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1 Accounting in Context

1.1 Introduction

When we reflect broadly upon accounting and its roles in organizations and society, different dimensions can be highlighted. In fact, accounting may be seen as a technical practice alone or may be more broadly conceived as a social practice, with implications for social and organizational functioning, that goes beyond the consideration of accounting as a neutral, if not benign, technical practice [1, p. 481]. Additionally, it is important to acknowledge that “accounting goes on at a more macrosociological level than is commonly assumed” and that accounting rules can be considered “not as features of particular organizations, but as properties of institutional domains, national societies, or now the evolving world” [1, p. 484; 2, p. 348, 354].

This broader nature of accounting allows us to identify different images of accounting [3]: accounting as an ideology ; accounting as a language ; accounting as a historical record ; accounting as a current economic reality ; accounting as an information system ; accounting as a commodity ; accounting as symbolic rituals ; accounting as rationale ; accounting as imagery ; accounting as experimentation ; and accounting as distortion . So, the question that emerges is: what is accounting?

1.2 What Is Accounting?

In a simplified way, accounting is the “language of business ”. Unless you can understand accounting, you will not understand business. But it is a very special and a living language [4], with its own symbols that allow to describe any business activity.

To fully understand the business, it is necessary to understand the language/concepts of accounting. The accounting language is strong and flexible enough to change as society changes, being determined by the context in which it operates (e.g. cultural, political, economic, technological and social factors). Therefore, accounting has been recognized as a social and institutional practice [5–7].

A broad definition of accounting that has stood the test of time is the one provided by the American Accounting Association (AAA). Accordingly, accounting is defined as “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information” [8].

This process comprises three phases: to identify economic events relevant to business; to count and measure; and to communicate the collected information in an aggregated way to interested users.

Accounting is not only about the production of accounting information (which comprises the functions of recording, classification and measurement ), but also concerns the uses of the information produced (related to the following functions: information for decisions, management control and communication).

Accounting is an essential tool to support decision-making process and for accountability and reporting. The decisions are based on financial and non-financial information. Historically, accounting information has been financial, but accounting is increasingly being used to address the social, environmental, economic and governance concerns.

1.3 From Medieval Times to the Present

Although pervasive in all aspects of the public and private domains in our society, accounting has a long history. Several studies positioned the origins of bookkeeping in ancient civilizations, dating back to about 4000–3000 B.C., such as Babylonian, Assyrian and Sumerian civilizations, with some rudimentary forms of record-keeping [3, 9]. Bookkeeping went through significant changes with the Egyptian civilization, where the scribes had an important status in society; with the Greek Civilization, where the accounts of the Athenian State where made available to public scrutiny; and the Roman civilization, where laws were issued imposing the elaboration by taxpayers of statements of their financial positions [10]. The changes that bookkeeping went through the ancient world have “been attributed to various factors, including the invention of writing, the introduction of Arabic numerals and of the decimal system, the diffusion of knowledge of algebra, the presence of inexpensive writing material, the rise of literacy, and the existence of a standard medium of exchange” [3, p. 2; see also 10, 11].

The period of the Middle Age is considered as a period of stagnation for bookkeeping in the European context, and it is only around the fourteenth century that developments in bookkeeping happened and resulted in the use of double entry bookkeeping [10]. Previous to the development of double entry bookkeeping, the technique used to keep the accounting books was single entry bookkeeping or charge and discharge accounting. Charge and discharge accounting covers a wide range of accounting systems, which operate on a single entry [11]. As common features it can be highlighted “that they are accounts of an individual rather than an organization, […] they cover the flow of resources over a period of time, and they make no distinction between capital and revenue transactions” [11, pp. 33–34]. As defined by Vangermeersch [12, p. 533], “Single entry bookkeeping is generally associated with accounting books containing only cash and personal (people and organizations) accounts (…)”. The main book used was the Memorial where data were presented in a narrative or paragraph form, or presented in separate lines with figures in columns [11].

However, to meet with the growing business requirements, in particular the increasing level and complexity of trading operations, this method evolved with an increasing number of books being used and adapted, which resulted, at a certain point in time, in the double entry bookkeeping system [11]. This can be summarized as a system in which every transaction has a corresponding positive and negative entry (debits and credits) in a closed system of accounts, which include five categories: persons, values, cash, income and capital. This system has the following key features: (a) keeping of accounting records based on monetary measurement ; (b) distinguishing between capital and income when analysing and classifying business transactions; and (c) the integrating role of the capital accounting, which is the recipient of all gains and losses, and the inherent state of balance between Assets and claims on those assets, also named Liabilities and Proprietorship [13, p. 311]. The characteristics of double entry bookkeeping can be summarized through the accounting equation: Assets – Liabilities = Proprietorship or Owner’s Equity . As main books, the system uses the Journal and the Ledger, which contains accounts of each asset and liability of the business and of the amount invested (capital) of the owner [14, pp. 372–373]. To simplify the organization of the information, the different elements are structured in accounts, where an account comprises the elements of the patrimony of an entity with similar characteristics. By convention, it has been assumed the following structure of the account, representing the ledger book opened:

As rules to register the movements in the accounts, it has been established, as a convention, the following:

 

Debit

Credit

Asset

+

−

Liability

−

+

Revenue

 

+

Expense

+

 

Capital

−

+

  1. Note + means Increase in the patrimonial element; − means Decrease in the patrimonial element

To exemplify the use of both single and double entry bookkeeping, let us use the following example: The merchant bought chairs and a desk for 300 euros, paid in cash.

