McGraw-Hill/Irwin

Chapter 1

The Nature and Purpose of Accounting

Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.

What Accounting Does

• Accounting is a system that provides information on:– Amounts of resources.– How resources were financed.– Results achieved by using resources.

• For either:– Parties inside or outside of organization.– Profit and nonprofit organizations.

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Categories of Accounting Information

• Operating• Financial accounting.• Management accounting.• Tax accounting.

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Operating Information

• Needed to conduct day-to-day activities.

• Largest quantity of accounting data.• Examples:

– Hours worked by employees.– Inventory on hand.– Amounts owed by customers.– Amount of money in bank.

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Financial Accounting Information

• For external users (investors) and managers.• Used by investors to make decisions to buy,

sell, or hold shares of a company.• Annual report and its financial statements.

– Common rules used so investors can compare with other companies’ financial statements.

– No “tailor-made” information

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Management Accounting Information

• For internal users such as president, marketing manager, production manager, etc.

• Used for three management functions:– Planning.– Implementation.– Control.

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Planning

• Deciding what actions should be taken.• Decision making involves:

1. Identify problem or opportunity.2. Specify and rank criteria.3. Identify alternatives.4. Analyze alternatives.5. Compare alternatives and select best.

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Planning

• Budgeting– Process of planning for a specified time,

often for one year.– Objective is to coordinate plans to provide

consistency

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Implementation

• Actions to provide human and other resources to achieve planned results.

• Requires supervision by managers.• Must change plans as conditions

require.

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Control

• Process to ensure employees perform properly.

• Accounting information is used to:– Communicate plans and expected actions.– Motivate employees to act consistently with

organization’s goals.– Focus attention on problem areas (via

feedback).– Appraise performance of managers and other

employees.1-10

Tax Accounting Information

• Prepare returns for taxing authorities:– Federal– State– Local– International

• Tax accounting rules can differ from financial accounting rules.

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Definition of Accounting

• Process of:– Identifying– Measuring– Communicating

• Economic information.• To make decisions.

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Accountants in Organizations

• Bookkeepers and other data entry personnel.– Maintain detailed operating records.

• Staff accountants.– Prepare and interpret reports.– Design and operate information systems.– Ensure accuracy of information.

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Certified Public Accountants (CPAs)

• Independent public accountants.• Audit publicly owned companies and

provide other services.• Licensed by state.• Work in large firms, small firms,

independent practices.• American Institute of CPAs (AICPA).

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Public Company Accounting Oversight Board (PCAOB)

• Monitors auditors of public companies.• Has power to:

– Set auditing standards.– Discipline auditors who do not follow

standards.

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Other Professional Organizations and Designations

• Institute of Management Accountants (IMA).– Certified Management Accountants (CMAs).

• Institute of Internal Auditors (IIA).– Certified Internal Auditors (CIAs).

• American Accounting Association (AAA).– Academic accountants.

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Role of Controller

• Top accounting manager.• Oversees:

– Accounting professionals in areas of management accounting, financial accounting, and tax accounting.

– Requests for information and reports.– Compliance with applicable rules and

regulations.– Design, installation, and operation of

information systems. 1-17

Approaches to Study Accounting

• Viewpoint of accountant (preparer). – Collecting, summarizing and reporting accounting

information.• Viewpoint of user.

– Understanding, analyzing, and interpreting accounting reports to make decisions.

• Our authors:– Emphasize perspective of current and potential

future users.– However, recognize need for some knowledge of

how accounting reports are prepared.1-18

Misconceptions about Accounting

• Actual value or “worth” of a business may not be included in usual financial reports.

• Not all resources (assets) of organizations are (or can be) measured and reported.– e.g., knowledge and skills of employees.

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Plan of Book/Course

• Part One: Financial Accounting– Chapters 1-4: Overview of basic structure

underlying all accounting.– Chapters 5-14: Reviews same material in more

detail.• Part Two: Management Accounting

– Chapters 15-28.– Often uses same or similar information as

financial accounting.– But tailor-made to meet the needs of a specific

organization.1-20

Financial Accounting Rules

• Terminology, rules and conventions evolved over centuries.

