(1) The accounting process: involves recording and summarising an organization’s transactions or business deals.

It starts with inputs, and these are things such as sales documents (e.g. invoices), purchasing documents (e.g. receipts), payroll records, bank records, travel and entertainment records. The data in these inputs is then processed by specialized software.

a., Entries are recorded chronologically into ’journals’.

b., Information from the journals is posted (= transferred) into ’ledgers’, where it accumulates in specific categories (e.g. cash account, sales account, or account for one particular customer)

- nominal ledger: the main books of account

- bought ledger: creditors are recorded in this book

c., A ’trial balance’ is prepared at the end of each accounting period: this is a summary of the ledger information to check whether the figures are accurate. Is is used directly to prepare the main financial statements (income statement, balance sheet and cash flow statement).

(2) Finance and organisational structure

CFO: Chief Financial Officer is on the Board. 3 senior managers below report to CFO.

Finance has always been seen as having two distinct functions:

• recording what has happened (financial accounting) and
• helping businesses to make decisions about the future (management accounting).
• today, it has a third function: financial strategy. This incorporates judgments about risk, which some companies (especially banks) have realized must play a larger part in financial decision-making.

a., Financial Controller:

• planning: preparing forecasts and budgets
• monitoring: comparing planned spending with actual spending
• producing financial data for the senior management tea
• analysing major investment decisions

b., Treasurer:

• managing cash-flow
• raising new funds

c., Chief Accounting Officer:

• keeping the company’s books
• preparing financial statements
• preparing tax returns
• developing strategies to minimize tax

• Accountant nicknames:
  • Accountaholic
  • Provisions peddlar
  • Double entry deviant
  • Reserved reconciler
  • Debits and credits dealer
  • Bean counter
  • Ledger lover
  • Counting consultant
  • Number cruncher
  • Beankeeper
  • Penny processor
• Areas:

a., Bookkeepimg: is the day-to-day recording of transactions

Double-entry bookkepping is a system that records two aspects of ecery transaction. Every transaction is both a debit – a deduction – in one account and a corresponding credit – an addition – in another. Each account records debits on the left and credits on the right. If the bookkeepers do their work correctly, the total debits always equal the total credits.

b., Financial accounting: includes bookkeeping, and preparing financial statements for shareholders and creditors (people or organizations who have lent money to a company)

c., Management accounting: involves the use of accounting data by managers, for making plans and decisions

• Issues in financial management:
  • cost centers: discrete business units where budgets are spent
  • profit centers: units where profits are generated
  • variance analysis: comparing planned costs (or income) with actual costs for income
  • costing methods (e.g. standard vs marginal costing)
  • valuing assets
  • ratio analysis (uses): to analyise performance in more depth, to compare companies in the same industry
  • ratio analysis (types): liquidity ratios, profitability ratios, leverage („debt”) ratios, activity ratios

Sources of new funds:

a., Debt financing:

- short-term: trade credit, bank loan

- long-term: issuing bonds

b., Equity financing:

- reinvested earnings

- sale of assets

- issue of new shares

• In management accounting, two factors are of particular importance: cash and costs. A management accountant works hard to provide accurate data on production costs, so that managers can make informed decisions about pricing, on outsourcing, and on which products to back with marketing spending.

a., Activity-based costing, which provides the most complete data on costs per unit, is the best way to do this. Ideally, an accounting system measures every aspect of every transaction and decision related to a particular product or service. Whereas traditional accounting systems estimate the overheads (perhaps by assuming that every unit produced at a factory should have the same share of the total overhead bill), activity-based costing is much more precise: it breaks down the overhead costs to find out which activities create which costs. This allows the company to realize that the cost of making a chocolate product, for example, is not “about 65 cents,” but exactly “59 cents.” This level of accuracy tends to be especially important when considering nonstandard products, such as the completion of a special order of merchandise for the Brazil Olympics in 2016. Activity-based costing might show that the costs associated with this special order are higher than they would be for standard products. This would help the business to set the right prices for the Olympic items. To perform effective activitybased costing, a company needs to:

• first, identify all the direct and indirect activities and resources;
• second, determine the costs per indirect activity;
• and third, identify the “cost drivers” for each activity.

A cost driver is a factor that influences or creates costs. For example, a bank teller has many activities— when measuring the cost driver of an activity such as handling incoming checks, the bank should figure out how long the teller spends on this task alone. From these three calculations, a company can calculate the total direct and indirect costs for a product or service. By dividing these costs by the quantity produced, an accurate unit cost can be obtained. The company can then establish reliable break-even points, identify the products with the profit margins that make them worth backing (with advertising support, perhaps), and allow clear comparisons for making sound investment decisions.

b., When trading is poor, however, management accountants place their tightest focus not on costs but on cash flow, following the maxim that “cash is king.” This arises because the worse the trading conditions, the more that companies try to hold onto the cash they have—making it much harder to get paid if they are your customers. The flow of cash dries up, so an early focus on cash flow makes sense: start your own cash hoard before others begin trying to create their own. For financial accountants, the traditional stance has long been “playing by the rules.”

Case study: Daewoo Group: In 1998, South Korea’s Daewoo Group encountered growing problems because of “increasing difficulties in arranging working capital and investment funds.” The group had been aggressively expanding, and admitted that its overall financial stability had been seriously undermined by a new reliance on borrowings, but insisted that it was a brief moment of crisis. Despite being one of the largest conglomerates in the world, the group collapsed the following yea due to massive cash shortfalls.

