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Accounting An Introduction 4th Edition Peter Atrill
Digital Instant Download
Author(s): Peter Atrill
ISBN(s): 9781408212158, 0273711369
Edition: 4th Revised edition
File Details: PDF, 11.68 MB
Year: 2007
Language: english
Accounting Fourth Edition
An Introduction Fourth Edition

Eddie McLaney Peter Atrill

Fourth Edition
Accounting
Accounting: An Introduction 4th edition is renowned for its clear, accessible and uncluttered style. It provides a
An Introduction
comprehensive introduction to the main principles of ﬁnancial accounting, management accounting, and the core
elements of ﬁnancial management. With a clear and unequivocal focus on how accounting information can be used

Accounting An Introduction
to improve the quality of decision making by managers, combined with a strong practical emphasis, this book
provides the ideal grounding for a career in management.
Eddie McLaney
Audience Features
Suitable for all those studying an introductory course ● Progress checks: numerous activities and Peter Atrill
in accounting, who are seeking an understanding of exercises enable you to constantly test
basic principles and underlying concepts without your understanding and reinforce learning.
detailed technical knowledge. ● Lively and relevant examples from the real
world demonstrate the practical application
Authors and value of concepts and techniques learnt.
Eddie McLaney is Visiting Fellow in Accounting and ● Interactive ‘open learning’ style is ideal for
Finance at the University of Plymouth. self study.
Peter Atrill is a freelance academic and author ● Decision making focus on the use of
working with leading institutions in the UK, Europe accounting information rather than its
and SE Asia. He was previously Head of Business preparation is highly appropriate for
and Management at the University of Plymouth tomorrow’s business managers.
Business School. ● Fully incorporates International Financial
Reporting Standards, which are crucial in
Visit the companion website at the European and world business arena.
www.pearsoned.co.uk/mclaney
● Key terms, glossary and bulleted summaries
are excellent revision aids.
● Clearer distinctions between process
costing and job order costing.
● More extensive coverage of corporate
governance and ethics issues.

The text is supported by MyAccountingLab, a completely new type of educational resource. MyAccountingLab
complements student learning by presenting the user with a study plan that adapts and customises to the student’s
individual requirements as they progress through online tests. Students can also practice problems before taking
tests, and because most of these are algorithmically driven, they can practice over and over again without repetition.

Peter Atrill
Eddie McLaney
Additionally, students have access to an eBook, animated guides to various key topics, and guided solutions, all of
which are designed to help them overcome the most difﬁcult concepts. Both students and lecturers have access to
gradebooks that allow them to track progress, and lecturers will have the ability to create new tests and activities
using the large number of problems available in the question database.

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ACCA_A01.qxd 7/08/2007 11:14 Page i

Accounting
An Introduction

Visit the Accounting: An Introduction, fourth edition Companion Website at

www.pearsoned.co.uk/mclaney to find valuable student learning material
including:

● Multiple choice questions to help test your learning

● Additional exercises and review questions
● Solutions to end of chapter review questions
● Links to relevant sites on the web
● An online glossary to explain key terms
ACCA_A01.qxd 7/08/2007 11:14 Page ii

We work with leading authors to develop the strongest

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ACCA_A01.qxd 7/08/2007 11:14 Page iii

4th
edition

Accounting
An Introduction

Eddie McLaney
and
Peter Atrill
ACCA_A01.qxd 7/08/2007 11:14 Page iv

Pearson Education Limited

Edinburgh Gate
Harlow
Essex CM20 2JE
England

and Associated Companies throughout the world

Visit us on the World Wide Web at:

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First published 1999 by Prentice Hall Europe

Second edition published 2002
Third edition published 2005
Fourth edition published 2008

© Prentice Hall Europe 1999

The rights of Eddie McLaney and Peter Atrill to be identified as authors of this work have
been asserted by them in accordance with the Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted in any form or by any means, electronic, mechanical, photocopying,
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Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS.

All trademarks used herein are the property of their respective owners. The use of any
trademark in this text does not vest in the author or publisher any trademark ownership
rights in such trademarks, nor does the use of such trademarks imply any affiliation with
or endorsement of this book by such owners.

ISBN 978-0-273-71136-0

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library

10 9 8 7 6 5 4 3 2 1
11 10 09 08 07

Typeset in 9.5/12.5pt Stone Serif by 35

Printed and bound by Mateu Cromo Artes Graficas, Spain

The publisher’s policy is to use paper manufactured from sustainable forests.

ACCA_A01.qxd 7/08/2007 11:14 Page v

Brief contents

Preface • How to use this book • Guided tours • Acknowledgements xxi–xxviii

1 Introduction to accounting and finance 1

Part 1 Financial accounting 35

2 Measuring and reporting financial position 37

3 Measuring and reporting financial performance 71
4 Accounting for limited companies (1) 115
5 Accounting for limited companies (2) 159
6 Measuring and reporting cash flows 192
7 Analysing and interpreting financial statements 221

Part 2 Management accounting 277

8 Relevant costs for decision making 279

9 Cost–volume–profit analysis 297
10 Full costing 332
11 Costing and pricing in a competitive environment 372
12 Budgeting 430
13 Accounting for control 470

Part 3 Financial management 507

14 Making capital investment decisions 509

15 Financing the business 566
16 Managing working capital 614

Part 4 Supplementary information 657

Appendix A Recording financial transactions 659

Appendix B Glossary of key terms 677
Appendix C Solutions to self-assessment questions 693
Appendix D Solutions to review questions 709
Appendix E Solutions to selected exercises 723
Appendix F Present value table 787

Index 789
ACCA_A01.qxd 7/08/2007 11:14 Page vi
ACCA_A01.qxd 7/08/2007 11:14 Page vii

Detailed contents

Preface xxi
How to use this book xxii
Guided tour of the book xxiv
Guided tour MyAccountingLab xxvi
Acknowledgements xxviii

1 Introduction to accounting and finance 1

Introduction 1
Learning outcomes 1
What are accounting and finance? 2
Who are the users of accounting information? 3
The conflicting interests of users 5
How useful is accounting information? 5
Evidence on the usefulness of accounting 6
Providing a service 7
But . . . is it material? 8
Weighing up the costs and benefits 9
Accounting as an information system 11
Management and financial accounting 13
Scope of this book 15
Has accounting become too interesting? 15
The changing face of accounting 16
Why do I need to know anything about accounting and finance? 17
Accounting for business 18
What is the purpose of a business? 18
What kinds of business ownership exist? 19
Sole proprietorship 19
Partnership 20
Limited company 20
How are businesses organised? 22
How are businesses managed? 24
What is the financial objective of a business? 25
Balancing risk and return 28
Not-for-profit organisations 28
Summary 30
Key terms 32
References 32
Further reading 32
Review questions 33
ACCA_A01.qxd 7/08/2007 11:14 Page viii

viii CONTENTS

Part 1 Financial accounting

2 Measuring and reporting financial position 37

Introduction 37
Learning outcomes 37
The major financial statements – an overview 38
The balance sheet 42
Assets 42
Claims 44
The effect of trading operations on the balance sheet 47
The classification of assets 49
Current assets 50
Non-current assets 50
The classification of claims 52
Balance sheet layouts 52
The balance sheet and time 55
Accounting conventions and the balance sheet 55
Business entity convention 55
Historic cost convention 56
Prudence convention 56
Going concern convention 57
Dual aspect convention 57
Money measurement 58
Goodwill and brands 59
Human resources 60
Monetary stability 60
Valuing assets on the balance sheet 61
Tangible non-current assets (property, plant and equipment) 61
Intangible non-current assets 63
The impairment of non-current assets 63
Inventories (stock) 64
Interpreting the balance sheet 65
Summary 66
Key terms 67
Further reading 67
Review questions 68
Exercises 68

