discuss with reference to the implications for accountants and accounting.
Suggested answer
The material to answer this question is contained in Section 3.2.
Question 4
Critically discuss the similarities and differences between the ASBs Statement of Principles and the IASB Conceptual Framework.
Suggested answer
Session 4, in its discussion of the ASBs Statement of Principles, in Section 4.3.1, points to the similarities and differences between this and the IASB Conceptual Framework. In addressing this question you will need to consider aspects in depth, so will need to refer back to Section 4.2, which discusses relevant issues in greater detail.
References
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References
Table of statutes
Great Britain. Charities Act 2006. Elizabeth II. Chapter 50. (2006) London: The Stationery Ofce.
Great Britain. Companies Act 1985. Elizabeth II. Chapter 6. (1985) London:
The Stationery Ofce.
Great Britain. Companies Act 1989. Elizabeth II. Chapter 40. (1989) London: The Stationery Ofce.
Great Britain. Companies Act 2006. Elizabeth II. Chapter 46. (2006) London:
The Stationery Ofce.
Great Britain. Companies (Audit, Investigations and Community Enterprise)
Act 2004. Elizabeth II. Chapter 27. (2004) London: The Stationery Ofce.
Great Britain. Limited Liability Partnerships Act 2000. Elizabeth II.
Chapter 12. (2000) London: The Stationery Ofce.
Great Britain. Limited Liability Partnerships Act (Northern Ireland) 2002.
Elizabeth II. Chapter 12. (2002) London: The Stationery Ofce.
7 Edw. VII, c. 24 (Limited Partnerships Act 1907).
53 & 54 Vict., c. 39 (Partnership Act 1890).
Books
Elliott, B. and Elliott, J. (2009) Financial Accounting and Reporting (13th
edn), Harlow, Essex, Pearson Education Limited.
Smith, T. (1992) Accounting for Growth, UK, Century Business.
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Acknowledgements
Grateful acknowledgement is made to the following sources: Text Activity 2.3: Annual Report (2010) www.j-sainsbury.co.uk. Material made available courtesy of J Sainsbury plc Figures Figure 7: FRC Ltd Board 2009. # Financial Reporting Council 2009 Figure 8: International Accounting Standards Board. Copyright # International Accounting Standards Committee Foundation Figure 9: # IASB 2009 Figure 10: Accounting Standards Board (1999) Statement of Principles for Financial Reporting. ASB Illustrations Page 8: Portrait of Luca Pacioli (c. 1445c.1514). # The Bridgeman Art Library Page 44: John Morris, www.CartoonStock.com Page 45: # David Brown, www.CartoonStock.com Page 45: Ms Lat 209 fol.6v Jupiter, detail of fruit and grain merchants, from 'De Sphaera', c.1470 (vellum) (detail of 308309), De Predis, Cristoforo (1440/4586) (attributed to) / Biblioteca Estense, Modena, Italy / Giraudon / The Bridgeman Art Library Page 49: Neil Bennet, www.CartoonStock.com Page 50: Copyright 2002 by Randy Glasbergen. www.glasbergen.com Page 61: With permission from Bill Monroe, www.MonroeArtist.com Page 62: With permission from Bill Monroe, www.MonroeArtist.com Every effort has been made to contact copyright holders. If any have been inadvertently overlooked the publishers will be pleased to make the necessary arrangements at the rst opportunity.

Unit 1: The Purpose and Context of Financial Accounting and Reporting

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B291 Financial accounting

Session 4 Accounting conceptual frameworks,

Learning aims and outcomes of Unit 1

Session 1 The purpose of accounting

1 0The purpose of accounting

1.1 Denitions of bookkeeping, accounting and reporting

Unit 1 The purpose and context of nancial accounting and reporting

Portrait of Luca Pacioli

Session 1 The purpose of accounting

Accounting and reporting

Unit 1 The purpose and context of nancial accounting and reporting

Session 1 The purpose of accounting

Unit 1 The purpose and context of nancial accounting and reporting

1.2 Reasons for and objectives of accounting

Planning and decision making

Session 1 The purpose of accounting

Unit 1 The purpose and context of nancial accounting and reporting

1.3 Management and nancial accounting

When information is prepared

Normally prepared on a monthly basis.

Session 1 The purpose of accounting

Take ten minutes or so to write down your answer.

1.4 The main elements of accounting information

Income and expenses

Unit 1 The purpose and context of nancial accounting and reporting

Example of an income statement

Session 1 The purpose of accounting

Assets and liabilities

Unit 1 The purpose and context of nancial accounting and reporting

Session 1 The purpose of accounting

Unit 1 The purpose and context of nancial accounting and reporting

10,000 of personal savings used by someone starting up a business.

Session 1 The purpose of accounting

1.5 The main nancial statements

To the above, we must also add:

Session 2 The context of accounting

2 0The context of accounting

2.1 Business and its objectives

Unit 1 The purpose and context of nancial accounting and reporting

2.2 Classifying business organisations

Classication by primary activity

Session 2 The context of accounting

Classication by legal form

Limited liability partnerships

Companies limited by shares

Companies limited by guarantee

Figure 5 Different business organisations by reference to legal form

Unit 1 The purpose and context of nancial accounting and reporting

Session 2 The context of accounting

Unit 1 The purpose and context of nancial accounting and reporting

Session 2 The context of accounting

Unit 1 The purpose and context of nancial accounting and reporting

Session 2 The context of accounting

Unit 1 The purpose and context of nancial accounting and reporting

(for example, the Professional Golf Association (PGA)

Session 2 The context of accounting

Unit 1 The purpose and context of nancial accounting and reporting

Session 2 The context of accounting

Classication by reference to prot aims

Unit 1 The purpose and context of nancial accounting and reporting

organisations (NFPs) or non-prot organisations (NPOs), and might include:

(Did you know that HMRC did all this?)