black ch01

Principles and practices

OBJECTIVES

By the end of this chapter you will be able to:

� Understand what is meant by ‘financial accounting’.� Contrast financial accounting with management accounting.� Identify the ‘user groups’ of accounting information.� Understand the underlying principles and concepts of financial accounting.� Appreciate the role of standard setting in a national and international context.� Consider the application of principles and policies to published annual reports.

1.1 Introduction

It is rare for accountancy to be worldwide news, talked about nightly on TV discussionshows and written about by editors of both serious and tabloid newspapers. Accountancyand scandal are words which are rarely seen in the same sentence—but in recent years, jour-nalists throughout the world have been writing articles on what they perceived to bea meltdown in accounting procedures and reliability. The collapse of a major US energysupply group, Enron Corporation, was blamed on dubious accounting rules, whilst in theUK many employees were finding that their pension benefits were being downgraded bycompanies citing as justification a new ‘accounting standard’. In the courts, previouslywell-respected company directors were being charged with ‘false accounting’, and govern-ments of several countries decided to order inquiries into the role of the accountancyprofession. New accounting rules in the USA were cited as being responsible for the writingoff of $60bn of assets by two telecoms groups, whilst the body responsible for devisingglobal accounting rules was itself accused of being part funded by the same companies it wastrying to regulate.

Accountants would claim that their role is not to portray a financial picture which isunique in its perfection, honesty, and reliability. What they do attempt is to present oftenhighly complex data that can be relied upon as a reasonably truthful and fair summary offinancial events. There has, historically, been considerable scope for different interpretation

1

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of similar transactions according to the discretion of company directors. Over time, variousrestraints have been imposed and sanctions applied to try and ensure uniformity of treat-ment, a process which is continuing and evolving.

In calling this book Applied Financial Accounting and Reporting, the intention is to linktheory with practice and give readers the opportunity to consider how specific accountingprocedures relate to actual companies, and to consider the legal and professional restraintsimposed on corporate reporting. For this purpose, the annual report of Domino’s Pizza UK &IRL plc, a pizza delivery company listed on the London Stock Market, is reproducedon pp. 000–0, and many topics referred to within chapters are linked to that company’sfinancial statements. If you want your own copy of the Domino’s Pizza annual report, goto www.dominos. co.uk, click on ‘The Business’ then ‘Investor relations’. You will be ableto download it in a ‘read-only’ format.

You will see the symbol to prompt you to look at a particular section of the report.Domino’s Pizza has been chosen for a number of reasons, including:

� it is a well-known high street brand;

� it is an expanding and profitable company (sales and profit more than doubling in four years);

� it publishes a clearly set-out annual report complying with best practice;

� it is not a complex multinational with highly intricate and specialized financial aspectswhich may confuse rather than enlighten.

As well as Domino’s Pizza plc, extracts from many other companies will be used to show thevariety of ways in which information might be presented. Look for the following symbol

. These companies are listed in the Acknowledgements on p. 6.There is a significant degree of change happening regarding the scope, quality, and content

of accountancy’s procedures, rules, and regulations (known as GAAP—Generally AcceptedAccounting Principles, or ‘regulatory framework’). In particular, a move from national tointernational rules, a process which has been gaining pace for several years, is accelerating.This means that countries which previously set their own rules for financial reporting arerapidly harmonizing them with their international equivalents. However, new legislation—national and international—is regularly introduced or updated, with new standards issuedor old ones rewritten. This book is based on the regulations existing in mid-2003.

1.2 The background to accounting

1.2.1 What is accounting?

There have been numerous attempts to develop an all-embracing definition of accounting.One which is often quoted was published by the American Accounting Association in 1966:

[Accounting is] The process of identifying, measuring and communicating economic informa-tion about an organisation or other entity, in order to permit informed judgements by users of theinformation.

2 PRINCIPLES AND PRACTICES

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The key aspects of accounting are, it suggests, identifying, measuring, and communicating:

� identifying the key financial components of an organization, such as assets, liabilities,capital, income, expenses, and cash flow;

� measuring the monetary values of the key financial components in a way whichrepresents a true and fair view of the organization;

� communicating the financial information in a way that is useful to the users of thatinformation.

The systematic recording of financial data is universally based on double-entry bookkeepingprinciples (see pp. 000–0), which have been in use by businesses for many centuries. How-ever, there is no global agreement regarding the way in which accounting informa-tion should be summarized and communicated. Analysis and appraisal can be distorted bynational differences in accounting procedures and there is a growing movement to harmo-nize the accounting treatment for specific areas of difficulty. Regulatory frameworks havebeen developed within national and international contexts to help ensure commonality ofapproach, and large organizations are expected or required to observe accounting stan-dards. These standards impose common procedures for coping with specific accountingdifficulties with the aim of avoiding inconsistencies between companies and encouragingthe improvement of the quality and usefulness of accounting statements.

1.2.2 Branches of accounting

Accounting is split into two key areas:

1. Financial accounting, which is that part of accounting which records and summarizesfinancial transactions to satisfy the information needs of the various ‘user groups’ such asinvestors, lenders, creditors, and employees. It is sometimes referred to as meeting theexternal accounting needs of the organization.

2. Management accounting, which is sometimes referred to as meeting the internalaccounting needs of the organization. It is designed to help managers with decisionmaking, planning, and control. As such it often involves estimates and forecasts, and is notsubject to the same regulatory framework as financial accounting. A leading professionalbody, the Chartered Institute of Management Accountants (CIMA), has defined manage-ment accounting as:

An integral part of management concerned with identifying, presenting and interpreting informa-tion used for:

� formulating strategy

� planning and controlling activities

� decision taking

� optimising the use of resources

� disclosure to shareholders and others external to the entity

� disclosure to employees

� safeguarding assets

PRINCIPLES AND PRACTICES 3

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The above involves participation in management to ensure that there is effective:

� formulation of plans to meet objectives: (strategic planning)

� formulation of short term operation plans: (budget/profit planning)

� acquisition and use of finance (financial management) and recording of transactions (financial accounting and cost accounting)

� communication of financial and operational information

� corrective action to bring plans and results into line (financial control)

� reviewing and reporting on systems and operations (internal audit, management audit).1

The CIMA definition is deliberately all embracing, and there are some obvious infringe-ments on what financial accountants might see as their ‘territory’. It reinforces the notionthat there are overlaps between financial and management accounting, particularly in therecording, interpreting, and communicating aspects. However, if you look at most (if notall) textbooks devoted to management accounting, there are unlikely to be any referencesto ‘disclosure to shareholders and others external to the entity’, and in practice this isusually seen as a financial accounting function.

1.3 A statement of principles

In the United Kingdom, an Accounting Standards Board (ASB) was set up in 1990 with theaim of improving standards of financial accounting and reporting. In 1999 the ASB pro-duced a statement of principles2 which sets out certain fundamental principles for thepreparation and presentation of financial statements. The Statement of Principles alsoidentifies the following seven groups of users of financial information, together with theinformation which they need from the financial statements:

User group Information needs

Investors Investors need to assess the financial performance of the organization they have investedin to consider the risk inherent in, and return provided by, their investments. For example,they would want to know if the company made a profit and what part of that profit wasbeing paid to shareholders as a dividend. Other areas of interest would be to find out ifthe company had more assets than liabilities, and if its cash inflow was greater than itsoutflow. ‘Earnings per share’ is a key indicator of performance. For example, see Domino’sPizza’s earnings per share shown at the foot of p. 000.

Lenders Lenders need to be aware of the ability of the organization to repay loans and interest.Potential lenders need to decide whether to lend, and on what terms. For example, to whatextent is the company’s profit before interest payments greater than those interest payments?

Suppliers and other trade Suppliers need to take commercial decisions as to whether or not they should sell to thecreditors organization and, if they do, whether they will be paid. They will be interested in such

aspects as how well the company is funded and how quickly it pays its creditors’ bills. For example, see Domino’s Pizza’s creditor payment policy on p. 000.


(Continued)

1 Management Accounting: Official Terminology (CIMA, London, 2000).2 Accounting Standards Board, Statement of Principles for Financial Reporting (London, 1999).

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Employees People will be interested in their employer’s stability and profitability, in particular that partof the organization (such as a branch) in which they work. They will also be interested inthe ability of their employer to pay their wages and pensions.

Customers Customers who are dependent on a particular supplier or are considering placing a long-term contract will need to know if the organization is likely to continue in businessfor the foreseeable future. Do the directors consider that the company is a ‘goingconcern’? For example, see Domino’s Pizza’s director’s report on p. 000—the fourth bulletpoint under the heading ‘Corporate Governance’.

Government and their Reliable financial data helps governments to assemble national economic statistics which agencies are used for a variety of purposes in controlling the economy. Specific financial

information from an organization also enables tax to be assessed.

The public Financial statements often include information relevant to local communities and pressuregroups such as attitudes to environmental matters, plans to expand or shut downfactories, policies on employment of disabled persons, etc. For example, see Domino’sPizza’s policy on the employment of disabled people on p. 000.

We could also add an eighth group—the management of the organization—as they are the‘stewards’ of the business and need to have reliable financial information on which to basetheir decisions.

1.3.1 Concepts, principles, and policies

As well as identifying the user groups, the Statement of Principles sets out the concepts thatunderlie the preparation of financial statements for external users. The Statement will bereferred to several times within this text as it contains important guidance on such mattersas definitions of key elements found within financial statements and how they should berecognized, measured, and presented. Overall, the Statement contains eight chapters, butthe first three are worthy of consideration at this early stage.

