Financial accounting 2e an international introduction by david alexander and christopher nobes

With a clear written style this accessible book is unique in teaching financial
accounting from a non-country specific perspective, using International Financial
Reporting Standards (IFRS) as its framework to explain concepts and standards.
Building on the success of the first edition this truly international book continues
to draw examples from Europe, the US and beyond, and has been updated to
incorporate the extensive changes of the past three years.
Key features
¥ New! Expanded and amended coverage of
group accounting and of financial analysis.
¥ Real-life examples are included from a wide
range of countries.

¥ End-of-chapter self-assessment questions and
answers.
¥ Exercises at the close of each chapter.

“This book is particularly timely. It is
written extremely clearly. It is unusual
in that it takes as its base the
International Accounting Standards,
which I firmly believe are going to be
the worldwide requirements of the
future.”
Sir David Tweedie, Chairman

Ideal for undergraduate and MBA students
worldwide, taking a first course in financial
accounting.

“Refreshing in its breadth and
comprehensiveness.”

International Accounting Standards Board

Dr Aileen Pierce
David Alexander is Professor of Accounting
and Head of the Department of Accounting and
Finance at the University of Birmingham
Business School, England.

University College Dublin
The British Accounting Review, 35 (2)

Christopher Nobes is PricewaterhouseCoopers
Professor of Accounting at the University of
Reading, England. From 1993 to 2001 he was a
representative on the board of the International
Accounting Standards Committee.

An imprint of

www.pearson-books.com

ALEXANDER & NOBES

¥ Includes a glossary of terms used in IFRS (and
UK and US) accounting.

SECOND EDITION

¥ Activities and Why it Matters boxes integrated

throughout each chapter to challenge students
and stimulate further interest.

Financial Accounting

An International Introduction

Looking for an introductory text in financial accounting? Then look
no further than this book, created by an experienced author team
specifically for those with little or no previous knowledge of the subject.


Financial Accounting


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Financial Accounting
An International Introduction
SECOND EDITION
DAVID ALEXANDER
CHRISTOPHER NOBES


Pearson Education Limited
Edinburgh Gate
Harlow
Essex CM20 2JE
England
and Associated Companies throughout the world
Visit us on the World Wide Web at:
www.pearsoned.co.uk

First published 2001
Second edition published 2004
© Pearson Education Limited 2001, 2004
The rights of David Alexander and Christopher Nobes to be identified as authors of this work have been
asserted by them in accordance with the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted in any form or by any means, electronic, mechanical,
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All trademarks used herein are the property of their respective owners. The use of any
trademark in this text does not vest in the author or publisher any trademark ownership rights
in such trademarks, nor does the use of such trademarks imply any affiliation with or
endorsement of this book by such owners.
ISBN 0 273 68520 1
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
A catalogue record for this book is available from the Library of Congress
10 9 8 7 6 5 4 3 2 1
08 07 06 05 04
Typeset in 912 1212 Stone Serif by 25
Printed and bound by Ashford Colour Press., Gosport
The publisher’s policy is to use paper manufactured from sustainable forests.


Contents
Foreword
Preface
Acknowledgements

Abbreviations

xi
xiii
xv
xvi

Part 1 THE CONTEXT OF ACCOUNTING
1

Introduction

3

Objectives

3

1.1
1.2
1.3
1.4
1.5

2

Purposes and uses of accounting
Accounting regulation and the accountancy profession
Language
Excitement in accounting

The path ahead

Summary
Exercises

11
11

Some fundamentals

12

Objectives

12

2.1
2.2
2.3
2.4
2.5

13
13
20
26
27

Introduction
The balance sheet

The income statement
Two simple equations
How cash flows fit in

Summary
Self-assessment questions
Annex: Introduction to double-entry bookkeeping
Exercises

3

4
7
9
9
10

29
29
31
42

Frameworks and concepts

46

Objectives

46

3.1
3.2
3.3
3.4

47
49
50
54

Introduction
Underlying concepts
The IASB’s concepts
A hierarchy of concepts and some inconsistencies