By using single entry bookkeeping , this transaction implies an expense and since it was paid the entry would be made only on the cash account: Decrease on the cash account.

By using double entry bookkeeping and for the accounting equation to be balanced, at least two accounts have to be used: Increase of Chair and Desk (Increase Asset) and Decrease in Cash (Decrease Asset).

But where and how this method was developed and how it spread throughout Europe? It is accepted that the method emerged by the end of the Middle Age in the Northern Italian cities (Genoa, Florence and Venice) where Italian merchants were the leading businessmen of Europe, with a superior organization when compared with the other European countries [15, 16]. These Italian cities were until the fifteenth century the most developed in intellectual capability such as through education, writing, reading and arithmetic [17]. In fact, while some authors claim that the oldest records using double entry bookkeeping belonged to the Farolfi company (1299–1300) [18], others argue that the earliest records using double entry bookkeeping belonged to a municipality, the Massari of Genoa (1340) [19, 20].

The diffusion throughout Europe of double entry bookkeeping was stimulated in the fifteenth century by an important innovation—the printing press, and by the publication in 1494 of the first printed book on double entry bookkeeping Summa de Arithmetica, Geometria, Proportioni et Proportionalita written by Fra Luca Pacioli [11]. This invention made possible, and stimulated in the following centuries, the publication of a considerable number of accounting books that were widely diffused and accessible to a considerable number of literate and numerate people who previously did not have access to this instructional literature. In general, the vehicles of transfer used in the diffusion of double entry bookkeeping were books, foreign merchants and schools. Pacioli’s pivotal book was an important instrument of diffusion, since it was translated into other languages and exerted a strong influence on the books published subsequently by authors from different countries [11, 21, 22]. However, the technique was not adopted on a large scale and many business men continued to routinely use simple, traditional accounting procedures they were accustomed to using. It was only after 1850 that double entry bookkeeping was adopted by a majority of businesses in Europe with the “manufacturing corporation, the income tax, and the emerging accounting profession as major stimulants” [23, p. 61]. The fact is that accounting theory and practice, in both financial and management accounting , either in private or in public institutions, went through considerable changes through the centuries, but double entry bookkeeping remains as the method still used in accounting today when preparing accounting information for different users, while single entry bookkeeping is only used for individuals and very small businesses.

1.4 Who Are the Users of Accounting Information and What Are Their Needs?

The accounting definition provided in Sect. 1.2 refers to the users of economic information and the decisions they make. Who are the users of accounting and why they need accounting information? The primary user of the accounting information is the business itself. In running a business , managers (e.g. finance directors, marketing managers and production supervisors) need past and prospective data for strategic and operational planning, for decision-making and for management control. Managers are named internal users of the accounting information. To these, information is accessible on an ongoing basis and its availability depends on the company itself.

In addition, there are individuals and organizations outside the entity who want financial information about the business. They are the so-called external users including present and potential investors, lenders, suppliers and other trade creditors, customers, competitors, employees, governments and their agencies, and the general public.

The information that each user needs depends upon the kinds of decisions the user makes. Table 1 illustrates some of the needs that accounting information may help to accomplish.

Table 1 Users of accounting and needs for information of accounting users
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Though all the information needs of these users cannot possibly be met directly and on an ongoing basis, there are needs that are common to all users. These common needs are met through entity’s preparation and presentation of general purpose financial statements (referred to as “financial statements”).

1.5 Financial Accounting and Management Accounting

There is only one discipline of accounting. As stated in Sect. 1.2, accounting identifies, measures and communicates financial information about economic entities to interested parties. However, a commonly distinction is made between financial accounting and management accounting , with the first being targeted primarily at those outside the business . Financial accounting (or general accounting, or financial accounting and reporting) is responsible for the preparation of financial reports on the entity for use by both internal and external users . While internal parties may require and have the power to obtain detailed information about the enterprise, most of the external users (e.g. investors, creditors, unions and government agencies) have to rely on the output of financial accounting— financial statements or accounts—as their major source of financial information. Financial statements form part of the process of financial reporting and are prepared and presented at least annually. The main components of a complete set of financial statements include the following, according to paragraph 10 of IAS 1:

  • a statement of financial position as at the end of the period;

  • a statement of profit or loss and other comprehensive income for the period;

  • a statement of changes in equity for the period ;

  • a statement of cash flows for the period;

  • notes, comprising significant accounting policies and other explanatory information [25].

