What Is Accounting? Business, Objectives and Users

Every business, from a stall in Onitsha market to a listed bank in Lagos, needs to know what it owns, what it owes and whether it is earning a profit. Accounting is the system that answers those questions in a form other people can rely on. This topic explains what accounting is, how it differs from bookkeeping, the forms a business can take and the people who read accounts.

It is the first topic in the Financial Accounting course, so the vocabulary here is used in every later one.

In the examination it appears as a definition or a short explanation, often as the opening question of Section B worth 8 to 14 marks, and as two or three multiple-choice questions in Section A. There are no calculations to learn, so the marks go to candidates whose answers are structured and precise. No earlier topic is needed.

What a business is

There is no single agreed definition of a business, and several are in use. A business is an economic system in which goods and services are exchanged for money or for each other. It is a commercial organisation run with the aim of making a profit. It is also an organised set of activities and assets that can be managed to give returns to investors or owners.

All three versions describe people putting resources to work to supply something that customers will pay for.

Businesses share five features.

• They exist mainly to make a profit.
• They earn profit by supplying goods or services to customers.
• A business that supplies goods may make them or buy them in. A supermarket buys from producers and sells to shoppers.
• Profit is the reward for taking risk. A trader at Mile 12 market who buys ₦900,000 of tomatoes may find that part of the stock spoils before it sells. The chance of that loss is the risk, and the profit on the stock that does sell is the reward for carrying it.
• The profit belongs to the owners, who may take a share of it from time to time.

Forms of business entity

The syllabus names three forms: the sole proprietorship, the partnership and the limited liability company. The accounting entries are similar in all three, but ownership, the liability of the owners and the reporting duties differ, and examiners often ask you to compare them.

Sole trader

A sole proprietorship is a business owned and managed by one person. Anyone who starts trading without forming a company is a sole trader. In Nigeria a sole trader registers the business name with the Corporate Affairs Commission (CAC) under Part E of the Companies and Allied Matters Act 2020 (CAMA), and section 814 allows a business name to be registered for a sole proprietorship or a partnership. Registration does not create a separate legal person. The owner:

• is legally the same person as the business and is personally liable for all its debts;
• is taxed personally on the business profit;
• keeps all the profit and owns all the assets;
• can take cash or goods out of the business, which are called Drawings;
• finances the business from personal capital, including profit left in the business, and from loans;
• usually runs the business day to day and keeps a high level of control;
• can sell the business as a going concern, although the business ends on the owner’s death because there is no perpetual succession.

If a sole trader owes a supplier ₦400,000 and the business has no money to pay it, the supplier can claim the debt from the owner’s personal assets.

Partnership

A partnership is the relationship between people who have agreed to share the profits of a business carried on by all or any of them acting for all. There must be two or more people carrying on a business together, and each contributes capital. The partners:

• are personally liable for the unpaid debts and other obligations of the business;
• share profit in an agreed ratio, and each partner’s share is taxed as personal income;
• own the profits and assets in that agreed ratio;
• can withdraw cash and other assets as drawings;
• finance the business from their capital, including retained profit, and from loans;
• usually take an active part in running the business, even when staff are employed;
• can sell the partnership as a going concern, although it ends when a partner dies because there is no perpetual succession.

If a partnership owes a supplier ₦400,000 and cannot pay, the partners must settle the debt from their personal resources.

Limited liability company

A company is a separate form of entity. Nearly all companies in business are limited by shares, so the liability of the owners is limited. In Nigeria companies are formed and regulated under the Companies and Allied Matters Act 2020 (CAMA), and Part B of the Act deals with the incorporation of companies.

• Ownership. Ownership is shown by shares. A small company may have a single share of ₦1 and a large public company may have millions. A person who holds 40 of 100 issued shares owns 40% of the company.
• Control. A large company has many shareholders, so they do not run it directly. They employ executive directors to manage it for them. This is the separation of ownership from control.
• Legal status. A company is a legal entity. It can own assets, make contracts and sue or be sued in its own name.
• Liability. The company alone is responsible for its debts. If it owes a supplier ₦400,000 and cannot pay, the shareholders are not asked to pay. A shareholder’s liability is limited to the capital paid or agreed to be paid.
• Tax. A company is taxed separately from its owners.
• Reporting. Shareholders who do not manage the business need regular reports on its position and performance, so company law imposes stricter reporting and audit rules than apply to other entities.