The objective of financial statements (chapter 1)The objective of financial statements is to provide information about the financial perform-ance and financial position of an enterprise that is useful to a wide range of users forassessing the stewardship of management and for making economic decisions. That objec-tive can usually be met by focusing exclusively on the information needs of present andpotential investors, the defining class of user.

Present and potential investors need information about financial performance andposition that is useful to them in evaluating the entity’s ability to generate cash (includingthe timing and certainty of generation) and in assessing the entity’s financial adaptability.

The reporting entity (chapter 2)This sets out the conditions that determine the principle whether companies shouldprepare general purpose financial statements, both as individual companies or withingroups of companies. It also focuses on situations where one business ‘controls’ anotheror where there is a significant investment in another company but not ‘control’. This is con-sidered in more detail on pp. 000–0. In essence, a business should prepare and publishfinancial statements if there is a legitimate demand for the information that its financialstatements would provide.


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The qualitative characteristics of financial information (chapter 3)For financial information to have value, it must first be material. It is material if its mis-statement or omission might reasonably be expected to influence the economic decisionsof users. Materiality is considered a ‘threshold quality’, i.e. without it the information isinsignificant. Assuming that the information is material, it must have:

� Content which is relevant. It is relevant if it has the ability to influence the economicdecisions of users and is provided in time to influence those decisions.

� Content which is reliable. It is reliable if it can be depended upon by users to representfaithfully what it either purports to represent or could reasonably be expected to rep-resent and therefore reflects the substance of transactions and other events that havetaken place; it is free from deliberate or systematic bias and material error and is complete;and if prepared under conditions of uncertainty, a degree of caution has been applied inexercising the necessary judgements.

� Comparability. It has comparability if users can discern and evaluate similarities ordifferences over time and between different companies.

� Understandability. It has understandability if its significance can be perceived by userswho have a reasonable knowledge of business and economic activities and accounting anda willingness to study with reasonable diligence the information provided.

The Statement contains a diagrammatic representation of its chapter 3, which is shown inFigure 1.1.

1.3.2 Accounting policies

Accounting policies determine which facts about a business are to be presented in thefinancial statements, and how those facts are to be presented. Policies should be adoptedthat enable a business’s financial statements to show a true and fair view. Indeed, one of theresponsibilities of a company’s auditors is to report on whether the financial statementsgive a true and fair view.


Look at Domino’s Pizza’s audit report (p. 000). What does the ‘Opinion’ say about the

report’s truth and fairness?

A UK accounting standard, FRS 18, was published in December 2000 which requires busi-nesses to adopt accounting policies which are ‘most appropriate’ to their particularcircumstances for giving a true and fair view. The policies must be reviewed regularly andchanged if others are more appropriate. Sufficient information must be disclosed in finan-cial statements to enable users to understand the policies adopted and how they have beenimplemented.

Two concepts, going concern and accruals, are considered to have a pervasive role in selectingpolicies. Both are referred to in the UK’s 1985 Companies Act as ‘fundamental principles’.

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Going concern conceptFinancial statements are drawn up on the basis that the business can continue in opera-tional existence for the foreseeable future. In other words, the business is assumed to bea ‘going concern’ (i.e. it can ‘keep going’) unless there is information to the contrary. Thisis extremely important, as investors, lenders, and suppliers may otherwise consider thecompany a suitable business to invest in, to lend money to, or provide goods and servicesto. If the business is not a going concern, the value of its assets (e.g. commercial premises,machinery, and stock) may need to be revalued to a much lower level than if the businesswas a viable, healthy organization.


What makes financial information useful?

Giving information that is not material may impair the usefulness ofthe other information given.

Materiality

Relevance Reliability Comparability Understandability

Threshold quality

Information that has the ability to

influence decisions

Information that is a complete and

faithful representation

Similarities and differences can be

evaluated

The significance of the information can

be perceived

Predictive value

Confirmatory value

Faithful representation

Neutral

Free from material error

Complete

Prudence

Consistency

Disclosure

Users’ abilities

Aggregation and classification

Figure 1.1 The qualitative characteristics of financial information

Source: Reproduced by kind permission of the Accounting Standards Board.

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Going concern

Scoot.com plc is in the development stage of its business and its strategy to develop a branded infomediaryservice. In the 15 month period to 31 December 2000, the Group incurred operating losses before excep-tional items and goodwill amortisation of £37.5m (1999: £16.4m loss); the net cash outflow from operat-ing activities was £37.3m (1999: £15.6m outflow).

In order to trade profitably with positive cash flow from operations, the Group must continue to identifynew subscribers to achieve the critical mass customer base necessary to generate sales levels that meet itsoperating costs. The directors are pleased with the progress that has been made in developing a profitablebusiness. To achieve this fully, the Group intends to increase the focus on operating efficiencies and raiseadditional lines of finance where necessary.

