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 FOR NON-SPECIALISTS
AND FINANCE
ACCOUNTING

F01 Accounting and Finance for Non 44013 Contents.indd 1 24/10/2018 14:42
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F01 Accounting and Finance for Non 44013 Contents.indd 2 24/10/2018 14:42
 ELEVENTH EDITION

ACCOUNTING
AND FINANCE
FOR NON-SPECIALISTS
Peter Atrill
Eddie McLaney

Harlow, England • London • New York • Boston • San Francisco • Toronto • Sydney
Dubai • Singapore • Hong Kong • Tokyo • Seoul • Taipei • New Delhi
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First published 1995 by Prentice Hall Europe (print)

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Third edition published 2001 by Pearson Education Ltd (print)
Fourth edition published 2004 (print)
Fifth edition published 2006 (print)
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Seventh edition published 2011 (print)
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ISBN: 978-1-292-24401-3 (print)

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Library of Congress Cataloging-in-Publication Data
Names: Atrill, Peter, author. | McLaney, E. J., author.
Title: Accounting and finance for non-specialists / Peter Atrill, Eddie McLaney.
Description: Eleventh edition. | Harlow, England ; New York : Pearson, [2019]
Identifiers: LCCN 2018035220| ISBN 9781292244013 | ISBN 9781292244051 (PDF) |
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F01 Accounting and Finance for Non 44013 Contents.indd 4 24/10/2018 14:42
 Brief contents

Preface xv
Acknowledgements xvii

1 Introduction to accounting and finance 1

Part One FINANCIAL ACCOUNTING 27

2 Measuring and reporting financial position 28

3 Measuring and reporting financial performance 72
4 Accounting for limited companies 113
5 Measuring and reporting cash flows 162
6 Analysing and interpreting financial statements 194

Part Two MANAGEMENT ACCOUNTING 245

7 The relevance and behaviour of costs 246

8 Full costing 285
9 Budgeting 327

Part Three FINANCE 365

10 Making capital investment decisions 366

11 Financing a business 408
12 Managing working capital 456

Appendix A: Glossary of key terms 504

Appendix B: Solutions to self-assessment questions 517
Appendix C: Solutions to critical review questions 532
Appendix D: Solutions to selected exercises 544
Appendix E: Present value table 572
Index 574

BRIEF CONTENTS v

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F01 Accounting and Finance for Non 44013 Contents.indd 6 24/10/2018 14:42
 Contents

Preface xv
Acknowledgements xvii

1 Introduction to accounting and finance 1

Introduction 1
What are accounting and finance? 2
Who are the users of accounting information? 2
Providing a service 5
Weighing up the costs and benefits 7
Accounting as an information system 10
Management accounting and financial accounting 11
Scope of this book 14
The changing face of accounting 14
Why do I need to know anything about accounting and finance? 16
The quest for wealth creation 17
Meeting the needs of other stakeholders 18
Balancing risk and return 20
Not-for-profit organisations 22
Summary 24
Key terms 25
Reference 26
Further reading 26
Critical review questions 26

Part One FINANCIAL ACCOUNTING 27

2 Measuring and reporting financial position 28

Introduction 28
The major financial statements – an overview 29
The statement of financial position 33
The effect of trading transactions 42

CONTENTS vii

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 Classifying assets 44
Classifying claims 46
Statement layouts 47
Capturing a moment in time 49
The role of accounting conventions 51
Money measurement 55
Valuing assets 58
Meeting user needs 63
Summary 65
Key terms 67
Reference 68
Further reading 68
Critical review questions 68
Exercises 69

3 Measuring and reporting financial performance 72

Introduction 72
The income statement 73
Different roles 74
Income statement layout 75
Further issues 77
Recognising revenue 81
Recognising expenses 83
Depreciation 89
Costing inventories 98
Trade receivables problems 103
Uses and usefulness of the income statement 105
Summary 106
Key terms 108
Further reading 108
Critical review questions 109
Exercises 109

4 Accounting for limited companies 113

Introduction 113
The main features of limited companies 114
The role of the Stock Exchange 120
Managing a company 120
The UK Corporate Governance Code 123
Financing limited companies 125
Borrowings 133
Withdrawing equity 134

viii CONTENTS

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 The main financial statements 137
Dividends 140
Additional financial statements 142
The directors’ duty to account 145
The need for accounting rules 145
Sources of accounting rules 146
The auditors’ role 147
Management commentary 148
Creative accounting 150
Summary 154
Key terms 156
Further reading 157
Critical review questions 157
Exercises 158

5 Measuring and reporting cash flows 162

Introduction 162
The statement of cash flows 163
Why is cash so important? 164
The main features of the statement of cash flows 166
A definition of cash and cash equivalents 166
The relationship between the main financial statements 168
The layout of the statement of cash flows 168
The normal direction of cash flows 171
Preparing the statement of cash flows 174
What does the statement of cash flows tell us? 184
Summary 187
Key terms 188
Further reading 188
Critical review questions 188
Exercises 189

6 Analysing and interpreting financial statements 194

Introduction 194
Financial ratios 195
Financial ratio classifications 196
The need for comparison 197
Calculating the ratios 199
A brief overview 200
Profitability 201
Efficiency 208
Relationship between profitability and efficiency 214

CONTENTS ix

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 Liquidity 216
Financial gearing 219
Investment ratios 224
Trend analysis 233
Using ratios to predict financial failure 234
Limitations of ratio analysis 234
Summary 237
Key terms 239
Further reading 239
Critical review questions 239
Exercises 240