Summary
References and research
Self-assessment questions
Exercises

56
56
57
57

v


Contents

4

5

Annex: More on double entry
Exercises on double entry

59
64

The regulation of accounting

66

Objectives

66

4.1
4.2
4.3
4.4
4.5

67
67
69
72
76

Summary
References and research
Self-assessment questions
Exercises

76
77
77
79

International differences and harmonization

80

Objectives

80

5.1
5.2
5.3
5.4
5.5

6

Introduction: various ways to regulate accounting
Legal systems
Enterprises
Examples of regulation

The regulation of International Standards

Introduction: the international nature of the development
of accounting
Classification
Influences on differences
Harmonization in the European Union
The International Accounting Standards Board

Summary
References and research
Self-assessment questions
Exercises

106
108
109
110

The contents of financial statements

112

Objectives

112

6.1
6.2
6.3

6.4
6.5

113
114
126
128
130

Introduction
Basic financial statements
Comprehensive income
Cash flow statements
Other general disclosure requirements

Summary
References and research
Self-assessment questions
Exercises

7

vi

81
82
88
98
103

133
134
135
136

Financial statement analysis

137

Objectives

137

7.1
7.2

138
139

Introduction
Ratios and percentages


Contents

7.3
7.4
7.5
7.6
7.7

7.8
7.9

Profit ratios
Profitability ratios
Liquidity ratios
Interest cover
Funds management ratios
Introduction to investment ratios
Some general issues

Summary
Self-assessment questions
Exercises

141
145
152
154
154
156
157
159
159
162

Part 2 FINANCIAL REPORTING ISSUES
8

9

Recognition and measurement of the elements of financial
statements

171

Objectives

171

8.1
8.2
8.3
8.4

172
172
174
182

Introduction
Primacy of definitions
Hierarchy of decisions
Income recognition

Summary
References and research
Self-assessment questions
Exercises

185
186
186
187

Tangible and intangible fixed assets

189

Objectives

189

9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8

190
191
192
194
196
209
211
214

Preamble: a tale of two companies
Introduction
The recognition of assets
Should leased assets be recognized?
Depreciation of cost
Impairment
Measurement based on revaluation
Investment properties

Summary
References and research
Self-assessment questions
Exercises

10 Inventories

215
216
216
219
221

Objectives

221

10.1 Introduction
10.2 Counting inventory

222
224

vii


Contents

10.3
10.4
10.5
10.6
10.7
10.8
10.9
10.10

Valuation of inventory at historical cost
Inventory flow
Other cost methods
Valuation of inventory using output values
Practice
Current replacement cost
Construction contracts
Construction contracts in practice

Summary
References and research
Self-assessment questions
Exercises

11 Financial assets, liabilities and equity

238
238
239
241

Objectives

243
243

11.1
11.2
11.3
11.4
11.5
11.6
11.7

244
244
246
250
254
257
260

Introduction

Cash and receivables
Investments
Liabilities
Equity
Reserves and provisions
Comparisons of debt and equity

Summary
References and research
Self-assessment questions
Exercises

261
262
262
263

12 Accounting and taxation

265

Objectives

265

12.1
12.2
12.3
12.4

266
268
271
272

Introduction
International differences in the determination of taxable income
Tax rates and tax expense
Deferred tax

Summary
References and research
Self-assessment questions
Exercises

276
276
277
278

13 Cash flow statements

280

Objectives

280

13.1
13.2

13.3
13.4
13.5

281
282
284
285
293

Introduction
An outline of the IAS 7 approach
Reporting cash flows from operating activities
The preparation of cash flow statements
A real example

Summary

viii

225
226
231
231
232
233
233
236

294

Contents

References and research
Self-assessment questions
Exercises

14 Group accounting

294
294
295
297

Objectives

297

14.1
14.2
14.3
14.4
14.5
14.6
14.7
14.8

298
301

304
313
314
315
316
317

Introduction: the group
Investments related to the group
Accounting for the group
Uniting of interests
Proportional consolidation
The equity method
Conclusion on group relationships
Hope for international harmonization

Summary
References and research
Self-assessment questions
Exercises

15 Foreign currency translation

318
318
319
320
323

Objectives

323

15.1
15.2
15.3
15.4

324
324
327
329

Introduction
Transactions
Translation of financial statements
A numerical illustration

