WHAT IS ACCOUNTING

Accounting is the collection and aggregation of information for decision makers including managers, investors, regulators, lenders, and the public. Accounting systems affect behavior and management and have affects across departments, organizations, and even countries. Information contained within an accounting system has the power to influence actions. Accounting information systems are particularly strong behavioral drivers within the context of a corporation where profits and the bottom line are daily concerns.

Types of accounting systems

National Accounting Systems
National accounts are national income and production accounts, such as the Gross National Product (GNP) and Gross Domestic Product (GDP) which aim to measure and track an economys contribution to the well-being of its inhabitants. National income accounts show the national demand or goods and services and are used to track and measure economic growth.

Financial Accounting Systems

Financial accounts, such as balance sheets and income statements are used to keep track of business incomes and outflows. These financial reports are for use by persons outside the firm - for example, lenders or investors . The overall objectives of a firms financial accounting statements are: 1) To provide information useful for making rational investment and credit decisions. 2) To allow investors and creditors to assess the amount, timing, and uncertainty of cash flows. 3) To provide information about the economic resources of a firm and the claims on those resources. 4) To provide information about a firms operating performance during a period.

5) To provide information on how a firm obtains and uses money and other financial resources. 6) To provide information on how management has discharged its stewardship responsibility to owners and the public.

Principal Financial Accounting Statements.

Balance Sheet Balance Sheets present a snapshot of the investing and financing activities of a firm at a particular moment in time (usually the last day of the firms fiscal year). The balance sheet presents a summary of the firms assets, liabilities and shareholders equity. In a balance sheet the sum of the assets must equal the sum of the liabilities and shareholders equity. There are strict guidelines governing the estimation of assets and liabilities.

Income Statement
The Income Statement presents the results of the operating activities of a company for a specific period of time - usually the fiscal year. The statement summarized the revenues and expenses and reveals the net income or earnings of the firm during the period of time covered.

Cash Flow Statement

The Cash Flow Statement shows the net cash flows related to operating, investing, and financing activities for a specific period of time - usually the firms fiscal year.

Management or Cost Accounting Systems and Capital Budgeting Management or cost accounting systems are part of an enterprises information system and refer to the internal cost tracking and allocation systems to track costs and expenditures. These are internal rather than external accounting systems. There are no fixed rules governing how an entity should keep track of cash flows internally, although there are many formal methods available for users. Capital budgeting is basically a form of predictive cost accounting over a set time frame which is used to analyze the costs of alternative projects or expenditures over the specified period of time. Managerial or cost accounting measures are the predominant financial drivers in day to day business decision making affecting every aspect of the firms activities. Good cost accounting is vital to understanding the profitability of current activities and to predicting the profitability of future activities.

The main objectives of managerial/cost accounting :

1) Providing managers with information for decision making and planning. 2) Assisting managers in directing and controlling operations. 3) Motivating managers towards the organizations goals. 4) Measuring the performance of managers and sub-units within the organization.

General Cost classifications

Variable Costs Variable costs change in total in proportion to the level of activity. For example if a carmakers production increases by 5%, its tire costs will increase by about 5%.

Fixed Costs A fixed cost remains unchanged in total as the level of activity varies. For example, the property tax on a rental apartment is the same regardless of the number of building occupants. Direct Costs A direct cost is the cost of direct labor and material used in making the product or delivering the service. Indirect Costs/Overhead Costs Indirect costs are costs of an activity which are not easily associated with the production of specific goods or services. Opportunity Costs The benefit that is sacrificed when the choice of one action precludes an alternative course of action. Sunk Costs Costs that have been incurred in the past and cannot be changed by current actions.

Shortcomings of accounting systems

National Accounting Systems It is possible for a country to act in such a way as to deplete its forests, exhaust its mineral resources, pollute its waters, and deplete its fisheries and wildlife without affecting measured GDP or GNP. In fact, activities such as mining or environmental cleanup, will actually contribute positively to a countries national account measures. Conversely, a country could vastly improve the quality or fertility of its land and natural resources and these improvements would not be reflected as increases in GDP/GNP. National accounts are actually inadequate measures of a countrys long-term economic welfare as they do not take into account activities, such as resource depletion, which will ultimately affect economic growth. The accounting systems also ignore or mislabel many of the costs and benefits associated with natural

resources and environmental quality. The costs of reducing the adverse effects of environmental degradation are treated as ordinary investment and consumption activities. Damages caused by pollution usually are included only to the extent that they influence productivity. Environmental services provided by the natural environment (waste disposal, pollution clean-up and dispersion etc.) are not accounted for at all. Financial Accounting Systems Corporate financial statements also exclude estimates of social costs beyond those directly impacting the bottom line. However, there are guidelines on the reporting of environmental liabilities - these pertain to likely remediation and liability issues, rather than long-term social issues. These liabilities are often reported in the statement footnotes since their magnitude is unknown. Managerial/Cost Accounting Systems Most corporate managerial accounting systems do not track costs closely. Easily identifiable costs, such as labor or raw materials, are often finely tracked and allocated to particular product or process lines, but many costs - such as administration costs and environment, health, and safety costs, are considered to be indirect or overhead costs and are allocated broadly across product and process lines. Placing a cost in an overhead account allows it to be shared across activities, but generally removes cost responsibility from any one particular product line or manager. If no one is responsible for a cost, it is likely to be ignored, or in the worst case, may increase as a result of efforts to reduce other costs.

BALANCE SHEET
INTRODUCTION The balance sheet is a statement of the financial position of the business at a specific point in time, such as the year end. It represents both what the company has (assets less liabilities) and where the funds came from originally (source of funds). As a result it must always balance. It should always be borne in mind that it is only a picture of the company at the specific point of time. Each transaction impacts on the accounting equation, hence the balance sheet just after the year end may be significantly different from that at the year end if a company has undertaken significant transactions.

Accounting Equation The accounting equation can be stated as Net assets = Shareholders' fun The total revenue of a business is generated from the provision of goods or services and may be, for example, in the form of: sales (goods) interest received (on loans) rents (from property) subscriptions (to TV channels) fees (professions) royalties (books, CDs). The total costs of a business include the expenditure incurred as a result of the generation of revenue. The total costs of a business include, for example: costs of goods purchased for resale costs of manufacturing goods for sale transport and distribution costs advertising promotion insurance costs of the consumption of fixed assets over their useful lives (depreciation) wages and salaries interest paid

 stationery costs photocopy costs communications costs electricity water and effluent costs travel expenses entertaining expenses postage.

As we can see, the accounting equation holds the balance sheet balances.

The four categories we have outlined are as follows. Assets These represent resources owned or controlled by the company and available for its use, such as stocks of goods for sale or production equipment. These can be sub-categorised under two headings,

 Fixed Assets Current Assets. Fixed Assets Assets acquired for continued use in the business to earn profit, not for resale. Examples of such items would include office and production buildings and equipment. Clearly these are intended for long-term use, not simply to be sold on at a profit. Current Assets Assets acquired for conversion to cash during the ordinary course of business. Examples of such assets would include stocks of goods available for sale to customers, or customers account balances which will be settled for cash. By convention, assets which are to be converted into cash within 12 months are deemed to be current. Liabilities Liabilities represent amounts owed by the company to outside suppliers and lenders. These too are sub-categorised as Creditors: amounts falling due within one year. These are also known as current liabilities. Creditors: amounts falling due after more than one year. These are also known as long-term liabilities. The purpose of the above classification is to provide a clear indication of the timescales for settlement. Share Capital This is money invested in the company by shareholders, i.e. money subscribed for shares. Reserves These generally represent profits earned and retained by the company since it began trading, though there may be other types of reserves as we will see later.

The general format for a balance sheet is prescribed in the Companies Acts and can be illustrated by the following example.