3 Measuring and reporting financial performance 71

Introduction 71
Learning outcomes 71
The income statement 72
The income statement and the balance sheet 73
Income statement layout 74
Some further issues 75
Cost of sales 76
ACCA_A01.qxd 7/08/2007 11:14 Page ix

CONTENTS ix

Classification of expenses 77
The accounting period 78
Recognising revenue 79
Long-term contracts 80
Services 81
Recognising expenses 82
When the expense for the period is more than the cash paid
during the period 83
When the amount paid during the year is more than the full
expense for the period 85
Profit, cash and accruals accounting 86
Depreciation 87
Tangible non-current assets (property, plant and equipment) 87
Depreciating intangible assets 93
Depreciation and the replacement of non-current assets 94
Depreciation and judgement 95
Costing inventories 97
First in, first out (FIFO) 97
Last in, first out (LIFO) 98
Weighted average cost (AVCO) 98
Inventories – some further issues 100
Dealing with trade receivables’ problems 101
Interpreting the income statement 107
Summary 107
Key terms 109
Further reading 109
Review questions 110
Exercises 110

4 Accounting for limited companies (1) 115

Introduction 115
Learning outcomes 115
The main features of limited companies 116
Legal nature 116
Perpetual life 116
Limited liability 117
Legal safeguards 119
Public and private companies 119
Taxation 121
Transferring share ownership: the role of the Stock Exchange 122
Managing a company 123
Strengthening the framework of rules 124
The Combined Code 124
Financing limited companies 128
The owners’ claim 128
The basic division 129
ACCA_A01.qxd 7/08/2007 11:14 Page x

x CONTENTS

Share capital 130

Reserves 131
Altering the nominal value of shares 133
Bonus shares 134
Share capital jargon 136
Raising share capital 136
Borrowings 137
Withdrawing equity 139
The main financial statements 142
The income statement 144
The balance sheet 144
Dividends 145
Accounting for groups of companies 145
Summary 150
Key terms 152
Reference 152
Further reading 152
Review questions 153
Exercises 153

5 Accounting for limited companies (2) 159

Introduction 159
Learning outcomes 159
The directors’ duty to account 160
The need for accounting rules 161
Sources of accounting rules 161
Presenting the financial statements 164
Income statement 165
Balance sheet 166
Statement of changes in equity 166
Cash flow statement 168
Explanatory notes 168
General points 168
The framework of principles 169
The IASB framework 169
The auditors’ role 170
Directors’ report 171
Segmental financial reports 171
Segmental reporting rules 172
Segmental disclosure 173
Problems of segmental reporting 174
Narrative reporting 175
The OFR framework 176
The business review and RS 1 179
Summary financial statements 180
Creative accounting 180
Creative accounting methods 180
ACCA_A01.qxd 7/08/2007 11:14 Page xi

CONTENTS xi

Checking for creative accounting 184

Creative accounting and economic growth 185
Summary 185
Key terms 187
Further reading 187
Review questions 188
Exercises 188

6 Measuring and reporting cash flows 192

Introduction 192
Learning outcomes 192
The cash flow statement (or statement of cash flows) 193
Why is cash so important? 194
The main features of the cash flow statement 195
A definition of cash and cash equivalents 195
The relationship between the primary financial statements 196
The form of the cash flow statement 197
The normal direction of cash flows 199
Preparing the cash flow statement 201
Deducing net cash flows from operating activities 201
Deducing the other areas of the cash flow statement 204
What does the cash flow statement tell us? 208
Summary 211
Key terms 212
Further reading 212
Review questions 213
Exercises 213

7 Analysing and interpreting financial statements 221

Introduction 221
Learning outcomes 221
Financial ratios 222
Financial ratio classifications 223
The need for comparison 223
Past periods 224
Similar businesses 224
Planned performance 224
Calculating the ratios 225
A brief overview 227
Profitablility 228
Return on ordinary shareholders’ funds (ROSF) 228
Return on capital employed (ROCE) 229
Operating profit margin 230
Gross profit margin 231
Efficiency 233
Average inventories turnover period 233
Average settlement period for trade receivables 234
ACCA_A01.qxd 7/08/2007 11:14 Page xii

xii CONTENTS

Average settlement period for trade payables 235

Sales revenue to capital employed 236
Sales revenue per employee 237
Relationship between profitablility and efficiency 238
Liquidity 240
Current ratio 240
Acid test ratio 241
Cash generated from operations to maturing obligations 241
Financial gearing 242
Gearing ratio 244
Interest cover ratio 245
Investment ratios 248
Dividend payout ratio 248
Dividend yield ratio 249
Earnings per share 250
Cash generated from operations per share 250
Price/earnings (P/E) ratio 251
Financial ratios and the problem of overtrading 256
Trend analysis 258
Using ratios to predict financial failure 260
Using single ratios 260
Using combinations of ratios 262
Z score models 263
Limitations of ratio analysis 264
Summary 266
Key terms 268
References 268
Further reading 268
Review questions 269
Exercises 269

Part 2 Management accounting

8 Relevant costs for decision making 279

Introduction 279
Learning outcomes 279
What is meant by ‘cost’? 280
Relevant costs: opportunity and outlay costs 282
Sunk costs and committed costs 286
Qualitative factors of decisions 287
Summary 289
Key terms 290
Further reading 290
Review questions 291
Exercises 291
ACCA_A01.qxd 7/08/2007 11:14 Page xiii

CONTENTS xiii

9 Cost–volume–profit analysis 297

Introduction 297
Learning outcomes 297
The behaviour of costs 298
Fixed costs 298
Variable costs 300
Semi-fixed (semi-variable) costs 301
Estimating semi-fixed (semi-variable) costs 302
Finding the break-even point 303
Contribution 307
Margin of safety 308
Operating gearing 311
Operating gearing and its effect on profit 311
Profit–volume charts 313
The economist’s view of the break-even chart 313
Failing to break even 315
Weaknesses of break-even analysis 315
Using contribution to make decisions: marginal analysis 317
Accepting/rejecting special contracts 318
The most efficient use of scarce resources 319
Make-or-buy decisions 322
Closing or continuation decisions 323
Summary 325
Key terms 326
Further reading 326
Review questions 327
Exercises 327

10 Full costing 332

Introduction 332
Learning outcomes 332
Why do managers want to know the full cost? 333
What is full costing? 334
Single-product businesses 334
Multi-product businesses 335
Direct and indirect costs 336
Job costing 337
Full (absorption) costing and the behaviour of costs 338
The problem of indirect costs 340
Overheads as service renderers 340
Job costing: a worked example 340
Selecting a basis for charging overheads 344
Segmenting the overheads 347
Dealing with overheads on a departmental basis 348
Batch costing 358
Full (absorption) cost as the break-even price 359
The forward-looking nature of full (absorption) costing 359
ACCA_A01.qxd 7/08/2007 11:14 Page xiv

xiv CONTENTS

Using full (absorption) cost information 360

Criticisms of full (absorption) costing 362
Full (absorption) costing versus variable costing 362
Which method is better? 363
Summary 364
Key terms 366
References 366
Further reading 366
Review questions 367
Exercises 367

11 Costing and pricing in a competitive environment 372

Introduction 372
Learning outcomes 372
Costing and the changed business environment 373
Costing and pricing in the traditional way 373
Costing and pricing in the new environment 374
Activity-based costing 374
An alternative approach to full costing 375
What drives the costs? 376
Cost pools 376
ABC and service industries 377
Criticisms of ABC 381
Other approaches to cost management 385
Total (or whole) life-cycle costing 385
Target costing 388
Costing quality control 389
Kaizen costing 390
Value chain analysis 390
Benchmarking 392
Non-financial measures of performance 393
The Balanced Scorecard 394
Measuring shareholder value 401
The quest for shareholder value 401
How can shareholder value be created? 401
The need for new measures 402
Economic value added (EVA®) 403
Pricing 409
Economic theory 409
Some practical considerations 416
Full cost (cost-plus) pricing 417
Pricing on the basis of relevant/marginal cost 420
Target pricing 422
Pricing strategies 422
Summary 423
Key terms 425
References 425
ACCA_A01.qxd 7/08/2007 11:14 Page xv