Summary
References and research
Self-assessment questions
Exercises

16 Accounting for price changes

331
331
331
332
334

Objectives

334

16.1
16.2
16.3
16.4
16.5
16.6
16.7
16.8
16.9

335
335
341
341
346
348
352
355
356

Introduction
Effects of price changes on accounting
European disagreement
General or specific adjustment
General price-level adjusted systems

Current value accounting
Mixed values – deprival value
Partial adjustments
Fair values

Summary
References and research
Self-assessment questions
Exercises

357
357
358
359

ix


Contents

Part 3 ANALYSIS
17 Financial appraisal

x

365

Objectives

365

17.1
17.2
17.3
17.4
17.5
17.6

366
366
371
373
373
374

Introduction
More on investment ratios
Interpreting the balance sheet
Valuation through expectations
Valuation through market values
Accounting policies and financial appraisal

Summary
References and research
Self-assessment questions
Exercises

382
383
383

385

18 International analysis

391

Objectives

391

18.1
18.2
18.3
18.4
18.5
18.6
18.7

392
392
396
397
398
399
401

Introduction
Language
Differences in financial culture
Accounting differences

Help by multinationals
Increasing international harmonization
A benchmark for international comparisons

Summary
References and research
Exercises
Annex: Special accounting features of Deutsche Telekom Group
(from published annual reports and accounts 1999)

404
404
405

Appendices

413
415

406

A Glossary of terms
B An outline of the content of the EU’s Fourth Directive on
Company Law
C An outline of the content of International Financial
Reporting Standards
D Suggested answers to self-assessment questions
E Feedback on exercises

434

444
449

Index

471

432


Foreword to the first edition
For many years Professor Christopher Nobes and I have worked together as the
two British representatives on the Board of the International Accounting
Standards Committee. He and I have argued in many fora for the notion that
there should be one single set of high quality worldwide standards so that a
transaction occurring in Stuttgart, Sheffield, Seattle or Sydney should be treated
in exactly the same way. That is not the case at present.
In a book recently published by Professor Christopher Nobes and David Cairns,
‘The Convergence Handbook’, they outlined the existing differences between
British and International Accounting Standards. The intention of the book and
the request by the UK’s Accounting Standards Board for its production was to
eliminate these differences. It is particularly important this should be done over
the next five years as the European Commission has stated its intention that all
consolidated statements of Listed Companies in the European Union should
comply with International Accounting Standards by 2005. Clearly British
Standards will have to change, although as British Standards themselves are of
high quality it is very likely that some International Standards will also change.
To meet this challenge and to ensure that all countries have the same accounting standards, the International Accounting Standards Committee has been
reconstituted with effect from 2001 to form a virtually full-time International
Accounting Standards Board whose main mission is to seek convergence of

accounting standards throughout the world.
This book by my friends, David Alexander and Christopher Nobes, is therefore
particularly timely. It is based on a background in the European Union. It is
written extremely clearly. (The real mark of a teacher is not to complicate but to
simplify and the authors have certainly done that.) It is unusual in that it takes as
its base not one country’s standards but International Accounting Standards,
which I firmly believe are going to be the worldwide requirements of the future.
The book will be of interest not only to the beginner but to those who wish to
understand the thrust of International Accounting Standards. The authors make
clear that accounting is still in many ways a primitive subject and is in a period of
change, removing the most irrelevant aspects of the historical cost model and
replacing them with accounting for fair values. Those coming into accounting
now are going to see huge changes in the first few years of their careers as many
of the ideas promulgated by academics many years ago become professional practice and as each country’s national standards are changed to converge with the
international consensus.
I enjoyed reading this book and I am sure that its many readers will also. I congratulate the authors for their foresight in producing such an excellent book and
wish them well.
SIR DAVID TWEEDIE
January 2001
Chairman, International Accounting Standards Board

xi



Preface
This is the second edition of our book that is designed as an introductory text in
financial accounting. What sets it apart from dozens of other books with that
basic aim is that this book is not set in any one national context. Consequently,
instead of references to national laws, standards or practices, the main reference

