2 Accounting: Information for Decision Making Chapter 1Chapter 1: Accounting—Information for Decision Making1-2
3 The Accounting Process Reported Results of Actions (decisions) Accounting links decision makers with economic activities ¾ and with the results of their decisions.AccountingInformationEconomic ActivitiesNot all transactions entered into by a business entity are capable of being recorded. The first task for accountants is to identify those economic events that can be recorded in the accounting system.Once the necessary economic information has been accumulated in a readable format, decision makers use this information to improve the decision-making process.Decisions made will impact future economic activities which will then find their way into the data accumulation process.Reported Results of Actions (decisions)Decision MakersActions (decisions)
4 Types of Accounting Information FinancialTaxManagementBroadly speaking, accounting information can be placed into one of three categories: financial, management, and tax. Financial accounting refers to information describing the financial resources, obligations, and activities of an economic entity (either an organization or an individual). Financial accounting information is designed primarily to assist investors and creditors in deciding where to place their scarce investment resources. Management (or managerial) accounting involves the development and interpretation of accounting information intended specifically to assist management in operating the business. A company’s managers and employees constantly need information to run and control daily business operations. Much management accounting information is financial in nature but is organized in a manner relating directly to the decision at hand. Tax accounting is a specialized field within accounting and focuses on the preparation of income tax returns and tax planning strategies.
5 Accounting SystemsAn accounting system consists of the personnel, procedures, technology, and records used by an organization to develop accounting information and to communicate this information to decision makers.An accounting system consists of the personnel, procedures, technology, and records used by an organization to develop accounting information and to communicate this information to decision makers.
6 Financial Information Provided Information SystemInformation UsersInvestorsCreditorsManagersOwnersCustomersEmployeesRegulators SEC-IRS-FTCFinancial Information ProvidedProfitabilityFinancial positionCash flowsDecisions SupportedPerformance evaluationsStock investmentsTax strategiesLabor relationsResource allocationsLending decisionsBorrowingInvestors, creditors, owners, customers, and regulatory agencies are external users of financial information. Managers of business operations are internal users of accounting information. Both external and internal users are interested in the profitability, financial position, and cash flows of the entity. Profitability is often measured on the Income Statement prepared for the company. The Statement of Financial Position, also known as the Balance Sheet, reports the financial position of the company at any point in time. The Statement of Cash Flows reports the cash inflows and outflows during a period of time.The examination of the financial statements of a company leads to decisions about the economic viability of the company. This assessment may impact the company’s ability to raise money in capital markets or negotiate with labor unions.
7 Determining Information Needs Although much accounting information clearly is essential to business operations, management still has many choices as to the types and amount of accounting information to be developed.Part IThe types of accounting information that a company develops vary with such factors as the size of the organization, whether it is publicly owned, and the information needs of management. The need for some types of accounting information may be prescribed by law. For example, income tax regulations require every business to have an accounting system that can measure the company’s taxable income and explain the nature and source of every item in the company’s income tax return. Federal securities laws require publicly owned companies to prepare financial statements in conformity with generally accepted accounting principles. These statements must be filed with the Securities and Exchange Commission, distributed to stockholders, and made available to the public.Part IIAlthough much accounting information clearly is essential to business operations, management still has many choices as to the types and amount of accounting information to be developed. For example, should the accounting system of a department store measure separately the sales of each department and of different types of merchandise? The answer to such questions depends on how useful management considers the information to be and the cost of developing the information.
8 Basic Functions of an Accounting System Interpret and record business transactions.Classify similar transactions into useful reports.Summarize and communicate information to decision makers.The first step in the accounting process is to identify and record business transactions. Often, the identification of economic events that can be recorded by accountants is a difficult process.After the economic information is gathered and recorded, similar transactions must be classified so they appear on the proper financial reports. Chapter 2 will spend a significant amount of time on mastering the preparation of the basic financial statements. Once the information has been properly grouped, the results may be communicated to users of the information. If the information is to have meaning, it must impact the decisions of an informed user.