CONTENTS xv

13 Accounting for control 470

Introduction 470
Learning outcomes 470
Budgeting for control 471
Types of control 472
Variances from budget 473
Flexing the budget 474
Sales volume variance 474
Sales price variance 477
Materials variance 478
Labour variances 479
Fixed overhead variance 480
Reasons for adverse variances 484
Non-operating-profit variances 486
Investigating variances 486
ACCA_A01.qxd 7/08/2007 11:14 Page xvi

xvi CONTENTS

Compensating variances 489

Making budgetary control effective 490
Behavioural issues 490
The impact of management style 491
Reservations about the Hopwood study 492
Failing to meet the budget 492
Standard quantities and cost 494
Setting standards 494
What kinds of standards should be used? 494
Information gathering 495
The learning-curve effect 496
Other uses for standard costing 497
Some problems . . . 497
The new business environment 498
Summary 499
Key terms 501
References 501
Further reading 501
Review questions 502
Exercises 502

Part 3 Financial management

14 Making capital investment decisions 509

Introduction 509
Learning outcomes 509
The nature of investment decisions 510
Investment appraisal methods 511
Accounting rate of return (ARR) 513
ARR and ROCE 515
Problems with ARR 515
Payback period (PP) 518
Problems with PP 520
Net present value (NPV) 522
Interest lost 523
Risk 523
Inflation 524
What will a logical investor do? 524
Using discount tables 527
Why NPV is better 529
NPV’s wider application 530
Internal rate of return (IRR) 530
Problems with IRR 533
Some practical points 534
ACCA_A01.qxd 7/08/2007 11:14 Page xvii

CONTENTS xvii

Investment appraisal in practice 537

Dealing with risk 541
Assessing the level of risk 541
Reacting to the level of risk 551
Managing investment projects 552
Stage 1: Determine investment funds available 553
Stage 2: Identify profitable project opportunities 554
Stage 3: Evaluate the proposed project 554
Stage 4: Approve the project 555
Stage 5: Monitor and control the project 555
Summary 557
Key terms 559
References 559
Further reading 559
Review questions 560
Exercises 560

15 Financing the business 566

Introduction 566
Learning outcomes 566
Sources of finance 567
Sources of internal finance 567
Long-term sources of internal finance 568
Retained profits 568
Short-term sources of internal finance 569
Tighter credit control 569
Reducing inventories levels 570
Delaying payment to trade payables 570
Sources of external finance 570
Long-term sources of external finance 570
Ordinary shares 571
Preference shares 572
Loans (borrowings) 573
Finance leases and sale-and-leaseback arrangements 580
Hire purchase 582
Gearing and the long-term financing decision 583
Share issues 586
Rights issue 586
Offer for sale and public issue 589
Private placing 590
Bonus issue 590
The role of the Stock Exchange 590
Advantages of a listing 592
Disadvantages of a listing 594
Alternative Investment Market 596
Short-term sources of external finance 597
Bank overdraft 597
ACCA_A01.qxd 7/08/2007 11:14 Page xviii

xviii CONTENTS

Debt factoring 597

Invoice discounting 598
Long-term versus short-term borrowing 600
Providing long-term finance for the small business 601
Venture capital 601
Business angels 603
Government assistance 603
Summary 605
Key terms 607
Further reading 607
Review questions 608
Exercises 608

16 Managing working capital 614

Introduction 614
Learning outcomes 614
The nature and purpose of working capital 615
Managing working capital 616
The scale of working capital 616
Managing inventories 618
Budgeting future demand 620
Financial ratios 620
Recording and reordering systems 620
Levels of control 622
Inventories management models 622
Managing receivables 627
Which customers should receive credit and how much should
they be offered? 627
Length of credit period 629
Cash discounts 631
Debt factoring and invoice discounting 632
Collection policies and reducing the risk of non-payment 632
Managing cash 635
Why hold cash? 635
How much cash should be held? 636
Controlling the cash balance 636
Cash budgets and managing cash 638
Operating cash cycle 638
Cash transmission 641
Bank overdrafts 642
Managing trade payables 642
Controlling trade payables 643
Working capital problems of the small business 644
Managing inventories 644
Credit management 644
Managing cash 645
Managing credit suppliers 645
ACCA_A01.qxd 7/08/2007 11:14 Page xix

CONTENTS xix

Summary 646
Key terms 648
Reference 648
Further reading 648
Review questions 649
Exercises 649

Part 4 Supplementary information

Appendix A Recording financial transactions 659

Introduction 659
Learning outcomes 659
The basics of double-entry bookkeeping 660
Recording trading transactions 662
Balancing acccounts and the trial balance 665
Preparing the financial statements (final accounts) 669
The ledger and its division 672
Summary 673
Key terms 673
Further reading 674
Exercises 675
Appendix B Glossary of key terms 677
Appendix C Solutions to self-assessment questions 693
Appendix D Solutions to review questions 709
Appendix E Solutions to selected exercises 723
Appendix F Present value table 787
Index 789
ACCA_A01.qxd 7/08/2007 11:14 Page xx

Supporting resources
Visit www.pearsoned.co.uk/mclaney to find valuable online resources

Companion Website for students

● Multiple choice questions to help test your learning
● Additional exercises and review questions
● Solutions to end of chapter review questions
● Links to relevant sites on the web
● An online glossary to explain key terms

For instructors
● Complete, downloadable Instructor’s Manual
● PowerPoint slides that can be downloaded and used for presentations
● Case study material with solutions
● Progress tests, consisting of various questions and exercise material with
solutions
● Tutorial/seminar questions and solutions
● Solutions to end of chapter review questions

Also: The Companion Website provides the following features:

● Search tool to help locate specific items of content
● E-mail results and profile tools to send results of quizzes to instructors
● Online help and support to assist with website usage and troubleshooting

For more information please contact your local Pearson Education sales
representative or visit www.pearsoned.co.uk/mclaney
ACCA_A01.qxd 7/08/2007 11:14 Page xxi

Preface

This text provides a comprehensive introduction to financial accounting, management

accounting and core elements of financial management. It is aimed both at students
who are not majoring in accounting or finance and at those who are. Those studying
introductory level accounting and/or financial management as part of their course in
business, economics, hospitality management, tourism, engineering or some other area
should find that the book provides complete coverage of the material at the level
required. Students who are majoring in either accounting or finance should find the
book useful as an introduction to the main principles, which can serve as a foundation
for further study. The text does not focus on technical issues, but rather examines basic
principles and underlying concepts. The primary concern throughout is the ways
in which financial statements and information can be used to improve the quality
of decision making. To reinforce this practical emphasis, there are, throughout the
text, numerous illustrative extracts with commentary from real life, including com-
pany reports, survey data and other sources.
In this fourth edition we have taken the opportunity to make improvements that
have been suggested by students and lecturers who used the previous edition. We have
also brought up to date and expanded the number of examples from real life. From
2005, most of the larger UK companies have had to adopt a new set of international
rules relating to their main financial statements. These new rules form the basis of the
section of the book that deals specifically with accounting for limited companies.
The text is written in an ‘open-learning’ style. This means that there are numerous
integrated activities, worked examples and questions throughout the text to help you
to understand the subject fully. You are encouraged to interact with the material and
to check your progress continually. Irrespective of whether you 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 you 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 concise definition, in the glossary given in Appendix
B towards the end of the book. This should provide a convenient point of reference
from which to revise.
A further important consideration in helping you to understand and absorb the top-
ics covered is the design of the text itself. The page layout and colour scheme have
been carefully considered to allow for the 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.
More detail about the nature and use of these features is given in the ‘How to use
this book’ section; and the main points are also summarised, using example pages from
the text, in the guided tour.
We hope that you will find the book readable and helpful.
Eddie McLaney
Peter Atrill
ACCA_A01.qxd 7/08/2007 11:14 Page xxii

How to use this book

We have organised the chapters to reflect what we consider to be a logical sequence

and, for this reason, we suggest that you work through the text in the order in which
it is presented. We have tried to ensure that earlier chapters do not refer to concepts or
terms that are not explained until a later chapter. If you work through the chapters in
the ‘wrong’ order, you will probably encounter concepts and terms that were explained
previously.
Irrespective of whether you are using the book as part of a lecture/tutorial-based
course or as the basis for a more independent mode of study, we advocate following
broadly the same approach.