Most very large businesses are companies, because a company can raise large sums of capital and limits the personal risk of its owners.

Advantages and disadvantages of each form

Background. The comparison table above sets out the advantages and disadvantages of each form. Examiners turn it into lists, for example by asking for seven advantages of a limited liability company over a sole proprietorship (May 2021, Question 5(a)). The lists below follow from the table and from the features set out earlier in this section.

What accounting is

There are many definitions of accounting, and the examiner accepts any that capture the same ideas. One describes it as the systematic process of identifying, recording, measuring, classifying, verifying, summarising, interpreting and communicating financial information. Another says it is the identification, measurement and communication of economic information so that users can make informed judgements and decisions.

A third stresses the recording of business transactions followed by summarising, analysing and reporting them.

Accounting has three main purposes.

• To keep a record of the financial value of transactions. A good record supports financial controls and reduces the risk of fraud.
• To help manage the financial affairs of the entity.
• To supply financial information that stakeholders use in making decisions.

The information serves two broad groups. Management needs it to run the business efficiently, and the branch that serves managers is management accounting. External users such as shareholders, tax authorities, investors and trade unions need it too, and the branch that serves them is financial accounting.

Financial accounting has two jobs: keeping the accounting records of business transactions and other financial activities, and reporting the entity’s financial position and performance through financial statements. The word entity covers companies, partnerships and sole proprietorships.

Types of accounting

Users have different needs, so accounting has several branches. There are ten, and an exam question may ask for any of them with their roles.

• Financial accounting. Recording, classifying, preparing and interpreting financial statements for internal and external users.
• Cost accounting. Collecting cost data so managers can plan, control and decide.
• Performance management. A continuing process in which managers and employees plan, monitor and review how effectively the workforce is meeting the entity’s objectives.
• Auditing. An independent examination of the financial statements by a professional auditor, who gathers evidence and gives an opinion in an audit report on whether the statements are fair.
• Government accounting. A branch of public sector accounting that records and reports the revenue and spending of ministries, departments and agencies, and supports compliance and planning.
• Taxation. Reported accounting profit is the starting point for taxable profit. Tax law differs from accounting standards, so the two must be reconciled.
• Financial management. Obtaining, using and accounting for the organisation’s resources so as to increase the wealth of the owners.
• Forensic accounting. Using accounting skills to investigate fraud, deliberate misstatement, misappropriation and embezzlement, often as part of legal proceedings to recover money.
• Social and environmental accounting. Accounting for and reporting the social and environmental effects of the entity’s activities to investors, management, employees, customers, suppliers and the local community.
• Bookkeeping. Recording transactions in the books, posting them and extracting a trial balance.

Bookkeeping and accounting compared

A business records transactions in a bookkeeping system, and its records are often called its accounts. Whatever the form of the business, the recording method is the same. It is double entry, which a later topic explains in full. Small firms may have one bookkeeper or accountant. Large companies have a finance department.

Bookkeeping is the foundation, and accounting builds on it. Both are needed for the financial health of any organisation.

Users of accounting information and what they need

Users are the reason accounts exist. They fall into Internal users, who work inside the entity, and External users, who do not. Each group asks different questions.

The IASB Conceptual Framework picks out Existing and potential investors, lenders and other creditors as the primary users of general purpose financial reports. They cannot ask the entity for tailor-made information, so they rely on the published reports. Three limits apply. The reports cannot supply every piece of information a user needs. They do not show what the entity is worth, although they help users estimate its value.

Different primary users want different things, so the standards aim to meet the needs of the greatest number. Regulators and the public may find the reports useful, but the reports are not aimed mainly at them. Management is interested in the figures but does not have to rely on general purpose reports, because it can call for any internal information it wants.

When a user asks how well the managers have looked after the resources placed in their hands, the information being sought is about stewardship. Shareholders in a company run by directors are the group most associated with it.