On the other hand, management accounting (or internal accounting) covers the internal accounting of an organization. It is responsible for tailoring information that managers and decision-makers inside the company need to plan, control and evaluate an entity’s operations. Management accounting identifies, measures, analyses and communicates to the managers information about resources that are used in the various business processes constituting the firm. Management accounting covers several areas: product cost issues, business-process cost analyses, budgeting, analysis of deviations from plans, management performance, strategic accounting and among others. Management accounting helps understanding how value is created so as to assist internal decision-makers.

2 Fundamentals of Financial Accounting

2.1 Core Concepts

Financial accounting is concerned with the identification, capture, record, process and presentation of the economic events (e.g. acquisition of resources, selling the firm’s output, payment of the monthly wages, obtaining a loan) that take place between the company and the outside partners (e.g. suppliers, customers, tax authorities, and financial institutions). To allow the valuation of transactions, events have to be materialized by documents (e.g. invoices, receipts, bank statement, contracts, tax and social security filings) that comprise both financial and non-financial elements. Documents are chronologically recorded, classified and analysed so as to permit for the periodic construction of synthetic reports, the financial statements .

Financial accounting involves both the preparation and the use of information to facilitate economic decision-making of individuals and organizations. This goal is also enclosed in the objective of general-purpose financial reporting defined by the International Accounting Standards Board (IASB ), the international accounting standards setter, in its Conceptual Framework for Financial Reporting .Footnote 1 Accordingly, the purpose of financial reporting is “to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity” (Conceptual framework, §1.2) [26]. While a wide range of parties may be interested in financial reporting, the IASB considers decision usefulness to capital providers (present and potential investors, lenders and other creditors) as the overarching objective.

The attributes that make the information provided in financial statements useful to users are called fundamental qualitative characteristics . If financial information is to be useful, it must be relevant and faithfully represent what it purports to represent (Fig. 1). Relevant accounting information is the one that is capable of making a difference in a decision. Information with no bearing on a decision is irrelevant. Financial information is capable of making a difference when it has predictive value, confirmatory value (it helps to confirm or revise their previous evaluations), or both (Conceptual framework , §§2.6–2.10) [26]. The second fundamental quality of accounting information is faithful representation. Faithful representation means that the numbers and descriptions match what really existed or happened. Faithful representation is necessary because most users have neither the time nor the expertise to evaluate the factual content of the information. Faithful representation represents the substance of an economic phenomenon rather than merely representing its legal form. To be a faithful representation, information must be (1) complete (it includes all information that is necessary for faithful representation), (2) neutral (free of bias), and (3) free of material error. For information to be neutral, it has to be prudent. Prudence is defined as the exercise of caution when making judgements under conditions of uncertainty (Conceptual framework , §§2.14–2.19) [26].

Fig. 1
figure 1

Qualitative characteristics of financial reporting information

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Adding to the fundamental qualitative characteristics, there are also the enhancing characteristics of useful financial information. These are characteristics that are complementary to the fundamental qualitative characteristics and help distinguish, for decision-making purpose , more useful information from less useful information. Enhancing characteristics of accounting information are given as: (1) comparability (to be useful, information about an entity has to be comparable, with similar information about other entities and with similar information about the same entity for some other period), (2) verifiability (different knowledgeable and independent observers could reach general consensus about the economic phenomena that is represented), (3) timeliness (to influence decisions information has to be available before it loses its opportuneness) and (4) understandability (users, who have a reasonable knowledge of business and economic activities and are able to read a financial report, comprehend the meaning of the information) (Conceptual framework , §§2.22–2.37) [26].

In providing information, companies must consider an overriding factor that limits the reporting. This constrain is cost . Cost constraint means that companies must weigh the costs of providing the information against the benefits that can be derived from using it. The benefits perceived to be derived from information must exceed the costs perceived to be associated with its preparation (Conceptual framework, §§2.38–2.42) [26].

Financial statements portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics. These basic building blocks are called the elements of financial statements. Assets , liabilities and equity are the elements of the statement of financial position and are associated with the measurement of an entity’s financial position (usually called balance sheet ). Income and expenses are the building blocks of the statement of profit or loss and are related to the measurement of performance. The definitions presented in the 2015 IASB Conceptual Framework are as follows:

  • Assets are present economic resources controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits (Conceptual framework, §§4.5–4.23) [26]. Examples of assets are lands, buildings, industrial equipment, furniture, inventory, cash, bank deposits, patents or licenses, equity investments, receivables and short-term investments.

  • Liabilities are present obligations of the entity to transfer an economic resource as a result of past events. A present obligation is an obligation to transfer economic resources that (a) the entity has no practical ability to avoid; and (b) has arisen from a past event (i.e. economic benefits already received or activities already conducted) (Conceptual framework, §§4.24–4.42) [26]. Liabilities include, for example, bank loans and overdrafts, accounts payables, tax liabilities, pension obligations and provisions for legal risks.