Part Two MANAGEMENT ACCOUNTING 245

7 The relevance and behaviour of costs 246

Introduction 246
What is meant by ‘cost’? 247
Relevant costs: opportunity and outlay costs 248
Cost behaviour 252
Fixed cost 253
Variable cost 255
Semi-fixed (semi-variable) cost 256
Finding the break-even point 257
Contribution 262
Margin of safety 263
Operating gearing and its effect on profit 266
Weaknesses of break-even analysis 268
Using contribution to make decisions: marginal analysis 270
Summary 279
Key terms 281
Further reading 281
Critical review questions 281
Exercises 282

8 Full costing 285

Introduction 285
What is full costing? 286
Why do managers want to know the full cost? 286
Single-product businesses 288
Multi-product businesses 289

x CONTENTS

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 Overheads as service renderers 295
Activity-based costing 308
Using full (absorption) cost information 316
Summary 319
Key terms 321
Further reading 321
Critical review questions 321
Exercises 322

9 Budgeting 327
Introduction 327
How budgets link with strategic plans and objectives 328
Time horizon of plans and budgets 330
How budgets help managers 331
Budgets and forecasts 333
Limiting factors 334
How budgets link to one another 334
Using budgets in practice 337
Preparing budgets 338
Non-financial measures in budgeting 345
Budgeting for control 345
Measuring variances from budget 346
Making budgetary control effective 353
Behavioural issues 354
The use of variance analysis 355
Summary 357
Key terms 359
Further reading 359
Critical review questions 359
Exercises 360

Part Three FINANCE 365

10 Making capital investment decisions 366

Introduction 366
The nature of investment decisions 367
Investment appraisal methods 368
Accounting rate of return (ARR) 370
Payback period (PP) 375
Net present value (NPV) 379

CONTENTS xi

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 Why NPV is better 386
Internal rate of return (IRR) 387
Some practical points 392
Investment appraisal in practice 396
Investment appraisal and strategic planning 398
Summary 399
Key terms 401
Further reading 401
Critical review questions 402
Exercises 402

11 Financing a business 408

Introduction 408
The main objective of financing policy 409
Sources of finance 409
Internal sources of finance 409
Internal sources of long-term finance 410
Internal sources of short-term finance 411
External sources of finance 414
External sources of long-term finance 414
Forms of borrowing 418
External sources of short-term finance 428
Long-term versus short-term borrowing 430
Gearing and the financing decision 432
Share issues 433
The role of the Stock Exchange 438
The Alternative Investment Market 441
Providing long-term finance for the small business 442
Islamic finance 446
Summary 448
Key terms 451
References 451
Further reading 451
Critical review questions 452
Exercises 452

12 Managing working capital 456

Introduction 456
What is working capital? 457
The scale of working capital 459
Managing inventories 462
Managing trade receivables 473

xii CONTENTS

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 Managing cash 484
Managing trade payables 492
Managing working capital 493
Summary 496
Key terms 499
Further reading 499
Critical review questions 499
Exercises 500

Appendix A: Glossary of key terms 504

Appendix B: Solutions to self-assessment questions 517
Appendix C: Solutions to critical review questions 532
Appendix D: Solutions to selected exercises 544
Appendix E: Present value table 572
Index 574

Lecturer Resources ON THE

WEBSITE
For password-protected online resources tailored to
support the use of this textbook in teaching, please visit
www.pearsoned.co.uk/atrillmclaney

CONTENTS xiii

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F01 Accounting and Finance for Non 44013 Contents.indd 14 24/10/2018 14:42
 Preface

This book provides an introduction to accounting and finance. It is aimed at:

■ Students who are not majoring in accounting or finance, but who are, nevertheless,
studying introductory-level accounting and finance as part of their course. The course may
be in business, economics, hospitality management, tourism, engineering or some other
area. For these students, the book provides an overview of the role and usefulness of
accounting and finance within a business or some other organisation.
■ Students who are majoring in either accounting or finance. These students should find
the book a helpful introduction to the main principles, which can serve as a foundation
for further study.

The book does not focus on technical issues, but rather examines basic principles and
underlying concepts. The primary concern throughout is the ways in which financial state-
ments and information can be used to improve the quality of the decisions made by those
who use them. To reinforce this practical emphasis, throughout the text, there are numerous
illustrative extracts with commentary from real life including company reports, survey data
and other sources.
The text is written in an ‘open-learning’ style. This means there are numerous integrated
activities, worked examples and questions throughout each of the chapters to help you
understand the topics fully. In framing these questions and tasks, we have tried to encour-
age critical thinking by requiring analysis and evaluation of various concepts and tech-
niques. To help broaden understanding, questions and tasks often require readers to go
beyond the material in the text and/or to link the current topic with material covered earlier
in the book. Readers are encouraged to interact with the material and to check their prog-
ress continually. Irrespective of whether they are using the book as part of a taught course
or for personal study, we have found that this approach is more ‘user-friendly’ and makes
it easier for them to learn.
We recognise that most readers will not have studied accounting or finance before, and
we have therefore tried to write in a concise and accessible style, minimising the use of
technical jargon. We have also tried to introduce topics gradually, explaining everything as
we go. Where technical terminology is unavoidable we try to provide clear explanations. In
addition, you will find all of the key terms highlighted in the text. These are then listed at the
end of each chapter with a page reference. They are also listed alphabetically, with a con-
cise definition, in the glossary given in Appendix A towards the end of the book. This should
provide a convenient point of reference from which to revise.

PREFACE xv

F01 Accounting and Finance for Non 44013 Contents.indd 15 24/10/2018 14:42
 A further consideration in helping readers to understand and absorb the topics covered
is the design of the text itself. The page layout and colour scheme have been carefully
considered to enable easy navigation and digestion of material. The layout features a large
page format, an open design and clear signposting of the various features and assessment
material.
In this eleventh edition, we have taken the opportunity to make improvements suggested
by students and lecturers who used the previous edition. We have, for example, substantially
revised the discussion of the conceptual framework of accounting to reflect the very recent
statements of the International Accounting Standards Board. We have updated and
expanded the number of examples from real life and have continued to reflect the latest
international rules relating to the main financial statements. To aid understanding, we have
also increased the number of student progress questions (Activities) and explanatory
diagrams.
This text is supported by its own MyLab Accounting which is an environment that gives
unlimited opportunities for practice using a range of questions, and which provides timely
feedback. Updates to MyLab Accounting for the 11th Edition include the addition of Case
Studies that will be of use to encourage application of concepts to realistic business sce-
narios. Another notable tool within the MyLab is Accounting in Action: a feature that provides
an extended scenario focusing on a small business as it develops, which contains work for
readers to do; its aim is to bring together the reader’s understanding of a number of
concepts.
For access to MyLab Accounting, students need both a course ID and an access card
(see the advert on the inside back cover of the book).
For lecturers, the diagrams in the text, along with other diagrams and key learning points,
are available as PowerPoint slides. These, plus an Instructor’s Manual, can be downloaded
from the ‘Instructor resources’ section of the website www.pearsoned.co.uk/
atrillmclaney.
Finally, the editorial team at Pearson would like to thank the following reviewers for their
very valuable comments on the book:

Karen McFarlane, Glasgow Caledonian University

Steve Astbury, INTO University of Exeter
Dr Peng Wang, Southampton University
Dr Yasser Eliwa, Loughborough University
Mr David Carpenter, Aston University
Elayne Taylor, University of Dundee

We hope that you will find the book readable and helpful.

Eddie McLaney
Peter Atrill

xvi PREFACE

F01 Accounting and Finance for Non 44013 Contents.indd 16 24/10/2018 14:42
 Acknowledgements

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ACKNOWLEDGEMENTS xvii

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 Council: Adapted from Financial Reporting Council (2016) UK Corporate Governance Code,
April, pages 5 and 6, www.frc.org.uk. 128 The Financial Times Limited: Extract from
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lems Undermine Four In Ten Small Firms, https://amicusplc.co.uk 7th December. 171
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margins are falling’, 4 November; Reuters: BNN (2017) ‘Volvo shares jump over new margin
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backs off profit targets’, Autonews, 31 July; The Financial Times Limited: McGee, P. (2016)
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xviii ACKNOWLEDGEMENTS

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 Limited 2017. All Rights Reserved. 226–28 The Financial Times Limited: Smith, T. (2014)
‘How investors ignored the warning signs at Tesco’, Financial Times, 5 September. © The
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medium-sized enterprises, CIMA, July 2013. 287 Times Higher Education: Morgan, J.
(2016) Cambridge’s ‘Cost of education’ rises to £18K per student Times Higher Education
Supplement, 8 September. 290–91 Elsevier: Al-Omiri, M. and Drury, C. (2007) A survey of
factors influencing the choice of product costing systems in UK organizations, Management
Accounting Research, December, pages. 399–424. 297 King’s Fund: NHS England (2014),
NHS Better care, better value indicators, NHS England, 15 May. 300 Elsevier: Brierley, J.
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C. and Drury, C. (2007) Product costing practices in different manufacturing industries: a
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 Holdings plc, Annual Report 2016, p. 64. 337 Elsevier: Dugdale, D., Jones, C. and Green,
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report 2016, page 13; Carillion plc, Annual Report 2014; Rentokil Initial plc, website www
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Suisse Global Investments Returns Yearbook, 2017. 396–97 Financial Management
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Corporation: Singer, N. (2017), £150.3 million recommended offer for Quantum Pharma by
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 Annual Report 2016, p. 123. 425 Whitbread PLC.: Whitbread plc press release, Whitbread
plc announces the sale and leaseback of two prime London sites, 12 January 2017. 426
Stagecoach Group plc: Stagecoach Group plc, Annual report 2017. 436 Laird plc: Based
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just-in-time parts policy’ Financial Times, 23 October and Ludwig, C. (2014) ’Local logistics
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settle bills within 30 days, 30 December. © The Financial Times Limited 2017. All Rights
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for-late-payment/. 489-90 EYGM Limited: Ernst and Young (2016) All Tied Up: Working
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 Chapter 1
INTRODUCTION TO
ACCOUNTING AND
FINANCE
INTRODUCTION
Welcome to the world of accounting and finance! In this opening chapter,
we provide a broad outline of these subjects. We begin by considering
the roles of accounting and finance and then go on to identify the main
users of financial information. We shall see how both accounting and
finance can be valuable tools in helping users improve the quality of their
decisions. In subsequent chapters, we develop this decision-making
theme by examining in some detail the kinds of financial reports and
methods used to aid decision-making.

For many of you, accounting and finance are not the main focus of your
studies and you may well be asking, ‘Why do I need to study these
subjects?’ So, after we have considered the key features of accounting
and finance, we shall go on to discuss why some understanding of them
is likely to be important to you.

Learning outcomes
When you have completed this chapter, you should be able to:
■ explain the nature and roles of accounting and finance;
■ identify the main users of financial information and discuss their
needs;
■ distinguish between financial accounting and management
accounting; and
■ explain why an understanding of accounting and finance is likely to be
relevant to you.

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 WHAT ARE ACCOUNTING AND FINANCE?
Let us begin by trying to understand the purpose of each. Accounting is concerned with
collecting, analysing and communicating financial information. The ultimate aim is to help
those using this information to make more informed decisions. Unless the financial informa-
tion being communicated can lead to better decisions being made, there really is no point
in producing it. We shall see who uses financial information and for what kind of decisions
it is useful a little later in the chapter.
Sometimes the impression is given that the purpose of accounting is simply to prepare
financial (accounting) reports on a regular basis. While it is true that accountants undertake
this kind of work, it does not represent an end in itself. These reports are prepared for a
reason. As already mentioned, the ultimate aim of the accountant’s work is to give users
financial information to improve the quality of their decisions. This decision-making per-
spective of accounting provides the theme for this book and shapes the way in which we
deal with each topic.
Finance (or financial management), like accounting, exists to help decision-makers. It
is concerned with the ways in which funds for a business are raised and invested. This lies
at the very heart of what business is about. In essence, a business exists to raise funds
from investors (owners and lenders) and then to use those funds to make investments (in
equipment, premises, inventories and so on) in order to create wealth. As businesses often
raise and invest large amounts over long periods, the quality of the financing and investment
decisions can have a profound impact on their fortunes.
Funds raised may take various forms and the particular forms chosen should fit with the
needs of the business. An understanding of finance should help in identifying:

■ the main forms of finance available;

■ the costs and benefits of each form of finance;
■ the risks associated with each form of finance; and
■ the role of financial markets in supplying finance.

Once funds have been raised, they must be invested in a suitable way. When deciding
between the investment opportunities available, an understanding of finance can help in
evaluating the risks and returns associated with each opportunity.
There is little point in trying to make a sharp distinction between accounting and finance;
we have seen that both are concerned with the financial aspects of decision-making. Fur-
thermore, there are many overlaps and interconnections between the two areas. Financial
(accounting) reports, for example, are a major source of information when making financing
and investment decisions.

WHO ARE THE USERS OF ACCOUNTING INFORMATION?

For accounting information to be useful, the accountant must be clear for whom the infor-
mation is being prepared and for what purpose it will be used. There are likely to be various

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 groups of people (usually known as ‘user groups’) with an interest in a particular organisa-
tion, in the sense of needing to make decisions about it. For a typical private sector busi-
ness, the more important of these groups are shown in Figure 1.1. Take a look at this figure
and then try Activity 1.1.

Owners Customers Competitors

Employees
Managers and their
representatives

Business

Lenders Government

Investment Community
Suppliers
analysts representatives

Several user groups have an interest in accounting information relating to a business. The majority
of these are outside the business but, nevertheless, have a stake in it. This is not an exhaustive
list of potential users; however, those groups identified are normally the most important.

Figure 1.1 Main users of financial information relating to a business

Activity 1.1
Ptarmigan Insurance plc (PI) is a large motor insurance business. Taking the user groups
identified in Figure 1.1, suggest, for each group, the sorts of decisions likely to be made
about PI and the factors to be taken into account when making these decisions.

Your answer may be along the following lines:

User group Decision

Customers Whether to take further motor policies with PI. This might
involve an assessment of PI’s ability to continue in business
and to meet customers’ needs, particularly in respect of any
insurance claims made.
➔

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 User group Decision

Competitors How best to compete against PI or, perhaps, whether to leave the
market on the grounds that it is not possible to compete profitably
with PI. This may involve competitors using various aspects of
PI’s performance as a ‘benchmark’ when evaluating their own
performance. They may also try to assess PI’s financial strength
and to identify changes that may signal PI’s future intentions (for
example, raising funds as a prelude to market expansion).
Employees Whether to continue working for PI and, if so, whether to
demand higher rewards for doing so. The future plans, profits
and financial strength of the business are likely to be of
particular interest when making these decisions.
Government Whether PI should pay tax and, if so, how much, whether it
complies with agreed pricing policies, whether financial support is
needed and so on. In making these decisions an assessment of
PI’s profits, sales revenues and financial strength would be made.
Community Whether to allow PI to expand its premises and/or whether to
representatives provide economic support for the business. When making these
decisions, PI’s ability to provide employment for the community,
its use of community resources and its willingness to fund
environmental improvements are likely to be important
considerations.
Investment analysts Whether to advise clients to invest in PI. This would involve an
evaluation of the likely risks and future returns associated with PI.
Suppliers Whether to continue to supply PI and, if so, whether to supply
on credit. This would require an assessment of PI’s ability to pay
for goods and services supplied at the due dates.
Lenders Whether to lend money to PI and/or whether to demand
repayment of any existing loans. PI’s ability to pay the interest
due and to repay the principal sum on time would be important
factors in such decisions.
Managers Whether the performance of the business needs to be improved.
Performance to date would be compared with earlier plans or
some other ‘benchmark’ to decide whether action needs to be
taken. Managers may also wish to consider a change in PI’s
future direction. This may involve determining whether it has the
financial flexibility and resources to take on new challenges.
Owners Whether to invest more in PI or to sell all, or part, of the
investment currently held. As with investment analysts (see
above) this would involve an evaluation of the likely risks and
returns associated with PI. Owners may also have to decide on
the rewards offered to senior managers. When doing so, the
financial performance and position of the business would
normally be considered.
Although this answer covers many of the key points, you may have identified other decisions
and/or other factors to be taken into account by each group.

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 PROVIDING A SERVICE
One way of viewing accounting is as a form of service. The user groups identified in
Figure 1.1 can be seen as the ‘clients’ and the accounting (financial) information produced
can be seen as the service provided. The value of this service to the various ‘clients’ can
be judged according to whether the accounting information meets their needs.
To be useful to users, particularly investors and lenders, the information provided should
possess certain qualities, or characteristics. In particular, it must be relevant and it must
faithfully represent what it is meant to represent. These two qualities, relevance and faith-
ful representation, are regarded as fundamental qualities and require further
explanation:

■ Relevance. Accounting information should make a difference. That is, it should be capa-
ble of influencing user decisions. To do this, it should help to predict future events (such
as predicting next year’s profit), or help to confirm past events (such as establishing last
year’s profit), or do both. By confirming past events, users can check on the accuracy
of their earlier predictions. This can, in turn, help them to improve the ways in which they
make predictions in the future.

To be relevant, accounting information must cross a threshold of materiality. An item of

information is considered material, or significant, if its omission or misstatement would
change the decisions that users make.