We notice that the balance sheet is shown for both this year end (31 December 2003) and the previous year end (31 December 2002) for comparison purposes.

PROFIT AND LOSS ACCOUNT STATEMENT

The profit and loss account (also called the income and expenditure account or the trading account) is the basic measure of the financial performance of an organisation. It tells you: What the value of the work done was What the value of

goods, labour and services used to do that work was Whether the value of the work done was more or less than the value of what was put in to it i.e. whether you made a profit or a loss. The profit and loss account does not tell you how much money the organisation received and how much money was spent since at a given point in time money will be owed by the organisation to its creditors and by debtors to the organisation. Include in the profit and loss account: All money paid out (wages incl. tax and national insurance, overheads, etc.) All money received (sales, rents, grants etc.) All unpaid invoices generated in the period covered All unpaid invoices received in the period covered Depreciation of equipment

Introduction
The profit and loss account statement provides a detailed analysis of how the company has generated its profit or loss for the accounting period. As already noted, it reconciles the change in the balance sheet profit and loss figure (the profit and loss account reserve) from one year to the next.

Terminology
In accordance with the accruals or matching principle, income and expenses are recognised in the profit and loss account statement when earned regardless of when paid. Any difference between the recognition of these items and the corresponding cash flow will be reflected in a balance sheet debtor or creditor. Turnover The turnover or sales figure represents the total value of goods or services provided to customers during the accounting period whether they have been paid for or not, in accordance with the accruals principle. Cost of Sales The cost of sales represents the total cost to the business of buying or making the actual items sold. Gross Profit Gross profit is the difference between the value of the sales and the value of the cost of goods sold. One measure frequently used in determining the performance of

the business is to consider its gross profit margin, which can be calculated as follows.

Clearly, the higher the margin for a particular level of operations, the higher the profit. However, this does not mean that low margins result in low profits. A number of businesses generate very healthy profits through selling very large numbers of items (achieving correspondingly large turnover) at low margins. Various Operating Costs These costs include all other expenses incurred in generating the turnover for the period by way of administrative involvement and delivery/distribution. Exceptional Items Exceptional items are unusually large items of income or expense arising during the year. They are separately classified as exceptional items to highlight their oneoff nature. An exceptional item Is material. Derives from events or transactions that fall within the ordinary activities of the business. Needs to be separately disclosed by virtue of its size or incidence if the financial statements are to give a true and fair view.

Interest Payable In common with most other business expenses, any interest payable goes to reduce the companys profit before tax and hence taxable profit by the gross amount payable. For example, if a company has in issue 100,000 of 10% loan stock, then the interest charge in its accounts each year will be 10,000. Tax on Profit on Ordinary Activities UK companies pay corporation tax on their taxable profits. The element of the total tax charge shown here is the tax on the ordinary activities of the business, excluding any extraordinary items.

Minority Interests Minority interests arise in a similar way as in the balance sheet. Where XYZ plc owns 80% of ABC Ltd, it will include all of ABC Ltds profit after tax in its own consolidated accounts on the basis that it controls all of ABC Ltds operations. However, it does not own all of that profit, with 20% belonging to the minority interests. The 20% of ABC Ltds profit after tax that belongs to the minority interests is deducted from the profit after tax, leaving the amount of profit attributable to the shareholders in XYZ plc. Extraordinary Item An extraordinary item is a large one-off item, similar to an exceptional item, that requires separate disclosure in order to ensure that the truth in the accounts (the trends, ratios, etc.) is not distorted. An extraordinary item Is material. Possesses a high degree of abnormality which arises from events or transactions that fall outside the ordinary activities of the business. Is not expected to recur. Note that this definition is exceedingly restrictive and it is highly unusual that a profit and loss account statement will have an extraordinary item shown. For that reason our illustrative accounts have shown the positioning of the item in the accounts but given a nil amount. In such a case, a company would dispense with the line altogether. Tax is payable on extraordinary items. The figure that would be shown on the face of the profit and loss account would be a net of tax figure.

