Part 1 THE CONTEXT OF ACCOUNTING 1 2 3 4 5 6 7 Itroductio Some fudametals Frameworks ad cocepts The regulatio of accoutig Iteratioal differeces ad harmoizatio The cotets of fiacial statemets Fiacial statemet aalysis
Chapter 1 Itroductio Cotets 1.1 Purposes ad users of accoutig 4 1.2 Accoutig regulatio ad the accoutacy professio 7 1.3 Laguage 9 1.4 Excitemet i accoutig 10 1.5 The path ahead 10 Summary 11 Exercises 11 Objectives After studyig this chapter carefully, you should be able to: explai the scope ad uses of accoutig; outlie the role of atioal ad iteratioal regulators; give some examples of the usages of accoutig terms i differet varieties of Eglish. 3
Chapter 1 Itroductio 1.1 Purposes ad users of accoutig There is o sigle authoritative ad geerally accepted defiitio of fiacial accoutig, or of accoutig i geeral. Accoutig bega as a practical activity i respose to perceived eeds, ad for most of its developmet it has progressed i the same way, adaptig to meet chages i the demads made o it. Where the eeds differed i differet coutries or eviromets, accoutig teded to develop i differet ways as a respose to a particular eviromet, essetially o the Darwiia priciple: useful accoutig survived. Because accoutig developed i differet ways, it is likely that defiitios suggested i differet surroudigs will vary. At a geeral level, accoutig exists to provide a service. I the box below there are three defiitios. These have all bee take from the same ecoomic ad cultural source (the Uited States) because that coutry has the logest history of attemptig explicit defiitios of this type. Note that each suggested defiitio seems broader tha the previous oe, ad the third oe does ot restrict accoutig to fiacially quatifiable iformatio. May would ot accept this last poit. As will be explored i this book, attitudes to accoutig ad its role differ substatially aroud the world ad certaily betwee Europea coutries. Some defiitios of accoutig Accoutig is the art of recordig, classifyig ad summarizig i a sigificat maer ad i terms of moey, trasactios ad evets which are, i part at least, of a fiacial character, ad iterpretig the results thereof. Review ad Resume, Accoutig Termiology Bulleti No. 1 (New York: America Istitute of Certified Public Accoutats, 1953), paragraph 5. Accoutig is the process of idetifyig, measurig ad commuicatig ecoomic iformatio to permit iformed judgemets ad decisios by users of the iformatio. America Accoutig Associatio, A Statemet of Basic Accoutig Theory (Evasto, IL: America Accoutig Associatio, 1966), p.1. Accoutig is a service activity. Its fuctio is to provide quatitative iformatio, primarily fiacial i ature, about ecoomic etities that is iteded to be useful i makig ecoomic decisios, i makig resolved choices amog alterative courses of actio. Accoutig Priciples Board, Statemet No. 4, Basic Cocepts ad Accoutig Priciples Uderlyig Fiacial Statemets or Busiess Eterprises (New York: America Istitute of Certified Public Accoutats, 1970), paragraph 40. 4 If iformatio is to be useful, the some obvious questios arise: useful to whom ad for what purposes? A umber of differet types of people are likely to be dealig with busiess etities: 1. Maagers. These are the people who have to take decisios, both day-to-day ad strategically, about how the scarce resources withi their cotrol are to be used. They eed iformatio that will eable them to predict the likely outcomes of alterative courses of actio. As part of this process, they eed feedback o
1.1 Purposes ad users of accoutig the results of their previous decisios i order to exted successful aspects of the decisios, ad to adapt ad improve the usuccessful aspects. 2. Ivestors. A large etity may have may ivestors who are ot the maagers of the etity. Some ivestors are owers (the shareholders); others provide log-term debt capital. These providers of capital are cocered with the risk iheret i, ad retur provided by, their ivestmets. They eed to determie whether they should buy, hold or sell their ivestmets. Shareholders are also iterested i iformatio to assess the ability of the etity to pay them a retur (kow as a divided). Potetial ivestors have similar iterests. 3. Other leders. Leders (such as baks) are iterested i whether loas, ad the iterest attachig to them, will be paid whe due. 4. Employees. Employees ad their represetative groups are iterested i the profitability of their employers. They also wat to assess the ability of the etity to cotiue to provide remueratio, retiremet beefits ad employmet opportuities. 5. Suppliers. These wat to be able to assess whether amouts owig will be paid whe due. Suppliers are likely to be iterested i a etity over a shorter period tha leders, uless they deped upo the etity as a major cotiuig customer. 6. Customers. Customers eed iformatio about the cotiuace of a etity, especially whe they have a log-term ivolvemet with the etity. 7. Govermets. Govermets ad their agecies eed iformatio i order to regulate the activities of etities ad to collect taxatio, ad as the basis for atioal icome ad similar statistics. 8. Public. Etities affect members of the public i a variety of ways; for example, etities pollute the atmosphere or despoil the coutryside. Accoutig statemets (geerally called fiacial statemets ) may give the public iformatio about the treds ad recet developmets of the etity ad the rage of its activities. This list leads to a very importat distictio, amely that betwee maagemet accoutig ad fiacial accoutig. Maagemet accoutig is that brach of accoutig cocered with the provisio of iformatio iteded to be useful to maagemet withi the busiess. Fiacial accoutig is the brach of accoutig iteded for users outside the busiess itself, i.e. groups 2 8 above. The above descriptios of these groups is closely based o a documet called Framework for the Preparatio ad Presetatio of Fiacial Statemets of the Iteratioal Accoutig Stadards Board (IASB), discussed further i Chapter 3. It is clear from the previous paragraphs that the eeds of users to whom fiacial accoutig is addressed are very diverse, ad so the same iformatio will ot ecessarily be valid for all their purposes. Nevertheless, it is usually assumed that oe set of fiacial statemets i the public domai should be able to satisfy most eeds. The IASB Framework (paragraph 10) goes o to assert that: While all of the iformatio eeds of these users caot be met by fiacial statemets, there are eeds which are commo to all users. As ivestors are providers of risk capital to the eterprise, the provisio of fiacial statemets that meet their eeds will also meet most of the eeds of other users that fiacial statemets ca satisfy. 5
Chapter 1 Itroductio This last setece would ear a fail mark o ay course i logic or philosophy, but the view is widely followed i practice; that is, fiacial reportig is see by the IASB as largely desiged to supply ivestors with useful iformatio. Acceptig, however, that the eeds of differet users are likely to be differet ad that differet users may predomiate i differet coutries, it is clear that differet atioal eviromets (cultural, political ad ecoomic) are likely to lead to differet accoutig practices. Ideed, fiacial reportig to various users (as opposed to the mere recordig of trasactios, which is kow as bookkeepig) reflects the biases ad orms of the societies i which it is embedded. This relatioship is developed later i Chapter 5. Activity 1.A I what various ways ca ad should fiacial reportig (the ed product of fiacial accoutig) be differet from reportig to maagemet? Thik about the differet purposes of these two types of accoutig, ad how these purposes affect their operatio. Feedback Maagemet accoutig ca be carried out o the basis that o iformatio eed be kept secret for commercial reasos ad that the preparers will have o icetive to disguise the truth. This is because the maagemet is givig iformatio to itself. So, the iformatio does ot eed to be exterally checked. It ca be more detailed ad more frequet tha for fiacial reportig because there is o expese of exteral checkig or publicatio. Also, the maagemet will ot wat ay biases, whereas some outside users may prefer a tedecy to uderstate profits ad values where there is ucertaity. Maagemet may be happy for may estimates about the future to be made, which might be too subjective for exteral reportig. Ideed, some maagemet accoutig figures ivolve forecastig all the importat figures for the ext year, whereas fiacial reportig cocetrates o the immediate past. Aother poit is that there do ot eed to be ay rules imposed o maagemet accoutig, because maagemet ca trust itself. By cotrast, fiacial reportig probably works best with some clear rules from outside the etity i order to cotrol the maagemet ad help towards comparability of oe etity with aother. Havig distiguished fiacial accoutig from maagemet accoutig, there are some further possible cofusios to address. The fuctio of exteral auditig is quite separate from that of fiacial accoutig. Auditig is a cotrol mechaism desiged to provide a exteral ad idepedet check o the fiacial statemets ad reports published by those etities. Fiacial reports o the state of affairs ad the past results of etities are prepared by accoutats uder the cotrol of the maagers of the etities, ad the the validity of the statemets is assessed by auditors. The wordig used by auditors i their reports o fiacial statemets varies cosiderably betwee coutries, ad the meaig ad sigificace of the words that they use varies eve more. There is ievitably some coflict betwee the ecessity for a auditor to keep the maagemet of the etity happy, ad the ecessity for provisio of a expert ad idepedet check. A study of auditig is outside the scope of this book, but the reader from ay particular coutry should ote that the role, objectives ad effectiveess of the audit fuctio i 6