point is International Financial Reporting Standards (IFRS).
Nevertheless, real enterprises operate in real countries even where they follow IFRS,
and so such enterprises also operate within national laws, tax systems, financial
cultures, etc. The background chosen in this book is the European Union (EU) and
the wider European Economic Area (EEA). Where useful, we refer to EU Directives
and to the rules or practices of particular European countries or companies.
This book is intended for those with little or no previous knowledge of financial accounting. It might be particularly appropriate for the following types of
financial accounting courses taught in English at the undergraduate or postgraduate (e.g. MBA) level:
n

n

n

courses in any country in the EU (or EEA), given the increasing use of IFRS by
companies including the compulsory use for listed companies’ consolidated
statements;
courses outside the EU where IFRS are likely to be a relevant reference point,
e.g. in Eastern Europe and the (British) Commonwealth;
courses anywhere in the world with a mixture of students from several
different countries.

Depending on the objectives of teachers and students, stress (or lack of it)
might be placed on particular parts of this book. For example, it would be possible to precede or accompany a course based on this book with an extensive
examination of double-entry bookkeeping, such that the Annexes to chapters 2
and 3 become unnecessary. Or, on some courses, there might not be space or
appetite for coverage of issues such as foreign currency translation (chapter 15) or
accounting for price changes (chapter 16).
In writing this book we have, of course, made use of our experience over many
years of writing and teaching in an international context. Thus, in some places

we have adapted and updated material that we have used elsewhere in more specialist books to which the intended readers of this text would not have easy
access. We have tried to remove British biases, but we may not have been fully
successful and we apologize to readers who can still detect some.
This edition is updated for the extensive changes of the three years since
writing the first edition. We have, also, expanded and amended the coverage of
group accounting and of financial analysis.
There are five appendices, which we hope readers will find useful during and
after a course based on this book. Appendix A contains a glossary of some terms

xiii


Preface

used in IFRS (and UK and US) accounting. Appendices B and C summarize the
requirements of the EU Fourth Directive and IFRS, respectively. Appendix D
provides answers to the end-of-chapter self-assessment questions. Appendix E
provides outline feedback to the first two of each chapter’s closing exercises.
Feedback on the other exercises is given in an Instructor’s Manual that is available
electronically via the Companion Website at www.booksites.net/alexander.
The manual also contains other material to assist lecturers.
In preparing the first edition, we were greatly assisted by comments from an
apparently tireless team of reviewers, listed immediately hereafter. Certain
reviewers have commented further this time. We are also grateful for much help
from colleagues at Pearson. Despite all this help, there may be errors and omissions in our book, and for this we must be debited (in your books).
DAVID ALEXANDER
University of Birmingham
CHRISTOPHER NOBES
University of Reading

Reviewers
This book has benefited very much from the advice and critical evaluation of the
following reviewers, whose comments throughout the preparation of the first
edition are greatly appreciated:
Willem Buijink, Department of Accounting Tilburg University, The Netherlands.
Niclas Hellman, Department of Accounting and Managerial Finance, Stockholm
School of Economics, Sweden.
Katerina Hellstrom, Department of Accounting and Managerial Finance,
Stockholm School of Economics, Sweden.
Dick van Offeren, Faculty of Economics and Econometrics, University of
Amsterdam, The Netherlands.
Frank Thinggaard, Department of Accounting, The Aarhus School of Business,
Denmark.
Stefan Wielenberg, Department of Economics, Bielefeld University, Germany.

xiv


Acknowledgements
We are grateful to the following for permission to reproduce copyright material:
Table 4.2 adapted and translated from the plan comptable general, The Conseil
National de la Comptabilite; Figure 5.1 adapted from ‘A judgemental international classification of financial reporting practices’, Journal of Business Finance
and Accounting, Spring 1983, Nobes, Blackwell Publishers; Figure 5.2 adapted from
‘Towards a general model of the reasons for international differences in financial
reporting’, Abacus Vol 34, Vol 2, 1998, Nobes, Blackwell Publishers; Table 5.16
adapted from Use of IASs in France, University of Reading Discussion Papers in
Accounting, Finance and Banking, No. 58, 1998, Zambon, S and Dick, W;
Figure 8.5 from Group profit and loss account for the 52 weeks ended 29 December
2002, Cadbury Schweppes Report & Accounts and Form 20-F, 2002; Table 9.1
derived from ‘A tale of two companies in numbers’, Fortune 500, 1995 and 1999,

