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Compiled by N. C. McGuigan and T. Kern © 2011 Pearson

Chapter 1

Introduction to accounting and

finance

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Learning objectives

1. Define accounting

2. Discuss the role of accounting information

3. List the main user groups for a business entity

4. Summarise the different uses that can be made of accounting information

5. Explain the different procedures involved in the accounting information system

6. State the key characteristics of accounting information

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Learning objectives cont’d

7. Discuss the recent crisis in accounting

8. Relate the steps in the planning process

9. Discuss the nature of control in the decision-making process

10. List some alternative business objectives

11. Compare and contrast financial and management accounting

12. Provide an overview of the main financial statements

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Nature and role of accounting

Learning objective 1: Define accounting

• Accounting is concerned with the collection, analysis and communication of economic information.

• Accounting information is useful to those who need to make decisions and plans about businesses, and for those who need to control those businesses.

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Nature and role of accounting cont’d

Learning objective 2: Discuss the role of accounting information

• Stewardship

The more traditional role of providing accountability reports of transactions for a given period

• Decision usefulness

The more recent role of assisting users with making informed choices about the allocation of scarce resources

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Nature and role of accounting cont’d

Figure 1.1

Learning objective 3: List the main user groups for a business entity

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Nature and role of accounting cont’d

Learning objective 4: Summarise the different uses that can be made of accounting information

User group Use

Customers To assess the ability of the business to continue in business and to supply the needs of the customers.

Suppliers To assess the ability of the business to pay for the goods and services supplied.

Government To assess how much tax the business should pay, whether it complies with agreed pricing policies, or with environmental legislation, etc.

Owners To assess how effectively the managers are running the business and to determine likely levels of risk and return in the future.

Lenders To assess the ability of the business to meet its obligations and to pay interest and to repay the principal.

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Nature and role of accounting cont’d

Learning objective 4: Summarise the different uses that can be made of accounting information cont’d

User group Use

Employees (non-management)

To assess the ability of the business to continue to provide employment and to reward employees for their labour.

Investment analysts

To assess the likely risks and returns of the business in order to determine its investment potential and to advise clients accordingly.

Community representatives

To assess the ability to continue to provide employment, to use community resources, to help fund environmental improvements, etc.

Managers To help make decisions and plans for the business and to help exercise control to try to ensure that plans come to fruition.

Competitors To stay abreast of what and how well other businesses in the market are doing.

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Accounting as an information system

Learning objective 5: Explain the different procedures involved in the accounting information system

• Identify and capture relevant economic information• Record the information collected in a systematic manner• Analyse and interpret the information collected• Report the information in a manner that suits the needs

of users

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Accounting as an information system cont’d

Figure 1.2

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Accounting as a service function

Learning objective 6: State the key characteristics of accounting information

• Relevance (ability to influence decisions)

• Reliability (free from material error or bias)

• Comparability (same treatment for measurement and presentation purposes for basically same items)

• Understandability (clarity and readability of presentation)

• Balance between benefit and cost of information (Is the benefit worth the cost?)

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Characteristics of accounting information

Figure 1.3

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Accounting in crisis

Learning objective 7: Discuss the recent crisis in accounting

• Enron, HIH, Feltex, and over 20 finance companies in

NZ are cases of recent notoriety

• HIH collapse caused losses of up to $5.3 billion

• Resultant scrutiny led to accusations of dubious

accounting practices

• Credibility of financial reports has been undermined

• Tighter controls on quality of financial information have

been introduced

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Decision making, planning and control

• Planning is vital for successful businesses of all sizes

• Where more than one manager is involved, coordination is vital

• Closely linked to planning is decision making

• Planning involves decisions about the best course of action

• Planning covers both long-term and short-term scenarios

• Over time, plans need to be adapted to changing circumstances

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Decision making, planning and control cont’d

Learning objective 8: Relate the steps in the planning process

Planning is usually broken down into three stages:

1. Setting the objectives or mission of the business

(Detailing what the business is basically trying to achieve)

2. Setting long-term plans

(Describing how the business will set out to achieve its long-term objectives, usually over a period of five years or more)

– Setting detailed short-term plans or budgets

(Typically financial plans for one year ahead)

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Decision making, planning and control cont’d

Learning objective 9: Discuss the nature of control in the decision-making process