The directors have prepared detailed forecasts for at least a year from the date of this statement thatreflect their plans, including aggressive marketing campaigns, close management of individual businessesand benefits expected from the continued integration of Loot in the UK. They expect Scoot (UK) to becomecash flow positive in the fourth quarter of 2001 and they expect the current operations of the Group as awhole, including its Benelux and France joint ventures, to become cash flow positive in the fourth quarter of2002. In the meantime, Scoot’s continuation as a going concern is dependent upon its ability to generatesufficient cash flows from other sources to meet its obligations as they fall due in the foreseeable future.

As the Group’s businesses continue to develop rapidly, this makes their future cash flows more difficult topredict than that of a more mature business. As a result, the directors will need to raise funds of potentiallyup to £20m from non-operating sources. To this end, an additional facility has already been secured in theform of an equity line of credit (the facility enables the directors to issue up to 60m ordinary shares). Thisfacility is subject to shareholder approval. If required, the directors intend to draw upon this facility at keypoints during the implementation of the Group’s plan . . . The directors have a range of other fundingoptions under consideration including the disposal of non-core assets and additional debt or equityfundraising from either existing or new investors, The directors expect that the final funding arrangementswill comprise a combination of these alternative sources.

On the basis of the combination of potential fund raising options above, the directors are confident thatthey can secure adequate resources to fund the development of the business. Accordingly, they considerthat it is appropriate to prepare these financial statements on a going concern basis, therefore no adjust-ments that would otherwise be required have been made.

CommentUnlike Domino’s Pizza, this loss-making company has had to justify in considerable detail its use of the

going concern. Note particularly the last sentence, ‘therefore no adjustments that would otherwise

be required have been made’. This refers to the fact that if the going concern concept was not

applicable, various values contained within the financial statements would have to be reassessed, par-

ticularly those of assets such as cars, computers, equipment, and stocks. If the business were to fail,

the amounts realized on such assets would often be a tiny fraction of their ‘going concern’ valuation.


Look at Domino’s Pizza’s ‘Corporate Governance’ Statement (p. 000). Has the ‘going

concern concept’ been adopted?

Look at the following extract from the annual report of Scoot.com plc:

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Accruals conceptWith the exception of cash flow information (see pp. 000–0), financial statements shouldbe prepared on the accrual basis of accounting. This requires the non-cash effects of trans-actions and other events to be reflected, as far as possible, in the financial statements for theaccounting period in which they occur, and not, for example, in the period in which anycash involved is received or paid. Revenue and profits dealt with when calculating profits orlosses are matched with associated costs incurred in earning them, so when calculatingprofit, all income and expenditure, whether or not ‘paid for’, must be included. The accru-als concept is sometimes referred to as the ‘matching’ concept.

In basic terms, the concept means that if you are told that a company made a profit of£10m in the year ended 31 December 2004, this has not been calculated by simply addingall the cash received in the year, and then deducting the cash paid! Every relevant transac-tion, regardless of whether cash is paid or received in the period, must be included whenarriving at the profit figure. Numerical examples of this are shown in Chapter 3.


Look at n. 15 on p. 000 of Domino’s Pizza’s annual report. Identify ‘Accruals and deferred

income’. This represents unpaid, not yet invoiced liabilities.

1.4 Published accounts

Large corporations will publish financial information, usually as a requirement of a specificstock exchange or due to national legislation. For example, in the UK, Acts of Parliamentrequire that all of the approximately one million limited companies must publish financialstatements. Although there is no equivalent in the USA of the UK’s Companies Acts, majorUS companies will be registered with the Securities and Exchange Commission (SEC), whichsets out detailed requirements for audit and the rules of financial reporting. For smaller UKcompanies, only a brief summary of their finances is required, but for the largest companies,including all plc’s (public limited companies), an ‘annual report’ must be prepared whichis sent (either physically or electronically) to all shareholders and Companies House, whichis the UK government’s ‘storehouse’ of company information. The public has a right ofaccess to the information, for example by using the website www.companies-house.gov.uk.UK companies whose shares are listed on the stock exchange will also publish an abbrevi-ated interim statement showing their results for the first six months of the financial period.To save printing and distribution costs, companies are permitted to provide an electronicversion on their website.

Many organizations regard their annual report as an opportunity to show off the bestof their company, in effect treating it as a public relations exercise. The glossy photographsof the company’s products and exotic locations of major contracts can give some reportsthe style of a travel brochure.

A key feature of UK and other EU published profit and loss accounts and balance sheetsis that they have to follow specific formats of presentation. These formats were devised to

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ensure a degree of uniformity across the European Community, as they apply to all membercountries. Although there is a small amount of flexibility allowed (for example a companycan produce statements in either a ‘vertical’ or ‘horizontal’ format), virtually all UK compa-nies follow the ‘vertical’ style format.


Look at pp. 000–0 of the Domino’s Pizza annual report. Notice how the information

flows from top to bottom on each page—hence the ‘vertical’ format. It is sometimes

also referred to as a ‘columnar’ format.

