Accounting is the systematic process of identifying, recording, measuring, classifying, interpreting and communicating financial information about a business. It provides information on the resources available to the business, the means employed to finance those resources, and the results achieved through their use. It reports on the profit or loss for a given period and the value and nature of a firm's assets, liabilities and owners' equity.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
Wilkins Micawber from Charles Dickens' novel David Copperfield.
Of all the business functions, probably none has the universal reach of accounting, which is found in nearly every community in the world. It deals with people and everyday life in the language of numbers. It provides a measure of success and failure; it allows performance of individuals and organisations to be compared; it underpins decision making in business and everyday life; it provides a system of control and allows individuals and organisations to plan for the future.
For the wide range of individuals and organisations affected by a particular business, relevant information can reduce risk and maximise opportunities. Different stakeholders will each have their own concerns and information needs. To satisfy these needs the government and other regulatory and financial bodies impose reporting requirements on businesses under a series of accounting standards (although specific to an individual country there are significant international overlaps). In addition, businesses themselves may volunteer additional information through a range of publications such as annual reports and websites.
As a student you may look at accounts and decide they are 'boring'. However, behind the numbers lies intrigue and deception that could be the script of any best-selling thriller - and indeed was in the 2005 film about the demise of Enron, The Smartest Guys in the Room.
After all, accounts can involve millions or possibly billions of dollars and the temptation to 'fiddle the books' has existed as long as even rudimentary accounts existed. Perhaps the US has suffered most from high profile scandals surrounding companies such as Enron, WorldCom and Tyco, which have left individuals ruined and others in prison with huge corporations like Arthur Andersen collapsing in the aftermath of the financial earthquake.
In the case of limited companies, accounts are public documents and the law lays down the information that must be included and the nature of how this information is reported. There is pressure on every business to make their accounts look as good as possible. The law and accounting regulators attempt to standardise reporting to provide a 'true and fair view' of a business. However, there are still ways that firms can 'window dress' their accounts to present their operations in the best possible financial light. Sometimes this 'financial massaging' of the accounts is legal and sometimes it is not.
The triumvirate of shame - Enron, WorldCom and Tyco
The early part of the millennium saw a number of financial scandals in the US typically involving misuse of funds, overstating revenues, understating expenses, overstating the value of corporate assets or under-reporting the existence of liabilities, sometimes with the cooperation of officials in other organisations, including company auditors.
Enron filed for bankruptcy in December 2001. The former energy giant was undone by accounting fraud and off-the-balance-sheet transactions. In the Enron case, many players were involved in fraud at multiple levels. Investigations implicated several former high level executives and have brought into question the roles of many others. Enron's accounting firm, Arthur Anderson, LLP, was convicted of obstruction of justice, because the firm allegedly destroyed documents pertinent to the Enron case.
The founder of Enron, Kenneth Lay, and the CEO, Jeffrey Skilling, went on trial in 2006. Lay pleaded not guilty to the eleven criminal charges, claiming he was misled by those around him. He faced a total sentence of up to 45 years in prison, but died before sentencing. Skilling was convicted of fraud and sentenced to 24 years and 4 months in prison. The chief financial officer, Andrew Fastow, pleaded guilty to two charges of conspiracy and was sentenced to ten years, with no parole, in a plea bargain to testify against Lay and Skilling.
- The Corporate Scandal - list of all the 2000 - 2002 financial scandals in the US reported in Forbes Magazine.
- Called to Account - the demise of Arthur Anderson reported in Time magazine.
- The Smartest Guys in the Room the trailer for the Enron film
Tyco International, Ltd. a US conglomerate, sold a diverse range of healthcare, security, telecommunications and electronics products worldwide. In 2002, three former top Tyco executives were indicted on fraud charges. Former CEO L. Dennis Kozlowski, former CFO Mark Schwartz, and former legal counsel Mark Belnick allegedly issued themselves low or no interest loans, which they then forgave through an unauthorized bonus program. They concealed their illegal actions from shareholders and other board members by keeping them out of the accounts. Tyco replaced its CEO and most of its Board in an attempt restore its reputation.
Kozlowski and Swartz were convicted on theft charges. Kozlowski was sentenced to no less than eight years and four months and no more than 25 years in prison. Swartz received the same sentence.
In July 2007, Tyco separated into three publicly independent companies.
For a while, WorldCom was the second largest long distance phone company in the US after AT&T. In July 2002, major accounting errors that hid vast amounts of debt led WorldCom to file bankruptcy. Investors were unaware of the company's problems because of the accounting mistakes and intentional cover-ups. Some former top executives of WorldCom were accused of altering transaction and account records to conceal company debt. The company emerged from Chapter 11 bankruptcy in 2004, with about $5.7 billion in debt and $6 billion in cash. In 2005, Verizon Communications agreed to acquire MCI for $7.6 billion.
In 2005, CEO Bernard Ebbers was found guilty of all charges and convicted of fraud, conspiracy and filing false documents and sentenced to 25 years in prison. Other former WorldCom officials were also charged with criminal offences.
Auditing of accounts
All firms are required to have their accounts audited by independent companies to ensure that they present a 'true and fair view' of the financial position of the firm. The auditors accept that they will become legally liable should it be established that they did not exercise due diligence and missed some irregularity or illegality.
However, following Arthur Andersen's audit of Enron, its rapid collapse thereafter as one of the world's major accountancy firms and the spiralling costs of professional indemnity insurance, governments have been forced to introduce the concept of liability limitation agreements to restrict the liability of auditors for claims.
Use of Accounts
There are three main groups of users of published accounts, each of which will be seeking different information for different purposes:
- Internal management who can use financial results as measures of their own performance and success. The accounts form the foundation of future strategic and financial planning.
- Other internal users such as employees and trade union representatives may use the information to support their claims for better term and conditions or for general information about the success or otherwise of the business. The accounts will allow employees to assess their job security.
- External users such as shareholders, customers, suppliers, financial investors and lenders of funds and the government, who want to know how successful and stable the business is and to gain a picture of its profitability, assets, liabilities and future prospects. Shareholders and other investors will want to know how their money was used and how their investment performed. Suppliers will want to know the likelihood of future orders and whether they will be paid if they do supply. The government will want financial information to assess tax liabilities and to support economic planning and reporting.
All companies must provide a set of final accounts including three major accounting statements:
- The profit and loss account (the income statement) calculates the surplus or deficit of income over all of the business costs across a specified period, usually one year. Income can come from trading activity in the form of sales revenue or from non-trading activity such as dividends on shares. Any costs which arise directly or indirectly from the process of selling of products are deducted. The resulting profit and loss after tax and other deductions is ploughed back into the business and this figure transferred to the balance sheet.
- The balance sheet is a summary statement showing the firm's sources of finance and their corresponding use at a given date. It shows the stock of 'assets' a business owns which is balanced against the amount of money a business owes.
- The cash flow (funds flow) statement shows the sources of new funding into the business and how these funds have been used or applied.
Types of financial information
There are two distinct areas of financial information: