Introduction to Accounting
Financial accounting does two jobs: it records every transaction a business makes, and at the end of each period it summarises those records into financial statements. This chapter sets the scene for the rest of BA3. It explains why accounting records are kept, the kinds of business you will meet in the exam, who uses financial statements and what each user wants from them, and how financial accounting differs from management accounting. There are no calculations yet — the bookkeeping starts in Chapter 2.
1 Introduction
In this chapter we will look at what accounting is and why accounting information is prepared. We will also consider the different types of business entity that you can be asked to deal with and also the different users of financial statements.
The lecture for this chapter follows the page closely, section by section. It uses UK examples (“Ltd” and “plc” after a company’s name); you will not be tested on those letters. Two things on this page go a little further than the lecture: the list of accounting records and the idea of stewardship in section 2, and what each user group wants to know in section 4.
2 Definition of accounting
Accounting comprises the recording of transactions, and the summarising of information.
Recording
Every time a business makes a transaction — buys goods, sells goods, pays wages, borrows money — a record of that transaction must be made. A busy business makes thousands of transactions a year, so the records have to be kept in an organised way. The main accounting records are:
Source documents — the evidence for each transaction: sales and purchase invoices, credit notes, receipts, cheque counterfoils, bank statements, payroll records.
Books of prime entry — the day books, the cash book, the petty cash book and the journal, where transactions are first listed (Chapter 10).
Ledger accounts — the nominal (general) ledger, where the double entry is made (Chapter 3), with the receivables and payables ledgers showing what each customer owes and what is owed to each supplier (Chapters 10 and 15).
Other records — for example the non-current asset register (Chapter 5) and inventory records.
The records are used to control the business day to day (who owes us money, whom we owe, how much cash we have), to provide evidence of what has happened, to work out the tax the business must pay, and — at the end of the period — to prepare the financial statements. A limited company is also required by law to keep proper accounting records.
Summarising
At the end of the accounting period (usually a year) the records are summarised. The statements do not list every individual sale; they show the total sales for the period, the total purchases, and so on. The two main financial statements are:
Statement of Financial Position (formerly called the balance sheet) — a summary of what the business owns (its assets) and what it owes (its liabilities) at the end of the period.
Statement of Profit or Loss — shows the income and expenses of the period, and so how much profit or loss the business has made.
Both statements are explained in Chapter 2.
Stewardship
Many businesses are run by people who are not the owners. The directors of a company manage its resources on behalf of the shareholders. This is called stewardship: the managers are the stewards of resources that belong to someone else, and they must account for how they have used them. The financial statements are the main way in which the directors report on their stewardship to the owners. Proper accounting records are what make that report possible — without them nobody could show what the business owns, what it owes or what profit it has made.
3 Types of business entity
There are two types of business entity that you can be asked to deal with in the examination:
Sole trader
A sole trader is one person in business on their own — for example someone who rents a market stall and buys and sells goods. Any profit belongs to the owner. In law the owner and the business are the same person, so the owner has unlimited liability: if the business cannot pay its debts, the owner must pay them personally, even if that means selling their own car or house.
Limited liability company
A limited liability company is usually owned by several people (its shareholders), who each put money into the business in return for shares. The company is registered with the state and is a separate legal entity: it exists in law separately from its owners, it can own assets, owe money and pay tax in its own name. Profits belong to the shareholders, but the shareholders have limited liability: if the company collapses owing money, the most a shareholder can lose is the amount they have put in (or agreed to put in) for their shares. Because of this protection there are more laws for companies, in particular about the layout of their financial statements (Chapter 16).
Additionally, you should be aware of the following, although you cannot be asked any accounting entries:
Partnerships
A partnership is like a sole trader except that two or more people are in business together. They each put in capital and share the profits (and losses) between them. In a traditional partnership the partners have unlimited liability. (Some countries also allow limited liability partnerships, which behave much more like companies; you do not need to know about them for this exam.)
Sole trader | Partnership | Limited liability company | |
Owned by | One person | Two or more partners | Shareholders |
Separate legal entity? | No | No (traditional partnership) | Yes |
Owners’ liability for debts | Unlimited | Unlimited | Limited to the amount paid or agreed for their shares |
Accounting entries examinable in BA3? | Yes | No — awareness only | Yes |
In all cases, we apply the separate entity concept – that is that the business is regarded as being separate from the owner (or owners) and that accounts are prepared for the business itself.
The separate entity concept leads straight to the accounting equation. The business keeps a record of what it owns (its assets) and of the two sources that paid for them: the amounts it owes to outsiders (its liabilities) and the amount it owes to the owner, who invested in it (its capital). So, from the business’s point of view:
Assets = Capital + Liabilities
This is the accounting equation. It can be rearranged to find any one figure from the other two — for example, capital = assets − liabilities. Chapter 2 develops it and shows that every transaction keeps it in balance.
Amina Diallo runs a catering business as a sole trader. At the end of her first year the business has assets of $60,000 (equipment, a van, inventory and cash) and owes $15,000 to suppliers and to the bank.
Capital = assets − liabilities = $60,000 − $15,000 = $45,000.
This $45,000 is what the business owes to Amina. Her own house and car are not in the business’s accounts at all — that is the separate entity concept at work — even though, as a sole trader, she is personally liable for the business’s debts.
4 Users of accounting information
Users of the financial information for a business will include the following. Each wants to know something different:
User | What they want to know |
Management | How well the business is doing, so that they can run it and plan ahead — which products are profitable, where costs can be cut. |
Owners / shareholders | How much profit the business is making, what return they are earning on their investment, and what the business is worth. |
Potential investors | Whether to put money into the business: its profits, its prospects and the risk involved. |
Lenders | Whether the business can pay interest and repay the amount borrowed, and what assets it has as security. |
Employees | Whether the business is secure enough to keep paying their wages and providing jobs, and whether it can afford a pay rise. |
The government | How much tax the business must pay; governments also use the information for statistics and regulation. |
The public | How a business affects the local community and economy — for example whether a large local employer is doing well. |
Management are internal users: they run the business and can see far more detailed information than the published statements. All the other groups are external users and usually rely on the financial statements. Suppliers deciding whether to give the business credit, and customers who depend on it for supplies, are external users too.
The main financial statements that are likely to be available to all users are the Statement of Financial Position and the Statement of Profit or Loss. Other statements may be required to be produced (or may be produced even if not required), such as a Statement of Cash Flows. We will consider these later.
5 Comparison of Financial Accounting with Management Accounting
Both kinds of accounts are often prepared by the same accountants from the same records, but they are two separate things with different purposes:
Management Accounting | Financial Accounting | |
Purpose | To help managers plan, control and make decisions in running the business | To report the performance and position of the business to the users listed in section 4 |
Timing | Usually monthly (or as often as managers need them) | Usually once a year, for the accounting period |
Legal requirement | None — most businesses prepare them because they are useful | Required by law (for companies) |
Layout | Any format managers find useful | Set by law and by accounting standards (IFRS) |
Users | Internal — managers only | External — shareholders, lenders, government and others (and managers) |
Content | Detailed (by product or department); includes budgets and forecasts as well as past results | Summarised for the business as a whole; mainly past (historical) results |
BA3 is about financial accounting: how transactions are recorded and how the financial statements are prepared. Management accounting is examined separately.
6 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Introduction to Accounting
12 questionsAnswer the questions one at a time. Your progress is saved so you can leave and come back.
Open chapter practice