Accuracy. Financial accounts are required to show a ‘true and fair’ view. For practical purposes this means that they should be as accurate as possible and not misleading. ‘Accuracy’ will depend upon the size of a business.
Management accounts
Purpose. Management accounts provide financial and non-financial information and are used to help managers make informed business decisions. They are usually confidential and not released outside the organization.
Focus. Use past and present information to make decisions about the future.
Scope. Can report on products, customers, departments, divisions or the whole business.
Frequency. Produced whenever required – usually at least monthly.
Requirement. There are no legal requirements for management accounts. Although, in practice, some external investors, such as banks, may insist on regular management accounts as a condition of funding.
Format. There are no standard formats or rules for management accounts but some popular established techniques are used, for example, the calculation of profit margins and other financial ratios.
Accuracy. Management accounts are required to be as accurate as possible as they are used to make critical business decisions. At the same time, as management accounts are used to predict an uncertain future, they can include reasonable approximations.
Financial accounts report historical data. Management accounts help managers make critical decisions.
You have to walk before you can run. This chapter explains the basic accounting fundamentals which are essential knowledge for anyone in business. The first step is to understand the language of finance used by accountants. Accountancy is notorious for jargon and I will start the chapter by explaining some of the more commonly used terms. I will then move on to some of the most basic financial concepts.
Those new to finance can take a while to get used to the terminology used by accountants. Here are some of the common terms used. You can also refer to the ‘jargon buster’ at the back of the book at any time.
Financial statements and accounting principles
Financial statements. The collection of formal financial records of a business’s activity (namely the balance sheet, income statement, statement of recognized income and expense, and statement of cash flows).
Matching (or accruals) concept. Costs are accounted for when incurred, and income when earned.
Going concern. An assumption that the business will continue in operation for the foreseeable future, which provides the basis for the valuation of business assets.
Prudence. Revenues and profits should only be recognized once their realization is reasonably certain. Conversely, liabilities are accounted for when they are foreseen.
Materiality. Amount above which an item’s omission or mis-statement would affect the view taken by a reasonable user of financial statements.
“People want to learn about finance because they want to know what accountants are talking about” Anonymous
Revenue, capital and assets
Asset. An item of value owned or controlled by a business that will generate a future benefit. Examples include buildings and inventory.
Capital expenditure. Payments to purchase or improve long-term assets such as property and equipment.
Revenue expenditure. Expenses incurred in running a business, which do not specifically increase the value of long-term assets.
Receivables (debtors). Amounts owed by customers paying on credit.
Prepayment. A payment for goods or services before they have been received. Examples include advance payment of insurance and rent.
Liabilities
Liability. Money owed by a business. A commitment to transfer economic benefit in the future. Examples include payables and loans.
Payables (or creditors). Amounts owed to suppliers who have offered credit.
Accrual. Goods or services received but not yet invoiced by the supplier. Examples include certain goods for resale and utility bills.
Provision. An amount set aside for a known liability whose extent and timing cannot be precisely determined, e.g. restructuring costs.
Contingent liability. A liability where the amount and/or likelihood of payment are uncertain. As such, no specific provision is made.
Be aware of common financial terms.
2.2 Discover why timing is essential
The timing of cash receipts and payments may not be the same as the sales and purchases recorded in financial statements. At the end of an accounting period, a business should make sure that everything has been accounted for, when it should be accounted for.
The importance of timing. Imagine you are shopping in January and make all your purchases using a credit card. Although, you’ve effectively ‘spent’ money (or ‘incurred’ expenditure) in January, you won’t actually pay any cash until you pay your credit card bill, perhaps during February. Therefore, the cash cost of the shopping in January is zero.
case study Aaron, a salesperson, would argue that he has made a sale when his customer has placed an order. Helena, a lawyer, would argue that she has made a sale when her client signs a contract. Others may argue it’s when goods are delivered, a service is performed, or a customer has paid. However, using the matching concept, Brian, the accountant who works for Aaron, Helena and other businesses, only recognizes a sale when it has been ‘earned’. Similarly, Brian recognizes a purchase made by Aaron and Helena only when their suppliers have ‘earned’ the revenue, not when an order is placed, a contract signed, goods received, or a payment made. Revenue and expense recognition is a complex area for Brian.
Now using a business example – imagine a credit sale made in March, where the customer pays in cash during April. Although the business has effectively ‘earned’ a sale in March, the cash receipts from that customer during March are zero.
These examples highlight the importance of timing in accounting. Expenses can be incurred at different times