  • Equity is the residual interest in the entity’s assets after deducting all its liabilities. Therefore, equity is claims that do not meet the definition of a liability and are established by contract, legislation or similar means. Although equity is defined as a residual, it may be subclassified in the balance sheet into various types of capital and reserves, such as shareholders’ capital, retained earnings, statutory reserves, and tax reserves (Conceptual framework , §§4.43–4.47) [26].

  • Income is increases in assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from holders of equity claims (Conceptual framework, §4.48) [26]. Sales, services rendered, assets yielding interests, royalties, and dividends are examples of incomes.

  • Expenses are decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims (Conceptual framework, §4.49) [26]. Examples of expenses are the cost of goods sold , salaries and social charges, utility costs (electricity, water and telephone), advertising costs, interest expenses, insurance premiums, and depreciation and amortization of certain assets.

Though income and expenses are defined in terms of changes in assets and liabilities, information about income and expenses is just as important as the information provided by assets and liabilities (Conceptual framework, §4.52) [26].

Only items that meet the definition of an asset, a liability or equity are recognized in the statement of financial position and only items that meet the definition of income or expenses are to be recognized in the statement(s) of financial performance. Recognition involves depicting items in words and by a monetary amount, and including that amount in totals in the relevant statement. Nevertheless, recognition depends on three criteria: their recognition provides users of financial statements with (1) relevant information about the asset or the liability and about any income, expenses or changes in equity, (2) a faithful representation of the asset or the liability and of any income, expenses or changes in equity, and (3) information that results in benefits exceeding the cost of providing that information (Conceptual framework , §§5.9–5.24) [26].

The prevailing objective of financial reporting is providing information that is decision usefulness to a large number of users. Consequently, there are several accounting principles (also called assumptions, conventions and concepts) which underpin the preparation of the financial statements. These could be behavioural rules or very operational guidelines about practice. There are two overriding assumptions underlying financial statements. These are the going concern and the accrual basis assumptions.

The financial statements are normally prepared assuming the entity is a going concern and will continue in operation for the foreseeable future, with neither the intention nor the necessity of liquidation, ceasing trading or seeking protection from creditors pursuant to laws or regulations (Conceptual framework, §3.10) [26]. The assessment of an entity’s ability to continue as a going concern is responsibility of the entity’s management. This involves making a judgement, at a particular point in time, taking into account “all available information about the future which is at least, but is not limited to, twelve months from the end of the reporting period” (IAS 1, §26) [25]. If management has significant concerns about the entity’s ability to continue as a going concern, the uncertainties must be disclosed. If management concludes that the entity is not a going concern, then the financial statements should not be prepared on a going concern basis, in which case IAS 1 requires disclosure the reasons why and the basis on which it prepared the financial statements (IAS 1, §25) [25].

The other underlying assumption is the accrual basis. Under this basis, the effects of transactions and other events are recognized when they occur and not when cash or its equivalent is received or paid. Therefore, transactions and other events are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Using the accrual basis to determine net income means that a company recognizes income when it provides the goods or services rather than when it receives cash or its equivalent. Similarly, it recognizes expenses when it incurs them rather than when it pays them. For example, an energy bill owing at the accounting year end is thus treated as an expense for this year even if it is paid in the next year. In other words, net income must include all and only the income/expenses that have been earned/consumed during the accounting period. IAS 1 in paragraph 27 defines that “an entity shall prepare its financial statements , except for cash flow information, using the accrual basis of accounting” [25]. Financial statements prepared on an accrual basis better informs about the entity’s present and continuing ability to generate favourable cash flows than does information limited to the financial effects of cash receipts and payments .

To a large extent, financial reports are based on estimates, judgements and models rather than exact representations. Measurement systems are fundamental to the determination of net income and to the measurement of net assets. Considering the objective of financial reporting, the qualitative characteristics of useful financial information and the cost constraint, there are different measurement bases for different assets , liabilities and items of income and expenses.Footnote 2 Measurement “is the process of quantifying, in monetary terms, information about an entity’s assets, liabilities , equity , income and expenses ” (Conceptual framework , §6.2) [26]. Measurement bases discussed in the 2015 IASB Conceptual Framework include the historical cost and current value bases (§6.4).

The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost, which is usually combined with other measurement bases (e.g. inventories are usually carried at the lower of cost and net realizable value). Under the historical cost, assets are recorded at the amount of cash (or cash equivalents) paid to acquire them. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy its liability. Although easy to use, historical cost measures of assets or liabilities do not reflect changes in prices. However, we do not use historical cost comprehensively in financial statements today. Measures based on historical cost do reflect changes such as the consumption or impairment of assets and the fulfilment of liabilities. This means that the historical cost of non-financial assets (e.g. property, equipment and patents) is adjusted over time to depict the depreciation or amortization of the assets (consumption), and/or the fact that part of the historical cost of the asset is no longer recoverable (impairment). Historical cost base also includes the amortised cost ,Footnote 3 the deemed cost Footnote 4 and the current cost .Footnote 5

In addition to measures based on historical cost , there are current value measurement bases, which include (1) fair value , and (2) value in use for assets and fulfilment value for liabilities . These provide monetary information about assets , liabilities, income and expenses using information that is updated to reflect conditions at the measurement date. Therefore, current values reflect any positive or negative changes, since the previous measurement date, in estimates of cash flows and other factors included in those current values (Conceptual framework , §§6.19–6.20) [26].