Integrated assessment material

Interspersed throughout each chapter are numerous Activities. You are strongly advised
to attempt all of these questions. They are designed to simulate the sort of quick-fire
questions that your lecturer might throw at you during a lecture or tutorial. Activities
serve two purposes:
● To give you the opportunity to check that you understand what has been covered
so far.
● To encourage you to think about the topic just covered, either to see a link between
that topic and others with which you are already familiar, or to link the topic just
covered to the next.
The answer to each Activity is provided immediately after the question. This answer
should be covered up until you have deduced your solution, which can then be com-
pared with the one given.
Towards the middle/end of each chapter there is a Self-assessment question. This
is more comprehensive and demanding than any of the Activities, and is designed to
give you an opportunity to check and apply your understanding of the core coverage
of the chapter. The solution to each of these questions is provided in Appendix C at the
end of the book. As with the Activities, it is important that you attempt each question
thoroughly before referring to the solution. If you have difficulty with a self-assessment
question, you should go over the relevant chapter again.

End-of-chapter assessment material

At the end of each chapter there are four Review questions. These are short questions
requiring a narrative answer or discussion within a tutorial group. They are intended
to help you assess how well you can recall and critically evaluate the core terms and
concepts covered in each chapter. Answers to these questions are provided in the student
access Companion Website. At the end of each chapter, except for Chapter 1, there are
ACCA_A01.qxd 24/08/2007 17:11 Page xxiii

HOW TO USE THIS BOOK xxiii

eight Exercises. These are mostly computational and are designed to reinforce your
knowledge and understanding. Exercises are graded as ‘basic’ and ‘more advanced’,
according to their level of difficulty. The basic-level questions are fairly straightforward;
the more advanced ones can be quite demanding but are capable of being successfully
completed if you have worked conscientiously through the chapter and have attempted
the basic exercises. Solutions to five of the exercises in each chapter are provided in
Appendix D at the end of the book. A coloured exercise number identifies these five ques-
tions. Here, too, a thorough attempt should be made to answer each exercise before
referring to the solution. Solutions to the other three exercises and to the review questions
in each chapter are provided in a separate Instructors’ Manual.
To familiarise yourself with the main features and how they will benefit your study
from this text, an illustrated Guided tour is provided on pages xxiv–xxv.

Content and structure

The text comprises 16 chapters organised into three core parts: financial accounting,
management accounting and financial management. A brief introductory outline of the
coverage of each part and its component chapters is given in the opening double-page
spread which precedes each part.
The market research for this text revealed a divergence of opinions, given the target
market, on whether or not to include material on double-entry bookkeeping techniques.
So as to not interrupt the flow and approach of the financial accounting chapters,
Appendix A on recording financial transactions (including Activities and three Exercise
questions) has been placed in Part 4.

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ACCA_A01.qxd 7/08/2007 11:14 Page xxiv

Guided tour of the book

38 CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

CHAPTER 1 The major financial statements – an overview

The major financial accounting statements aim to provide a picture of the financial
position and performance of a business. To achieve this, a business’s accounting sys-
tem will normally produce three particular statements on a regular, recurring basis.
These three are concerned with answering the following questions:
Introduction to accounting ● What cash movements (that is, cash in and cash out) took place over a particular

and finance ●
period?
How much wealth (that is, profit) was generated, or lost, by the business over that
Key terms The key concepts
period? (Profit (loss) is defined as the increase (decrease) in wealth arising from
trading activities.) and techniques in each
● What is the accumulated wealth of the business at the end of that period and what
form does the wealth take?
chapter are highlighted in
To address each of the above questions, there is a separate financial statement. The
Introduction financial statements are:
colour where they are first
➔ ● the cash flow statement

In this opening chapter we begin by considering the roles of accounting and finance. We
shall see that both can be valuable tools for decision-making purposes. We shall identify
➔
➔
●
●
the income statement (also known as the profit and loss account)
the balance sheet (also known as the statement of financial position).
introduced, with an adjacent
the main users of accounting and financial information and discuss the ways in which this
information can improve the quality of decisions that those users make. In subsequent
chapters, we develop this decision-making theme by considering in some detail the kinds
When taken together, they provide an overall picture of the financial health of the
business.
icon in the margin to help you
Perhaps the best way to introduce these financial statements is to look at an example
of financial reports and methods used to aid decision making.
Since this book is concerned with accounting and financial decision making for private- of a very simple business. From this we shall be able to see the sort of information that refer back to them.
sector businesses, we shall devote some time to examining the business environment. We each of the statements can usefully provide. It is, however, worth pointing out that,
shall, therefore, consider the purpose of a private-sector business, the main forms of business while a simple business is our starting point, the principles that we consider apply
enterprise and the ways in which a business may be structured. We shall also consider equally to the largest and most complex businesses. This means that we shall frequently
what the key financial objective of a business is likely to be. These factors are important as encounter these principles again in later chapters.
they all exert an influence on the kind of accounting and financial information produced.
Example 2.1 Examples At frequent
Learning outcomes Paul was unemployed and unable to find a job. He therefore decided to embark
on a business venture. Christmas was approaching, and so he decided to buy gift
intervals throughout most
wrapping paper from a local supplier and to sell it on the corner of his local high
When you have completed this chapter, you should be able to:
● Explain the nature and roles of accounting and finance.
street. He felt that the price of wrapping paper in the high street shops was
excessive. This provided him with a useful business opportunity.
chapters, there are numerical
● Identify the main users of financial information and discuss their needs.
He began the venture with £40 in cash. On Monday, Paul’s first day of trading,
he bought wrapping paper for £40 and sold three-quarters of it for £45 cash.
examples that give you step-
● Identify and discuss the characteristics that make accounting
information useful.
● What cash movements took place during Monday?
For Monday, a cash flow statement showing the cash movements for the day
by-step workings to follow
can be prepared as follows:
● Explain the purpose of a business and describe how businesses are
organised and structured. Cash flow statement for Monday
through to the solution.
£
Opening balance (cash introduced) 40
Add Cash from sales of wrapping paper 45
Remember to create your own 85
personalised Study Plan Less Cash paid to buy wrapping paper 40
Closing balance of cash 45

Introductions A brief introduction, detailing the topics covered in the chapter, and also showing
how chapters are linked together.
Learning outcomes Bullet points at the start of each chapter show what you can expect to learn
from the chapter, and provide a brief checklist of the core issues.