• Rules that worked and were useful were kept.

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Accounting: The Language of Business

• But like any language:– Many words have similar, but not same,

meaning.– Some rules are definite others are not.– Rules continue to evolve.– Differing presentations.

• XBRL (extensible business reporting language).– Helps adjust for presentational differences.

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Accounting Principles

• General rule or law.• Flexibility.• Evolutionary.• Criteria:

– Relevance. Useful and meaningful.– Objectivity. Reliable and verifiable.– Feasibility. Implemented without undue cost.

• Trade-off among criteria.1-23

Generally Accepted Accounting Principles (GAAP)

• Currently established by Financial Accounting Standards Board (FASB).– 7 member board with diverse

backgrounds.– Supported by professional staff.– Nongovernmental organization.– Due process procedure to establish

standards.1-24

Generally Accepted Accounting Principles (GAAP)

• Not legally required.• Emerging Issues Task Force for “quick

decisions”• FASB Accounting Standards Codification

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Securities Exchange Commission (SEC)

• U.S. agency empowered by Congress to protect investors.

• Jurisdiction over publicly traded companies.

• Enhances accounting rules through Regulation S-X, Financial Reporting Series Releases, and Staff Accounting Bulletins.

• Delegated authority for GAAP to FASB.1-26

International Accounting Standards Board (IASB)

• International Financial Reporting Standards (IFRS)

• No authority to require compliance.• But, required by European Union (EU)

for listed companies.• Similar to US GAAP in many ways.• Convergence project with FASB.

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Financial Statements Required by GAAP

• Statement of Financial Position (Balance Sheet).

• Income Statement.• Statement of Cash Flows.

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Status vs. Flow

• Status Report: Resources and obligations at a point in time:– Balance sheet.

• Flow Report: Activity over a period of time:– Income statement.– Statement of cash flows.

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Sources of Financial Statements

• Company websites:– www.cocacola.com– www.ge.com– www.microsoft.com

• SEC’s EDGAR:– www.sec.gov

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Balance Sheet

Assets = Liabilities + Owners’ equity

Resources Sources of financing

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Balance Sheet

• Assets: Resources of entity.– Cash.– Accounts Receivable.– Inventory.– Equipment.– Investments.– etc.

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Balance Sheet

• Liabilities: Claims by creditors.– Accounts payable.– Notes payable.

• Owners’ Equity: Claims by investors.– Amounts provided directly by equity

investors (Paid-in-capital).– Amounts retained from earnings, i.e.

profits (Retained earnings).1-33

Fundamental Accounting Equation

• Assets = Liabilities + Owners’ Equity.• Every accounting transaction maintains

equality of equation.• Purchase $20,000 of equipment for cash.

– Increase Equipment (asset) by $20,000 and decrease Cash (asset) by $20,000. No net change to assets.

• Purchase $20,000 of equipment on credit.– Increase Equipment (asset) by $20,000 and

increase Notes Payable (liability) by $20,000. 1-34

Income Statement

• Summaries results of operating activity over a period of time.

• Revenues – Expenses = Net Income.• Net income (or net loss) is the amount

added to (subtracted from) Retained earnings.

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Financial Statement Objectives

• Is useful for investment decisions. (All financial statements).

• Is comprehensible. (All financial statements).• Shows economic resources and claims on

resources (Balance Sheet).• Shows financial performance during a period

(Income Statement).• Shows cash flows (Statement of Cash Flows).

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Sarbanes-Oxley Act (2002)

• Chief executives and chief financial officers of public companies certify financial statements filed with SEC are materially accurate and complete.

• Potential civil and criminal liability.

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Financial vs. Income Tax vs. Management Reporting

• Operating information summarized under three different sets of rules.

• Differences among:– Financial Reporting (GAAP).– Income Tax Reporting (Congress and IRS).– Management Reporting (Top management).

• Similarities tend to be greater than differences.

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