Fair value is determined from the perspective of market participants (e.g. estimates of future cash flows, uncertainty inherent in the cash flows and the time value of money) and is defined as “the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date” (Conceptual framework , §6.21) [26]. Fair value measurement is simple and verifiable if fair values can be observed in active markets. When it is not the case, valuation techniques (that can include the use of cash-flow-based measurements) may be needed to estimate that fair value. Consequently, identical assets or liabilities may be measured at different amounts.Footnote 6 IFRS 13-Fair Value Measurement sets out a framework for measuring fair value and requires disclosures about fair value measurements [13]. To increase consistency and comparability in fair value measurement s and related disclosures, IFRS 13 establishes a fair value hierarchy that categorizes into three levels the inputs to valuation techniques used to measure fair value. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability (IFRS 13, §§72–90) [29].

Contrasting to fair value , value in use and fulfilment value are determined from the entity perspective. They are defined as the present value of the cash flows that an entity expects: (1) to derive from the continuing use of an asset and from its ultimate disposal, in the case of the value in use; (2) to incur as it fulfils a liability, in the case of the fulfilment value. Value in use and fulfilment value cannot be directly observed on the market, so they are determined using cash-flow-based measurement techniques (Conceptual framework, §§6.34–6.46) [26].

To select a measurement basis, the qualitative characteristics of useful financial information should be taken into consideration. Therefore, for information provided by a particular measurement basis to be useful, it must be relevant (e.g. what information it will be produced about both financial position and financial performance; how the asset or liability contributes to future cash flows; what are the characteristics of the asset or liability; what is the level of measurement uncertainty) and it must faithfully represent what it purports to represent (e.g. there should be a consistent use of measures for related items). In addition, the information provided should be comparable (that is, using the same measurement bases between periods and between entities), verifiable (implies using measurement bases that result in measures that can be independently corroborated), timely (this characteristic has no implication in the chosen measurement base) and understandable (depend on the number of different measurement bases used and on whether they change over time). In addition, as with all other areas of financial reporting , the cost constraint affects the selection of a measurement basis (Conceptual framework , §§6.53–6.63) [26]. The accounting standards, analysed in the following section, should define the appropriate measurement bases for each element of the financial statements .

2.2 Nature and Purpose of Accounting Standards

The users of financial statements, identified in Sect. 1.4, need to understand financial information in the same way. Accordingly, financial accounting is based on a set of rules and accounting standards. Accounting standards “include specific principles, bases, conventions, rules and practices necessary to capture the data and prepare the financial statements” [4, p. 15]. Originally, due to different political economic, social and cultural backgrounds, each country, through its regulatory bodies and/or professional accountancy bodies, has issued its own accounting standards or financial reporting standards.

However, since the middle of the twentieth century, the scenario of businesses has become increasingly global. Therefore, financial reporting is taking place in an international context that is characterized by impressive growth in international trade and foreign direct investment; cross-border mergers and acquisitions; the rise of multinational corporations; the widespread ownership of modern corporations; changes in world politics; an unstable international monetary system; and global international capital markets [30, 31]. Within this global scenario, “narrowly national views of accounting and financial reporting can no longer be sustained” [30, p. 5].

Pressures for common accounting standards—that is for accounting harmonization—have come from users, preparers and regulators of financial statements. But it was the globalization of the capital markets that brought to the forefront the increasing need for more comparable and reliable financial information. The major player promoting international accounting harmonization nowadays is the IASB , whose origins go back to the formation of its predecessor, the International Accounting Standards Committee (IASC) in 1973.

The IASB is the standard-setting body of the IFRS Foundation that aims to “develop a single set of high-quality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles” [32]. Since its initial standardsFootnote 7 characterized as insufficiently prescriptive, and that often permitted the use of almost all the accounting treatments existing in the world, to its current International Financial Reporting Standards (IFRS ), the IASB has come a long way. IFRS are, nowadays, followed by overseas registrants in most of the world’s stock exchanges, supported by international organizations (e.g. EU, G20, World Bank, IMF, IOSCO, Basel Committee), national accounting standard setters, governments, developing and emerging countries. Today, almost 120 countries require or permit the use of IFRS by public companies [32]. IFRS are a generally principles-based set of standards that covers all accounting and financial reporting topics. IFRS prescribe (1) the items that should be recognized as assets, liabilities , income and expense; (2) how to measure those items; (3) how to present them in a set of financial statements; (4) and related disclosures about those items. Table 2 presents the standards in force as on August 2015.

