Principles of accounting

Principles of accounting
J. Ireland
2790025
2005
Undergraduate study in
Economics, Management,
Finance and the Social Sciences

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This guide was prepared for the University of London External Programme by:
Jennifer Ireland, Department of Accounting and Finance, London School of Economics
and Political Science.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the author is unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable
or unfavourable, please use the form at the back of this guide.
This subject guide is for the use of University of London External students registered for
programmes in the ?elds of Economics, Management, Finance and the Social Sciences
(as applicable). The programmes currently available in these subject areas are:
Access route
Diploma in Economics
BSc Accounting and Finance
BSc Accounting with Law/Law with Accounting
BSc Banking and Finance
BSc Business
BSc Development and Economics
BSc Economics
BSc (Economics) in Geography, Politics and International Relations, and Sociology
BSc Economics and Management
BSc Information Systems and Management
BSc Management
BSc Management with Law/Law with Management
BSc Mathematics and Economics
BSc Politics and International Relations
BSc Sociology.
The External Programme
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University of London
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London WC1H 9EZ
United Kingdom
Web site: www.londonexternal.ac.uk
Published by: University of London Press
© University of London 2005
Printed by: Central Printing Service, University of London, England

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Contents
Contents
Introduction 1
The study of accounting
1
Aims of the unit
2
Learning outcomes
2
Reading 2
Structure of the subject guide
3
How to use the subject guide
4
Examination advice
6
List of abbreviations used in this subject guide
8
Chapter 1: Accounting in context
11
Aims and learning objectives
11
Essential reading
11
Further reading
11
Introduction 11
What is accounting?
12
Accounting theory and practice
15
Accounting information and its uses
16
Financial accounting
16
Management accounting
17
Summary 17
Sample examination question
18
Chapter 2: Fundamentals of ?nancial accounting
19
Aims and learning objectives
19
Essential reading
19
Further reading
19
Introduction 19
An introduction to the ?nancial statements
20
Accounting concepts, bases and policies
27
Summary 29
Sample examination question
30
Chapter 3: Data processing
31
Aims and learning objectives
31
Essential reading
31
Further reading
31
Introduction 31
One transaction: two effects
32
Recording transactions: books of prime entry
34
Getting it right: internal control
37
Double-entry bookkeeping
38
Trial balance
45
Summary 47
Sample examination question
47
Chapter 4: Preparing ?nancial statements 1
49
Aims and learning objectives
49
Essential reading
49
Further reading
49
Introduction 49
Inventory, purchases and sales
50
Accruals and prepayments
53
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Principles of accounting
Bad and doubtful debts
56
Depreciation of ?xed assets
57
Disposal of ?xed assets
60
Summary 61
Examination questions
61
Chapter 5: Preparing ?nancial statements 2
63
Aims and learning objectives
63
Essential reading
63
Introduction 63
Preparing the balance sheet and pro?t and loss account
64
Incomplete information
72
A note on suspense accounts
76
Summary 81
Sample examination question
81
Chapter 6: Preparing ?nancial statements 3
83
Aims and learning objectives
83
Essential reading
83
Further reading
83
Introduction 83
Different formats for different purposes
84
Preparing company accounts
87
Preparing the cash ?ow statement
92
Summary 99
Sample examination questions
99
Chapter 7: Using and understanding ?nancial statements
105
Aims and learning objectives
105
Essential reading
105
Further reading
105
Introduction 105
Ratio analysis
106
Writing a report
117
Summary 118
Sample examination question
119
Chapter 8: Alternative valuation approaches
121
Aims and learning objectives
121
Essential reading
121
Introduction 121
Accounting pro?t and economic income
122
Historic cost accounting and current values
126
Summary 129
Sample examination question
129
Chapter 9: Fundamentals of management accounting
131
Aims and learning objectives
131
Essential reading
131
Introduction 131
Planning and co-ordination
132
Control, communication and motivation
134
Information for decision-making
135
Summary 135
Chapter 10: Cost accounting
137
Aims and learning objectives
137
Essential reading
137
Further reading
137
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Contents
Introduction 137
Understanding costs
138
Stock valuation – marginal costing
141
Stock valuation – full costing
141
Effects of different stock valuation methods
146
Summary 148
Sample examination questions
148
Chapter 11: Making decisions 1
151
Aims and learning objectives
151
Essential reading
151
Further reading
151
Introduction 151
Cost-volume-pro?t analysis
152
Relevant costs
156
Limiting factors
159
Summary 161
Sample examination questions
161
Chapter 12: Making decisions 2
165
Aims and learning objectives
165
Essential reading
165
Further reading
165
Introduction 165
Capital investments
166
Payback period
166
Accounting rate of return (ARR)
169
Summary 171
Sample examination question
171
Chapter 13: Making decisions 3
173
Aims and learning objectives
173
Essential reading
173
Further reading
173
Introduction 173
Discounted cash ?ow techniques
174
Summary 182
Sample examination questions
182
Chapter 14: Planning for the future
185
Aims and learning objectives
185
Essential reading
185
Further reading
185
Introduction 185
Goals and objectives
186
Budgets and forecasts
187
Working capital management
191
Summary 193
Sample examination question
194
Chapter 15: Budgets for control
195
Aims and learning objectives
195
Essential reading
195
Further reading
195
Introduction 195
Standard costs
196
Behavioural effects of using budgets
197
Variance analysis – an introduction
198
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Principles of accounting
Summary 206
Sample examination question
207
Appendix 1: Suggested solutions to selected activities and
sample examination questions
209
Appendix 2: Sample examination paper
280
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Introduction
Introduction
This subject guide is written for those of you who are studying Principles of
Accounting. The unit is intended as a broad introduction to the subject, both
for non-specialist students, and as a foundation for further study in the area.