The information needs in more detail

Financial statements are drafted to be useful to most users but cannot satisfy every need, so users must look elsewhere for extra information. People with an interest in a business are its Stakeholders. It describes the needs group by group.

• Investors are the providers of risk capital. Unless they also manage the business, they invest to earn a financial return and need information for informed decisions. For shareholders in a company the decisions are usually whether to buy, hold or sell shares. They may analyse past performance and position and try to predict future outcomes, and the statements give some indication of the company’s ability to pay dividends out of profits.
• Lenders, such as banks, use the statements to assess the borrower’s ongoing ability to pay interest and to repay the loan principal when it falls due.
• Suppliers and other trade creditors include those owed for goods on credit and those owed for rent, electricity or telephone charges. They use the statements to judge how much credit they can safely extend.
• Government and its agencies use the information for regulating business and for setting taxation policy.
• The public may be interested because a company contributes to the local economy through the people it employs and its purchases from local suppliers.
• Employees need to know the financial stability and profitability of the employer. An assessment of profitability helps them form a view on the employer’s ability to pay higher wages or offer better job opportunities.
• Customers may care about the financial strength of an entity, especially if they depend on it for the long-term supply of key goods or services.
• Managers are not usually included among the users by the IASB Framework, because they can obtain much more detailed information than the statements give. They remain interested in the statements, because management is responsible for producing them.

Financial statements and who prepares them

The ledger records are summarised at the end of each period, usually a year, in financial statements. The period is called the financial year, accounting period or reporting period.

The two statements met first in this course are the Statement of financial position, which shows what the entity owns and owes at the end of the period, and the Statement of profit or loss and other comprehensive income, which shows its performance over the period. Some adjustments and additions are needed to get from the ledger balances to the finished statements, particularly for companies.

A set of financial statements is often called the accounts of the business.

Financial statements are prepared on the basis that the business is separate from its owners. This is the business entity concept. Only the financial activities of the business go into its records, and the owner’s personal affairs stay out. For a company the separation has legal force. For a sole trader or partnership it applies for reporting only. Suppose Emeka Eze trades as Eze Builders.

Legally a debt of Eze Builders is a debt of Emeka personally. In the books, Eze Builders is still treated as a separate entity, so Emeka’s house and family spending are not recorded in it.

A sole trader’s statements are private. They go to the tax authorities and sometimes to a bank that has lent money. They should follow accepted accounting practice but need not meet every accounting standard. A partnership’s statements are private in the same way. A company’s statements are prepared for its shareholders and are usually audited.

The auditor gives an opinion on whether they give a true and fair view. Under CAMA 2020, section 378(2) requires the statements to give a true and fair view, section 401 deals with the appointment of auditors, section 404 with the auditors’ report, and section 402 exempts some small companies and single-shareholder companies from appointing auditors.

Section 417 requires annual returns to be filed with the CAC, which is the government agency concerned, and the statements then become open to the public. Companies listed on a stock exchange also publish them, often on their websites. Company statements are subject to more regulation than those of sole traders or partnerships.

The ideas in more depth

Why separation of ownership from control matters

When one person owns and runs a business, that person already knows what is happening and needs no report. A company with thousands of shareholders is different. The shareholders own it, the directors run it, and the only way owners can judge the directors is through the financial statements. This opens the way for managers to present results in a flattering or misleading manner.

Company law responds by requiring statements to follow accounting standards, by requiring an audit, and by requiring public filing. The extra regulation exists because shareholders cannot supervise the business themselves.

Legal separateness and accounting separateness

These two ideas are often confused. Legal separateness means the business is a distinct person in law, and only a company has it. Accounting separateness means the records of the business are kept apart from the owner’s private finances, and every entity has it.

A practical result is that when a sole trader takes cash from the till for personal use, the entry is drawings, a reduction in the owner’s claim on the business. It is not an expense of the business. In a company the equivalent payment to shareholders is a dividend.

General purpose reports and special requests

General purpose financial reports are written for the many users who cannot ask for tailor-made information. A bank considering a large loan can ask for more, such as forecasts or monthly accounts, and managers receive detailed internal reports. This is why the standards define their primary users narrowly and why other users read the same reports with their own purposes in mind.

Records as a control

A reliable record of every transaction lets an owner check cash, stock and debts against the books. The reduction of fraud risk is also among the purposes of accounting. Forensic accountants start from these records when they investigate a loss.

How the form of business changes the accounts

The method of recording is the same for all three forms, but the equity section is not. A sole trader has a capital account and drawings. A partnership has capital and current accounts for each partner and shares profit in an agreed ratio. A company has share capital, reserves and retained earnings and pays dividends. Later topics deal with each form in turn.

Sources and references

• Companies and Allied Matters Act 2020: Part E and section 814 (business names), Part B (incorporation of companies), sections 377 and 378 (financial statements and the true and fair view), sections 401, 402 and 404 (auditors, exemption from audit, and the auditors’ report) and section 417 (annual returns).
• IASB, Conceptual Framework for Financial Reporting (March 2018): Chapter 1, from paragraph 1.2, on the objective of reporting and the primary users.

Worked example: a shoe business in Aba

1. Shortfall. Debts ₦2,400,000 less assets ₦1,700,000 = ₦700,000.
2. Sole proprietorship. The owner is personally liable, so Chidinma pays ₦700,000 from personal assets.
   Her personal assets fall to ₦6,000,000 − ₦700,000 = ₦5,300,000.
   The suppliers are paid in full.
   Check: ₦1,700,000 + ₦700,000 = ₦2,400,000.
3. Company. The company alone owes the debt, so the suppliers can only take the company’s assets of ₦1,700,000. Chidinma’s personal assets stay at ₦6,000,000, and her ₦500,000 of share capital was already part of the assets lost. The suppliers receive ₦1,700,000 of ₦2,400,000 and bear the ₦700,000 loss.
   Check: ₦1,700,000 + ₦700,000 = ₦2,400,000.
4. Capital and ownership.
   Capital = 1,000 × ₦500 = ₦500,000, which agrees with the amount paid in.
   Chidinma owns 600 ÷ 1,000 = 60%.
   Obinna owns 400 ÷ 1,000 = 40%.
   Check: 60% + 40% = 100%.
5. Shares of profit.
   Chidinma receives 60% × ₦1,200,000 = ₦720,000.
   Obinna receives 40% × ₦1,200,000 = ₦480,000.
   Check: ₦720,000 + ₦480,000 = ₦1,200,000.
   The company’s tax is ignored here and is dealt with in a later topic.
6. Classification. Recording daily sales, posting entries to the ledger and extracting a trial balance are Bookkeeping. Preparing the statement of financial position, analysing why profit fell and advising on a bank loan are Accounting. That makes three tasks in each group.

Common mistakes in the exam

• Writing that bookkeeping and accounting are the same, or giving one-word differences. Each difference needs both sides explained.
• Saying a sole trader or partnership is a separate legal person. Only a company is, although every entity is separate for accounting.
• Listing users without saying what each one wants. Marks go to the need, not to the name.
• Calling managers external users, or treating lenders and shareholders as having the same interest.
• Mixing up drawings, which belong to sole traders and partners, with dividends, which belong to companies.
• Saying shareholders are liable for company debts without limit. Their liability is limited to the capital paid or agreed to be paid.
• Listing only a few of the types of accounting when the question asks for the roles of the various types.

Quick revision

• Business: supplies goods or services to earn profit, bears risk, profit belongs to owners.
• Three forms: sole trader, partnership, limited liability company. Only a company is a separate legal entity with limited liability.
• Accounting: identify, record, measure, classify, summarise, interpret and communicate information for decisions.
• Bookkeeping records and posts, and ends with the trial balance. Accounting reports, analyses and advises.
• Ten types: financial, cost, performance management, auditing, government, taxation, financial management, forensic, social and environmental, bookkeeping.
• Primary users of general purpose reports: investors, lenders and other creditors. Management does not rely on them.
• Business entity concept: business separate from owner for reporting, whatever the legal form.
• Company statements are audited and filed. Sole trader and partnership statements are private.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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