Many large mainland European companies not only produce corporate reports in their ‘home’

language but also produce English-language versions for wider circulation. An example can be

found at www.bmw.com (follow links to ‘Investor Relations’ and then click on ‘Annual Report’).

1.5 Diversity of international accounting practice

The method of recording day-to-day financial transactions is common throughout theworld, being based on the double-entry system (see pp. 000–0). However, there are signifi-cant differences in approach when summarizing information for inclusion in publishedannual reports. In many countries, the accounting profession has been relatively weak, andfinancial reporting practices have tended to be set by formal government legislation ratherthan by relatively informal professional rules. A number of distinct country groupings haveevolved in this respect, the principal ones being:

� United States and United Kingdom and countries historically influenced by them, e.g. Commonwealth countries such as Australia, India, and Malaysia;

� Mainland European countries, such as France and Germany—though Holland hastended towards the US/UK approach.

The reasons for the disparity of accounting procedures include:

� the relative strength of the accounting profession in the countries,

� the nature of the country’s legal system,

� the main types of business organization, and

� the relationship between taxation requirements and financial reporting requirements.

The key industrialized nations have developed their own specific accounting regulations.This rarely has a major impact when applied to domestic companies within those coun-tries, but may have dramatic implications when international investment decisions haveto be made. See p. 000 for details of how accounting standards within the EU for listedcompanies are changing from 2005.

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There are many reasons why countries developed dissimilar procedures, including:

The legal systemSome countries (e.g. France and Germany) have all-embracing sets of rules and regulationswhich apply to businesses, whereas countries such as the UK and the USA have more generalstatute laws backed up by case law, allowing more flexibility for individual companies. Forexample, in the USA, individual companies decide the rates at which assets depreciate, butin Germany the government decides what are appropriate.

Types of ownership patternsCountries with wide share ownership (e.g. UK, USA) have developed strong independentprofessional accountancy associations to provide reliable financial data to shareholders.Those countries with predominantly small, family-run businesses (e.g. France) or withbanks owning most shares of large companies (e.g. Germany), have had less need forproviders of independent financial information.

The accounting professionStrong independent professional associations of accountants developed in those countries(e.g. UK, USA) with the most liberal company laws and widest share ownership. Countrieswith restricted patterns of business ownership and rigid company legislation (e.g. France,Germany) had weak groupings of accountants, and sometimes the governments themselvescontrolled the profession.

ConservatismFinancial statements produced by independent accountants should ideally show a ‘trueand fair view’. This is open to many interpretations, not least being the problem of assetvaluation. Should assets be valued at original cost, what they might be sold at today, whatit would cost to replace them, or a depreciated value based on usage, wear and tear, etc.?

� US practice is conservative—don’t revalue, depreciate on a reasonable basis over theasset’s lifetime.

� German practice is also conservative—don’t revalue, but depreciate on a basis decreedby the government.

� UK practice is liberal—allowing companies either to revalue at intervals or show assets at cost, and depreciate on a reasonable basis.

1.5.1 International accounting standards

In 1973, an International Accounting Standards Committee (IASC) was formed with theaim of harmonizing accounting practices throughout the world. Now renamed as theInternational Accounting Standards Committee Foundation (IASCF), its objectives are:

� to develop, in the public interest, a single set of high-quality, understandable, andenforceable global accounting standards that require high-quality, transparent, andcomparable information in financial statements and other financial reporting to helpparticipants in the world’s capital markets and other users make economic decisions;

� to promote the use and rigorous application of those standards; and


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� to bring about convergence of national accounting standards and InternationalAccounting Standards3 to high-quality solutions.

Since April 2001, the standards-setting work has been undertaken by a subsidiary of the IASCF,the International Accounting Standards Board (IASB). The IASB’s responsibilities include:

� responsibility for all IASCF technical matters including the preparation and issuing ofInternational Accounting Standards;

� publishing an ‘Exposure Draft’ (a preliminary version of the proposals, made availablefor public debate and feedback) on all projects and normally will publish a DraftStatement of Principles or other discussion document for public comment on majorprojects;

� full discretion over the technical agenda of the IASCF and over project assignments on technical matters; in organizing the conduct of its work, the Board may outsourcedetailed research or other work to national standard setters or other organizations;

� working to identify and review all the issues related to a topic and study other national accounting standards and practice;

� the possible holding of public hearings to discuss proposed standards, although there is no requirement to hold public hearings for every project;

� undertaking field tests (both in developed countries and in emerging markets) to ensure that proposed standards are practical and workable in all environments,although there is no requirement to undertake field tests for every project.

