Chapter 1: Introduction to accounting

Chapter learning objectives

Upon completion of this chapter you will be able to:

• define accounting
• explain the different types of business entity:
  • sole trader
  • partnership
  • limited liability company
• explain who users of the financial statements are and their information needs
• explain the nature, principles and scope of accounting
• explain how the accounting system contributes to providing useful information and complies with organisational policies and deadlines.

1 Definition of accounting

Analysing data is also an important feature of accounting. Financial statements are prepared so that we can examine and evaluate all information, in order to make key decisions.

2 Types of business entity

A business can be organised in one of several ways:

• Sole trader – a business owned and operated by one person.
• Partnership – a business owned and operated by two or more people.
• Company – a business owned by many people and operated by many (though not necessarily the same) people.

Differences between a sole trader, partnership and company

Sole trader

The simplest form of business is the sole trader. This is owned and managed by one person, although there might be any number of employees. A sole trader is fully and personally liable for any losses that the business might make.

Partnership

A partnership is a business owned jointly by a number of partners. The partners are jointly and severally liable for any losses that the business might make. Traditionally the big accounting firms have been partnerships, although some are converting their status to limited liability companies.

Companies

Companies are owned by shareholders. There can be one shareholder or many thousands of shareholders. Shareholders are also known as members. Each shareholder owns part of the company. As a group, they elect the directors who run the business. Directors often own shares in their companies, but not all shareholders are directors.

Companies are almost always limited companies. This means that the shareholders will not be personally liable for any losses the company incurs. Their liability is limited to the nominal value of the shares that they own. Their shares may become worthless, but they will not be forced to make good the losses.

This limited liability is achieved by treating the company as a completely separate legal entity.

For all three types of entity, the money put up by the individual, the partners or the shareholders, is referred to as the business capital. In the case of a company, this capital is divided into shares.

Advantages and disadvantages of operating as a limited company, sole trader or partnership

Sole trader

As the name suggests, this is an organisation owned by one person.

Accounting conventions recognise the business as a separate entity from its owner. However, legally, the business and personal affairs of a sole trader are not distinguished in any way. The most important consequences of this is that a sole trader has complete personal unlimited liability. Business debts which cannot be paid from business assets must be met from sale of personal assets, such as a house or a car.

Sole trading organisations are normally small because they have to rely on the financial resources of their owner.

The advantages of operating as a sole trader include flexibility and autonomy. A sole trader can manage the business as he or she likes and can introduce or withdraw capital at any time.

Partnership

A partnership is two or more persons associated for the purpose of a business or a profession. Like a sole trader, a partnership is not legally distinguished from its members. Personal assets of the partners may have to be used to pay the debts of the partnership business.

The advantages of trading as a partnership stem mainly from there being many owners rather than one. This means that:

• more resources may be available, including capital, specialist knowledge, skills and ideas;
• administrative expenses may be lower for a partnership than for the equivalent number of sole traders, due to economies of scale; and
• partners can substitute for each other.

Partners can introduce or withdraw capital at any time, provided that all the partners agree.

Limited company

A limited company is a distinct, artificial 'person' created in order to separate legal responsibility for the affairs of a business (or any other activity) from the personal affairs of the individuals who own and/or operate the business.

The owners are known as shareholders (or members) and the people who run the business are known as directors. In a small corporation, owners and directors are often the same people.

Limited Liability

The concept of limited liability is based on the premise that the company's debts and liabilities are those of the company and not those of the members.

Limited liability refers to the liability of each shareholder being limited to any unpaid amount on their shares. Usually, all the shares are fully paid so the members have no liability.

Comparison of limited companies to sole traders and partnerships

The fact that a company is a separate legal entity means that it is very different from a sole trader or partnership in a number of ways.

• Property holding

  The property of a limited company belongs to the company. A change in the ownership of shares in the company will have no effect on the ownership of the company's property. (In a partnership the firm's property belongs directly to the partners who can take it with them if they leave the partnership.)

• Transferable shares

  Shares in a limited company can usually be transferred without the consent of the other shareholders. In the absence of agreement to the contrary, a new partner cannot be introduced into a firm without the consent of all existing partners.

• Suing and being sued

  As a separate legal person, a limited company can sue and be sued in its own name. Judgements relating to companies do not affect the members personally.

• Number of members

  There is no upper limit on the number of members in a company. In a partnership, except in certain restricted categories, such as accountants and stockbrokers, the maximum number of partners is 20. This limitation on numbers makes it difficult for a partnership to raise large amounts of capital.