1.2 Accoutig regulatio ad the accoutacy professio other coutries may differ from those of his or her experiece. For example, i Japa, the statutory auditors of most compaies are ot required to be either expert or idepedet; i cotrast, i some other coutries, statutory auditors have to comply with striget techical ad idepedece requiremets. Aother set of distictios which must be made clear are those betwee fiace, fiacial maagemet ad fiacial accoutig. Very broadly, fiace is cocered with the optimal meas of raisig moey, fiacial maagemet is cocered with the optimal meas of usig it, ad fiacial accoutig is the reportig o the results from havig used it. Fially, fiacial accoutig must be carefully distiguished from bookkeepig. Bookkeepig uderlies other types of accoutig. It is about recordig the data about keepig records of moey ad fiacially related movemets. It is fiacial accoutig (ad maagemet accoutig) that takes these raw data, ad the chooses ad presets them as appropriate for various purposes. It is fiacial accoutig that acts as the commuicatig process to those outside the etity. 1.2 Accoutig regulatio ad the accoutacy professio Activity 1.B How should the provisio of accoutig iformatio to users outside the etity be cotrolled? Thik of as may regulators ad ways of regulatig as you ca. Feedback Accoutig could be regulated i may ways, for example by: the market the govermet, through miistries parliamet, through laws or codes a stock exchage a govermetal regulator of stock exchages the accoutacy professio a committee of members from large compaies a idepedet foudatio or trust. Two extreme aswers to the questio of regulatio ca be evisaged. The first is that it should be determied purely by market forces. A potetial supplier of fiace will be more willig to supply it if a busiess gives relevat ad reliable iformatio about how ad by whom the fiace will be used. So, a busiess providig a good quality ad quatity of fiacial iformatio will obtai more ad cheaper fiace. Therefore, etities have their ow market-iduced icetive to provide accoutig iformatio that meets the eeds of users. The secod extreme aswer is that the whole process should be regulated etirely by the state, ad some legal or bureaucratic body should specify what is to be reported ad should provide a eforcemet mechaism. Neither extreme is cosistet with moder capitalist-based ecoomies, but the balace adopted betwee the two varies quite sharply aroud the world. The poits metioed so far i this sectio oly cosider the market ad the state, 7
Chapter 1 Itroductio but there is a third importat force to cosider, amely the private sector, icludig the accoutacy professio. The professio is orgaized ito associatios uder atioal jurisdictios. For example, the Europea Uio requires two types of orgaizatio: qualifyig bodies (which set exams ad might set techical rules) ad regulatory bodies (which are uder govermet cotrol ad which supervise statutory audit). I some coutries, such as the Uited Kigdom, various accoutacy bodies are allowed to fulfil both roles, ad may members of the professio do ot work as auditors. I some other coutries, such as Frace ad Germay, the roles are fulfilled by separate bodies of accoutats ad auditors, e.g. i Frace by experts comptables ad commissaires aux comptes respectively. Professioal bodies are resposible for moitorig the activities of their members ad for stadards of both geeral ethics ad professioal competece. However, i some coutries the professio also takes o much of the role of creatig the auditig rules uder which its members will operate. I some coutries (e.g. Australia, Demark, the Netherlads, the Uited Kigdom ad the Uited States), the rules that gover how etities perform their fiacial reportig are also set by professioal bodies or by idepedet private-sector committees of accoutats ad others (as stadard setters). There is ow widespread agreemet withi EU member states, ad others elsewhere, of the eed for carefully thought-out comprehesive regulatio. This statemet leaves ope two importat poits of detail. The first is the extet to which comprehesive regulatio eeds to be flexible i detailed applicatio, or (alteratively) to