• Control is the process of making planned events actually occur• Accounting is useful in the control process to compare planned

with actual outcomes in commonly specified terms• Managers can take steps to get the business back on track if

accounting information highlights relevant variances between planned and actual outcomes

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Overview of the planning and control process

Step 1

Step 2

Step 3

Step 4

Step 5

Step 6

Step 7

Identify business objectives

Consider options

Prepare a long-term plan based on the most appropriate option(s)

Perform and collect information on actual performance

Prepare short-term plans (budgets)

Respond to divergences between plans and actuals,and exercise control

Revise plans (and budgets) if necessary Figure 1.4

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Business objectives

Learning objective 10: List some alternative business objectives

The popular suggested business objectives include:

• Maximisation of sales revenue (this does not consider the need to cover business costs)

• Maximisation of profit (this takes in to account sales revenues as well as expenses, but is limited as it does not include other factors such as the level of investment or risk)

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Business objectives cont’d

• Maximisation of return on capital employed (accounts for level of profit as well as the level of investment)

• Survival (this is the aim of most businesses, however it is rarely a primary objective)

• Long-term stability (like survival, most businesses aim for it, but it is rarely a primary objective)

• Growth (encompasses survival and long-term stability and aims to strike a balance between short- and long-term benefits, however it is probably not a specific enough target)

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Business objectives cont’d

• Satisficing (attempting to grant a satisfactory return to all stakeholders – not just the owners; difficult to define as a practical benchmark for business decisions)

• Achieving sustainable development (achieving economic growth while minimising or eliminating environmental impact and meeting society’s expectations of good corporate citizenship)

• Enhancement/maximisation of business wealth (the business takes decisions intended to make it worth more; encompasses all the valuable features of the previous suggested objectives and is likely to be the main financial objective for many businesses)

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Financial and management accounting

Learning objective 11: Compare and contrast financial and management accounting

• Management accounting is concerned with providing managers with information required for the day-to-day running of the business

• Financial accounting is concerned with providing the other users with useful information

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Financial and management accounting cont’d

Financial accounting Management accounting

Focus Mainly external Internal only

Nature of reports General purpose Specific purpose

Level of detail Broad overview Quite detailed

Restrictions Accounting standards and other regulations

No restrictions

Reporting interval Mainly semi-annual or annual Whenever required

Time horizon Mainly historical Both past and future

Range of information Quantifiable in money terms; focus on objective and verifiable data

Can contain non-financial information; less focus on objectivity and verifiability

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The main financial statements – an overview

Learning objective 12: Provide an overview of the main financial statements

There are four main financial statements:• The statement of cash flows (shows the sources and uses of

cash for a period)• The statement of comprehensive income (commonly referred

to as the income statement, sometimes called the profit and loss statement; measures and reports how much profit has been generated in a period)

• The statement of changes in equity (sometimes referred to as the statement of changes in owners’ equity; shows all changes in owners’ interest in the net assets from transactions during the period)

• The statement of financial position (commonly referred to as the balance sheet; shows the assets of a business and the claims on those assets)

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• Paul starts a wrapping paper sales business with $100

• On the first day, he uses the $100 to purchase wrapping paper

(‘inventory’)

• On the same day he sells 75% of that inventory for $110 in total

What cash movements took place in the first day of trading?

• Closing cash balance for the day is $110 (opening balance $100

– $100 stock purchase + $110 sales = $110)

A simple example

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A simple example cont’d

How much did wealth increase as a result of the first day’s trading?

• The increase or decrease in wealth is measured as the difference between sales made and the cost of goods sold

• sales were $110 less cost of goods sold $75 = profit of $35

Note that only the cost of the paper sold is measured against the sales to find profit, not the total cost of the wrapping paper purchased.

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A simple example cont’d

What is the financial position at the end of the first day?

At the end of the first day, a balance sheet is drawn up, showing the resources held by the business:

Cash (closing balance) = $110 Inventory (stock available for resale) = $25 Total business wealth at end of day = $135

Note that the profit of $35 has led to an increase in wealth of $35.Note also that the increase in cash of $10 is not the same as the increase in wealth because wealth does not exist only in the form of cash (see inventory).

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Financial statements relationships

Balance sheet at the beginning of Period 1

Balance sheet at the end of Period 2

Balance sheet at the end of Period 1

Period 1 Period 2 Time

Income statement Income statement

Cash flow statement

Statement of changesin equity

Cash flow statement

Statement of changesin equity

Figure 1.6