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ACCOUNTING DIPLOMA |
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UNIT ONE The Role of Accounting in Business Decision Making |
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In this unit, we are concerned with introducing the role and nature of accounting, the users of accounting information and their information needs. We begin by explaining the primary role of accounting, which is to aid economic decision making. Unless accounting can help users of accounting information to make more informed decisions it has no real value. We then consider which groups are interested in using accounting information and what kind of information they are seeking. You may think that cash is what really matters in a business and that all that is needed to help users is a statement of the cash generated for a particular period. However, this is not the case. Using an example, we illustrate why the reporting of cash is not sufficient to meet the needs of users. Following on from this example, we consider the main reports that may be helpful for decision-making purposes. Although accounting information may be far from perfect, it can often be more useful for making economic decisions than other sources of information available to users. However, a key issue is how the usefulness of accounting information may be assessed. One approach is to examine the extent to which the accounting information produced contains certain desirable qualities. In this unit, we discuss the main qualities that accounting information should possess. The unit is concerned with accounting within a business context and so the main forms of business enterprise are briefly considered. We describe the main characteristics of each form of business enterprise and discuss the factors that influence the decision concerning which form of enterprise to adopt.
By the end of this unit, you should be able to:-
Most commercial activity occurs because business people (entrepreneurs) see an opportunity to make a profit, that is, to increase their wealth. Given the nature of the free-market economy, with generally free entry and exit into markets, those ventures which yield high returns (profits) are likely to attract new entrants into the industry, thus pushing profits back down to lower levels. Entrepreneurs who find themselves in ventures which are giving low returns will tend to get out of the industry, leaving the more efficient to remain. Given the ever-changing state of the world economy, changes in technology, and a host of other factors, it is clear that business is in an ever-changing state of flux. It is, therefore, not surprising that those who run businesses require information to help them navigate their way through the uncertain environment. In this section, we consider the kind of decisions that business people must make and the way in which accounting information can help them.
In making decisions, entrepreneurs need to be as fully aware as possible of the underlying economic situation, both in terms of general economic conditions, and in terms of the specifics of the particular venture. In order to remain profitable, businesses must be aware of the conditions in the particular market(s) in which they trade. They should be fully aware of the costs they are currently incurring, as well as the current and future prices they expect to be able to charge. Much of this information should be available if records (known as accounts) are kept of the historical transactions in which the business engages. Indeed it is difficult to see how decisions can be made effectively unless records of this sort are kept. Business decision making usually involves choices between alternative courses of action. These alternative courses of action are often subject to constraints of various types. Alternatives are then evaluated, and the decision made. It is usual to then monitor or check the actual decision to see whether in fact the results were in line with what was expected. If not, questions need to be asked. Monitoring can provide useful insights into what went wrong and how to rectify it. Business decisions can cover a multitude of different things. Possible decisions might include:
It is worth pointing out that, in general, we may expect that ventures that carry higher degrees of risk will (on average) achieve higher rates of return. This is because investors will usually only be prepared to take higher risks if they have the opportunity to make higher returns.
Accounting is concerned with the provision of economic information that will be useful to those directly (and to some extent indirectly) connected with an organisation. The information provided should be useful in assessing both the performance of those who manage the organisation and the performance and position of the organisation itself. Once the interested parties have made these assessments, they will be in a position to make more informed economic decisions concerning the organisation. This view of accounting as an aid to economic decision making has been increasingly accepted in recent years. The American Accounting Association adopted this perspective when it defined accounting as 'the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by the users of the information'. Though this is only one of very many published definitions of accounting, it is widely quoted in accounting texts because it emphasises the primary purpose of accounting as providing information that will help users make decisions. This decision-making emphasis is one that you should constantly bear in mind. Many people, including many who work in accounting, consider that accounting is concerned with getting accounting statements prepared each month or each year as if that were an end in itself. While this may describe what some accountants do, it does not describe the purpose of accounting. Unfortunately, some textbooks on accounting do not really emphasise that accounting is not, or should not be, carried on for its own sake. You should never lose sight of the decision-making objective of accounting information.
So accounting exists in order to provide information for interested parties to make decisions, now we can logically ask: 'Who are these interested parties?' and 'For what kind of decisions is accounting information required?' Figure 1.1 shows the major groups of people who have an interest in an organisation. The figure relates to a private sector business but minor alterations in the titles of the participants would make it equally relevant to any organisation - for example, a government department, a local government unit, a charity, a nationalised industry, a school or a college. Owners are concerned with making two types of decisions:
Investment decisions are primarily concerned with increasing the wealth of the owners. Those who own businesses normally do so with the intention of increasing their wealth. Therefore, owners will wish to assess the extent to which the business has generated financial benefits (profits etc.) and the likely future prospects of the business. They will also wish to assess the degree of risk associated with their investment in the business. Information relating to associated risks and returns will be useful when deciding whether to hold or sell their ownership interest in the business.
In larger businesses, the owners tend not to exercise day-to-day control over the activities of the business. Instead, managers will often run the business on behalf of the owners. Although managers are expected to operate the business in the interests of the owners, they do have discretion over the way in which the resources of the business are used and there is, therefore, the potential for conflict between managers and owners. This potential conflict creates a need among owners to receive accounting information from the managers that reveals how the resources of the business have been used. The provision of information by managers to owners for this purpose is referred to as stewardship accounting. This information may be used by owners, among other things, as a basis for rewarding or dismissing managers.
Businesses are taxed on the basis of their accounting profits (subject to certain adjustments); government (in the form of the Inland Revenue) needs information on each business in order to decide how much tax to charge.
A government may also need information relating to a business for regulatory purposes. For example, information relating to costs and profits may be required in order to decide whether policies promoting greater competition are being adhered to or are necessary.
Governments may also use accounting information relating to businesses to help in the general management of the economy. For example, accounting information may be useful in deciding whether to give support to businesses in a particular industry.
The government may award contracts on a 'cost plus' basis (i.e. the cost of supplying the goods or service plus an additional profit element) and therefore will be interested in the costs of goods or services supplied by the contractor. This approach is often used when awarding defence contracts. The government will also be interested to see if businesses are making excessive profits as a result of their dealings with the government. Management The management of the business is the user group who need most accounting information. Managers are charged with planning the activities of the business. They, therefore, require forecast information in order to assess the likely outcome of implementing particular policies in order to decide whether such policies are feasible. Forecast information is also useful in identifying future problems and opportunities for the business, i.e. they may try to ensure that the actual results of the business coincide with the earlier planned results. They therefore require information concerning actual performance and the extent of any deviation from earlier planned performance.
Of course, managers will also be interested in accounting information that measures financial performance of a business as it may be of direct interest to their future prosperity. For example, good performance may result in a bonus being paid whereas poor performance may result in dismissal. (End of Sample Material) |
Introduction