be precise but iflexible. The secod is the relative positio ad importace of state regulatio (e.g. Compaies Acts or Commercial Codes) compared with private-sector regulatio (e.g. accoutig stadards). As will be see later (particularly i Chapter 4), differeces i attitudes to both these questios ca be sigificat i their effects o accoutig practice i differet jurisdictios. The coordiatig orgaizatio for the accoutacy professio aroud the world is the Iteratioal Federatio of Accoutats (IFAC). Its stated purpose is to develop ad ehace a coordiated world-wide accoutacy professio with harmoized stadards. Iteratioal auditig stadards are produced by IFAC s Iteratioal Auditig ad Assurace Stadards Board. A importat aspect of IFAC was its relatioship with the IASB ad its predecessor, the Iteratioal Accoutig Stadards Committee (IASC). The latter was created i 1973 ad, util 2001, all member bodies of IFAC were automatically members of IASC. As discussed i more detail i Chapter 5, with effect from 2001 the Iteratioal Accoutig Stadards Committee ad the orgaisatios surroudig it were completely restructured. The old IASC disappeared ad was replaced by the IASC Foudatio whose mai operatig arm is the Iteratioal Accoutig Stadards Board (IASB). We geerally refer to the IASB i this book, uless temporal specificity requires otherwise. The IASC s Iteratioal Accoutig Stadards (IASs) were adopted by the IASB but ew stadards are called Iteratioal Fiacial Reportig Stadards (IFRSs). Take together, IASs ad IFRSs are geerically called IFRSs. 8
1.3 Laguage The IASB is idepedet ad has total autoomy i the settig of iteratioal stadards. The objectives of the IASC Foudatio are as follows: (a) to develop, i the public iterest, a sigle set of high quality, uderstadable ad eforceable global accoutig stadards that require high quality, trasparet ad comparable iformatio i fiacial statemets ad other fiacial reportig to help participats i the world s capital markets ad other users to make ecoomic decisios; (b) to promote the use ad rigorous applicatio of those stadards; (c) i fulfillig (a) ad (b), to take accout of, as appropriate, the special eeds of small ad medium-sized etities ad emergig ecoomies; ad (d) to brig about covergece of atioal accoutig stadards ad IFRS to high quality solutios. The implicatios of diverse atioal backgrouds ad attitudes, of diverse regulatory groupigs, ad of diverse attitudes to such factors as the role of law, professioal idepedece ad so o are a major uderlyig theme of this book. 1.3 Laguage May readers of this book will be tryig ot oly to master a subject ew to them but also doig so i a laguage that is ot their first. Oe added difficulty is that there are several forms of the Eglish laguage, particularly for accoutig terms. UK terms ad US terms are extesively differet. Some examples are show i the first two colums of Table 1.1. At this stage, you are ot expected to uderstad all of these terms; they will be itroduced later, as they are eeded. The Iteratioal Accoutig Stadards Board operates ad publishes its stadards i Eglish, although there are approved traslatios i several laguages. The IASB uses a mixture of UK ad US terms, as show i the third colum of Table 1.1. O the whole, this book uses IASB terms. Table 1.1 Some examples of UK, US ad IASB terms UK US IASB Stock Ivetory Ivetory Shares Stock Shares Ow shares Treasury stock Treasury shares Debtors Receivables Receivables Creditors Payables Payables Fiace lease Capital lease Fiace lease Turover Sales (or reveue) Sales (or reveue) Merger Poolig of iterests Uitig of iterests Fixed assets No-curret assets No-curret assets Profit ad loss accout Icome statemet Icome statemet Associate Equity accouted affiliate Associate 9
Chapter 1 Itroductio 1.4 Excitemet i accoutig Accoutig is ot uiversally regarded as a excitig ad exhilaratig area of activity or study, but it ca be fasciatig, i several ways: i itself, because it is a icomplete ad rapidly evolvig disciplie ad its study cotais ucertaity ad discovery; i applicatio, because the theoretical ideas become itimately boud up with huma attitude ad huma ature; i effects, because it has a major impact o fiacial decisios, share prices, etc.; i the iteratioal sphere, because of its itegratio with cultural, ecoomic ad political chage. At preset, a further elemet exists that icreases the iterest of accoutig. I the early years of this milleium there is eormous chage i several factors coected with accoutig. Busiess is icreasigly beig carried out electroically; old types of idustry are givig way to ew; markets have become global; accoutig iformatio ca travel faster ad more cheaply. I Europe i