Time Inc.; Table 9.9 adapted from Depreciation of plant and machinery, FEE
European Survey of Published Accounts, London, 1991; Table 10.13 adapted from
Valuation basis of long-term contracts, FEE European Survey of Published
Accounts, London, 1991; Table 18.1 adapted from UK and US accounting terms, the
BT Annual Report 1999, British Telecom; Table 18.2 from Comparative
International Accounting, Chapter 18, McLeay, S.J. in Nobes, C.W. and Parker, R.H.,
Financial Times Prentice Hall, 2000; Table 18.3 from Norsk Hydro annual reports,
Norsk Hydro; and Chapter 15 (page 326) from BASF Group – Notes to the
Consolidated Financial Statements, BASF.
In some instances we have been unable to trace the owners of copyright material,
and we would appreciate any information that would enable us to do so.

xv


Abbreviations

xvi

ABC

activity-based costing

AE

anonymos etairia (public company, Greece – transliteration of Greek
equivalent)

AG

Aktiengesellschaft (public company, Germany and Austria)

AktG

Aktiengesetz (German Stock Corporation Law)

ApS

anspartsselskab (private company, Denmark)

AS

aktieselskab (public company, Denmark)
aksjeselskap (private company, Norway)

ASA

almennaksjeselskap (public company, Norway)

BV

besloten vennootschap (private company, Belgium and the Netherlands)

COB

Commission des Operations de Bourse
(Commission for Stock Exchange Operations, France)

CoCoA

continuously contemporary accounting

CONSOB

Commissione Nazionale per le Societa e la Borsa
(National Commission for Companies and the Stock Exchange, Italy)

CPP

current purchasing power

CRC

current replacement cost

CV

current value

DCF

discounted cash flow

DRSC

Deutches Rechnungslegungs Standards Committee
(German Regulatory Standards Committee)

DV

deprival value

EBIT

earnings before interest and tax

EEA

European Economic Area

EFRAG

European Financial Reporting Advisory Group

EPE

etairia periorismenis efthynis (private company, Greece –
transliteration of Greek equivalent)

EPS

earnings per share

EU

European Union

EV

economic value

FAR

Foreningen Auktorisade Revisorer (a national accountancy body,
Sweden)

FASB

Financial Accounting Standards Board

FIFO
GAAP

first in, first out
generally accepted accounting principles


Abbreviations

GmbH
GPLA
HC
HGB
IAS
IASB
IASC
IFAC
IFRIC
IOSCO
JV

Lda
LIFO
Ltd
NBV
NRV
NV

Gesellschaft mit beschranker Haftung (private company, Germany and
Austria)
general price level adjusted
historical cost
Handelsgesetzbuch (Commercial Code, Germany)
International Accounting Standard
International Accounting Standards Board
International Accounting Standards Committee
International Federation of Accountants
International Financial Reporting Interpretations Committee
International Organization of Securities Commissions
joint venture
sociedade por quotas (private company, Portugal)
last in, first out
private limited company (United Kingdom)
net book value
net realizable value
naamloze vennootschap (public company, Belgium and the
Netherlands)

NYSE

New York Stock Exchange

Oy

Osakeyhtio-yksityinen (private company, Finland)

Oyj

Osakeyhtio julkinen (public company, Finland)

PE

price earnings

PCG

plan comptable general (general accounting plan, France)

plc

public limited company (United Kingdom)

PPE

property, plant and equipment

RC

replacement cost

RJ

Raad voor de Jaarverslaggeving (Council for Annual Reporting, the
Netherlands)

ROCE

return on capital employed

ROE

return on equity

ROOE

return on ordinary owners’ equity

SA

sociedade anonima (public company, Portugal)
sociedad anonima (public company, Spain)
societe anonyme (public company, Belgium, France and Luxembourg)

Sarl

societe a responsabilite limitee
(private limited company, Belgium, France and Luxembourg)

SEC

Securities and Exchange Commission (United States)