• Security for loans

  A company has greater scope for raising loans by, for example, borrowing on debentures (long-term borrowings) and may secure them with floating charges. A floating charge is a mortgage over the constantly fluctuating assets of a company providing security for the lender of money to a company. It does not prevent the company dealing with the assets in the ordinary course of business. Such a charge is useful when a company has no non-current assets such as land, but does have a large and valuable inventories.

  The law does not permit partnerships or individuals to secure loans with a floating charge.

• Taxation

  Because a company is legally separated from its members, it is taxed separately from its members. Tax payable by companies is known as corporation tax. Partners and sole traders are personally liable for income tax on the profits made by their business.

• Disadvantages of incorporation

  The disadvantages of being a limited company arise principally from restrictions imposed by the Companies Act 2006.

Formalities, publicity and expenses

When they are being formed, companies have to register and to file a Memorandum and Articles of Association (formal constitution documents) with the Registrar. Registration fees and legal costs have to be paid.

The accounts of larger limited companies are subject to an annual audit inspection (this requirement has been lifted for small companies). The costs associated with this can be high. Partnerships and sole traders are not subject to this requirement unless as members of professional bodies whose own rules apply.

A registered company's accounts and certain other documents are open to public inspection. The accounts of sole traders and partnerships are not open to public inspection.

Capital maintenance

Limited companies are subject to strict rules in connection with the introduction and withdrawal of capital and profits.

Management powers

Members of a company may not take part in its management unless they are directors, whereas all partners are entitled to share in management, unless the partnership agreement provides otherwise.

3 Users of the financial statements

Different user groups are interested in a company's financial statements for different reasons:

• Management need detailed information in order to control their business and plan for the future. Budgets will be based upon past performance and future plans. These budgets will then be compared with actual results. Information will also be needed about the profitability of individual departments and products. Management information must be very up to date and is normally produced on a monthly basis.
• Investors and potential investors are interested in their potential profits and the security of their investment. Future profits may be estimated from the target company’s past performance as shown in the income statement. The security of their investment will be revealed by the financial strength and solvency of the company as shown in the statement of financial position. The largest and most sophisticated groups of investors are the institutional investors, such as pension funds and unit trusts.
• Employees and trade union representatives need to know if an employer can offer secure employment and possible pay rises. They will also have a keen interest in the salaries and benefits enjoyed by senior management. Information about divisional profitability will also be useful if a part of the business is threatened with closure.
• Lenders need to know if they will be repaid. This will depend on the solvency of the company, which should be revealed by the statement of financial position. Long-term loans may also be backed by ‘security’ given by the business over specific assets. The value of these assets will be indicated in the statement of financial position.
• Government agencies need to know how the economy is performing in order to plan financial and industrial policies. The tax authorities also use financial statements as a basis for assessing the amount of tax payable by a business.
• Suppliers need to know if they will be paid. New suppliers may also require reassurance about the financial health of a business before agreeing to supply goods.
• Customers need to know that a company can continue to supply them into the future. This is especially true if the customer is dependent on a company for specialised supplies.
• Competitors wish to compare their own performance against that of other companies and learn as much as possible about their rivals in order to help develop strategic plans.
• The public may wish to assess the effect of the company on the economy, local environment and local community. Companies may contribute to their local economy and community through providing employment and patronising local suppliers. Some companies also run corporate responsibility programmes through which they support the environment, economy and community by, for example supporting recycling schemes.

Test your understanding 1

Which of the following users do you think require the most detailed financial information to be made available to them?

A Competitors

B Management of the business

C Trade unions

D Investors

4 Types of accounting

Financial accounting and management accounting

Financial accounting

Financial accounting is concerned with the production of financial statements for external users. These are a report on the directors’ stewardship of the funds entrusted to them by the shareholders.

Investors need to be able to choose which companies to invest in and compare their investments. In order to facilitate comparison, financial accounts are prepared using accepted accounting conventions and standards. International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs) help to reduce the differences in the way that companies draw up their financial statements in different countries.

The financial statements are public documents, and therefore they will not reveal details about, for example, individual products’ profitability.

Management accounting

Management require much more detailed and up-to-date information in order to control the business and plan for the future. They need to be able to cost-out products and production methods, assess profitability and so on. In order to facilitate this, management accounts present information in any way which may be useful to management, for example by operating unit or product line.

Management accounting is an integral part of management activity concerned with identifying, presenting and interpreting information used for:

• formulating strategy
• planning and controlling activities
• decision making
• optimising the use of resources.

