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1: Introduction to accounting Part A The context and purpose of financial reporting
amounts owed by their businesses, the shareholders of a limited liability company are only responsible for
the
amount to be paid for their shares. Limited liability companies are dealt with in more detail in
Chapter 20
.
In law sole traders and partnerships are not separate entities from their owners. However, a limited
liability company is legally a separate entity from its owners and it can issue contracts in the company’s
name.
For
accounting purposes, all three entities are treated as separate from their owners. This is called the
business entity concept. We will see
the practical consequence in
Chapter 5
.
2.3 Advantages of trading as a limited liability company
(a)
Limited liability makes investment less risky than investing in a sole trader or partnership.
However, lenders to a small company may ask for a shareholder's personal guarantee to secure
any loans.
(b) It
is
easier to raise finance because of limited liability and there is no limit on the number of
shareholders.
(c)
A limited liability company has a
separate legal identity from its shareholders. So a company
continues to exist regardless of the identity of its owners. In contrast, a partnership ceases, and a
new one starts, whenever a partner joins or leaves the partnership.
(d) There
are
tax advantages to being a limited liability company. The company is taxed as a separate
entity from its owners and the tax rate on companies may be lower than the tax rate for individuals.
(e)
It is relatively easy to
transfer shares from one owner to another. In contrast, it may be difficult to
find someone to buy a sole trader's business or to buy a share in a partnership.
2.4 Disadvantages of trading as a limited liability company
(a)
Limited
liability companies have to
publish annual financial statements. This means that anyone
(including competitors) can see how well (or badly) they are doing. In contrast, sole traders and
partnerships do not have to publish their financial statements.
(b)
Limited liability company financial statements have to comply with
legal and accounting
requirements. In particular the financial statements have to comply with accounting standards.
Sole traders and partnerships may comply with accounting standards, but are not compelled to do
so.
(c)
The financial statements of larger limited liability
companies have to be
audited. This means that
the statements are subject to an independent review to ensure that they comply with legal
requirements and accounting standards. This can be inconvenient, time consuming and expensive.
(d)
Share issues are regulated by law. For example, it is difficult to reduce share capital. Sole traders
and partnership can increase or decrease capital as and when the owners wish.
3 Nature, principles and scope of financial reporting
You should be able to distinguish the following:
Financial
accounting
Management
accounting
You may have a wide understanding of what accounting and financial reporting is about. Your job may be in one
area or type of accounting, but you must understand the breadth of work which an accountant undertakes.
3.1 Financial accounting
So far in this chapter we have dealt with
financial accounts. Financial accounting is mainly a method of
reporting the results and financial position of a business. It is not primarily concerned with providing
information towards the more efficient running of the business. Although financial accounts are of interest
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Part A The context and purpose of financial reporting
1: Introduction to accounting
7
to management, their principal function is to satisfy the information needs of persons not involved in
running the business.
They provide
historical information.
3.2 Management accounting
The information needs of management go far beyond those of other account users. Managers have the
responsibility of planning and controlling the resources of the business. Therefore they need much more
detailed information. They also need to
plan for the future (eg budgets, which predict future revenue and
expenditure).
Management (or cost) accounting is a management information system which
analyses data to provide
information as a basis for managerial action. The concern of a management accountant is to present
accounting information in the form most helpful to management.
You need to understand this distinction between management accounting and financial accounting.
Question
Accountants
They say that America is run by lawyers and Britain is run by accountants, but what do accountants do in
your organisation or country? Before moving on to the next section, think of any accountants you know
and the kind of jobs they do.
4 Users' and stakeholders' needs
4.1 The need for financial statements
There are various groups of people who need information about the activities of a business.
Why do businesses need to produce financial statements? If a business is being run efficiently, why
should it have to go through all the bother of accounting procedures in order to produce financial
information?
The International Accounting Standards Board states in its document Framework for the preparation and
presentation of financial statements (which we will examine in detail later in this Study Text):
'The objective of financial statements is to provide information about the
financial position, performance
and
changes in financial position of an entity that is useful to a wide range of users in making economic
decisions.'
In other words, a business should produce information about its activities because there are various
groups of people who want or need to know that information. This sounds rather vague: to make it clearer,
we will study the classes of people who need information about a business. We need also to think about
what information in particular is of interest to the members of each class.
Large businesses are of interest to a greater variety of people and so we will consider the case of a large
public company, whose shares can be purchased and sold on a stock exchange.
4.2 Users of financial statements and accounting information
The following people are likely to be interested in financial information about a large company with listed
shares.
(a)
Managers of the company appointed by the company's owners to supervise the day-to-day
activities of the company. They need information about the company's financial situation as it is
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Key term