Activity 1.2
Do you think that what is material for one business will also be material for all other
businesses?

No, it will normally vary from one business to the next. What is material will depend on fac-
tors such as the size of the business, the nature of the information and the amounts involved.

Ultimately, what is considered material is a matter of judgement. When making this kind of
judgement, managers should consider how this information is likely to be used by users. If
a piece of information is not considered material, it should not be included within the
accounting reports. It will merely clutter them up and, perhaps, interfere with the users’
ability to interpret them.

■ Faithful representation. Accounting information should represent what it is meant to

represent. To do so, the information provided must reflect the substance of what has
occurred rather than simply its legal form. Take, for example, a manufacturer that pro-
vides goods to a retailer on a sale-or-return basis. The manufacturer may wish to treat
this arrangement as two separate transactions. Thus, a contract may be agreed for the
sale of the goods and a separate contract agreed for the return of the goods if unsold
by the retailer. This may result in a sale being reported when the goods are delivered to
the retailer even though they are returned at a later date. The economic substance,

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 however, is that the manufacturer made no sale as the goods were subsequently
returned. They were simply moved from the manufacturer’s business to the retailer’s
business and then back again. Accounting reports should reflect this economic sub-
stance. To do otherwise would be misleading.

To provide a perfectly faithful representation, the information should be complete. In other

words, it should incorporate everything needed to understand what is being portrayed.
Thus, information relating to a particular item would normally contain a description of its
nature, some suitable numerical measurement and, where necessary, explanations of
important facts. Information should also be neutral, which means that the it should be pre-
sented and selected without bias. No attempt should be made to manipulate the information
in such a way as to influence user attitudes and behaviour. Finally, it should be free from
error. This is not the same as saying that it must be perfectly accurate. Accounting informa-
tion often contains estimates, such as futures sales or costs, which may turn out to be
inaccurate. Nevertheless, estimates may still be faithfully represented providing they are
accurately described and properly prepared.

Activity 1.3
In practice, do you think that each piece of accounting information produced will be
perfectly complete, neutral and free from error?

Probably not – however, each piece of information should be produced with these aims in
mind.

Accounting information should contain both fundamental qualities – relevance and faithful
representation – in order to be useful. There is usually little point in producing information
that is relevant, but which lacks faithful representation, or producing information that is
irrelevant, even if it is faithfully represented.

Further qualities
Where accounting information is both relevant and faithfully represented, there are other
qualities that, if present, can enhance its usefulness. These are comparability, verifiability,
timeliness and understandability. Each of these qualities is now considered.

■ Comparability. When choosing between alternatives, users of accounting information

seek to make comparisons. They may want to compare performance of the business
over time (for example, profit this year compared to last year). They may also want to
compare certain aspects of business performance (such as the level of sales achieved
during the year) to those of similar businesses. To help users make comparisons, items
that are alike should be treated in the same way – both over time and between busi-
nesses. Items that are not alike, on the other hand, should not be treated as though they
are. Users must be able to detect both similarities and differences in items being
compared.

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 ■ Verifiability. This quality provides assurance to users that the accounting information
provided faithfully portrays what it is supposed to portray. Accounting information is
verifiable where different, independent experts can reach broad agreement that it pro-
vides a faithful portrayal. Verification can be direct, such as checking a bank account
balance, or indirect, such as checking the underlying assumptions and methods used to
derive an estimate of a future cost.
■ Timeliness. Accounting information should be made available in time for users to make
their decisions. A lack of timeliness undermines the usefulness of the information.
Broadly speaking, the later accounting information is produced, the less useful it
becomes.
■ Understandability. Accounting information should be presented in as clear and as con-
cise a form as possible. Nevertheless, some accounting information may be too complex
to be presented in an easily digestible form. This does not mean, however, that it should
be ignored. To do so would result in reporting only a partial view of financial matters (see
Reference 1 at the end of the chapter).

Activity 1.4
Accounting reports are aimed at users with a reasonable knowledge of accounting and
business and who are prepared to invest time in studying them. Do you think, however,
that accounting reports should be understandable to users without any knowledge of
accounting or business?

It would be very helpful if everyone could understand accounting reports. This, however, is
unrealistic as complex financial events and transactions cannot normally be expressed in
simple terms. Any attempts to do so are likely to produce a very distorted picture of
reality.

It is probably best that we regard accounting reports in the same way that we regard a
report written in a foreign language. To understand either of these, we need to have had
some preparation. When producing accounting reports, it is normally assumed that the user
not only has a reasonable knowledge of business and accounting but is also prepared to
invest some time in studying the reports. Nevertheless, the onus is clearly on accountants
to provide information in a way that makes it as understandable as possible to
non-accountants.
It is worth emphasising that the four qualities just discussed cannot make accounting
information useful; they can only enhance the usefulness of information that is already
relevant and faithfully represented.

WEIGHING UP THE COSTS AND BENEFITS

Even when a piece of accounting information may have all the qualities described, it does
not automatically mean that it should be collected and reported to users. There is still one
more hurdle to jump. Consider Activity 1.5.

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 Activity 1.5
Suppose an item of information is capable of being provided. It is relevant to a particular
decision and can be faithfully represented. It is also comparable, verifiable, timely and
could be understood by the decision-maker.
Can you think of a good reason why, in practice, you might decide not to produce the
information?

The reason is that you judge the cost of doing so to be greater than the potential benefit of
having the information. This cost–benefit issue will limit the amount of accounting information
provided.