CREATIVE ACCOUNTING 181 196 CHAPTER 6 MEASURING AND REPORTING CASH FLOWS

be designed to bend the rules or may be designed to break the rules. Below we consider
some of the more important ways in which rules may be bent or broken. Activity 6.2 Activities These short
Overstating revenue
Some creative accounting methods are designed to overstate the revenue for a period.
At the end of its accounting period, Zeneb plc’s balance sheet included the following
items: questions, integrated
1 A bank deposit account where one month’s notice of withdrawal is required. This
These methods often involve the early recognition of sales revenue or the reporting of
sales transactions that have no real substance. Real World 5.8 provides examples of deposit was made because the business has a temporary cash surplus that it will
need to use in the short term for operating purposes;
throughout each chapter,
both types of revenue manipulation.
2 Ordinary shares in Jones plc (a Stock Exchange listed business). These were
acquired because the business has a temporary cash surplus and Zeneb plc’s
allow you to check your
directors believed that the share represented a good short-term investment. The
Real World 5.8 funds invested will need to be used in the short term for operating purposes.
3 A bank deposit account that is withdrawable instantly. This represents an investment
understanding as you
Overstating revenue
Hollow swaps: telecoms companies sell useless fibre optic capacity to each other in order to
of surplus funds that are not seen as being needed in the short term.
4 An overdraft on the business’s bank current account. progress through the text.
generate revenues on their income statements. Example: Global Crossing.
Channel stuffing: a company floods the market with more products than its distributors can sell,
artificially boosting its sales. SSL, the condom maker, shifted £60 million in excess inventories on
Which (if any) of these four items would be included in the figure for cash and cash
equivalents? They comprise either a
to trade customers. Also known as ‘trade loading’.
Round tripping: also known as ‘in-and-out trading’. Used to notorious effect by Enron. Two or more
traders buy and sell energy among themselves for the same price and at the same time. Inflates
Your response should have been as follows: narrative question requiring
trading volumes and makes participants appear to be doing more business than they really are.
Pre-dispatching: goods such as carpets are marked as ‘sold’ as soon as an order is placed. . . .
This inflates sales and profits.
1 A cash equivalent because the deposit is part of the business’s normal cash manage-
ment activities and there is little doubt about how much cash will be obtained when you to review or critically
the deposit is withdrawn.
Note that some of the techniques used, such as round tripping, may inflate the sales
revenue for a period but will not inflate reported profits. Nevertheless, this may still bene-
2 Not a cash equivalent. Although the investment was made as part of normal cash
management, there is a significant risk that the amount expected (hoped for!) when the
consider topics, or a
shares are sold may not actually be forthcoming.
fit the business. Sales revenue growth has become an important yardstick of performance
for some investors and can affect the value they place on the business. 3 Not a cash equivalent because this represents an investment rather than a short-term
surplus amount of cash.
numerical problem requiring
Source: ‘Dirty laundry: how companies fudge the numbers’, The Times, Business Section, 22 September 2002.
4 This is cash itself, though a negative amount of it. The only exception to this classifica-
tion would be where the business is financed in the longer term by an overdraft, when you to deduce a solution.
it would be part of the financing of the business.
The manipulation of revenue has been at the heart of many of the accounting
scandals recently exposed. Given its critical role in the measurement of performance, A suggested answer is given
this is, perhaps, not surprising. Real World 5.9 provides an example of the impact of
the early recognition of revenue on the financial results of one well-known business. As can be seen from the responses to Activity 6.2, whether a particular item falls
within the definition of cash and cash equivalent depends on two factors:
immediately after each
Real World 5.9
●
●
the nature of the item; and
why it has arisen.
activity.
In practice, it is not usually difficult to decide whether an item is a cash equivalent.
Not to be copied
One case of overstating revenue is alleged to have been carried out by the Xerox
The relationship between the primary financial statements
Corporation, a large US company and a leading player in the photocopying business. It is
alleged that the company brought forward revenues in order to improve reported profits
The cash flow statement is now accepted, along with the income statement, the state-
as its fortunes declined in the late 1990s. These revenues related to copier equipment
ment of changes in equity and the balance sheet, as a primary financial statement. The
sales, particularly in Latin America. To correct for the overstatement of revenues, Xerox
relationship between the four statements is shown in Figure 6.1. The balance sheet
had to restate its equipment sales revenue figures for a five-year period. The result was a
reflects the combination of assets (including cash) and claims (including the owners’
reversal in reported revenues of a staggering $6.4bn, although $5.1bn was reallocated to
other revenues as a result. This restatement was one of the largest in US corporate history. claim) of the business at a particular point in time. The cash flow statement, the income
In June 2002 the company paid a fine of $10m but denied any wrongdoing. statement and the statement of changes in equity explain the changes over a period to
two of the items in the balance sheet. The cash flow statement explains the changes
Sources: Based on information in ‘Can’t tell the scandals without a scorecard’, Wall Street Journal Europe, October 2003, p. A5; and
‘Xerox acts to put itself on a firmer footing’, FT.com, 28 June 2002. to cash. The income statement, together with the statement of changes in equity,
explains changes to the owners’ claim (equity).

‘Real World’ illustrations Integrated throughout the text, these illustrative examples highlight the
practical application of accounting concepts and techniques by real businesses, including extracts
from company reports and financial statements, survey data and other insights from business.
ACCA_A01.qxd 7/08/2007 11:14 Page xxv

GUIDED TOUR OF THE BOOK xxv

Self-assessment questions Towards the end of most chapters you will encounter one of these questions,
allowing you to attempt a comprehensive question before tackling the end-of-chapter assessment material.
To check your understanding and progress, solutions are provided in Appendix C.

384 CHAPTER 11 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT 646 CHAPTER 16 MANAGING WORKING CAPITAL

Self-assessment question 11.1 Summary Bullet point chapter

Psilis Ltd makes a product in two qualities, called Basic and Super. The business is able The main points of this chapter may be summarised as follows.
to sell these products at a price that gives a standard profit mark-up of 25 per cent of full
cost. Management is concerned by the lack of profit. Working capital
summary Each chapter ends
● Working capital is the difference between current assets and current liabilities.
Full cost for one unit of a product is calculated by charging overheads to each type of
product on the basis of direct labour hours. The costs are as follows: ● That is, working capital = inventories + receivables + cash − payables − bank overdrafts. with a bullet point summary,
● An investment in working capital cannot be avoided in practice – typically large
Basic
£
Super
£
amounts are involved.
Inventories
highlighting the material
Direct labour (all £10/hour) 40 60
Direct material
The total overheads are £1,000,000.
15 20 ● There are costs of holding inventories, which include:
– lost interest
covered in the chapter and
– storage cost
Based on experience over recent years, in the forthcoming year the business expects
to make and sell 40,000 Basics and 10,000 Supers.
– insurance cost
– obsolescence.
serving as a quick reminder of
Recently, the business’s management accountant has undertaken an exercise to try to
identify cost drivers in an attempt to be able to deal with the overheads on a more precise
basis than had been possible before. This exercise has revealed the following analysis of
● There are also costs of not holding sufficient inventories, which include:
– loss of sales and customer goodwill the key issues.
– production dislocation
the annual overheads: – loss of flexibility – cannot take advantage of opportunities
– reorder costs – low inventories imply more frequent ordering.
Activity (and cost driver) Cost Annual number of activities ● Practical points on inventories management include:
– identify optimum order size – models can help with this
£000 Total Basic Super – set inventories reorder levels
– use budgets
Number of machine set-ups 280 100 20 80 – keep reliable inventories records
Number of quality-control inspections 220 2,000 500 1,500 – use accounting ratios (for example, inventories turnover period ratio)
Number of sales orders processed 240 5,000 1,500 3,500 – establish systems for security of inventories and authorisation
General production (machine hours) 260 500,000 350,000 150,000 – consider just-in-time (JIT) inventories management.
Total 1,000
Trade receivables
● When assessing which customers should receive credit, the five Cs of credit can be
The management accountant explained the analysis of the £1,000,000 overheads as
used:
follows:
– capital
● The two products are made in relatively small batches, so that the amount of the – capacity
finished product held in inventories is negligible. The Supers are made in very small – collateral
batches because their demand is relatively low. Each time a new batch is produced, the – condition
machines have to be reset by skilled staff. Resetting for Basic production occurs about – character.
20 times a year and for Supers about 80 times: about 100 times in total. The cost of ● The costs of allowing credit include:
employing the machine-setting staff is about £280,000 a year. It is clear that the more – lost interest
set-ups that occur, the higher the total set-up costs; in other words, the number of – lost purchasing power
set-ups is the factor that drives set-up costs. – costs of assessing customer creditworthiness
● All production has to be inspected for quality and this costs about £220,000 a year. The – administration cost
higher specifications of the Supers mean that there is more chance that there will be – bad debts
quality problems. Thus the Supers are inspected in total 1,500 times annually, whereas – cash discounts (for prompt payment).
the Basics need only about 500 inspections. The number of inspections is the factor ● The costs of denying credit include:
that drives these costs. – loss of customer goodwill.
● Sales order processing (dealing with customers’ orders, from receiving the original ● Practical points on receivables management:
order to despatching the products) costs about £240,000 a year. Despite the larger – establish a policy
amount of Basic production, there are only 1,500 sales orders each year because the – assess and monitor customer creditworthiness
Basics are sold to wholesalers in relatively large-sized orders. The Supers are sold – establish effective administration of receivables
mainly direct to the public by mail order, usually in very small-sized orders. It is believed – establish a policy on bad debts
that the number of orders drives the costs of processing orders. – consider cash discounts