The status of International Accounting Standards (IASs) was given a significant boost in2001 when the European Commission proposed that from 2005 listed companies through-out the EU should be obliged to follow IASs rather than national standards. The other keydriver in their growing acceptance may follow the accounting scandals in the USA (princi-pally related to Enron and World Com), where the perception of weak US standards maylead to a much greater role for their international equivalent. In the UK, all new standardscontain an explanation of the extent to which they are in accordance with IASs. In mostrespects they are closely aligned, but occasionally there are significant differences dueto perceived ‘national’ requirements. One example is the area of deferred taxation (seepp. 000–0), where a UK standard issued in 2000 has key differences from the IAS, also issuedin that year. As the ex-chairman of the UK Accounting Standards Board, Sir David Tweedie,was subsequently appointed chairman of the IASB, it would not be unexpected if the inter-national standards develop in line with the UK’s position rather than vice versa.

1.6 Chapter summary

� Accounting is defined as ‘The process of identifying, measuring and communicatingeconomic information about an organisation or other entity, in order to permitinformed judgements by users of the information’.


3 Standards ‘inherited’ from the old IASC. New standards will in fact be referred to as International FinancialReporting Standards (IFRSs).

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� There are two main branches: financial accounting and management accounting.Financial accounting concentrates more on the recording and summarizing of financial information and compliance with GAAP and relevant legislation. Management accounting tends to concentrate on decision making, planning, and control.

� There is a ‘Statement of Principles’ for the preparation and presentation of financialstatements.

� There are seven user groups defined in the Statement: investors; lenders; suppliers and other trade creditors; employees; customers; government and their agencies; the public.

� Qualitative characteristics of financial information are that it should be: material;relevant; reliable; comparable; understandable.

� Policies are needed which enable a true and fair view to be shown.

� Going concern and accruals concepts have a ‘pervasive role’ in selecting policies.

� Published accounts in the EU must follow defined formats.

� International accounting practices vary but there is great impetus towardsharmonization.

� US accounting scandals have boosted the influence of international standards.

� GLOSSARY

accounting The process of identifying, measuring, and communicating economicinformation about an organization or other entity, in order to permitinformed judgements by users of the information

accounting policies Principles, bases, conventions, rules, and practices applied by an entitythat specify how the effects of transactions and other events are to bereflected in its financial statements through recognizing, selectingmeasurement bases for, and presenting assets, liabilities, gains, losses,and changes to shareholders’ funds

accounting standards Rules to be followed by accountants when preparing financialinformation

Accounting Standards The body which sets accounting standards within the UK Board

accrual concept The non-cash effects of transactions and other events should bereflected, as far as possible, in the financial statements for the accountingperiod in which they occur, and not, for example, in the period in whichany cash involved is received or paid

double-entry A logical system which allows a record to be made of allbookkeeping the financial aspects of an entity

exposure draft A preliminary version of an accounting standard, circulated for public debate and comment


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financial accounting The day-to-day recording of an organization’s financial transactions and the summarizing of those transactions to satisfy the informationneeds of various user groups in accordance with the regulatoryframework

formats Standard layouts required by the European Union which ensureconsistency of presentation of published financial information bycompanies in member states

going concern Financial statements are drawn up on the basis that the business canconcept continue in operational existence for the foreseeable future

International Accounting standards developed by the International AccountingAccounting Standards Board and its predecessor to harmonize and improve Standards global financial reporting practices

management The internal accounting needs of an organization, involving planning, accounting forecasting, and budgeting for decision-making purposes

materiality A ‘threshold quality’ of financial information. To be material, itsmisstatement or omission might reasonably be expected to influence theeconomic decisions of users

published accounts Financial information required to be disclosed by entities as a result of legislation, accounting standards, or stock exchange requirements

regulatory framework The rules and regulations followed by financial accountants, imposed (inthe UK) mainly by company legislation and the Accounting StandardsBoard

true and fair view An accounting concept requiring financial summaries to reflect areasonable and objective approach in their representation of theorganization’s affairs

user groups Key groups who have a need for financial information

� MULTIPLE CHOICE QUESTIONS

1. Financial data is recorded by means of a system known as:

a Management accounting

b Auditing

c Double-entry bookkeeping

d Generally Accepted Accounting Principles

2. Which one of the following is not specifically identified as a ‘user group’ by

the UK’s ‘Statement of Principles’:

a Management

b Customers

c Lenders

d Investors


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3. Which of the following is a key indicator of performance for investors?

a Number of shares issued by a company

b Number of directors

c Ratio of customers to suppliers

d Earnings per share

4. According to the ‘Statement of Principles’, for financial information to have value it must first be:

a Material

b Relevant

c Reliable

d Comparable

5. Once an accounting policy is adopted by a company, it:

a Must never be changed

b Must be changed on an annual basis

c Can be changed if another policy is more appropriate

d Can only be changed with the government’s approval

6. If a company is said to be a ‘going concern’, which one of the following statements is certain

about that company?

a It is about to go out of business

b It is assumed to be able to continue in business for the foreseeable future

c It is a company that people are concerned about

d It is profitable and has more assets than liabilities

7. The ‘accruals’ concept means that, when calculating a company’s profit or loss:

a All relevant transactions, whether or not cash transfers are involved, are included

b Any money owed by customers at the end of the period is ignored

c Any invoices received but not paid in the period are ignored

d Only cash paid and received in a period is included

8. The summary of company information which UK companies have to send to Companies

House is called the:

a Profit sheet

b Annual report

c Cash summary

d Tax return

9. ‘Formats’ are followed by EU companies when presenting published company financial

information. The most common format used in the UK is the:

a Vertical format

b Horizontal format

c Circular format

d Diagonal format

10. ‘Harmonization’ of international accounting practice refers to:

a International accounting standards being replaced by national standards

b US standards being replaced by European standards


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c Non-US standards being replaced by US standards

d National accounting standards being brought into line with international standards

(Note: answers are shown in Appendix 2.)