particular, closer cooperatio is uderway. A commo currecy (the euro) operates ad expasio of the Europea Uio cotiues. The fial reaso oe that particularly relates to the authors is that we are seekig to commuicate the importace of accoutig i a geuiely iteratioal rather tha a atioal cotext. We hope that our work leads to greater uderstadig by readers (ad betwee readers), whatever their backgroud ad startig poit. 1.5 The path ahead The structure of the remaider of this book is as follows. Part 1 cotiues by ivestigatig the fudametal priciples ad covetios that form the basis of accoutig thought ad practice. Chapter 2 outlies the basic fiacial statemets, ad their relatioships. There is also a substatial appedix to the book to itroduce double-etry bookkeepig. Chapter 3 looks at the mai covetios uderlyig accoutig, ad particularly at the framework of cocepts used by the IASB. For the reader with o accoutig backgroud, it is essetial to uderstad the thikig that uderlies what accoutats do; for the reader with previous accoutig or possibly bookkeepig experiece, the two chapters should still be regarded as essetial readig, for they brig out the iterrelatioships betwee the various ideas ad techiques. Depedig o the ature of the studets ad the course, a study of the double-etry material i Appedix A might be suitable before, after or alogside Chapter 3. Chapter 4 the looks at ways i which fiacial reportig ca be regulated, ad how it is regulated i several coutries. Chapter 5 itroduces the iflueces o, ad the ature of, iteratioal differeces i accoutig. Chapter 6 outlies the ormal cotets of the aual reports of large commercial etities. The stadards of the IASB are used as the mai poit of referece. Fially i Part 1, Chapter 7 itroduces the topic of aalysis: how to iterpret fiacial statemets ad how to compare oe etity with aother. 10
Exercises Part 2 (comprisig Chapters 8 16) explores the major topics of fiacial reportig i some detail. I may cases a variety of theoretical coclusios are possible, ad a variety of differet practices ca be foud i differet coutries. These are explored both for themselves ad for their causes ad implicatios. Agai, the mai cotext for the discussios is the stadards of the IASB. Fially, i Part 3 (Chapters 17 ad 18) the techiques of aalysig fiacial statemets that were itroduced i Part 1 are take further, ad the valuatio of etities is examied. This Part ca be see as the culmiatio of what has goe before. Fiacial accoutig is about commuicatio, ad study of the various iflueces o accoutig i Part 1 ad of the ways of tacklig the problem issues i Part 2 should help i appreciatig the real iformatio cotet of accoutig umbers both what they mea ad, just as importatly, what they do ot mea. Summary Accoutig is desiged to give fiacial iformatio to particular groups of users. Differet users may eed differet iformatio. This book is especially cocered with fiacial reportig by busiess etities to outside ivestors. Because the maagers of a etity are ofte differet people from the ivestors, the reports prepared by maagers for those ivestors ad other users eed to be checked by auditors. The state ad the accoutacy professio may both play roles i the regulatio of fiacial reportig. The Iteratioal Accoutig Stadards Board (IASB) is a idepedet body that sets stadards for fiacial reportig. The use of accoutig terms differs cosiderably betwee UK, US ad IASB practice.? EXERCISES Feedback o the first two of these exercises is give i Appedix D. 1.1 Is fiacial accoutig really ecessary? 1.2 At least eight differet groups of users of accoutig iformatio ca be distiguished, i.e.: Maagers Ivestors Leders Employees Suppliers ad other creditors Customers Govermets ad their agecies Public Suggest the iformatio that each is likely to eed from accoutig statemets ad reports. Are there likely to be difficulties i satisfyig the eeds of all the groups you have cosidered with oe commo set of iformatio? 11
Chapter 1 Itroductio 1.3 Outlie the relative beefits to users of fiacial reports of: (a) iformatio about the past; (b) iformatio about the preset; (c) iformatio about the future. 1.4 Do you thik that users kow what to ask for from their accoutat or fiacial adviser? Explai your aswer. 1.5 I the cotext of your ow atioal backgroud, rak the seve exteral user groups suggested i the text (i.e. omittig maagers), i order of the priority that you thik should be give to their eeds. Explai your reasos. 1.6 If at all possible, compare your aswer to Exercise 1.5 with the aswers of studets from differet atioal backgrouds. Try to explore likely causes of ay major differeces that emerge, i terms of legal, ecoomic ad cultural eviromets. 12