Robin Jarvis

Introduction to accounting

This chapter will introduce you to the role of accounting, its uses and its users. It will also give you an appreciation of the role of accounting both within a business organization and in its external impacts. We shall introduce some ideas about the ways in which accounting assists managers in meeting business objectives through, for example, providing the information necessary to make a decision about buying or renting premises. The impacts of the size and type of organization on accounting will be discussed. For example, in very small organizations such as a window cleaning business the accounting requirements are likely to be less complex than is the case with a larger business such as British Rail. Another factor that both affects and is affected by accounting is the environment. The effects of the environment on accounting can be through the impact of government legislation as happens every time we adopt a new Companies Act or when a new EC Directive on accounting is added to the United Kingdom’s statute book. Apart from government action, accounting can be affected at this level by changes in technology. For instance the move towards greater use of flexible manufacturing systems poses a major challenge to accountancy whilst the introduction of information technology has allowed accounting information to be provided more quickly and efficiently, thus enabling different decisions to be taken than would otherwise have been the case. From this brief resume we can see that the accounting activity interacts with all levels of the ‘Business in Context’ model as explained in the Series foreword.

Financing and business Structures

In this chapter, we shall consider the different forms of finance a business uses and the effects of the organizational structure upon the sources of finance available. We shall also consider the financing structure of an organization and its effect on financial risk. For these purposes, it is necessary to differentiate between business risk and financial risk.

Cash flow statements

In this chapter we shall consider cash flow statements, the information they provide and their uses. At present, cash flow statements are additional or supplementary statements, although some have argued that a system based on cash accounting should be used as an alternative to the accrual accounting system, with which you are now familiar. Such arguments are beyond the scope of this chapter and the interested reader is referred to the further reading at the end of this chapter. We shall start with a discussion of the need for cash flow information and then move on to look at the contents of the cash flow statement. Finally we shall demonstrate how such statements are constructed and how the information is interpreted.

The profit and loss account

We have already seen that we can measure profit by measuring wealth at two points in time. We have also shown that the way in which wealth is measured in accounting terms can be roughly equated with balance sheets, and we have looked at some of the issues arising from the alternative choices in respect of assigning monetary values to wealth measurement.

Fixed assets and depreciation

In Chapter 3 we discussed the definitions of assets and of fixed and current assets. We defined an asset in accordance with the definition suggested by R. M. Lall reproduced below. The distinction that we made in earlier chapters between assets and expenses is that an asset relates to present or future benefits whereas an expense relates to past or expired benefits. Thus we have stocks of goods held at the year end shown as an asset and the cost of the stocks sold during the year charged as an expense. Similarly some of the assets we hold change form during a period or from one period to the next. For example, debtors become cash, or they become expenses when a debt becomes uncollectable. This applies to all assets in the long run but in the case of fixed assets it takes longer to use up the future benefits than it does with current assets. We defined fixed assets in Chapter 3.

Wealth and the measurement of profit

In Chapter 1 we established that there are a number of different users of accounting information, each of whom needs different information for different purposes. However, there are some items of information that are required by most users. These relate to what an enterprise owns and what it owes, and to some information on how it has performed or is performing — in other words a measure of performance. The former information, i.e. about what an enterprise owns and what it owes, could be termed the worth of the enterprise or its wealth. This measure of wealth or worth relates to a point in time. The other information required is about the way in which the enterprise performed over a period of time. This performance during a period can be measured as a change in wealth over time. Thus if you increase your wealth you have performed better, in financial terms, than someone whose wealth has decreased over the same period of time. This measurement of changes in wealth over time is referred to in accounting terminology as profit measurement. In this chapter we shall be looking at the ways in which accountants can measure wealth and profit and discussing some of the merits of the alternatives available. We shall also examine in some detail the way in which the choice of a measurement system affects the resultant profit and wealth measures. To do this we need to start by defining profit or wealth as these two ideas are directly linked.