Dividends These represent the cash dividends paid out or proposed to be paid out to shareholders net of starting rate income tax. Most of the time companies pay out dividends which are less than their profits after tax, i.e. the dividend is being paid from this years profits and is said to be covered. However, it is not essential for a dividend to be covered. It may be financed from previously retained profits which, as we have seen, are accumulated in the balance sheet profit and loss account reserve balance. XYZ plcs di vidend for 2002 is uncovered in our example.

In most cases, companies pay dividends in two stages. Interim dividend paid this is paid out during the year based on the half years performance. Final dividend proposed this is paid to shareholders following the approval of the year end accounts at the AGM.

What does the profit and loss account tell us

The profit and loss account and income statement are two terms that really mean the same thing. Profit (or loss) may be considered in two ways, which both give the same result. The profit and loss account shows the change in wealth of the business over a period. The wealth of the business is the amount it is worth to the owners, the shareholders. The accumulation of the total change in wealth since the business began, up to a particular point in time, is reflected within the equity section of the balance sheet under the heading retained profits. The profit and loss account measures the change in the balance sheet from one pause to another. An increase in equity is a profit and a decrease in equity is a loss. The profit and loss account may also be considered in its measurement of the trading performance of the business . The profit and loss account calculates whether or not the company has made a profit or loss on its operations during the period, through producing and selling its goods or services. The result, the net earnings or net profit (or loss), is derived from deducting expensesincurred from revenues derived throughout the period between two pauses. The total of the expenses (debits) and revenues (credits) accounts within the general ledger comprise the profit and loss account. The total of these may be a net debit or a net represents a loss and a net credit represents a profit. The net profit or loss is reflected in the balance sheet of the business under the heading retained profits, which is part of shareholders equity. All the other accounts within the general ledger, other than expenses and revenues, may be summarized into various other non-profit and loss account categories and these represent all the other balances that complete the overall balance sheet of the business. There are three main points to consider regarding the profit and loss account and how it differs from the cash flow statement. First, revenues (or sales or income) and expenses (or costs or expenditure) are not necessarily accounted for when cash transfers occur. Sales are normally accounted for when goods or services are delivered and accepted by the customer. Cash will rarely be received immediately from the customer, except in businesses like high-street retailers and supermarkets; it is normally received weeks or months later. Second, the profit and loss account does not take into account all the events that impact on the financial position of the company. For example, an issue of new shares in the company, or a loan to the company, will increase cash but they are neither revenue nor expenses.

Third, non-cash flow items, for example depreciation and bad debts, reduce the profit, or increase the loss, of the company but do not represent outflows of cash. The profit and loss account of a private limited company or a public limited company should be able to tell us all about the results of the companys activities over specified accounting periods. The profit and loss account should show the period covered, the sales (and other income), and the directly attributable cost of the sales. For instance, a restaurant would show the sales from meals and the cost of the food purchased to make the meals. The profit and loss account should then list all other items of expenditure. If the organisation has more than one division, then the profitability of each could be measured by drawing up separate profit and loss accounts. The profit and loss account is most useful when comparing departments or periods and so spotting trends, or assessing the impact of changes made to the way the organisation operates.

Terminology Cost of sales is the cost of selling goods or services. It will include the cost of materials and may also include direct wages costs or power costs. Gross profit is the profit made by selling goods or services before deducting the other (fixed) costs of the business. Cost of sales = Stock at start + Purchases - Stock left at end Gross profit = Income from sales - Cost of sales Percentage cost of sales measures the ability of the business to cover its costs. Many businesses are expected to have a higher or lower % cost of sales and people appraising them will judge a business proposal by these expectations. Gross profit Income from sales x 100 = Percentage cost of sales Its the rate at which goods are being sold. It is calculated by: Cost of sales (Opening stock x closing stock) / 2 = Rate at which stock has turned