Understanding Accounting Essentials: Users, Reporting & Business Types

1. Chapter 1 Who needs accounting?

2. Definition of accounting Accountingis the process of identifying, measuring and communicating financial information about an entity to permit informed judgements and decisions by users of the information

3. The development of a conceptual framework A conceptual framework for accounting is a statement of principles which provide generally accepted guidance for the development of new reporting practices and for challenging and evaluating the existing practices.

4. Conceptual framework (Continued) • Who are the users of financial statements? • What are the information needs of users? • What types of financial statements will best satisfy their needs? • What are the characteristics of financial statements which meet these needs? • What are the principles for defining and recognising items in financial statements? • What are the principles for measuring items in financial statements?

5. External reporting A conceptual framework is particularly important when practices are being developed for reporting to those who are not part of the day-to-day running of the business. This is called external reporting or financial accounting.

6. Internal reporting • For those who are managing the business on a day-to-day basis, special techniques have been developed. • This is called internal reporting or management accounting.

7. Types of business entity • Sole trader • Partnership • Limited liability company

8. Sole trader • An individual may enter into business alone, either selling goods or providing a service. • If cash is not available, the sole trader may borrow from a bank to start the business. • Sole trader’s business may be very much intertwined with the personal life. • For accounting purposes, the business is regarded as a separate economic entity, of which the sole trader is the owner who takes the risk of the bad times and the benefit of the good times.

9. Sole trader (Continued) • The owner may hardly feel any great need for accounting information because he or she knows the business very closely, but accounting information will be needed by: • Government (HM Revenue and Customs) for tax collecting purposes. • The bank for the purposes of lending money to the business or • A person intending to buy the business when the existing owner retires.

10. Partnership • Sole trader may expand to enter into partnership with one or more people. • Permits a pooling of skills or may allow one person with ideas to work with another who has the money to provide the resources needed to turn the ideas into a profit. • But there are real financial risks if the business is unsuccessful.

11. Partnership (Continued) • One partner may be required to meet all the obligations of the partnership if the other partner does not have sufficient personal property, possessions and cash. This is described in law as joint and several liability. • For accounting purposes, the partnership is seen as a separate economic entity, owned by the partners.

12. Partnership (Continued) Need for accounting information: • Partners wishing to be sure that they are receiving a fair share of the partnership profits. • HM Revenue and Customs. • Banks who provide finance. • Other persons who may be invited to join the partnership. The major risk attached to either a sole trader or a partnership is that of losing their personal property and possessions including the family home, if the business fails.

13. Limited liability company To encourage the development of larger business entities owners needed the protection of limited liability. This meant that if the business failed, then the owners might lose all the money they had put into the business but their personal wealth would be safe.

14. Plc and Ltd • A private limited company has the word ‘Limited’ (abbreviated as ‘Ltd’) in its title. • A public limited company has the abbreviation ‘plc’ in its title. • A private limited company is prohibited by law from offering its shares to the public, (appropriate to a family-controlled business). • The public limited company is permitted to offer its shares to the public. In return, it has to satisfy more onerous regulations.

15. Formation Table 1.1 Differences between a partnership and a limited liability company

16. Running the business Accounting information Table 1.1 Differences between a partnership and a limited liability company (Continued)

17. Meeting obligations Table 1.1 Differences between a partnership and a limited liability company (Continued)

18. Users and their information needs Management • Concerned with running the business, using assets to generate profit. Need information on performance and position. Table 1.1 Differences between a partnership and a limited liability company (Continued)

19. Users and their information needs (Continued) Owners as investors • In larger companies there is separation of ownership from management. • Owners as investors. Is the return from the investment, at present and in the future, adequate? Make decisions about buying, holding and selling shares. Interested in the entities financial performance and financial position. • Most shares of listed companies are traded by fund managers of financial institutions on the advice of equity analysts.

20. Users and their information needs (Continued) Employees • Ability to pay wages and continuity of employment. • Issues associated with the working environment. Lenders • Economic stability. • Vulnerability.

21. Users and their information needs (Continued) Suppliers or trade creditors • Will the company pay for supplies delivered on credit terms? Customers or trade debtors • Continuity of supply.

22. Users and their information needs (Continued) Governments and their agencies • Governmental planning, national statistics, taxation and regulation of utilities Public interest • Impact on local economy • Environmental concerns

23. General purpose or specific purpose ? • Each user group has its specific information needs. • But there is a view that a general purpose financial statement can be designed which is useful to more than one user group. • Owners and long-term lenders regarded as primary users but all potential users are interested in financial performance and financial position of the reporting entity.

24. Agency theory • Relationship between the owner (principal) and the manager (agent). • There is an inherent conflict between the interests of owners and managers. This conflict is partly resolved by the managers being required to provide information on a regular basis to the owners so their decisions and behaviour can be monitored and assessed.