• Assumptions:
  • The separate entity or business entity assumption: a business is an accounting unit separate from its owners, creditors and managers, and their assets. These people can all change, but the business continues as before.
  • The time-period assumption: economic life of the business can be divided into (artificial) time periods such as the financial year.
  • The continuity / going concern: a business will continue into the future, so the current market value of its assets is not important.
  • The unit of measure assumption: all financial transactions are in a single monetary unit of currency. Companies with subsidiaries – that is, other companies that they own – in different countries have to convert their results into one currency in consolidated financial statements for the whole group of companies.
• Principles:
  • the full-disclosure principle: financial reporting must include all significant information
  • the principle of materiality: very small and unimportant amounts do not need to be shown
  • the principle of conservatism: where different accounting methods are possible, you choose the one that is least likely to overstate or over-estimate assets or income
  • the objectivity: accounts should be based on facts and should be verifiable
  • the revenue recognition: revenue is recorded when a service is provided or goods delievered, not when they are paid for
  • the matching principle: each cost or expense related to revenue earned must be recorded in the same accounting period as the revenue it helped to earn.
• In 1992, British banking analyst Terry Smith published a book called Accounting for Growth. This publication set out the remarkable array of opportunities for publicly traded companies to provide an artificial boost to their stated profit levels.

a., UK: The book had a huge impact, and influenced the UK’s newly formed Accounting Standards Board, which in turn developed new accounting rules („standards” or conventions) in an attempt to minimize the scope for “creative accounting.”

b., Global: Today, most countries around the world follow the rules laid down by the International Financial Reporting Standards (IFRS). As a consequence, the income statements and balance sheets of companies in most countries follow the same format.

c., US: Although the time frame for implementation is unclear, a widely supported plan is in place to merge the IFRS with the US’s Generally Accepted Accounting Principles (GAAP) to provide globally recognized accounting rules.

• Some “creative accountancy” practices stretch the flexibility within the rules so far that they can produce potentially misleading accounts.

a., “Mark to market” (fair value) accounting, for example, values assets at their current market value. This means that when the stock market is booming, any investment (such as shares in another business) will also be booming. This boosts the value of the company’s balance sheet and may encourage it to expand beyond its means. All it takes is a fall in the stock market for this valuable shareholding to become worth considerably less.

b., It is better to use “historic(al) cost” accounting than “mark to market,” since this provides a more stable set of figures; it values assets at their cost at time of purchase, minus any depreciation that has taken place, rather than at their current market value.

c., inflation accounting systems: it takes account of changing prices (e.g. in Latin America)

d., replacement cost accounting: it values all assets at their current replacement cost

The argument of rigid rules vs. looser-based principles will be heard repeatedly when the merger talks between the US’s rules-based GAAP system and the IFRS become serious. Even though the IFRS is far more rule-based than its predecessors, it retains a greater reliance on principles than the US’s GAAP system.

• Depreciation and amortization: as fixed asssets wear out or become obsolete, they are depreciated: their value on a balance sheet is reduced each year by a charge against profits on the profit and loss account. However, it can be charged during all the years it is ued. This is an example of the matching principle.

Land is not depreciated because it tends to appreciate or gain in value. British companies occasionally revalue appreciating fixed assets like land and buildings in their balance sheets. The revaluation is at either current replacement cost (net realizable value) – how much they could be sold for. This is not allowed in the USA. Apart from this exception, appreciation is only recorded in countries that use inflation accounting systems.

• a., straigtht-line depreciation: charging equal annual amounts against profits during the lifetime of the asset (e.g. deducting 10 % of the cost of an asset’s value from profits every year for 10 years).
• b., accelerated appreciation: deducting the whole cost of an asset in a short time. Accelerated depreciation allowances are an incentive to investment. E.g.: If a company deducts the entire cost of an asset in a single year, it reduced its profits, and therefore the amount of taxi t has to pay. Consequently, new assets, including huge buildings, can be valued at zero on balance sheets. In Britain, this would not be considered a true and fair view of the company’s assets.

 Video 1: Depreciation

• Auditing: The financial statements of large companies have to be checked by an external firm or auditors, who ’sign off on the accounts’ (= officially declare the accounts are correct). They are publicly available, and appear in the company’s annual report. Users of financial statements include: shareholders, creditors (lenders, e.g. banks), customers, suppliers, journalists, financial analysts, government agencies, etc.

a., internal auditing: An internal audit is the examination of a company’s accounts by its own internal auditors or controllers. They evaluate the accuracy or correctness of the accounts, and check for errors. The make sure that the accounts comply with, or follow, established policies, procedures, standards, laws and regulations. The internal auditors alco check the company’s systems of control, related to recording transactions, valuing assets and so on. They check to see that these are adequate or sufficient, and if necessary, recommend changes to existing policies and procedures.

b., external auditing: Public companies have to submit their financial statements to external auditors – independent auditors who do not work for the company. The auditors have to give an opinion about whether the financial statements represent a true and fair view of the company’s financial situation and results. During the audit, the external auditors examine the company’s systems of internal control, to see whether transactions have been recorded correctly.

• They check whether the assets mentioned on the balance sheet actually exist, and whether their valuation is correct. For example, they usually check that some of the debtors recorded on the balance sheet are genuine.
• They also check the annual stock take – the count of all the goods held ready for sale.
• They also look for any unusual items in the company’s account books or statements.

Until recently, the big auditing firms also offered consulting services to the companies whose accounts they audited, giving them advice about business planning, strategy, and restructuring. But after a number of big financial scandals (accounting irregularities), most accounting firms separated their auditing and consulting divisions, because an auditor who is also getting paid to advise a client is no longer independent.

Regulators are demanding more transparency:

• auditor rotation: the principle that companies should be obliged to change their auditors regularly
• conflict of interests: a company’s auditors should not be allowed to do its consultancy work

 Exercise 1: Fill in the gaps with the missing words!