In theory, a particular item of accounting information should be produced only if the costs
of providing it are less than the benefits, or value, to be derived from its use. In practice,
however, these costs and benefits are difficult to assess.
To illustrate the practical problems of establishing the value of information, let us assume
that we accidentally reversed our car into a wall in a car park. This resulted in a dented boot
and scraped paintwork. We would like the dent taken out and the paintwork re-sprayed at
a local garage. We know that the nearest garage would charge £450 but we believe that
other local garages may offer to do the job for a lower price. The only way of finding out the
prices at other garages is to visit them, so that they can see the extent of the damage. Visit-
ing the garages will involve using some fuel and will take up some of our time. Is it worth
the cost of finding out the price for the job at the various local garages? The answer, as we
have seen, is that if the cost of discovering the price is less than the potential benefit, it is
worth having that information.
To identify the various prices for the job, there are several points to be considered,
including:

■ How many garages shall we visit?

■ What is the cost of fuel to visit each garage?
■ How long will it take to make all the garage visits?
■ At what price do we value our time?

The economic benefit of having the information on the price of the job is probably even
harder to assess in advance. The following points need to be considered:

■ What is the cheapest price that we might be quoted for the job?
■ How likely is it that we shall be quoted a price cheaper than £450?

As we can imagine, the answers to these questions may be far from clear – remember that
we have only contacted the nearest garage so far. When assessing the value of accounting
information we are confronted with similar problems.
Producing accounting information can be very costly. The costs, however, are often difficult
to quantify. Direct, out-of-pocket costs, such as salaries of accounting staff, are not usually
a problem, but these are only part of the total costs involved. There are other costs such as
the cost of users’ time spent on analysing and interpreting the information provided.

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 Activity 1.6
What about the economic benefits of producing accounting information? Do you think it
is easier, or harder, to assess the economic benefits of accounting information than to
assess the costs of producing it?

It is normally much harder to assess the economic benefits. We must bear in mind that
accounting information will be only one factor influencing a decision; other factors will also
be taken into account. Furthermore, the precise weight attached to each factor when making
the decision cannot normally be established.

There are no easy answers to the problem of weighing costs and benefits. Although it is
possible to apply some ‘science’ to the problem, a lot of subjective judgement is normally
involved.
The qualities, or characteristics, influencing the usefulness of accounting information,
discussed above are summarised in Figure 1.2.

COST
CONSTRAINT Qualities

Fundamental Enhancing

Faithful
Relevance
representation

Predictive Confirmatory Freedom

Completeness Neutrality
value value from error

Materiality
threshold

Understand-
Comparability Timeliness Verifiability
ability

There are two fundamental qualities that determine the usefulness of accounting information. In
addition, there are four qualities that enhance the usefulness of accounting information. The benefits
of providing the information, however, should outweigh the costs.

Figure 1.2 The qualities that influence the usefulness of accounting information

WEIGHING UP THE COSTS AND BENEFITS 9

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 ACCOUNTING AS AN INFORMATION SYSTEM
We have already seen that accounting can be viewed as the provision of a service to ‘cli-
ents’. Another way of viewing accounting is as a part of the business’s total information
system. Users, both inside and outside the business, make decisions concerning the alloca-
tion of scarce resources. For these resources to be efficiently allocated, they often need
financial (accounting) information on which to base decisions. It is the role of the accounting
system to provide this information.
The accounting information system should have certain features that are common to
all information systems within a business. These are:

■ identifying and capturing relevant information (in this case financial information);
■ recording, in a systematic way, the information collected;
■ analysing and interpreting the information collected; and
■ reporting the information in a manner that suits users’ needs.

The relationship between these features is set out in Figure 1.3.

Information Information Information Information

identification recording analysis reporting

There are four sequential stages of an accounting information system. The first two stages are
concerned with preparation, whereas the last two stages are concerned with using the information
collected.

Figure 1.3 The accounting information system

Given the decision-making emphasis of this book, we shall be concerned primarily with
the last two elements of the process: the analysis and reporting of financial information. We
shall focus on the way in which information is used by, and is useful to, users rather than
the way in which it is identified and recorded.
Efficient accounting information systems are an essential ingredient of an efficient busi-
ness. When they fail, the results can be disastrous. Real World 1.1 describes how spread-
sheets, which are widely used to prepare accounting and financial information, may
introduce errors that can lead to poor financial decisions.

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 REAL WORLD 1.1

Systems error!
Almost one in five large businesses have suffered financial losses as a result of errors in
spreadsheets, according to F1F9, which provides financial modelling and business forecast-
ing to large businesses. It warns of looming financial disasters as 71% of large British busi-
nesses always use spreadsheets for key financial decisions.
The company’s new white paper entitled Capitalism’s Dirty Secret showed that the abuse
of the humble spreadsheet could have far-reaching consequences. Spreadsheets are used
in the preparation of British company accounts worth up to £1.9 trillion and the UK manu-
facturing sector uses spreadsheets to make pricing decisions for up to £170 billion worth of
business.
In total, spreadsheet calculations represent up to £38 billion of British private sector
investment decisions per year, data harvested through YouGov found. Yet 16% of large
companies have admitted finding inaccurate information in spreadsheets more than 10 times
in 2014.
Grenville Croll, a spreadsheet risk expert, said of the findings: ‘Spreadsheets have been
shown to be fallible yet they underpin the operation of the financial system. If the uncontrolled
use of spreadsheets continues to occur in highly leveraged markets and companies, it is only
a matter of time before another “Black Swan” event occurs causing catastrophic loss.’
The report warns that while 33% of large businesses report poor decision-making as a
result of spreadsheet problems, a third of the financial decision-makers using spreadsheets
in large UK businesses are still given zero training.
Source: Adapted extract from Burn-Callander, R. (2015) ‘Stupid errors in spreadsheets could lead to Britain’s
next corporate disaster’, Daily Telegraph, 7 April.

MANAGEMENT ACCOUNTING AND FINANCIAL

ACCOUNTING
Accounting is usually seen as having two distinct strands. These are:

■ management accounting, which seeks to meet the accounting needs of managers; and
■ financial accounting, which seeks to meet the needs of the other users identified, earlier
in the chapter (see Figure 1.1).