� DISCUSSION QUESTIONS

To answer these, you should refer to the Domino’s Pizza annual report on pp. 000–0.

1. Read the auditors’ report (see p. 000) and comment on the extent to which you regard it as an

objective opinion of the company’s financial statements.

2. Look at the Chairman’s report (see p. 000). See if you can identify any areas which give an

indication as to the future strengths or weaknesses of the company.

3. Contrast the ‘profit for the financial year’ as shown in the profit and loss account (see p. 000)

with the ‘increase or decrease in cash’ as shown in the cash flow statement (see p. 000). Are

they the same? Can you think of reasons why they might be different?

(Note: Suggested answers or discussion points are available on the companion website.)

� LONGER QUESTIONS

Questions marked W have suggested answers on the companion website. Other questions are

answered in Appendix 3.

1. Look at the ‘cash flow statement’ of Manchester United plc for 2002 (with comparative

figures given for 2001) shown in Fig. 1.2, then answer the questions below.

a How did the overall cash flow differ between 2001 and 2002?

b Which year saw more cash spent on the purchase of footballers?

c Can you think why taxation paid in 2002 was greater than in 2001, even though the

‘net cash inflow from operating activities’ shown on the top line shows more in 2001

than in 2002?

2. Sandygate plc has summarized its key financial information for the past year, as follows:

£

Total sales made in the year 560,000

Total cash received in the year from customers 490,000

Total expenses and goods bought for resale 160,000

Total cash paid in the year for expenses and goods bought for resale 170,000

a What was the total profit which Sandygate plc made during the year?

b How can the ‘cash paid in the year for expenses and goods bought for resale’ be greater

than the ‘total expenses and goods bought for resale’?


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3. Read the following extract and then answer the question that follows it.

Monotub Industries in a spin as founder gets Titan for £1Monotub Industries, maker of the Titan washing machine, yesterday passed into corporate history withvery little ceremony and only a whimper of protest from minority shareholders.

At an extraordinary meeting held in a basement room of the group’s West End headquarters,shareholders voted to put the company into voluntary liquidation and sell its assets and intellectual


Figure 1.2 Manchester United plc

Source: Manchester United plc 2002 Annual Report.

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property to founder Martin Myerscough for £1. The shares, which once reached 650p were dulysuspended on Aim [author’s note: Aim is a stock market] at 3/4p.

The only significant opposition came from Giuliano Gnagnatti, who along with other shareholdershas seen his investment shrink faster than a wool twin-set on a boil wash. The not-so-proud owner of100,000 Monotub shares, Mr Gnagnatti, the managing director of an online retailer, has referred thesale to the Department of Trade and Industry.

Yesterday he described the sale of Monotub as a ‘free gift’ to Mr Myerscough. This assessment wasdenied by Ian Green, the chairman of Monotub, who said the closest the beleaguered company hadcome to a sale was an offer of £60,000 that gave no guarantees against liabilities which are thought toamount to £750,000.

The quiet passing of the washing machine, eventually dubbed the Titanic, was in strong contrast to itsperformance in many kitchens. Originally touted as the ‘great white hope’ of the washing machineindustry with its larger capacity and removeable drum, the Titan ran into problems when it kept stoppingduring the spin cycle, causing it to emit a loud bang and leap into the air.

Summing up the demise of the Titan, Mr Green said; ‘Clearly, the machine had some revolutionaryaspects, but you can’t get away from the fact that the machine was faulty and should not have beenlaunched with those defects’.

The usually vocal Mr Myerscough, who has promised to pump £250,000 into the company and giveMonotub shareholders £4 for every machine sold, refused to comment on his plans for the Titan or revealwho his backers were. But eschewing another public listing, he did say that he intended to ‘take the Titanforward’.

Lisa Urquhart, Financial Times, 23 Mar. 2003

For each of the seven ‘user groups’ identified in the Accounting Standards Board’s ‘Statement

of Principles’, suggest key areas of information which they might need concerning Monotub

Industries.

4W. A company has reported record profits and increased asset values, but has also disclosed that

it is unable to be considered as a ‘going concern’. Suggest three reasons why a profitable

company might be in imminent danger of financial collapse.

5W. ‘A limited company’s financial affairs should not be disclosed to anyone other than its directors

and shareholders.’ Criticize this statement by reference to the ‘user groups’ identified in the

Statement of Principles.

6W. Write a brief report distinguishing between the key aspects of ‘financial accounting’ as

contrasted with ‘management accounting’.

� MINI CASE STUDY

Minnie’s ambitions

Minnie von Mausen is about to set up a company that deals in exotic animals, selling them to zoos

throughout the world. She is ambitious and realizes that her company could one day be the global

leader in its field. She wants to make sure that she understands the financial implications of her

enterprise, so has consulted an accountant, and asks the following questions:

1. How will I know if the company has made a profit?

2. What key accounting rules and regulations have to be considered?


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3. What is the main objective of providing financial statements?

What answers is the accountant likely to give to Minnie? (Suggested solutions can be found in

Appendix 4.)

� MAXI CASE STUDY

Ahold

Read the following extract then answer the questions that follow it:

$500m accounts scandal engulfs Dutch retailerEurope was last night facing one of its biggest accounting scandals when the Dutch retailer Aholddisclosed ‘significant accounting irregularities’ and said its chief executive and finance director wouldresign.

The announcement, just over a year since Enron shook corporate America, fuelled speculation that theworld’s third-largest grocer may be broken up and fall victim to bids from rivals . . .

The Dutch group, which expanded rapidly through a series of US acquisitions in the late 1990s, saidincome at US Foodservice, the second-largest US food distribution company, had been overstated bymore than $500m (£314m). Some of its executives have been suspended and 2002 operating earningswill be reduced.

Accountants are also investigating the ‘accounting and legality’ of transactions by Disco, an Argentinesubsidiary, Ahold said.

The news knocked share prices across the continent, which had hoped to avoid a US-style accountingdebacle. Ahold fell nearly two-thirds to €3.59, barely a tenth of the price a year ago, leaving it witha market value of €3 bn.

Analysts said Ahold might now have to sell assets even if the diminished valuation did not attract a bidder for the entire group . . .

The irregularities had been discovered in the last two weeks, during the audit of the 2002 accounts.[The company chairman said] ‘We believe that there are other accounting issues, but we are determinedto pursue the investigation as far as possible.’

Deloitte & Touche, Ahold’s auditor, insisted it had done its job properly.Ahold issued two profit warnings last year, related principally to Latin American subsidiaries and slow-

ing organic growth. It said net profit would now be ‘significantly lower’ and it would restate earnings for2001 and the first nine months of 2002.

Adapted from Ian Bickerton and Susannah Voyle, Financial Times (London), 25 Feb. 2003.

Questions:

1. The company disclosed ‘significant accounting irregularities’, with income overstated by $500m.

Do you think that there could ever be an agreed system of rules and regulations

that would be able to prevent similar problems from occurring in the future?

2. Although the auditor of Ahold ‘insisted it had done its job properly’, the ‘irregularities’ still

occurred. What do you consider is the auditor’s role, if any, in preventing such ‘accounting

scandals’?

(Suggested answers and discussion areas are available on the companion website.)


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� WEB LINKS

American Accounting Association http://raw.rutgers.edu/raw/aaa/

Annual Report Service (to obtain copies of annual reports) http://ft.ar.wilink.com or: www.reportgallery.com/

Chartered Institute of Management Accountants www.cimaglobal.com/

Companies House (UK government’s official information registry) www.companieshouse.gov.uk/

Company Reporting (an independent business information research company which

monitors company compliance with best financial reporting practice)

www.companyreporting.com/home.htm

The International Accounting Standards Board www.iasb.co.uk

The UK’s Accounting Standards Board www.asb.org.uk

Company websites(Companies referred to in this chapter)

Ahold www.ahold.com

BMW www.bmw.com

Domino’s Pizza www.dominos.co.uk

Enron Corporation www.enron.com

Manchester United plc www.manutd.com/corporateinformation/corporate.sps

Scoot (now part of British Telecommunications plc) www.scoot.com/

WorldCom Inc www.worldcom.com/global/about/facts/

� FURTHER READING

Britton, A., and Waterston, C. (2003). Financial Accounting, 3rd edn. (Harlow: FT/Prentice Hall),chapter 1.

Dyson, J. R. (2003). Accounting for Non-accounting Students, 5th edn. (Harlow: FT/Prentice Hall),chapters 1, 2, 13.

Meek, G., and Gernon, H. (2001). Accounting: An International Perspective, 5th edn. (Maidenhead: McGraw-Hill), chapters 1–3.

Weetman, P. (2003). Financial and Management Accounting: An Introduction, 3rd edn. (Harlow: FT/Prentice Hall), chapters 1, 16.

Also:

A regularly updated website for news relating to the accounting profession: www.accountingeducation.com

� COMPANION WEBSITE MATERIALS

Additional materials are available for students and lecturers on the companion website, at

www.????????.co.uk


AQ: Please update web address

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