1. The Purpose of Accounting Information

Question 1

What is accounting?

Answer 1

Accounting is a way of recording, analysing and summarising the transactions of an entity (a term used to describe any business organisation).

One of the roles of an accountant is to measure the revenue and expenditure of an entity and, if it is a business, its profit. This is not as straightforward as it may seem.

Question 2

What are the three main types of profit-focused business entity?

Answer 2

1. Sole Traders
2. Partnerships
3. Limited Liability Companies

Question 3

Define a Sole Trader.

Give an example of a Sole Trader.

Answer 3

Sole Traders are people who work for themselves. The term Sole Trader refers to the ownership of the business; sole traders can have employees.

Examples include a local shopkeeper, plumber of hairdresser.

Question 4

Define a Partnership.

What two forms can a Partnership take?

Give examples of a Partnership.

Answer 4

Partnerships occur when two or more people decide to share the risks and rewards of a business together.

A partnership can take one of two forms:
1. General Partnership - like two or more sole traders
2. Limited Liability Partnership LLP (more like a company)

Examples include an accountancy, medical or legal practice.

Question 5

Define a Limited Liability Company.

Answer 5

Limited Liability Companies are incorporated to take advantage of ‘limited liability’ for their owners (shareholders). This means that while sole traders (always) and partners (usually) are personally responsible for the amounts owed by their businesses, the owners (shareholders) of a limited liability company are only responsible for the amount to be paid for their shares.

Question 6

Why do businesses need to produce accounting information in the form of financial statements?

Answer 6

According to the IFRS Foundation’s Conceptual Framework for Financial Reporting, the objective of financial reporting is to ‘provide information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity’.

Question 7

Who are the three primary users of financial statements?

Answer 7

Existing and potential:
1. Investors
2. Lenders
3. Other Creditors

Question 8

What do the three primary users (investors, lenders and other creditors) use the financial statements to assess when making decisions? (2)

Answer 8

1. The economic resources of an entity (e.g. its cash and other assets), claims against the entity (e.g. its liabilities) and changes in those resources and claims.
2. How efficiently and effectively the entity’s management have discharged their responsibilities relating to the management of the entity’s resources. (Conceptual Framework: para 1.4)

Question 9

Why is cash important to a business?

What does the timing and certainty of cash flow determine? (4)

Answer 9

An entity needs to be able to use its resources to generate cash and use that cash to settle its claims. The timing and certainty of cash flows determines whether the business can:
1. Pay its employees and suppliers
2. Meet interest payments
3. Repay loans
4. Pay something to its owners

Question 10

Why are managers/directors likely to be interested in financial information about a large company with listed shares?

Answer 10

Managers/directors are appointed by the company’s owners to supervise the day-to-day activities of the company.

They need information about the company’s present and future financial situation. This enables them to manage the business effectively (exercising the stewardship function) and to make effective decisions about matters such as pricing, output, employment and financing.

Managers may also be responsible for meeting ESG targets. They will need information on these measures and how they are performing against them.

Question 11

Why are owners of the company likely to be interested in financial information about a large company with listed shares?

Answer 11

Owners of the company (shareholders) want to assess management performance.

They are the providers of capital for the company, so they are interested in the risk to their capital, and the return they will get for taking that risk. They need information to help them determine whether they should buy, hold or sell shares.

They want to know how profitable and sustainable the company’s operations are and how much profit is available for distribution to the shareholders through a dividend. In addition the value of their investment in the company is affected by the company’s profitability.

The owners will also be interested in how the entity’s dependencies on ESG issues can affect its ability to create and maintain value. Dependencies could include for example, climate risks, resource availability, worker health, diversity, regulatory risks and consumer expectations.

Owners will want to know whether the entity’s policies and practices in relation to its impact on the environment and society, are in keep with the investors’ expectations. This could include for example, policies on worker rights, human rights issues within its supply chains, GHG emissions and water usage.

Question 12

Why are lenders likely to be interested in financial information about a large company with listed shares?

Answer 12

Lenders include banks which allow the company to operate an overdraft or, provide longer term loan finance secured on the company’s assets.

A bank wants to ensure that the company is able to keep up loan payments.

