UNDERSTANDING ACCOUNTING AND FINANCE

This first chapter of the book introduces some of the principles underlying the preparation of financial statements. Financial statements are prepared for a variety of users with a variety of needs. In general though, all user groups need information that will be useful for making economic decisions. Learning outcomes • Define accounting and the information it provides • Identify the users of financial accounting information • Identify and explain the various accounting conventions WHAT IS ACCOUNTING? A definition of accounting issued by the American Accounting Association in 1966 suggested that accounting consists of identifying, measuring and communicating business information to facilitate judgement and decision making. This definition placed its emphasis firmly on the provision of data for users and played down the more traditional roles of the accountant in recording, classifying and summarizing financial data. It is of course, necessary to record and summarize transactions before financial information can be measured and used by decision-makers. Of great importance to accountants, however, is the need to communicate the information derived from their records, and if necessary to interpret that information to improve its comprehension by the users, who may after all have borne the cost of the information systems. Thus, accounting is seen not as an end in itself but as a costly activity with a purpose whose benefits must exceed the cost. Accounting is, therefore, concerned with: 1. Identification and recording of economic transactions. A transaction is an economic event which will affect the financial situation of the entity, such as the sale of a product, payment of salaries, purchase of machinery, and so on. The system must be organized so that all transactions are recognized when they occur and are then recorded by being entered into the accounting system. This is part of the bookkeeping aspect of accounting and concerns the maintenance of accurate records of what has taken place. 2. Classification and measurement of transactions once they are recorded. Economic events may create assets (items which the business owns), or liabilities (what is owed), or revenues (income from sales), or expenses (amounts incurred to make products or operate the business), so classification is important. Once transactions are classified into appropriate headings, measurement must be undertaken to ensure that each classified transaction is processed in the accounting system at a proper value. It is at this point that bookkeeping gives way to accounting, and judgement is required to measure each transaction properly, e.g. how much of the costs concerns this year’s accounts, and how much should be carried forward to next year. Two accountants may exercise judgement in different ways over the same item such as the valuation of a doubtful debt, so what is considered to be correct may depend on estimate and opinion. 3. Summarizing of what has been recorded, to assess the performance of the entity during a period (a month or a year) and its financial position at the beginning and end of the period. Financial statements such as the income statement and the balance sheet are summaries of economic events, and the cash flow statement gives yet another view of how transactions have affected the cash and liquid funds held by the entity. 4. Communicating, analysis and interpretation. Financial statements report to a wide range of users and must therefore be drafted with care to enable the recipient to understand the message which they contain. If necessary the accountant will analyze and interpret that message to enhance the value of the information provided.