Table 2 IAS and IFRS as of 1 August 2015 (in brackets, the year of the original issue or major amendment)
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As stated, the IASB is an independent, private sector standards setter that has no authority to mandate or supervise the adoption of IFRS. Countries need to establish their own mechanisms for bringing IFRS formally into national law and for ensuring consistent and rigorous application. For the increased legitimacy and stature of the IASB worldwide, much has contributed the European Union’s “Regulation No 1606/2002 on the application of International Accounting Standards” (known as IAS Regulation) that requires European companies, listed on a regulated market, to prepare consolidated accounts in accordance with the IASB standards, from 2005 onwards [33].Footnote 8 The IAS Regulation gives member states the option to require or permit IFRS as adopted by the EU in separate company financial statements (statutory accounts) and/or in the financial statements of companies whose securities do not trade on a regulated securities market. The approval of this Regulation is responsible for a radical change in the financial reporting and framework in most of the European countries and beyond.Footnote 9

Despite the widespread global adoption of IFRS , international differences in corporate financial reporting remain. IFRS accounts are still influenced by pre-IFRS national accounting and reporting traditions. “This is partly because IFRS is used in many countries only for consolidated statements, and partly because different national versions of IFRS practice exist” [30, p. 19].Footnote 10 A profile about the use of IFRS in individual jurisdictions (the G20 jurisdictions plus 120 others) is available at http://go.ifrs.org/global-standards.Footnote 11

2.3 Accounting Process and Financial Statements

Financial statements are the final output of the accounting process. The accounting process consists in a structured multiset progressive classification and aggregation process of elemental data [4]. This relies on the use of technical tools and requires human intervention and interpretation. The accounting process includes four stages: analysis of supporting documents; posting to accounts; control; and synthesis [4].

In the stage of analysis of supporting documents, the document materializes each accounting transaction and is the basis for an entry in a journal. This accounting tool provides a chronological list of all transactions and it depends on the computer software.

Then the effects of the accounting events are transferred to (posted to) the specialized ledgers and the general ledger where the components of the description of the transaction are structured by nature and/or type of transaction. The posting to accounts’ stage is a purely mechanical task.

The third stage of accounting process is control. Detailed individual accounts entries are grouped together and replaced by the balance of the aggregated account, and recapitulated in the trial balance. The aim is to check that the sum of all the debit entries or balances is equal to the sum of all the credit entries or balances.

Finally, the synthesis of the accounting process is materialized in financial statements , also called “accounts”. According to IAS 1, paragraph 36, “an entity shall present a complete set of financial statements (including comparative information) at least annually. (…) Normally, an entity consistently prepares financial statements for a one-year period” [25]. Usually that date coincides with the end of civil or fiscal year. As reported in Sect. 1.5, the balance sheet , the profit or loss statement , the notes to financial statements, the statement of changes in equity and the cash flows statement constitute a complete set of financial statements. The first three documents are the minimum reporting required by a large majority of countries.

  • Balance sheet

The balance sheet reports on a company’s financial position at a point in time. Assets, liabilities and equity are the elements of the balance sheet, which shows the accounting equation or balance sheet equation:

This equation keeps balanced due to the double entry accounting.

Assets are divided into two categories: current and non-current assets . According to IAS 1, paragraph 66 [25], “an entity shall classify an asset as current when: (a) it expects to realise the asset, or intends to sell or consume it, in its normal operating cycle; (b) it holds the asset primarily for the purpose of trading; c) it expects to realise the asset within twelve months after the reporting period; or (d) the asset is cash or cash equivalent (…) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period. An entity shall classify other assets as non-current”.

The main categories of current assets are inventories (e.g. merchandise, raw materials, work-in-process and finished products), receivables (accounts receivable) and cash. Non-current assets are divided into tangible assets (e.g. property, plant and equipment), intangible assets (e.g. trademarks, patents or software) and financial assets (e.g. shares or bonds of another business , or the representation of medium- or long-term credit extended to a third-party business).

As assets, liabilities are also divided into current and non-current liabilities . According to IAS 1, paragraph 69 [25], “an entity shall classify a liability as current when: (a) it expects to settle the liability in its normal operating cycle; (b) it holds the liability primarily for the purpose of trading; c) the liability is due to be settled within twelve months after the reporting period; or (d) it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period (…). An entity shall classify other liabilities as non-current”.

As stated before (Sect. 2.1), although equity is defined as a residual, it may be sub-classified in the balance sheet into various types of capital and reserves, such as shareholders’ capital, retained earnings, statutory reserves, tax reserves (Conceptual framework , §4.45) [26]. In a simple way, equity increases through investments by shareholders and positive net income (profit ) from business operations, and decreases through negative net income (loss) and dividends’ payment . So, the net income of the current accounting period is a component of equity .