SIC

Standing Interpretations Committee

SpA

societa per azioni (public company, Italy)

SRL

societa a responsabilita limitata (private company, Italy)
sociedad de responsabilidad limitada (private company, Spain)

xvii


Abbreviations

xviii

SRS

Svenska Revisorssamfundet (a Swedish accountancy body)

TFV

true and fair view

UK

United Kingdom

US

United States


Part 1
THE CONTEXT OF ACCOUNTING
1

Introduction

2

Some fundamentals

3

Frameworks and concepts

4

The regulation of accounting

5

International differences and harmonization

6

The contents of financial statements

7

Financial statement analysis



1
Introduction
CONTENTS 1.1 Purposes and users of accounting
1.2
1.3
1.4
1.5

Accounting regulation and the accountancy profession
Language
Excitement in accounting
The path ahead
Summary
Exercises

4
7
9
9
10

11
11

OBJECTIVES After studying this chapter carefully, you should be able to:
n
n
n

explain the scope and uses of accounting;
outline the role of national and international accountancy bodies;
give some examples of the usages of accounting terms in different varieties
of English.

3


Chapter 1 · Introduction

1.1 Purposes and users of accounting
There is no single authoritative and generally accepted definition of financial
accounting, or of accounting in general. It began as a practical activity in
response to perceived needs, and for most of its development it has progressed in
the same way, adapting to meet changes in the demands made on it. Where the
needs differed in different countries or environments, accounting tended to
develop in different ways as a response to a particular environment, essentially on
the Darwinian principle: useful accounting survived. Because accounting developed in different ways, it is likely that definitions suggested in different contextual surroundings will vary.
At a general level it is at least safe to say that accounting exists to provide a
service. In the box below there are three definitions. These have all been taken
from the same economic and cultural source (the United States) because that
country has the longest history of attempting explicit definitions of this type.

Note that each suggested definition seems broader than the previous one, and the
third one, from 1970, does not restrict accounting to financially quantifiable
information at all. Many would not accept this last point even in the US context
and, as will be explored at length in this book, attitudes to accounting and its role
differ substantially around the world and certainly between European countries.
Some definitions of accounting
Accounting is the art of recording, classifying and summarizing in a significant manner
and in terms of money, transactions and events which are, in part at least, of a
financial character, and interpreting the results thereof.
‘Review and Resume’, Accounting Terminology Bulletin No. 1 (New York: American Institute of Certified
Public Accountants, 1953), paragraph 5.

Accounting is the process of identifying, measuring and communicating economic
information to permit informed judgements and decisions by users of the information.
American Accounting Association, A Statement of Basic Accounting Theory (Evanston, IL: American
Accounting Association, 1966), p. 1.

Accounting is a service activity. Its function is to provide quantitative information,
primarily financial in nature, about economic entities that is intended to be useful in
making economic decisions, in making resolved choices among alternative courses of
action.
Accounting Principles Board, Statement No. 4, ‘Basic Concepts and Accounting Principles Underlying
Financial Statements or Business Enterprises’ (New York: American Institute of Certified Public
Accountants, 1970), paragraph 40.

If information is to be useful, then some obvious questions arise: useful to
whom and for what purposes? A moment of thought will suggest a number of different types of people likely to be dealing in some way with business enterprises:
1. Managers. These are the people who have to take decisions, both day-to-day and
strategic, about how the scarce resources within their control are to be used.
They need information that will enable them to predict the likely outcomes of

alternative courses of action. As part of this process, they will need feedback on

4


1.1 Purposes and users of accounting

2.

3.
4.

5.

6.
7.

