1.2 Financial accounting
Accounting is a process of identifying, measuring and communicating economic information to allow informed
decisions by the users of that information. Accounting systems are often described as either financial accounting
systems (where periodic financial statements are p...
principles of corporate finance brealey notes 13th edition
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1
Introduction to financial accounting
ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO:
v describe the basic purpose of financial accounting
v identify the users of accounting information and the decisions they make that require
accounting information
v identify the people who are involved in financial accounting
v describe how accrual accounting differs from cash accounting
v calculate accrual profit for an organisation
v explain the basic contents of the three key financial statements and describe the purpose of
each statement
v describe the basic principles and assumptions of accounting
v explain why accounting is important.
CHAPTER OVERVIEW
This chapter introduces you to financial accounting and illustrates some useful accounting concepts and
techniques. It outlines a way of thinking about financial accounting that will be important to your career,
whether you become an accountant or a user of accounting in business or in other walks of life. You will
be introduced to the social setting of financial accounting and some of the people involved. Financial
accounting is complex and requires much judgement because it attempts to serve the needs of all
these people, not all of whom necessarily see things the same way. You will then be introduced to one
of the cornerstones of how financial accounting works: accrual accounting, the broad framework within
which financial accounting reports are prepared. You will also be introduced to the three key financial
statements and the basic financial statement assumptions. Examples from the financial press will
hopefully convince you of the importance of accounting information.
,2 v FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
1.1 Use and preparation of accounting
Use
Financial accounting has value because the information it produces is used in a variety of ways. Users
include managers, investors, bankers, financial analysts and many others. Such people study accounting to
learn how to use information effectively and do their jobs better. For accountants, this information is essential
to the services they provide.
Preparation
Accounting is a complex human activity. Accounting information doesn’t just happen: it is produced by a large set of
people, activities and computers. To be effective users of the information, people need to know something about
how and why the information is prepared. Accountants’ expertise is all about the how and the why.
The demand for useful information shapes how financial accounting information is prepared; for example,
when producing annual or monthly performance reports. How it is prepared shapes its use; for example, in
financial analysis and managerial decisions.
FOR YOUR INTEREST
Learning terminology is important. To help you with that, this book has a Glossary of terms at the back. If
you’re not sure what a term means, look it up right away.
Accounting is a challenging discipline that involves many capabilities: assigning numbers to represent
financial phenomena; providing explanations of those numbers; analysing and verifying the information
prepared by others; understanding the needs of those who use accounting’s reports to make decisions;
engaging in oral and written communication with the many people involved in an organisation’s financial
activities; having familiarity with computers and other electronic media; and maintaining judgement that
is sound, objective and ethical.
Much of the challenge of accounting is in figuring out which numbers to use, deciding what ‘story’ the
numbers should tell. Adding and subtracting the numbers is often the easy part. This makes accounting
both easier and harder to learn than you might have thought. Accounting is rooted in the financial
setting, and has its own vocabulary and viewpoints, so don’t expect it all to make perfect sense at the
beginning. It will take a while for you to acquire the knowledge that creates an understanding of business
and accounting as they really are in our world. This understanding will be based on your knowledge of
both concepts and techniques, and of the viewpoints of both accountants and the users of accounting.
The going will not all be easy, but if you give it your best effort, you may be surprised at the high level
of sophistication you will reach. Here is one important suggestion. The only way to learn accounting is to
do problems. It is vital that you do more than just read the examples. After reading the chapter, come
back and do the examples to check your understanding.
1.2 Financial accounting
Accounting is a process of identifying, measuring and communicating economic information to allow informed
decisions by the users of that information. Accounting systems are often described as either financial accounting
systems (where periodic financial statements are provided to external decision-makers (such as investors,
creditors and customers)) or management accounting systems (including information for planning and
performance reports to managers throughout the organisation (internal decision-makers)).
Financial accounting measures an enterprise’s performance over time and its position (status) at a point in time,
and does so in Australian dollars, US dollars, yen, euros or whatever currency is judged relevant to the enterprise.
, Chapter 1 Introduction to financial accounting v 3
This measurement of financial performance and financial position is done for all sorts of
enterprises: large and small businesses, governments from local to national levels, universities, charities,
churches, clubs, international associations and many others. The financial statements, which are financial
accounting’s reports, summarise the measurements of financial performance and financial position in standard
ways thought to be useful in evaluating whether the enterprise has done well and is in good shape. These
financial statements include notes, which contain many words (sometimes dozens of pages) of explanation
and interpretation, in addition to the numbers. The statements report on the economic and financial matters
and are largely for the use of people outside the enterprise, such as investors, lenders, club members,
regulatory agencies and taxation authorities.
