Chapter 1

The Nature and Purpose of Accounting

McGraw-Hill/Irwin

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. 2. 3. 4. 5. Identify problem or opportunity. Specify and rank criteria. Identify alternatives. Analyze alternatives. 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.
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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.

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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.
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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.

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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.

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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.
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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.
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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).
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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.
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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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