Lenders often include financial and non-financial conditions the business must meet each year, otherwise the loan may be withdrawn or the terms changed.

Increasingly lenders are including ESG related conditions, for example emission levels, which directly link to the interest rate on the loan. The higher the emissions, the higher the interest rate.

Question 13

Why are other creditors likely to be interested in financial information about a large company with listed shares?

Answer 13

Other creditors are those such as suppliers who provide goods and services on credit and customers who purchase goods or services.

Suppliers want to know about the company’s ability to pay its debts. Trade creditors are likely to be interested in an entity over a shorter period than lenders, unless they are dependent upon the continuation of the entity as a major customer.

Suppliers are also interested in the company’s corporate values such as its fair trade policies, how it treats its employees and its environmental practices.

Question 14

Why are trade contacts likely to be interested in financial information about a large company with listed shares?

Answer 14

Trade contacts, which includes suppliers as above and customers need to know that the company is a secure source of supply, so that repeat purchases and after-sales care will be available.

Question 15

Why are HMRC likely to be interested in financial information about a large company with listed shares?

Answer 15

HMRC want to know about business profits in order to assess the company’s tax liabilities.

Question 16

Why are employees likely to be interested in financial information about a large company with listed shares?

Answer 16

Employees and their representative groups need information about the stability and profitability of their employers, so they can assess the entity’s ability to provide remuneration, retirement benefits and employment opportunities.

Employees are also interested in how the company does business so that they can assess whether they want to be a part of the organisation. Issues such as the ethical stance of the company and pay equality between genders.

Question 17

Why are financial analysts and advisers likely to be interested in financial information about a large company with listed shares?

Answer 17

Financial analysts and advisers need information for their clients or audience.

For example, stock brokers need information to advise investors; credit agencies want information to advise potential suppliers of goods to the company; and journalists need information for their reading public.

Question 18

Why are government agencies likely to be interested in financial information about a large company with listed shares?

Answer 18

Government agencies are interested in the efficient allocation of resources and therefore in the activities of enterprises.

They also require information in order to provide a basis for national statistics.

They may want to assess how entities are implementing mandatory reporting requirements to disclose information, for example the disclosure requirements of the Task Force on Climate-related Financial Disclosures (TCFD).

Question 19

Why are the public likely to be interested in financial information about a large company with listed shares?

Answer 19

The public are affected by business entities in a variety of ways. For example, they may make a substantial contribution to a local economy by providing employment and using local suppliers. Another important factor is the effect of an entity on the natural environment, for example as regards the levels of pollution generated by the entity.

Question 20

Why are regulatory bodies likely to be interested in financial information about a large company with listed shares?

Answer 20

Regulatory bodies such as the FCA which regulates the financial services industry, require information to ensure compliance with regulations and the law.

Question 21

What is the information gap in financial statements?

Answer 21

Some of the stakeholders may have conflicting needs or information needs that are not satisfied by the financial statements.

This ‘information gap’ is likely to be greater in large companies.

Question 22

How should management be thought of in relation to the financial statements? Why?

Answer 22

Management should primarily be thought of as responsible for the preparation and presentation of the financial statements.

Managers of a business need financial information to help them make planning and control decisions. They do not, however, rely on the financial statements as they have access to internal business information. Managers can obtain extra information through the cost and management accounting system.

Question 23

In addition to the financial statements, what additional accounting information is often prepared for the benefit of other stakeholders to satisfy their specific information needs? (2)

Answer 23

1. HMRC will receive information to make tax assessments.
2. A bank might demand a cash flow forecast as a pre-condition of granting an overdraft.

Question 24

What other types of organisation prepare financial statements? (2)

Answer 24

Not-for-profit entities:
1. Charities and clubs
2. Government (public sector) organisations

Question 25

Why are ethical considerations important to accountants? (2)

Answer 25

1. In order for the work of accountant to continue to be valuable, the financial information that they provide must be perceived as being trustworthy. If this reliability becomes compromised, then users will no longer depend on the information and the value of the profession will be damaged.
2. By adhering to a code of conduct and ethical behaviour, accountants can maintain public confidence in the profession and thus maintain the value of accounting.