8.

the results of their previous decisions in order to extend successful aspects of
the decisions, and to adapt and improve the unsuccessful aspects.
Investors. A large enterprise may have many owners (investors and or shareholders) who are not the managers of the enterprise. These providers of capital
are concerned with the risk inherent in, and return provided by, their investments. They need to determine whether they should buy, hold or sell their
investments. Shareholders are also interested in information to assess the
ability of the enterprise to pay them a return (known as a dividend). Potential
shareholders have similar interests.
Lenders. Lenders (such as banks) are interested in whether loans, and the interest attaching to them, will be paid when due.
Employees. Employees and their representative groups are interested in the
profitability of their employers. They also want to assess the ability of the
enterprise to continue to provide remuneration, retirement benefits and

employment opportunities.
Suppliers. These want to be able to assess whether amounts owing will be paid
when due. Suppliers are likely to be interested in an enterprise over a shorter
period than lenders, unless they depend upon the enterprise as a major
continuing customer.
Customers. Customers need information about the continuance of an enterprise, especially when they have a long-term involvement with the enterprise.
Governments. Governments and their agencies need information in order to
regulate the activities of enterprises and to collect taxation, and as the basis for
national income and similar statistics.
Public. Enterprises affect members of the public in a variety of ways; for
example, enterprises pollute the atmosphere or despoil the countryside.
Accounting statements (generally called ‘financial statements’) may give the
public information about the trends and recent developments of the enterprise and the range of its activities.

This list leads to a very important distinction, namely that between management accounting and financial accounting. Management accounting is that branch
of accounting concerned with the provision of information intended to be useful
to management within the business. Financial accounting is the branch of
accounting intended for users outside the business itself, i.e. groups 2–8 above.
The wording for these groups is closely based on a document called Framework for
the Preparation and Presentation of Financial Statements issued by the International
Accounting Standards Committee (IASC), discussed further in chapter 3.
It is clear from the previous paragraphs that the needs of users to whom financial accounting is addressed are very diverse, and so it does not follow that the
same information will be valid for all their purposes. Nevertheless, it is usually
assumed that one set of financial statements in the public domain should be able
to satisfy most needs. The IASC Framework (paragraph 10) goes on to assert that:
While all of the information needs of these users cannot be met by financial statements, there are needs which are common to all users. As investors are providers of
risk capital to the enterprise, the provision of financial statements that meet their
needs will also meet most of the needs of other users that financial statements can
satisfy.

5


Chapter 1 · Introduction

This last sentence would certainly earn a fail mark on any course in logic or
philosophy, but the view is widely followed in practice; that is, financial reporting is seen by the IASC as largely designed to supply investors with useful information. Accepting, however, that the needs of different users are likely to be
different and that different users may predominate in different countries, it is
clear that different national environments (cultural, political and economic) are
likely to lead to different accounting practices. Indeed, financial reporting to
various users (as opposed to the mere recording of transactions, which is known
as bookkeeping) reflects the biases and norms – sometimes long term, sometimes
transitory – of the societies in which it is embedded. This area is developed later
in chapter 5.

Activity 1.A

In what various ways can and should financial reporting (the end product of
financial accounting) be different from reporting to management? Think about
the different purposes of these two types of accounting, and how these purposes
affect their operation.

Feedback Management accounting can be carried out on the basis that no information need
be kept secret for commercial reasons and that the preparers will have no incentive
to disguise the truth. This is because the management is giving information to
itself. So, the information does not need to be externally checked. It can be more
detailed and more frequent than for financial reporting because there is no
expense of external checking or publication. Also, the management will not want
any biases, whereas some outside users may prefer a tendency to understate profits
and values where there is uncertainty. Management may be happy for many

estimates about the future to be made, which might be too subjective for external
reporting. Indeed, some management accounting figures involve forecasting all the
important figures for the next year, whereas financial reporting concentrates on
the immediate past.
Another point is that there do not need to be any rules imposed on management
accounting because management can trust itself. By contrast, financial reporting probably works best with some clear rules from outside the enterprise in order to control
the management and help towards comparability of one enterprise with another.

Having distinguished financial accounting from management accounting,
there are some further possible confusions to address. The function of external
auditing is quite separate from that of financial accounting. Auditing is a control
mechanism designed to provide an external and independent check on the financial statements and reports published by those enterprises. Financial reports on
the state of affairs and the past results of enterprises are prepared by accountants
under the control of the managers of the enterprises, and then their validity is
assessed by auditors. The wording used by auditors in their reports on financial
statements varies considerably between countries, and the meaning and significance of the words that they use varies even more. There is inevitably some
conflict between the necessity for an auditor to keep the management of the
enterprise happy, and the necessity for provision of an expert and independent
check. A study of auditing is outside the scope of this book, but the reader from

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