Key terms summary At the end of each chapter, there is a list (with page references) of all the key
terms introduced in that chapter, allowing you to refer back easily to the essential points.

Guided tour of MyAccountingLab

MyAccountingLab puts students in control of their own learning through a suite of study and
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ACCA_A01.qxd 7/08/2007 11:15 Page xxvii

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Generated by the student's own performance on a practice test, additional practice exercises are
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tutorial instruction resources.

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Launched from the additional practice exercises, tutorial instruction is provided in the form of
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Additional MyAccountingLab tools

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We offer lecturers personalised training and support for MyAccountingLab. We have a dedicated
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ACCA_A01.qxd 7/08/2007 11:15 Page xxviii

Acknowledgements

We are grateful to the following for permission to reproduce copyright material:

NI Syndication Limited for extracts from ‘Dirty Laundry: How companies fudge the
numbers’ published in The Times 22nd September 2002, ‘The Thoughts of Warren
Buffett’ published in The Times 26th September 2002 and ‘Ryanair alert hits shares’
published in The Times 4th June 2003; Manchester United Limited for an extract from
it’s Annual Report 2005; Marks and Spencer plc (company) for extracts from it’s Annual
Report 2006; Thorntons plc for extracts from it’s Annual Report 2006; Alliance Boots
plc for extracts from it’s Annual Report 2006; Jarvis plc for extracts from it’s Annual
Report 2006; British Sky Broadcasting for extracts from it’s Annual Report 2005; VNU
Business Media Europe for an extract from ‘JJB massages results to boost profits’ pub-
lished in Accountancy Age 20th October 2005; J. D. Wetherspoon plc for extracts from
it’s Annual Report 2006; Pennon Group plc for an extract from ‘Investor Information’
published at www.pennon.co.uk; C. William (Bill) Thomas for an extract from ‘The
Rise and Fall of Enron’ published in The Journal of Accountancy vol 194 no 3 April 2002;
Dr Terry O’Brien CEO LiDICO Group plc for an extract from it’s Annual Report 2006;
SAB Miller for extracts from it’s Annual Reports 2004 and 2005; Harvard Business
School Publishing for an extract from ‘Beyond Budgeting’ by Hope and Fraser pub-
lished in Management Accounting January 1999; Next plc for an extract from it’s Annual
Report 2006; British Airways plc for an extract from it’s Annual Report 2006; Figure
11.5 reprinted by permission of Harvard Business School Press from The Balanced
Scorecard by Kaplan R. and Norton D., Boston, MA 1996, copyright © 1996 by the
Harvard Business School Publishing Corporation, all rights reserved; Figure 14.2 adapted
from Investment appraisal in UK manufacturing: Has it changed since the mid-1990s?
D. Godden, www.cbi.org.
We are grateful to the Financial Times Limited for permission to reprint the following
material:
Real World 1.1 Morrison in uphill battle to integrate Safeway, © Ft.com, 26 May 2005;
Real World 1.6 Fair Shares?, © Ft.com, 11 June 2005; Real World 1.7 Profit without
honour, © Financial Times Weekend, 29/30 June 2002; Real World 1.8 Tsunami:
Finding the right figures for disaster, © Ft.com, 7 March 2005; Real World 2.4 Goodwill
charges at record levels, © Ft.com, 30 May 2006; Real World 3.8 Household debt adds
to rise in bank write-offs, © Financial Times, 28 March 2005; Real World 4.1 Monotub
Industries in a spin as founder gets Titan for £1, © Financial Times, 23 January 2003;
Real World 4.12 MyTravel set to resume its dividend, © Ft.com, 14 March 2006; Real
World 6.1 Eurotunnel takes £1.3bn impairment charge, © Ft.com, 9 February 2004;
Real World 6.3 WaterfordWedgwood face some intense questions over its cash flow, ©
Financial Times, 17 June 2004; Real World 8.2 MFI furniture retail arm bought for £1,
© Ft.com, 22 September 2006; Real World 9.4 Ford puts Aston Martin up for auction,
© Ft.com, 31 August 2006; Real World 11.14 How to put ideas to work, © Ft.com,
23 May 2006; Real World 14.8 Satellites need space to earn, © Ft.com, 14 July 2003;
ACCA_A01.qxd 7/08/2007 11:15 Page xxix

ACKNOWLEDGEMENTS xxix

Real World 15.3 New appetite develops for Eurobonds, © Financial Times, 18 Sep-
tember 2004; Real World 15.4 Volatility prompts European issuance, © Financial Times,
12 July 2006; Real World 15.5 Gcap attacks note on breaching covenants, © Financial
Times, 9 September 2006; Real World 15.13 page 22, © Financial Times, 8 August 2003;
Real World 16.2 Poor cash management hits profits, © Financial Times, 29 August
2005; Real World 16.4 Small stores keep up with the big boys, © Financial Times,
5 February 2003.
In some instances we have been unable to trace the owners of copyright material and
we would appreciate any information that would enable us to do so.
ACCA_A01.qxd 7/08/2007 11:15 Page xxx
ACCA_C01.qxd 7/08/2007 11:20 Page 1

CHAPTER 1

Introduction to accounting
and finance

Introduction
n this opening chapter we begin by considering the roles of accounting and finance. We
I shall see that both can be valuable tools for decision-making purposes. We shall identify
the main users of accounting and financial information and discuss the ways in which this
information can improve the quality of decisions that those users make. In subsequent
chapters, we develop this decision-making theme by considering in some detail the kinds
of financial reports and methods used to aid decision making.
Since this book is concerned with accounting and financial decision making for private-
sector businesses, we shall devote some time to examining the business environment. We
shall, therefore, consider the purpose of a private-sector business, the main forms of business
enterprise and the ways in which a business may be structured. We shall also consider
what the key financial objective of a business is likely to be. These factors are important as
they all exert an influence on the kind of accounting and financial information produced.

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.

● Identify and discuss the characteristics that make accounting

information useful.

● Explain the purpose of a business and describe how businesses are

organised and structured.

Remember to create your own

personalised Study Plan
ACCA_C01.qxd 7/08/2007 11:20 Page 2

2 CHAPTER 1 INTRODUCTION TO ACCOUNTING AND FINANCE

What are accounting and finance?

