ch1

MALKOV, O. and HORK, J. Introduction to Financial Accounting. Workbook.

1

CHAPTER 1

THE NATURE AND PURPOSE OF ACCOUNTING

Key terms Information, accounting, definition of accounting, accounting history, users of accounting information, stakeholders, accounting language.

The need of information. Accounting as an information

Our economic environment is one where the production and distribution of goods and services is primarily left to individuals or to a group of people. It is based on the principle that these entrepreneurs can own property and conduct their business with the view of making a profit from their efforts. All businesses need a system of planning and maintaining information about their financial affairs.

Different types of information might be useful to people interested in the firm. Information can be either quantitative or non-quantitative. Examples of non-quantitative information are visual impressions, conversations, television programs, newspaper stories. Quantitative information is such information that is expressed in numbers.

Accounting is primarily concerned with quantitative information but it is one of several types of quantitative information which is distinguished from the other types in that it usually is expressed in monetary amounts (i.e. acquisition cost of purchased equipment). Nonmonetary information is often included in accounting reports for reader's understanding the report (i.e. number of employees or products sold).

Figure 1.1 depicts the different types of information that might be useful to people interested in the firms.

MALKOV, O. and HORK, J. Introduction to Financial Accounting. Workbook.

2

Consists of

Consists of

Consists of

Figure 1.1 Types of information Source: ANTHONY, R. N. REECE, J. S. Accounting Principles. 7th ed. USA: Irwin, 1995. p. 4

Accounting information consists of operating information, financial accounting and management accounting.

Operating information is required to conduct an organization's day-to-day activities. This information constitutes the largest quantity of accounting information and provides the basic data for both management accounting and financial accounting. (Example: In the stockroom the material list has to be known to order new supply of depleted sorts).

Financial accounting provides information both for internal users (owners, managers) as well as external users (shareholders, banks, trade partners, government, investors, general public). Content of financial accounting reports is

Information

Nonquantitative Information Quantitative Information

Accounting Information

Nonaccounting Information

Operating Information

Financial Accounting

Management Accounting

MALKOV, O. and HORK, J. Introduction to Financial Accounting. Workbook.

3

identical for every entrepreneur (it is needed for comparison among firms and sectors of industry) and users will not understand them without knowing the ground rules of their preparation.

Management accounting information is shaped from summaries of operating and other information. This information is used by persons who have to carry out their management responsibilities and it is used in three management functions planning, implementation and control.

Definition of accounting

Accounting is the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information.1

Accounting history

Accounting has existed for many centuries. Symbols recording transactions between tribes have been found to date back to 5000 BC. The Sumerian civilization in Mesopotamia kept such records on clay tablets beginning about 3200 BC and more than 3000 years ago scribes in Babylonia and Egypt actually received what was in effect formal accounting training in schools. Persia about 500 BC had government scribes who performed surprise audits of the accounts of the provinces, and similar audits were made in the Hebrew civilization, in which the chief scribe was the second highest position in government.

Accounting later became more prestigious in Greece. Here records of construction costs of government buildings were carved on the structures. In the Roman Empire in about 200 BC, quaestors in the territories were responsible for supervising the local government accountants. The quaestors reports to Rome were given in person and

1 American Accounting Association, A Statement of Basic Accounting Theory. Sarasota, Fla.: 1966

MALKOV, O. and HORK, J. Introduction to Financial Accounting. Workbook.

4

heard by an examiner (today auditor). In the Byzantine Empire (4th century AD) a public administration school was founded here accounting was taught.

The double-entry bookkeeping system of data records as we know it today was depicted by Lucas Pacioli in 1494 (first author of an accounting text2). He wrote about the system of transaction records used by Merchant of Venice.

Accounting framework

Accounting has evolved over a period of many centuries, and during this time certain terminology, rules, and conventions have come to be accepted as useful. If readers are to understand accounting reports the end products of an accounting system they must be familiar with the rules and conventions lying behind these reports. Accounting is called the language of business.

Accounting ethics

Ethics in accounting is a complex issue. Ethics is a topical subject given the collapse of Enron in USA and HIH Insurance in Australia in late 2001 and 2002 respectively. Virtues considered essential to ethical behaviour are:

Honesty and integrity. Trustworthiness and faithfulness. Reliability and dependability. Ability to care about others.3

2 PACIOLI, L. Summa de Arithmetica Geometria Proportioni et Proporcionalita. Paganino de Paganini.

Venice, 1494

3 CONNELL, D. A case for ethics. National Accountant, vol. 18, No. 5, October/November 2002.

MALKOV, O. and HORK, J. Introduction to Financial Accounting. Workbook.

5

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 1.2.

Figure 1.2 Main users of accounting information relating to an enterprise Source: Own elaboration

The majority of user groups are outside the business but, nevertheless, they have a stake in it. The groups above identified are normally the most important.

Enterprise

OwnersShareholders

Government

Creditors

Suppliers

Customers Public

Competitors

Employees

Investors

Managers

MALKOV, O. and HORK, J. Introduction to Financial Accounting. Workbook.

6

EXERCISE 1.1

Devise an example of existing firm; taking the user groups identified below, suggest what sort of decision each group is likely to make about this firm.

Name of the firm: . Characterization: ............

Owners ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

Managers ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

Shareholders ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

Creditors-lenders ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

Suppliers ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

Customers ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

MALKOV, O. and HORK, J. Introduction to Financial Accounting. Workbook.

7

Competitors ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

Government ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

Employees and their representatives ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

Investors and their analysts ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

Public ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

Others: ........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................