5 How an accounting system contributes to providing useful information

The main features of an accounting system and how it helps in providing information to the business are as follows:

• In a computerised system all information about the business transactions can be quickly accessed. This will help in decision making.
• It provides details of transactions of the business in the relevant accounts.
• When the accounts are closed off the balances for each outstanding account are determined. This will give the value of assets and liabilities in the business.
• It gives a summary of outstanding balances.
• This summary can then be used for the preparation of financial statements.
• Normally the financial statements are prepared at regular intervals. The accounting system will allow the business to obtain the data and also prepare the financial statements to determine the profitability, liquidity, risks, etc. applicable to the business for a particular period. For internal reporting purposes this could be monthly, whilst for external reporting purposes this is usually yearly.

6 The regulatory system

Structure of the international regulatory system

International Financial Reporting Standards (IFRS) Foundation

The IFRS Foundation (formerly known as the International Accounting Standards Committee Foundation (IASC)):

• is the supervisory body for the IASB
• has 22 trustees
• is responsible for governance issues and ensuring each body is properly funded

The objectives of the IFRS Foundation are to:

• develop a set of global accounting standards which are of high quality, are understandable and are enforceable
• which require high quality, transparent and comparable information in financial statements to help those in the world’s capital markets and other users make economic decisions
• promote using and applying these standards
• bring about the convergence of national and international accounting standards.

International Accounting Standards Board (IASB)

The IASB:

• is solely responsible for issuing International Accounting Standards (IASs)
• standards now called International Financial Reporting Standards (IFRSs)
• is made up of 15 members
• has the same objectives as the IFRS Foundation.

The IASB and national standard setters

The intentions of the IASB are:

• to develop a single set of understandable and enforceable high quality worldwide accounting standards, however
• the IASB cannot enforce compliance with its standards, therefore
• it needs the co-operation of national standard setters.

In order to achieve this the IASB works in partnership with the major national standard-setting bodies:

• All the most important national standard setters are represented on the IASB and their views are taken into account so that a consensus can be reached.
• All national standard setters can issue IASB discussion papers and exposure drafts for comment in their own countries, so that the views of all preparers and users of financial statements can be represented.
• Each major national standard setter ‘leads’ certain international standard-setting projects.

The IASB intends to develop a single set of understandable and enforceable high quality worldwide accounting standards.

As far as possible, future international standards will be more rigorous than previously and will no longer allow alternative treatments. The Chairman of the IASB, Sir David Tweedie has already stated that there will not be ‘convergence for the sake of convergence by the issue of a set of ‘lowest common denominator’ accounting standards’.

Because the IASB on its own cannot enforce compliance with its standards, it needs the co-operation of national standard setters. Without their support, rigorous new international standards are unlikely to be adopted by everybody. Therefore, the IASB works in partnership with the major national standard setting bodies, including the UK Accounting Standards Board (ASB) and the US Financial Accounting Standards Board (FASB).

Each major national standard setter ‘leads’ certain international standard-setting projects, e.g. the UK ASB is carrying out much of the work to develop a new international standard on leasing.

All the major national standard-setters are now committed to international convergence.

The regulatory framework of accounting in each country which uses IFRS is affected by a number of legislative and quasi-legislative influences as well as IFRS:

• national company law
• EU directives
• security exchange rules.

Why a regulatory framework is necessary

A regulatory framework for the preparation of financial statements is necessary for the following reasons:

• Financial statements are used by a wide range of users – investors, lenders, customers, etc.
• They need to be useful to these users.
• They need to be comparable.
• They need to provide at the least some basic information.
• They increase users’ understanding of, and confidence in, financial statements.
• They regulate the behaviour of companies towards their investors.

Accounting standards on their own would not be a complete regulatory framework. In order to fully regulate the preparation of financial statements and the obligations of companies and directors, legal and market regulations are also required.

Principles-based and rules-based framework

Principles-based framework:

• based upon a conceptual framework such as the IASB's Framework
• accounting standards are set on the basis of the conceptual framework.

Rules-based framework:

• ‘Cookbook’ approach
• accounting standards are a set of rules which companies must follow.

In the UK there is a principles-based framework in terms of the Statement of Principles and accounting standards and a rules-based framework in terms of the Companies Acts, EU directives and stock exchange rulings.

IFRIC

International Financial Reporting Interpretations Committee (IFRIC)

• issues rapid guidance on accounting matters where divergent interpretations of IFRSs have arisen
• issues interpretations called IFRIC 1, IFRIC 2, etc.

The IFRIC addresses issues of reasonably widespread importance, not issues that are of concern to only a small minority of entities. The interpretations cover both:

• newly identified financial reporting issues not specifically dealt with in IFRSs; or
• issues where unsatisfactory or conflicting interpretations have developed, or seem likely to develop in the absence of authoritative guidance, with a view to reaching a consensus on the appropriate treatment.

In 1997 the IASC formed the Standing Interpretations Committee (SIC) to ensure proper compliance with IFRSs by considering points of contention where divergent interpretations have emerged and issuing an authoritative view; 33 interpretations (entitled SIC 1, SIC 2, etc) were issued by the SIC before its change of name (see below).

SICs are important because IAS 1 (revised) states that financial statements cannot be described as complying with IFRSs unless they comply with each IAS/IFRS and each interpretation from the SIC/IFRIC.

In 2002 the SIC changed its name to the International Financial Reporting Interpretations Committee (IFRIC). Interpretations are now designated IFRIC 1, IFRIC 2, etc.

IFRS Advisory Council (IAC)

The Advisory Council (formerly known as the Standards Advisory Council – SAC) provides a forum for the IASB to consult a wide range of interested parties affected by the IASB's work, with the objective of:

• advising the Board on agenda decisions and priorities in the Board's work,
• informing the Board of the views of the organisations and individuals on the Council on major standard-setting projects, and
• giving other advice to the Board or to the Trustees.

Development of an IFRS

The procedure for the development of an IFRS is as follows:

• The IASB identifies a subject and appoints an advisory committee to advise on the issues.
• The IASB publishes an exposure draft for public comment, being a draft version of the intended standard.
• Following the consideration of comments received on the draft, the IASB publishes the final text of the IFRS.
• At any stage the IASB may issue a discussion paper to encourage comment.
• The publication of an IFRS, exposure draft or IFRIC interpretation requires the votes of at least eight of the 15 IASB members.

Status of IFRS's

Neither the IFRS Foundation, the IASB nor the accountancy profession has the power to enforce compliance with IFRSs. Nevertheless, some countries adopt IFRSs as their local standards, and others ensure that there is minimum difference between their standards and IFRSs. In recent years, the status of the IASB and its standards has increased, so IFRSs carry considerable persuasive force worldwide.

7 Company ownership and control

8 What is ‘corporate governance’?

The Cadbury Report 1992 provides a useful definition:

• 'the system by which companies are directed and controlled'.

An expansion might include:

• 'in the interests of shareholders' highlighting the agency issue involved
• 'and in relation to those beyond the company boundaries' or
• 'and stakeholders' suggesting a much broader definition that brings in concerns over social responsibility.

To include these final elements is to recognise the need for organisations to be accountable to someone or something.

Governance could therefore be described as:

• 'the system by which companies are directed and controlled in the interests of shareholders and other stakeholders'.

Coverage of governance

Companies are directed and controlled from inside and outside the company. Good governance requires the following to be considered:

Direction from within:

• the nature and structure of those who set direction, the board of directors
• the need to monitor major forces through risk analysis
• the need to control operations: internal control.

Control from outside:

• the need to be knowledgeable about the regulatory framework that defines codes of best practice, compliance and legal statute
• the wider view of corporate position in the world through social responsibility and ethical decisions.

9 Purpose and objectives of corporate governance

Corporate governance has both purposes and objectives.

• The basic purpose of corporate governance is to monitor those parties within a company which control the resources owned by investors.
• The primary objective of sound corporate governance is to contribute to improved corporate performance and accountability in creating long-term shareholder value.

Test your understanding 2

Briefly describe the role of corporate governance.

Is governance relevant to all companies?

Issues in corporate governance relate to companies, and in particular listed companies whose shares are traded on major stock markets. However, similar issues might apply to smaller companies, and certainly to many large not-for-profit organisations.

• Corporate governance is a matter of great importance for large public companies, where the separation of ownership from management is much wider than for small private companies.
• Public companies raise capital on the stock markets, and institutional investors hold vast portfolios of shares and other investments. Investors need to know that their money is reasonably safe.
• Should there be any doubts about the integrity or intentions of the individuals in charge of a public company, the value of the company’s shares will be affected and the company will have difficulty raising any new capital should it wish to do so.
• The scope of corporate governance for private and not-for-profit organisations will be much reduced when compared with a listed company, especially as there are no legal or regulatory requirements to comply with.
• The ownership and control, organisational objectives, risks and therefore focus may be different from a listed company. However, many of the governance principles will still be applicable to other entities.
• The public and not-for-profit sectors have voluntary best practice guidelines for governance which, while appreciating the differences in organisation and objective, cover many of the same topics (composition of governing bodies, accountability, risk management, transparency, etc.) included within the Combined Code.
• In not-for-profit organisations, a key governance focus will be to demonstrate to existing and potential fund providers that money is being spent in an appropriate manner, in line with the organisations’ objectives.