The study of accounting
From the outside, accounting can appear to be a purely practical subject. It
would be very easy to focus on just the applications of techniques and
procedures. But accounting is more than just a set of calculations; unless
we can understand and interpret the ?gures we produce, the calculations
are pointless!
Accounting provides information for a wide variety of different users and
purposes, and its practices can only be properly understood and assessed in
relation to the economic and social environment in which they are applied.
Therefore there are four aspects to this subject:
1. Techniques for recording, calculation, classi?cation and reporting of
accounting information.
2. The legal and institutional background associated with accounting
information.
3. The economic and administrative problems which the information
is required to solve.
4. The interpretation of reports prepared using 1 in the light of 2 and 3.
The accounting information referred to in 1 need not be ?nancial, although
for our purposes in this unit it will almost always be.
The problems referred to in 3 are largely concerned with the planning of,
and control over, the use of economic resources. They are also concerned
with the measurement of income and of various kinds of value changes.
In order to properly interpret accounting information as in 4, and apply it
to the problems in 3, we need to understand the theory and principles
which underlie the techniques in 1.
The study of accounting is traditionally divided into two parts according to
the types of users of the accounting information. Financial accounting is
primarily concerned with the needs of users outside the business (or other
organisation). Therefore it relates to the external control and management
of resources (for example, by shareholders of the company in which they
have invested their funds, or by banks making loans). A key part of
?nancial accounting is reporting the performance and position of the
business to these external users, via the ?nancial statements. The form
and content of ?nancial statements is usually highly regulated. In contrast,
management accounting is concerned with the needs of users inside the
business. Therefore it relates to the internal control and management of
resources (for example, by the directors, management or employees of a
company). Management accounting statements may be more detailed than
those prepared for external users, and do not normally need to meet any
legal requirements.
Countries around the world organise their economic and ?nancial activities
in different ways so, inevitably, legal requirements, regulation and
administrative procedures also vary across countries. The syllabus is based
on the system pertaining to the UK, but the amount of institutional
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Principles of accounting
material that you need to know is kept to a minimum. Even though the
material in this text is based on the system in the UK, accounting rules and
guidelines around the world are becoming more similar (converging). This
is part of a general drive to harmonise international accounting practices.
It is important to note that a knowledge of UK Statements of Standard
Accounting Practice and Financial Reporting Standards, and of
International Accounting Standards, is not part of the syllabus.
Aims of the unit
The aims of the unit are to:
• introduce you to the principles underlying accounting
• enable you to apply, interpret and explain key accounting techniques
• provide a broad understanding of the theory and practice of ?nancial
and management accounting.
The unit is intended both for non-specialist students, and as a foundation
for further study in the area.
Learning outcomes
By the time you sit the examination, you should be able to:
• distinguish between different uses of accounting information and relate
these uses to the needs of different groups of users
• explain and apply ?nancial accounting concepts and conventions
• prepare basic ?nancial statements from both structured and
unstructured data
• analyse, interpret and communicate the information contained in basic
?nancial statements, and explain the limitations of such statements and
their analysis
• categorise cost behaviour, and prepare and contrast stock valuations
under different costing methods
• describe the budgeting process and discuss the use of budgets in
planning and control
• explain, discuss and apply relevant techniques to aid internal users in
decision-making.
Reading
Essential reading
Glautier, M.W.E. and B. Underdown Accounting theory and practice. (Harlow:
Financial Times Prentice Hall, 2001) seventh edition [ISBN 0273651617].
Further reading
McLaney, E. and P. Atrill Accounting: an introduction. (Harlow: Financial Times
Prentice Hall, 2002) second edition [ISBN 0273655507].
Those who prefer to use a textbook other than that by Glautier and
Underdown (2001) (including if you are using an earlier edition of Glautier
and Underdown) should ensure that all topics outlined in this subject guide
are covered. In addition, you should ensure that appropriate emphasis is
placed on underlying theories and principles, and the ability to explain and
interpret accounting information, as well as the preparation of this
information.
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Introduction
Those who have problems with double-entry bookkeeping may ?nd it
useful to refer to McLaney and Atrill (2002). This text is of general use
as a second source of information and examples for most other areas of the
course. The text also has a companion website.