The difference in their targeted user groups has led each strand of accounting to develop
along different lines. The main areas of difference are as follows:

■ Nature of the reports produced. Financial accounting reports tend to be general-purpose.

Although they are aimed primarily at providers of finance such as owners and lenders,
they contain financial information that will be useful for a broad range of users and

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 decisions. Management accounting reports, meanwhile, are often specific-purpose
reports. They are designed with a particular decision in mind and/or for a particular
manager.
■ Level of detail. Financial accounting reports provide users with a broad overview of the
performance and position of the business for a period. As a result, information is aggre-
gated (that is, added together) and detail is often lost. Management accounting reports,
however, often provide managers with considerable detail to help them with a particular
operational decision.
■ Regulations. The financial accounting reports of many businesses are subject to regula-
tions imposed by the law and by accounting rule makers. These regulations often require
a standard content and, perhaps, a standard format to be adopted. Management
accounting reports, on the other hand, are not subject to regulation and can be designed
to meet the needs of particular managers.

Activity 1.7
Why do you think financial accounting reports are subject to regulation, whereas manage-
ment accounting reports are not?

Financial accounting reports are for external publication. To protect external users, who
depend on the quality of information provided by managers, they are subject to regulation.
Management accounting reports, on the other hand, are produced exclusively for managers
and are for internal use only.

■ Reporting interval. For most businesses, financial accounting reports are produced on
an annual basis, though some large businesses produce half-yearly reports and a few
produce quarterly ones. Management accounting reports will be produced as frequently
as needed by managers. A sales manager, for example, may need routine sales reports
on a daily, weekly or monthly basis so as to monitor performance closely. Special-
purpose reports can also be prepared when the occasion demands: for example, where
an evaluation is required of a proposed investment in new equipment.
■ Time orientation. Financial accounting reports reveal the performance and position of a
business for the past period. In essence, they are backward-looking. Management
accounting reports, on the other hand, often provide information concerning future per-
formance as well as past performance. It is an oversimplification, however, to suggest
that financial accounting reports never incorporate expectations concerning the future.
Occasionally, businesses will release forward-looking information to other users in an
attempt to raise finance or to fight off unwanted takeover bids. Even the routine prepara-
tion of financial accounting reports for the past period typically requires making some
judgements about the future (as we shall see in Chapter 3).
■ Range and quality of information. Two key points are worth mentioning. First, financial
accounting reports concentrate on information that can be quantified in monetary terms.
Management accounting also produces such reports, but is also more likely to produce
reports that contain information of a non-financial nature, such as physical volume of

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 inventories, number of sales orders received, number of new products launched, physi-
cal output per employee and so on. Second, financial accounting places greater empha-
sis on the use of objective, verifiable evidence when preparing reports. Management
accounting reports may use information that is less objective and verifiable, but neverthe-
less provide managers with the information they need.

We can see from this that management accounting is less constrained than financial
accounting. It may draw from a variety of sources and use information that has varying
degrees of reliability. The only real test to be applied when assessing the value of the
information produced for managers is whether or not it improves the quality of the deci-
sions made.
The main differences between financial accounting and management accounting are
summarised in Figure 1.4.

Management accounting Financial accounting

Nature of the
reports produced Tend to be specific purpose Tend to be general purpose

Level of detail
Often very detailed Usually broad overview

Regulations Usually subject to

Unregulated
accounting regulation

Reporting interval
As short as required by managers Usually annual or bi-annual

Time orientation Often based on projected future Almost always

information as well as past information historical

Range and quality Tend to contain financial and Focus on financial information,
of information non-financial information, often uses great emphasis on objective,
non-verifiable information verifiable evidence

Although management and financial accounting are closely linked and have broadly common
objectives, there are a number of differences in emphasis.

Figure 1.4 Management and financial accounting compared

The differences between management accounting and financial accounting suggest

differences in the information needs of managers and those of other users. While differ-
ences undoubtedly exist, there is also a good deal of overlap between the information
needs of both.

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 Activity 1.8
Can you think of any areas of overlap between the information needs of managers and
those of other users? (Hint: Think about the time orientation and the level of detail of
accounting information.)

Two points that spring to mind are:

■ Managers will, at times, be interested in receiving a historical overview of business opera-

tions of the sort provided to other users.
■ Other users would be interested in receiving detailed information relating to the future,
such as the planned level of profits and non-financial information, such as the state of
the sales order book and the extent of product innovations.

To some extent, differences between the two strands of accounting reflect differences
in access to financial information. Managers have much more control over the form and
content of the information that they receive. Other users have to rely on what managers are
prepared to provide or what financial reporting regulations insist must be provided. Although
the scope of financial accounting reports has increased over time, fears concerning loss of
competitive advantage and user ignorance about the reliability of forecast data have meant
that other users do not receive the same detailed and wide-ranging information as that
available to managers.

SCOPE OF THIS BOOK

This book covers both financial accounting and management accounting topics. The next
five chapters (Part 1, Chapters 2 to 6) are broadly concerned with financial accounting, and
the following three (Part 2, Chapters 7 to 9) with management accounting. The final part of
the book (Part 3, Chapters 10 to 12) is concerned with the financial management, that is,
with issues relating to the financing and investing activities of the business.

THE CHANGING FACE OF ACCOUNTING

Over the past four decades, the business environment has become increasingly turbulent
and competitive. Various reasons have been put forward to explain these changes,
including:

■ the increasing sophistication of customers;

■ the development of a global economy where national frontiers become less important;
■ rapid changes in technology;
■ the deregulation of domestic markets (for example, electricity, water and gas);
■ increasing pressure from owners (shareholders) for competitive economic returns; and
■ the increasing volatility of financial markets.