  • Profit or loss statement

The profit or loss statement reports on a company’s performance over a period of time (between two balance sheet dates), presenting the income, expenses and the difference between them. This difference (income less expenses) yields the bottom-line net income amount. When income exceeds expenses, the entity got positive net income (after tax) or profit during the accounting period; otherwise, the entity got a negative net income or loss. At the end of the accounting, period net income or loss amount is transferred to equity in the balance sheet.

  • Statement of changes in equity

The statement of changes in equity includes, for each component of equity, a reconciliation between the carrying amount at the beginning and the end of the period (IAS 1, §106) [25].

  • Statement of cash flows

A statement of cash flows summarizes information concerning the cash inflows (receipts) and outflows (payments) for a specific period of time, providing “users of financial statements with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilise those cash flows” (IAS 1, §111) [25].

  • Notes

In Notes, the entity explains and gives more details that complement the remaining financial statements . Notes shall present information about the basis of preparation of the financial statements and the specific accounting policies used, disclose the information required by accounting standards that is not presented elsewhere in the financial statements, and provide information that is not presented elsewhere in the financial statements, but is relevant to an understanding of any of them (IAS 1, §112) [25]. Notes should be systematically presented, and each item in the statements should be cross-referenced to the relevant note.

  • Links between financial statements

Financial statements reflect the economic activity of the company and are a means to communicate the companys’ financial strength and the profitability of the business . Financial statements provide a comprehensive and synthetic portrait of the business and are able to satisfy the users’ different needs for information. Financial statements are intricately linked, as shown in Fig. 2.

Fig. 2
figure 2

Links between financial statements. Source [4, p. 92] adapted

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3 Cost Accounting and Management Accounting

3.1 Fundamentals of Management Accounting

As mentioned before, financial accounting provides information for external users , notwithstanding accountants also seek to produce the information necessary for internal users to have a better understanding about how they can increase value to the organization (entity).

The business performance is considerably better as more appropriate and effective is the accounting information system , and the performance of accounting information system will be better when its contribution to decision-making leads to improved business performance [36]. Therefore, and different from financial accounting, as described previously, management accounting , or cost accounting , produces information that is designed for managers , and “because the managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information in other organizations” [37, p. 6].

As Fig. 3 represents, the accounting processes, which aim to identify, measure and communicate all relevant economic information for the assessment and assist the decision-making, are the objects of the study of management accounting . Therefore, the performance of management will increase when the management accounting processes achieve the purposes of its existence. For this to happen, management accounting must seek to adapt the models, tools and techniques so that the information produced is appropriate and necessary for decision-makers.

Fig. 3
figure 3

Accounting information system. Source [36, p. 30] adapted

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Management accounting, also named internal accounting, aims to produce the required information to help managers developing a better understanding of an entity’s costs . This is the first step for managers to add value to the organization. The information provided by management accounting is useful for all kinds of organizations, whether for small or larger organizations, profit and non-for-profit organizations, or even government agencies. However, the benefits from an improved cost/management accounting system “come from better decision making. If the benefits do not exceed the cost of implementing and maintaining the new accounting system, managers will not implement it” [37, p. 9].

Since the goal of management accounting is to assist the decision-makers (managers) in obtaining the maximization of the entity’s value, internal accounting seeks to anticipate the impact of future decisions of decision-makers. In particular, management accounting pays considerable attention to cost and the way income of a specific period is obtained. However, accounting allows the establishment of three types of performance results through different perspectives: (i) economic competence; (ii) financial competence and (iii) cash competence.

In this context, and as presented in Fig. 4, the performance result obtained by the economic competence flow is obtained by subtracting costs to the income. On the other hand, the performance result for the financial competence flow is obtained by subtracting the expenses to the revenues . And yet, the performance result obtained by the cash flow competence is obtained by subtracting payments to the receipts.

Fig. 4
figure 4

Competence flow

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Although the definitions of accounting concepts have been provided earlier based on the international accounting standards , in cost/management accounting it is important to detail differently some concepts, as follows:

Income : Income is the benefit obtained by an intentional asset delivery of activity from the organization and susceptible to monetary quantification (e.g. value of goods produced and/or sold , delivery of a service, rent of a property, exploration grant).

Revenue: Revenue is the right to receive a monetary amount or equivalent (e.g. sales invoice, attributed subsidies).

Receiving : Receiving is the effective input on cash or equivalent means (implies a receipt or equivalent document).

Cost : A cost is an intentional sacrifice of resources. The cost is related to the core of the business and susceptible to monetary quantification and generally associated with the expectation to obtain a certain income (e.g. consumption of raw materials, personnel costs, depreciation). A cost can be classified as direct or as indirect.

Expenses: Expenses is the obligation (commitment) of payment (e.g. purchase invoice of raw materials, payroll processing, statement of damages, fines, income tax statement).

Payment: Payment is the effective delivery of cash or equivalent means (implies a receipt or equivalent document).