In summary:
v Financial performance means generating new resources from day-to-day operations over a period of time.
v Financial position is the enterprise’s set of financial resources and obligations at a point in time.
v Financial statements are the reports describing financial performance and position.
v Notes are part of the statements, adding explanations to the numbers.
As we will see throughout this book, financial performance and position are highly related. Good
performance is likely to lead to a healthy financial position; if a company has been making profits, it will
probably build up resources. On the other hand, a healthy financial position facilitates performance; if you
have lots of resources compared to obligations, the company can undertake activities that lead to good
performance.
Another branch of accounting, management accounting, is orientated towards helping managers and others
inside the enterprise, in contrast to financial accounting’s more external focus. While management accounting is
not examined in this book, students interested in how financial accounting measures managerial performance
will find frequent references to the relationship between managers and financial accounting. In the end, all
forms of accounting exist to help people such as managers, investors, bankers, legislators and the public make
financial decisions.
HOW’S YOUR UNDERSTANDING?
Here is a question you should be able to answer, based on what you have just read. If you can’t answer
it, it would be best to reread the material.
What are the two main things that financial accounting measures?
(Your answer should be: financial performance and financial position.)
1.3 Who uses financial accounting
information?
This book will show you the many ways in which financial accounting has been shaped by the development of
business and society. Financial accounting helps:
v stock market investors decide whether to buy, sell or hold shares of companies
v banks and other lenders decide whether or not to lend
v managers run enterprises on behalf of owners, members or citizens (in addition to the help provided by
management accounting and other sources of information)
, 4 v FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
v management by providing basic financial records for the purposes of day-to-day management, control,
insurance and fraud prevention
v governments in monitoring the actions of enterprises and in assessing taxes, such as income tax and the
goods and services tax (GST).
Whole books can be, and have been, written about each of the many functions. Though this book
emphasises externally orientated financial accounting for business firms, don’t forget that there are many other
organisations that use, and are affected by, accounting. When words like ‘organisation’, ‘company’ or ‘enterprise’
are used, the implications often go well beyond business firms.
The centre of our interest in this book, financial accounting for the enterprise, operates within and serves a
complex social setting. It seeks to monitor and report on financial events initiated by or happening to the
enterprise. Accounting is not a passive force within the social setting: it tells us what is going on, but in doing
so it affects our decisions and actions and, therefore, also affects what is going on.
The social setting is composed of many people, including groups, companies, institutions and other parties
interested in, or having an influence on, the company’s financial accounting. As we will see many times in this
book, these parties do not share the same interest in the company’s accounting, and may even be in
competition or conflict with each other. Most will be in the same country as the company and its management
but, increasingly, companies and other enterprises are operating internationally. The other groups interested in,
and affecting, the company’s financial accounting may be located anywhere on the planet.
Let’s consider some possible users of financial statements of a listed company:
v A company’s board of directors manages the company on behalf of its shareholders. One function of
the board, which involves the financial statements, is hiring the company’s top operating management –
especially the chief executive officer (CEO). Suppose you are a member of the board and are preparing for
a discussion at the next board meeting. The board evaluates the CEO’s performance continuously, which is
its responsibility. The financial statements have been provided to the board prior to the meeting, and will be
a major contribution to this evaluation.
v A company’s shares are listed (that is, can be bought and sold) on the Australian Stock Exchange (ASX). Suppose
you are a financial analyst for an investment dealer and are preparing a report projecting future earnings and
making recommendations about whether the company’s shares are worth buying, or keeping if already held, or
instead should be sold. You have the financial statements and will use them to support your report.
v A company has several hundred millions of dollars in bank borrowings and lines of credit (pre-authorised
borrowing capability) for millions of dollars more. Suppose you are a commercial lending officer for a bank,
conducting a regular review of the company’s borrowing status. You must consider the quality of the company’s
financial performance and assets (many of which have been assigned as security on bank loans, and therefore
could be seized if the company didn’t pay its loans back on schedule). Financial performance is important
because net profit generates cash to pay loans, and a good past record suggests that the company is likely
to be able to earn profit in the future. You have requested the financial statements to use in your review.
v A company depends on a large number of suppliers to obtain goods and services. Suppose you are the sales
manager of a stationery supplier and are considering signing a long-term contract to supply the company.
You want to sign the contract because your company needs the business, but you have to be satisfied that
your shipments will be paid for. More positively, you hope that if you do a good job, you will have an
opportunity to grow with the company. Most of the information you need has been received already, but
you have obtained the financial statements and are reviewing them as you make your final decisions about
the contract.
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