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 This new, more complex environment has brought fresh challenges for managers and
other users of accounting information. Their needs have changed and both financial
accounting and management accounting have had to respond. This has led to a radical
review of the kind of information to be reported.
The changing business environment has given added impetus to the search for a clear
conceptual framework, or framework of principles, upon which to base financial accounting
reports. Various attempts have been made to clarify their purpose and to provide a more
solid foundation for the development of accounting rules. The conceptual frameworks that
have been developed try to address fundamental questions such as:

■ Who are the users of financial accounting information?

■ What kinds of financial accounting reports should be prepared and what should they
contain?
■ How should items such as profit and asset values be measured?

The internationalisation of businesses has created a need for accounting rules to have
an international reach. It can no longer be assumed that users of accounting information
are based in the country in which the particular business operates or are familiar with the
accounting rules of that country. Thus, there has been increasing harmonisation of account-
ing rules across national frontiers.

Activity 1.9
How should the harmonisation of accounting rules benefit:
(a) An international investor?
(b) An international business?

An international investor should benefit because accounting terms and policies used in
preparing financial accounting reports will not vary across countries. This should make the
comparison of performance between businesses operating in different countries much
easier.
An international business should benefit because the cost of producing accounting
reports in order to comply with the rules of different countries can be expensive. Harmonisa-
tion can, therefore, lead to significant cost savings. It may also broaden the appeal of the
business among international investors. Where there are common accounting rules, they
may have greater confidence to invest.

In response to criticisms that the financial reports of some businesses are opaque and
difficult for users to interpret, great efforts have been made to improve reporting rules.
Accounting rule makers have tried to ensure that the accounting policies of businesses are
more comparable and more transparent and that the financial reports portray economic
reality more faithfully.
Management accounting has also changed by becoming more outward-looking in its
focus. In the past, information provided to managers has been largely restricted to that
collected within the business. However, the attitude and behaviour of customers and rival

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 businesses have now become the object of much information-gathering. Increasingly, suc-
cessful businesses are those that are able to secure and maintain competitive advantage
over their rivals.
To obtain this advantage, businesses have become more ‘customer driven’ (that is,
concerned with satisfying customer needs). This has led to the production of management
accounting information that provides details of customers and the market, such as cus-
tomer evaluation of services provided and market share. In addition, information about the
costs and profits of rival businesses, which can be used as ‘benchmarks’ by which to gauge
competitiveness, is gathered and reported.
To compete successfully, businesses must also find ways of managing costs. The cost
base of modern businesses is under continual review and this, in turn, has led to the devel-
opment of more sophisticated methods of measuring and controlling costs.

WHY DO I NEED TO KNOW ANYTHING ABOUT

ACCOUNTING AND FINANCE?
At this point you may well be asking yourself, ‘Why do I need to study accounting and
finance? I don’t intend to become an accountant!’ Well, from the explanation of what
accounting and finance is about, which has broadly been the subject of this chapter so far,
it should be clear that the accounting/finance function of a business, or of most other types
of organisation, is a central part of its management information system. On the basis of
information provided by the system, managers make decisions concerning the allocation
of resources. These decisions may concern whether to:

■ continue with certain business operations;

■ invest in particular projects; or
■ sell particular products.

These decisions can have a profound effect on all those connected with the organisation.
It is important, therefore, that all of those who intend to work in a managerial position
should have a fairly clear idea of certain important aspects of accounting and finance. These
aspects include:

■ how financial reports should be read and interpreted;

■ how financial plans are made;
■ how investment decisions are made;
■ how businesses are financed; and
■ how costs are managed.

Many, perhaps most, students have a career goal of being a manager within a business –
perhaps a human resources manager, production manager, marketing manager or IT man-
ager. If you are one of these students, an understanding of accounting and finance is very
important. When you become a manager, even a junior one, it is almost certain that you will
have to use financial reports to help you to carry out your role. It is equally certain that it is

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 partly, perhaps largely, on the basis of financial information and reports that your perfor-
mance as a manager will be judged.
As part of your management role, it is likely that you will be expected to help in plotting
the future path of the business. This will often involve the preparation of forward-looking
financial reports and setting financial targets. If you do not understand what the financial
reports really mean and the extent to which the financial information is reliable, you will find
yourself at a distinct disadvantage to those who do. Along with other managers, you will
also be expected to help decide how the limited resources available to the business should
be allocated between competing options. This will require an ability to evaluate the costs
and benefits of the different options available. Once again, an understanding of accounting
and finance is important to carrying out this management task.
This is not to say that you cannot be an effective and successful human resources pro-
duction, marketing or IT manager unless you are also a qualified accountant. It does mean,
however, that you need to become a bit ‘streetwise’ in accounting and finance if you are to
succeed. This book aims to give you that street wisdom.

THE QUEST FOR WEALTH CREATION

A business is normally formed to enhance the wealth of its owners. Throughout this book
we shall assume that this is its main objective. This may come as a surprise, as other objec-
tives might be pursued that would fulfil the needs of others with a stake in the business.

Activity 1.10
What other objectives might a business pursue? Try to think of at least two.

A business may seek:

■ to provide well-paid jobs and good working conditions for its employees;
■ to conserve the environment for the local community;
■ to produce products or services that will benefit its customers; and/or
■ to support local suppliers.

You may have thought of others.

Although a business may pursue other such objectives, it is normally set up primarily to
increase the wealth of its owners. In practice, the behaviour of businesses over time appears
to be consistent with this objective.
Within a market economy there are strong competitive forces at work that ensure that
failure to enhance owners’ wealth will not be tolerated for long. Competition for the funds
provided by the owners and competition for managers’ jobs will normally mean that the
owners’ interests will prevail. If the managers do not provide the expected increase in own-
ership wealth, the owners have the power to replace the existing management team with a
new team that is more responsive to owners’ needs.

THE QUEST FOR WEALTH CREATION 17

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