Supplementary reading
Accounting is an evolving and, at times, controversial subject. You are
encouraged to stay informed of the current issues in accounting. These
issues are often reported in the press, so this may be done by reading the
?nancial pages of a quality daily, or weekly, newspaper. In addition,
specialist publications which are worth reading on a regular basis include
Accountancy, the of?cial monthly journal of the Institute of Chartered
Accountants in England and Wales, and Accountancy Age (available online
at www.accountancyage.com). Journals of other professional accountancy
bodies in the UK and elsewhere are also suitable. Press, comment and
other information can also be found at www.accountingweb.co.uk.
In recent times, accounting for pensions and ?nancial instruments have
been regular features in the UK news. Your country may have very different
accounting issues. You may not be able to understand all the technical
details, but you should try to understand the main arguments. Who do you
think is right, and why? What may be the real motivations behind the
arguments? How do the policy-makers respond? What are the causes of
accounting scandals that occur? What do you think can be done to prevent
these scandals, and why?
Reference books
Collin, P.H. Dictionary of accounting. (London: Bloomsbury, 2004) third edition
[ISBN 0747569916].
Hussey, R. A dictionary of accounting. (Oxford: Oxford University Press, 1999)
second edition [ISBN 019280099X].
Nobes, C. The Penguin dictionary of accounting. (London: Penguin Books, 2002)
?rst edition [ISBN 0141514880].
These (or any similar) dictionaries of accounting provide a quick source of
reference for any new terms you meet in this subject. You may ?nd a
dictionary particularly useful when you approach this subject for the ?rst
time, as accounting terminology can sometimes cause unnecessary
confusion. You should be aware that precise terminology, particularly with
respect to ?nancial reporting terms, may differ from one country to
another. If you do not have a dictionary of accounting, you should be able
to ?nd the information you need in either Glautier and Underdown, or
McLaney and Atrill.
Structure of the subject guide
This subject guide is divided into 15 chapters which, with the exception of
Chapter 1, are organised in two sections:
• Chapter 1 is a general introduction to the subject, which also
distinguishes between ?nancial and management accounting.
• Chapters 2–8 form Section 1 on ?nancial accounting. This section
introduces and explains ?nancial accounting concepts and conventions,
and provides a grounding in double-entry bookkeeping and the
preparation of basic ?nancial statements. This section also enables you
to analyse and interpret the information contained in these ?nancial
statements, and to explain their limitations, with reference to
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Principles of accounting
underlying theories and principles. Although a grounding in double-
entry bookkeeping is provided, you should note that it is possible to
prepare basic ?nancial statements from both structured and
unstructured information without making use of this technique;
double-entry bookkeeping is used by businesses to record ?nancial
transactions as they occur, but if this data is already provided then it
can be directly manipulated for ?nancial reporting purposes.
• Chapters 9–15 form Section 2 on management accounting. This section
introduces a range of management accounting applications and
techniques for planning, decision-making and control. These techniques
are supported by discussion of the underlying theories and principles,
and emphasis is placed on the ability to interpret and critique their use.
• Finally, Appendix 1 gives some suggested solutions to the exercises
and sample examination questions set in the chapters. Appendix 2
contains a sample examination paper and extracts from interest
(discount factor) tables.
How to use the subject guide
This subject guide is intended to supplement the essential reading
indicated in the text, not to replace it. The guide relies on the
recommended text (Glautier and Underdown) to provide the theoretical
grounding for the material and for many de?nitions, examples and
explanations. The subject guide:
• provides a framework for your study of the subject using the
recommended text
• contains aims and learning objectives for each topic, and references
to the essential and further reading
• acts as a pointer to the most important issues dealt with in the reading
• provides additional explanations where appropriate
• contains additional worked examples, exercises for you to work through
yourself, and sample examination questions.
It is important to attempt all the exercises and to ensure you take the time
to fully understand the material covered in each chapter of the subject
guide.
You should complete Chapter 1 ?rst of all, before progressing to the other
sections of the guide. Thereafter, you are strongly advised to attempt the
work relating to ?nancial accounting (Section 1) in the order in which it is
presented in the guide. However, you may progress to Section 2
(management accounting) before attempting Chapters 7 and 8.1 Although
1 It is important to study
it is also important to attempt the work relating to management accounting
Chapters 2–6 on ?nancial
in the general order in which it is presented in the guide, Chapters 14 and
accounting before starting the
material on management
15 may be attempted (in that order) at any time after you have completed
accounting, because you will
Chapters 9 and 10.
need to understand both
terminology from the ?nancial
It is also possible to leave part of Chapter 3 (Data processing) and return to
accounting material, and the way
it at a later date, if it is causing you problems. The section of this chapter
that ?nancial statements ?t
together, in order to understand
that you may return to later deals with double-entry bookkeeping. You
all of the material on
will see that it is not necessary to perform double-entry bookkeeping when
management accounting.
preparing ?nancial statements from structured and unstructured
information. The most important part of this chapter to understand before
progressing onwards is the interpretation, rather than the production,
of the trial balance.
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