THE PURPOSE OF ACCOUNTING

WHAT IS ACCOUNTING?

You may have a wide understanding of what accounting and financial reporting is. Your job may be in one area or type of accounting, but you must understand the breadth of work which an accountant undertakes. In particular, you need to understand the distinction between financial accounting and management accounting.

Definition

Accounting is the process of recording, analysing and summarising transactions of a business and communicating that information to decision makers.

Renaissance scholar Luca Pacioli wrote the first printed explanation of double-entry bookkeeping in 1494. Double-entry bookkeeping involves entering every transaction as a debit in one account and a corresponding credit in another account, and ensuring that they 'balance'. Pacioli's description of the method was widely influential. The first English book on the subject was written in 1543 by John Gouge. The practice of double-entry  bookkeeping has barely changed since then and is standard across the world, based upon the concept that every transaction has a dual effect expressed as debits equals credits. The original role of the accounting function was to record financial information and this is still its main focus.

FINANCIAL ACCOUNTING

Definition

Financial accounting is a method of reporting the results and financial position of a business. It is not primarily concerned with providing information towards the more efficient running of the business. Although financial accounts are of interest to management, their principal function is to satisfy the information needs of persons not involved in running the business, in particular shareholders. Financial accounts provide historical information.

MANAGEMENT ACCOUNTING

The information needs of management go far beyond those of other account users. Managers have the responsibility of planning and controlling the resources of the business and for making decisions about the direction of the business both in the longer term and on a day to day basis.

Therefore they need much more detailed information. They also need to plan for the future e.g. budgets, which predict future revenue and expenditure.

Definition

Management accounting, sometimes known as cost accounting, is a management information system which analyses data to provide information as a basis for managerial action. The concern of a management accountant is to present accounting information in the form most helpful to management.

WHAT IS A BUSINESS?

Definitions

Businesses of whatever size or nature exist to make a profit. A business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants. There are a number of different ways of looking at a business. Some ideas are listed below.

· A business is a commercial or industrial concern  which exists to deal in the manufacture, re-sale or supply of goods and services.

· A business is an organisation that uses economic resources to create goods or services which customers will buy.

· A business is an organisation providing jobs for people.

· A business invests money in resources e.g. buildings, machinery, employees, in order to make even more money for its owners.

This last definition introduces the important idea of profit. Businesses vary from very small businesses e.g. the local shopkeeper or plumber, to very large ones e.g. IKEA, Nestlé, Unilever. However all of them want to earn profits.

Definition

Profit is the excess of revenue (income) over expenses. When expenses exceed revenue, the business is running at a loss. One of the jobs of an accountant is to measure revenue and expenditure, and so profit.

TYPES OF BUSINESS ENTITY

There are three main types of business entity:

· sole traders;

· partnerships; and

· limited liability companies.

Sole traders are people who work for themselves. Examples may include the local shopkeeper, a plumber and a hairdresser. The term sole trader refers to the ownership of the business – sole traders can have employees.

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Partnerships occur when two or more people decide to run a business together. Examples may include an accountancy practice, a medical practice and a legal practice. Limited liability companies are incorporated to take advantage of 'limited liability' for their owners  (shareholders). This means that, unlike sole traders and partners, who are personally responsible for the amounts owed by their business, the shareholders of a limited liability company are only responsible for the amount unpaid on their shares. This means that if the shareholders have purchased shares costing $100 but have only paid $40 to date, they would have to contribute the remaining $60 towards paying the company's debts.

Generally, in law sole traders and partnerships are not separate entities from their owners. This is true in many jurisdictions, for example Australia, the UK, India, New Zealand, China, Japan and Germany. In the US, however, partnerships do have separate legal personality but the partners are wholly liable for debts of the partnership. In all cases, however, a limited liability company is legally a separate  entity from its owners and it can issue contracts in the company's name.

For accounting purposes, all three entities are treated as separate from their owners. This is called the business entity concept. The methods of accounting used in all three types of business entity will be very similar, although will tend to become more complex the larger the entity.

NON-COMMERCIAL UNDERTAKINGS

It is not only businesses that need to prepare financial statements. Charities and clubs, for example, may need to prepare financial statements every year. Financial statements also need to be prepared forgovernment organisations (public sector organisations such as hospitals and local councils).