10 Internal corporate governance stakeholders

Within an organisation there are a number of internal parties involved in corporate governance. These parties can be referred to as internal stakeholders.

Stakeholder theory will be covered again later in this chapter, and in more detail in chapter 7. A useful definition of a stakeholder, for use at this point, is 'any person or group that can affect or be affected by the policies or activities of an organisation'.

Each internal stakeholder has:

• an operational role within the company
• a role in the corporate governance of the company
• a number of interests in the company (referred to as the stakeholder 'claim').

Internal stakeholders

The board of directors

• Has the responsibility for giving direction to the company.
• Delegates most executive powers to the executive management, but reserves some decision-making powers to itself, such as decisions about raising finance, paying dividends and making major investments.
• Executive directors are individuals who combine their role as director with their position within the executive management of the company.
• Non-executive directors (NEDs) perform the functions of director only, without any executive responsibilities.
• Executive directors combine their stake in the company as a director with their stake as fully paid employees, and their interests are, therefore, likely to differ from those of the NEDs.
• More detail on directors will be found in chapter 3.

The company secretary

• Often responsible for advising the board on corporate governance matters and ensuring board procedures are followed.
• Duties vary with the size of the company, but are likely to include:
  • arranging meetings of the board
  • drafting and circulating minutes of board meetings
  • ensuring that board decisions are communicated to staff and outsiders
  • completing and signing of various returns
  • filing accounts with statutory authorities
  • maintaining statutory documents and registers required by the authorities.
• Company secretary may act as the general administrator and head office manager. This role may include a responsibility for maintaining accounting records, corresponding with legal advisers, tax authorities and trade associations.
• Does not have the same legal responsibilities as directors.
• Should always act in the interests of the company in any event of conflict or dispute with directors.
• Is responsible to the board and accountable through the chairman and Chief Executive Officer (CEO) for duties carried out.
• Has the same interests and claims in the company as other employees.
• Remuneration package should be settled by the board or remuneration committee.

Management

• Responsible for running business operations.
• Accountable to the board of directors (and more particularly to the CEO).
• Will take an interest in corporate governance decisions which may impact their current position and potential future positions (as main board directors, possibly).
• Individual managers, like executive directors, may want power, status and a high remuneration.
• As employees, they may see their stake in the company in terms of the need for a career and an income.

Employees

• Have a stake in their company because it provides them with a job and an income.
• Have expectations about what their company should do for them, e.g. security of employment, good pay and suitable working conditions.
• Some employee rights are protected by employment law, but the powers of employees are generally limited.

Trade unions

• Primary interest will be in the pay and working conditions of their members.
• Will be concerned by poor corporate governance, for example lack of protection for whistleblowers or poor management of health and safety risks, and hence assist in the checks and balances of power within a company.
• Can ‘deliver’ the compliance of a workforce, particularly in a situation of business reorganisation.
• Can optimise industrial relations, easing workforce negotiations, and hence ensure an efficient and supportive relationship.
• Can be used by management of the company to distribute information to employees or to ascertain their views, hence can play a helpful role in business.
• Power of trade unions will vary between countries, with it being much stronger in countries such as France where union rights are extended to all employees.

11 External corporate governance stakeholders

A company has many external stakeholders involved in corporate governance.

Each stakeholder has:

• a role to play in influencing the operation of the company
• its own interests and claims in the company.

Chapter summary

Test your understanding answers

Test your understanding 1

B Management

They need detailed information in order to control their business and make informed decisions about the future. Management information must be very up to date and is normally produced on a monthly basis.

Other parties will need far less detail:

• Competitors will be monitoring what the competition are currently planning and working on, but they will not be making the key decisions themselves.
• Trade unions will only require information which relates to their job role. They will only be particularly interested in disputes.
• Investors are interested in profitability and the security of their investment.

Test your understanding 2

The role of corporate governance is to protect shareholder rights, enhance disclosure and transparency, facilitate effective functioning of the board and provide an efficient legal and regulatory enforcement framework.

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