The focus of cost accounting is on costs, not expenses or payments . It is not important if we pay by cash or use another asset and whether we pay now or later. Accordingly, the income statement within cost/management accounting is prepared by adopting the economic competence flow, also named income statement by function.

3.2 Cost of Goods Manufactured and Sold

Since the financial accounting has as main objective to prepare information for outside partners, the information it produces is not sufficient for internal decision-makers, such as for the valuation of inventories or for the determination of costs by activity, by department or by sections. In this regard, within cost/ management accounting , the costs are reclassified by their functions in the organization.

The components of manufactured products are the direct materials, the direct labour cost and the manufacturing overhead costs, as presented in Fig. 5. The work finished during the period is transported from the production section to the finished goods storage to be sold . On the other hand, when the products are not finished, in a specific period, its production cost is considered in the Work-in-Process inventory account. Finally, the cost of goods manufactured and sold is determined as presented in Fig. 6.

Fig. 5
figure 5

Components of manufactured product cost

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Fig. 6
figure 6

Statement of the cost of goods manufactured and sold

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3.3 Fundamentals of Cost–Volume–Profit Analysis

  • Cost Behaviour Patterns

Changes in volume have a significant impact on operating leverage of organizations. This sensitivity is greater when the cost structure has high fixed cost. Therefore, it is very important that managers know the cost structure of its organization. They have to know very well the potentialities or dangers that changes in the level of production/sales can induce in operating leverage [38].

In a general way, we can classify the costs as: (i) variable costs; (ii) fixed costs; and (iii) semi-variable or semi-fixed costs. This classification attends to their sensitivity to changes in the organization’s activity level. Thus, fixed costs are the ones that do not change because of changes in the level of activity. In turn, the variable costs are those that are sensitive to changes in the organization’s activity level, and usually they can be progressive, proportional or regressive, as presented in Fig. 7.

Fig. 7
figure 7

Fixed and variable costs

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  • The concept of coverage or contribution margin

The coverage or contribution margin (CM) is the excess of the value of sales after subtracting the variable costs. This margin shows the net value of individual coverage of each product. We can calculate the unit or total amount of the contribution margin. Also, we can calculate the contribution margin ratio, which represents the percentage of sales revenue net (without the variable costs).

The analysis of the contribution margin exposes how changes in the number of units sold modify the operating income. This knowledge enables the manager to decide which quantities or which goods will contribute to a better performance of the organization. Besides, managers can understand more clearly the direct consequences that a reduction/increase in the selling price will have in the reduction/increase in the operating income. Thus, this analysis will allow managers to make better decisions about the best mix of products and the best choice for the selling price.

  • Finding Breakeven point

The breakeven point tells us the value and quantity of sales resulting in a zero operating income. In order to determinate the breakeven point, it is necessary to check the following requirements: (i) it is possible to classify the costs as fixed or variable; (ii) variable costs are proportional to the manufacturing; (iii) fixed costs remain unchanged during the period of analysis; (iv) the unit selling price is fixed; (v) the change in manufacturing does not exist or is insignificant; (vi) the sales value is the only income; and (vii) the cost can be translated by a linear regression.

Cost –volume–profit analysis is demonstrated in Fig. 8. We can observe the behaviour of sales, variable costs and fixed costs when changing the quantities sold . The breakeven point occurs when the line of total costs crosses the line of sales. Otherwise, the breakeven point occurs when the contribution margin is enough to cover the fixed costs.

Fig. 8
figure 8

Cost–volume–profit analysis

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We can also determine the value and quantity of the equilibrium point using the formulas presented in Fig. 9. Moreover, it is also interesting to calculate and to analyse the margin of safety , because this margin represents the excess of actual (or projected) sales over the breakeven point.

Fig. 9
figure 9

Formulas for cost–volume–profit analysis

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4 Review

4.1 Learning Outcomes

At the end of this chapter, you should be able to:

  1. 1.

    Identify the purpose of accounting.

  2. 2.

    Distinguish between single entry bookkeeping and double entry bookkeeping.

  3. 3.

    Describe the origins of double entry bookkeeping.

  4. 4.

    Describe the primary groups of users at which general-purpose financial statements are aimed.

  5. 5.

    Identify the qualitative qualities that make financial information useful.

  6. 6.

    Define the basic elements of financial statements —assets , liabilities , equity, income and expenses .

  7. 7.

    Define the criteria recognition of the financial statement elements and identify the historical cost and the current value bases as the different measurement bases of the financial statements.

  8. 8.

    Understand the accrual basis and going concern assumptions which underlie the preparation of financial statements.

  9. 9.

    Identify IFRS as the accounting and reporting standards followed in a worldwide basis.

  10. 10.

    Identify and describe the components of a complete set of financial statements. Understand the links between the financial statements.

  11. 11.

    Distinguish between financial accounting and management accounting .

  12. 12.

    Identify the usefulness and users of cost/management accounting information .