Let us start our study of accounting and finance by trying to understand the purpose of
➔ each. Accounting is concerned with collecting, analysing and communicating financial
information. This information is useful for those who need to make decisions and plans
about businesses, including those who need to control those businesses. For example,
the managers of businesses may need accounting information to decide whether to:
● develop new products or services (such as a computer manufacturer developing a
new range of computers);
● increase or decrease the price or quantity of existing products or services (such as a
telecommunications business changing its mobile phone call and text charges);
● borrow money to help finance the business (such as a supermarket wishing to
increase the number of stores it owns);
● increase or decrease the operating capacity of the business (such as a beef farming
business reviewing the size of its herd); and
● change the methods of purchasing, production or distribution (such as a clothes
retailer switching from UK to overseas suppliers).
The information provided should help in identifying and assessing the financial con-
sequences of such decisions.
Though managers working within a business are likely to be significant users of
accounting information about that particular business, they are by no means the only
users. There are those outside the business (whom we shall identify later) who may
need information to decide whether to:
● invest or disinvest in the ownership of the business (for example, buy or sell shares);
● lend money to the business;
● offer credit facilities (for example, a bank to grant an overdraft); and
● enter into contracts for the purchase of products or services.
Sometimes the impression is given that the purpose of accounting is simply to pre-
pare financial reports on a regular basis. While it is true that accountants undertake this
kind of work, the preparation of financial reports does not represent an end in itself.
The ultimate purpose of the accountant’s work is to give people better information on
which to base their decisions. This decision-making perspective of accounting dictates
the theme of 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 a 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 (equipment, premises, inventories and so on) in an attempt to make the
business, and its owners, wealthier. It is important that funds are raised in a way that
is appropriate to the particular needs of the business and 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 the funds are raised, they must be invested in a way that will provide the busi-
ness with a worthwhile return. An understanding of finance should help in evaluating:
ACCA_C01.qxd 7/08/2007 11:20 Page 3

WHO ARE THE USERS OF ACCOUNTING INFORMATION? 3

● the returns from an investment; and

● the risks associated with an investment.
Businesses tend to raise and invest funds in large amounts for long periods of time.
The quality of the investment decisions made can, therefore, have a profound impact
on the fortunes of the business.
There is little point in trying to make a sharp distinction between accounting and
finance. We have already seen that both are concerned with the financial aspects of
decision making. There is considerable overlap between the two subjects, for example
accounting reports are a major source of information for financing and investment
decision making. In this book, we shall not emphasise the distinctions between
accounting and finance.

Who are the users of accounting information?

For accounting information to be useful, the accountant must be clear for whom the
information is being prepared and for what purpose the information will be used. There
are likely to be various groups of people (known as ‘user groups’) with an interest in
a particular organisation, in the sense of needing to make decisions about it. For the
typical private-sector business, the most important of these groups are shown in
Figure 1.1. Take a look at this figure and then try Activity 1.1.

Figure 1.1 Main users of financial information relating to a business

There are several user groups with an interest in the accounting information relating to a busi-
ness. The majority of these are outside the business but, nevertheless, they have a stake in it.
This is not meant to be an exhaustive list of potential users; however, the groups identified are
normally the most important.
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4 CHAPTER 1 INTRODUCTION TO ACCOUNTING AND FINANCE

Activity 1.1

Ptarmigan Insurance plc (PI) is a large motor insurance business. Taking the user groups
identified below, 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 as follows:

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 their
needs, particularly in respect of any insurance claims made.
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 might involve using PI’s performance in various aspects as a
‘benchmark’ when evaluating their own performance. They might also
try to assess PI’s financial strength and to identify significant changes
that may signal PI’s future actions (for example, raising funds as a
prelude to market expansion).
Employees Whether to continue in employment with PI and, if so, whether to
demand higher rewards for their labour. 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 its profits, sales
revenues and financial strength would be made.
Community Whether to allow PI to expand its premises and/or whether to provide
representatives economic support for the business. PI’s ability to continue to provide
employment for the community, to use community resources and to
help fund environmental improvements are likely to be considered when
arriving at such decisions.
Investment Whether to advise clients to invest in PI. This would involve an assess-
analysts ment 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 involve an assessment of PI’s ability to pay for any goods
and services supplied.
Lenders Whether to lend money to PI and/or whether to require repayment of any
existing loans. PI’s ability to pay the interest and to repay the principal
sum 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 decide whether there should be a change in
PI’s future direction. This would involve looking at PI’s ability to perform
and at the opportunities available to it.
Owners Whether to invest more in PI or to sell all, or part, of the investment
currently held. This would involve an assessment of the likely risks and
returns associated with PI. Owners may also be involved with decisions
on rewarding senior managers. The financial performance of the busi-
ness would normally be considered when making such a decision.
Although this answer covers many of the key points, you may have identified other deci-
sions and/or other factors to be taken into account by each group.
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HOW USEFUL IS ACCOUNTING INFORMATION? 5

The conflicting interests of users

We have seen above that each user group looks at a business from a different perspective
and has its own particular interests. This means that there is always the risk that the
interests of one group will collide with those of another group. Conflict between user
groups is most likely to occur over the way in which the wealth of the business is
generated and/or distributed. A good example is the conflict that may arise between
the managers and the owners of the business. Although managers are appointed to act
in the best interests of the owners, there is always a danger that they will not do so.
Instead, managers may use the wealth of the business to award themselves large pay
rises, to furnish large offices or to buy expensive cars for their own use. Accounting
information has an important role to play in reporting the extent to which various
groups have benefited from the business. Thus, owners may rely on accounting
information to check whether the pay and benefits of managers are in line with
agreed policy.
A further example is the potential conflict of interest between lenders and owners.
There is a risk that the funds loaned to a business will not be used for purposes that
have been agreed. Lenders may, therefore, rely on accounting information to check
that the funds have been applied in an appropriate manner and that the terms of the
loan agreement are not being broken.

Activity 1.2
Can you think of other examples where accounting information may be used to monitor
potential conflicts of interest between the various user groups identified?

Two possible examples that spring to mind are:

● Employees (or their representatives) wishing to check that they are receiving a ‘fair
share’ of the wealth created by the business and that agreed profit-sharing schemes
are being adhered to.
● Government wishing to check that the profits made from a contract that it has given to
a business are not excessive.

You may have thought of other examples.

How useful is accounting information?

No one would seriously claim that accounting information fully meets all of the needs
of each of the various user groups. Accounting is still a developing subject and we still
have much to learn about user needs and the ways in which these needs should be met.
Nevertheless, the information contained in accounting reports should help users make
decisions relating to the business. The information should reduce uncertainty about
the financial position and performance of the business. It should help to answer ques-
tions concerning the availability of funds to pay owners a return, to repay loans, to
reward employees and so on.
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6 CHAPTER 1 INTRODUCTION TO ACCOUNTING AND FINANCE

Typically, there is no close substitute for the information provided by the financial
statements. Thus, if users cannot glean the required information from the financial
statements, it is often unavailable to them. Other sources of information concerning
the financial health of a business are normally much less useful.

Activity 1.3
What other sources of information might users use in an attempt to gain an impression
of the financial position and performance of a business? What kind of information might
be gleaned from these sources?

Other sources of information available include:

● Meetings with managers of the business

● Public announcements made by the business
● Newspaper and magazine articles
● Websites, including the website of the business
● Radio and TV reports
● Information-gathering agencies (for example, agencies that assess businesses’ credit-
worthiness or credit ratings)
● Industry reports
● Economy-wide reports.

These sources can provide information on various aspects of the business, such as
new products or services being offered, management changes, new contracts offered or
awarded, the competitive environment within which the business operates, the impact
of new technology, changes in legislation, changes in interest rates and future levels of
inflation. However, the various sources of information identified are not really substitutes
for accounting reports. Rather, they are best used in conjunction with the reports in order
to obtain a clearer picture of the financial health of a business.

Evidence on the usefulness of accounting

There are arguments and convincing evidence that accounting information is at least
perceived as being useful to users. Numerous research surveys have asked users to rank
the importance of accounting information, in relation to other sources of information,
for decision-making purposes. Generally speaking, these studies have found that users
rank accounting information very highly. There is also considerable evidence that
businesses choose to produce accounting information that exceeds the minimum
requirements imposed by accounting regulations. (For example, businesses often produce
a considerable amount of accounting information for managers, which is not required
by any regulations.) Presumably, the cost of producing this additional accounting
information is justified on the grounds that users find it useful. Such arguments and
evidence, however, leave unanswered the question of whether the information produced
is actually used for decision-making purposes, that is: does it affect people’s behaviour?
It is normally very difficult to assess the impact of accounting on decision making.
One situation arises, however, where the impact of accounting information can be
➔ observed and measured. This is where the shares (portions of ownership of a business)
are traded on a stock exchange. The evidence reveals that, when a business makes an
announcement concerning its accounting profits, the prices at which shares are traded
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PROVIDING A SERVICE 7

and the volume of shares traded often change significantly. This suggests that investors
are changing their views about the future prospects of the business as a result of this
new information becoming available to them and that this, in turn, leads them to
make a decision either to buy or to sell shares in the business.
Although there is evidence that accounting reports are perceived as being useful and
are used for decision-making purposes, it is impossible to measure just how useful
accounting reports are to users. As a result we cannot say with certainty whether the
cost of producing those reports represents value for money. Accounting information
will usually represent only one input to a particular decision and so the precise weight
attached to the accounting information by the decision maker and the benefits which
flow as a result cannot be accurately assessed. We shall now go on to see, however, that
it is at least possible to identify the kinds of qualities which accounting information
must possess in order to be useful. Where these qualities are lacking, the usefulness of
the information will be diminished.

Providing a service
One way of viewing accounting is as a form of service. Accountants provide economic
information to their ‘clients’, who are the various users identified in Figure 1.1. The
quality of the service provided is determined by the extent to which the needs of the vari-
ous user groups have been met. In other words, how fit for purpose is the information?
To meet these users’ needs, it can be argued that accounting information should
possess certain key qualities, or characteristics. These are:

➔ ● Relevance. Accounting information must have the ability to influence decisions.

Unless this characteristic is present, there is really no point in producing the informa-
tion. The information may be relevant to the prediction of future events (for example,
in predicting how much profit is likely to be earned next year) or relevant in
helping to confirm past events (for example, in establishing how much profit was
earned last year). The role of accounting in confirming past events is important
because users often wish to check the accuracy of earlier predictions that they have
made. The accuracy (or inaccuracy) of earlier predictions may help users to judge the
accuracy of current predictions. To influence a decision, the information must, of
course, be available when the decision is being made. Thus, relevant information
must be timely.
➔ ● Reliability. Accounting should be free from significant errors or bias. It should be cap-
able of being relied upon by managers to represent what it is supposed to represent.
Though both relevance and reliability are very important, the problem that we often
face in accounting is that information that is highly relevant may not be very
reliable, and that which is reliable may not be very relevant.

Activity 1.4
To illustrate this last point, let us assume that a manager has to sell a custom-built
machine owned by the business and has recently received a bid for it. This machine is
very unusual and there is no ready market for it.
What information would be relevant to the manager when deciding whether to

➔
accept the bid? How reliable would that information be?
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8 CHAPTER 1 INTRODUCTION TO ACCOUNTING AND FINANCE

Activity 1.4 continued

The manager would probably like to know the current market value of the machine
before deciding whether or not to accept the bid. The current market value would be highly
relevant to the final decision, but it might not be very reliable because the machine is
unique and there is likely to be little information concerning market values.
Where a choice has to be made between providing information that has either more
relevance or more reliability, the maximisation of relevance is usually the guiding rule. No
matter how reliable the information is, it is useless if it is not relevant. On the other hand,
information that is not totally reliable can be useful if it is relevant.

➔ ● Comparability. This quality will enable users to identify changes in the business over
time (for example, the trend in sales revenue over the past five years). It will also
help them to evaluate the performance of the business in relation to similar busi-
nesses. Comparability is achieved by treating items that are basically the same in the
same manner for accounting purposes. Comparability tends also to be enhanced by
making clear the policies that have been adopted in measuring and presenting the
information.
➔ ● Understandability. Accounting reports should be expressed as clearly as possible and
should be understood by those at whom the information is aimed.

Activity 1.5
Do you think that accounting reports should be understandable to those who have not
studied accounting?

It would be useful if anyone could understand accounting reports, but realistically this is
not likely to be the case. Complex financial events and transactions cannot always be
reported easily. It is probably best that we regard accounting reports in the same way as
we regard a report written in a foreign language. To understand either of these, we need
to have had some preparation. Generally speaking, accounting reports assume 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.

Despite the answer to Activity 1.5, the onus is clearly on accountants to provide
information in a way that makes it as understandable as possible to non-accountants.

But . . . is it material?
The qualities, or characteristics, that have just been described will help us to decide
whether accounting information is potentially useful. If a particular piece of informa-
tion has these qualities then it may be useful. However, this does not automatically
mean that it should be reported to users. We also have to consider whether the informa-
tion is material, or significant. This means that we should ask whether its omission
or misrepresentation in the accounting reports would really alter the decisions that
users make. Thus, in addition to possessing the characteristics mentioned above,
➔ accounting information must also cross the threshold of materiality. If the information
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WEIGHING UP THE COSTS AND BENEFITS 9

is not regarded as material, it should not be included within the reports as it will
merely clutter them up and, perhaps, interfere with the users’ ability to interpret the
financial results. The type of information and amounts involved will normally deter-
mine whether it is material.

Weighing up the costs and benefits

Having read the previous sections you may feel that, when considering a piece of
accounting information, provided the four main qualities identified are present and it
is material it should be gathered and made available to users. Unfortunately, there is
one more hurdle to jump. Something may still exclude a piece of accounting informa-
tion from the reports even when it is considered to be useful. Consider Activity 1.6.

Activity 1.6
Suppose an item of information is capable of being provided. It is relevant to a particu-
lar decision, it is also reliable, comparable, can be understood by the decision maker
concerned and is material.
Can you think of a reason why, in practice, you might choose not to produce the
information?

The reason that you may decide not to produce, or discover, the information 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 extent to which accounting information is provided.

In theory, a particular item of accounting information should only be produced

if the costs of providing it are less than the benefits, or value, to be derived from
its use. Figure 1.2 shows the relationship between the costs and value of providing
additional accounting information. The figure shows how the value of information
received by the decision maker eventually begins to decline. This is, perhaps, because
additional information becomes less relevant, or because of the problems that a
decision maker may have in processing the sheer quantity of information provided.
The costs of providing the information, however, will increase with each additional
piece of information. The broken line indicates the point at which the gap between
the value of information and the cost of providing that information is at its greatest.
This represents the optimal amount of information that can be provided. This theor-
etical model, however, poses a number of problems in practice. We shall now go on
to discuss these.
To illustrate the practical problems of establishing the value of information, suppose
that we wish to have a car serviced at a local garage. We know that the nearest garage
would charge £250 but believe that other local garages may offer the same service for
a lower price. The only ways of finding out the prices at other garages are either to tele-
phone them or to visit them. Telephone calls cost money and involve some of our
time. Visiting the garages may not involve the outlay of money, but more of our time
will be involved. Is it worth the cost of finding out the price of a car service 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.
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