9 Components of Internal Control Control EnvironmentRisk AssessmentControl ActivitiesInternal control is a process designed to provide reasonable assurance that the organization produces reliable financial reports, complies with applicable laws and regulations, and conducts its operations in an efficient and effective manner. The five components of internal control are the control environment, risk assessment, control activities, information and communication, and monitoring.An organization’s control environment is the foundation for all the other elements of internal control, setting the overall tone for the organization. Risk assessment involves identifying, analyzing, and managing those risks that pose a threat to the achievement of the organization’s objectives. Control activities are the policies and procedures that management puts in place to address the risks identified during the risk assessment process. Information and communication includes the information systems developed to capture and communicate operational, financial, and compliance-related information necessary to run the business. Monitoring enables the company to evaluate the effectiveness of its system of internal control over time.Information and CommunicationMonitoring
10 External Users of Accounting Information OwnersCreditorsPotential investorsLabor unionsGovernmental agenciesSuppliersCustomersTrade associationsGeneral publicExternal users of accounting information are individuals and other enterprises that have a current or potential financial interest in the reporting enterprise, but that are not involved in the day-to-day operations of that enterprise. External users of financial information may include the following: owners, creditors, potential investors, labor unions, governmental agencies, suppliers, customers, trade associations, and the general public.
11 Objectives of External Financial Reporting Provide specific information about economic resources, claims to resources, and changes in resources and claims.Provide information useful in assessing amount, timing and uncertainty of future cash flows.Provide general information useful in making investment and credit decisions.The objectives of external financial reporting range from general to specific. The most general objective is to provide information useful in making investment and credit decisions.A more specific objective is to provide information that is useful in assessing the amount, timing and uncertainty of future cash flows. Without positive future cash flows a company cannot sustain operations.The most specific objective is to provide information about economic resources, claims against those resources, and changes in the balance of resources and claims.
12 Objectives of External Financial Reporting The primary financial statements.Balance SheetIncome StatementThere are three basic financial statements that we will study in this course. These three include the balance sheet, income statement, and statement of cash flows. The balance sheet is often referred to as the statement of financial position because it shows the resources of a business and the claims against those resources. The income statement is often referred to as the statement of operations. This financial statement measures the revenues earned by a company during a period of time and the expenses incurred to generate those revenues. The statement of cash flows provides information about how a company receives its cash and where it spends its cash during a period of time.Statement of Cash Flows
13 Characteristics of Externally Reported Information A Means to an EndUsefulness Enhanced via ExplanationBroader than Financial StatementsBased on General-Purpose AssumptionFinancial information that is reported to investors, creditors, and others external to the reporting enterprise has certain qualities that must be understood for the information to have maximum usefulness. First, financial information is a means to an end, not an end in and of itself. Second, financial reporting is broader than financial statements. Third, externally reported financial information is generally historical in nature. Fourth, externally reported financial information may have a look of great precision, but in fact much of it is based on estimates, judgments, and assumptions that must be made about both the past and the future. Fifth, we assume that, by providing information that meets the needs of investors and creditors, we also meet the information needs of other external parties. So, we opt for preparing what is referred to general-purpose information that we believe is useful to multiple user groups. And, sixth, the accounting profession believes that the value of externally reported financial information is enhanced by including explanations from management.Historical in NatureResults from Inexact and Approximate Measures
14 Users of Internal Accounting Information Board of directorsChief executive officer (CEO)Chief financial officer (CFO)Vice presidentsBusiness unit managersPlant managersStore managersLine supervisorsExamples of internal users of accounting information include: board of directors, CEOs, CFOs, vice-presidents of information services, human resources, and ethics, business unit managers, plant managers, store managers, and line supervisors.
15 Typical Simple Organization Chart PlantAccountantsManagersBusiness Unit ManagersV.P. Human ResourcesV.P. Information ServicesChief Financial Officer (CFO)Chief ExecutiveOfficer(CEO)Board ofDirectorsOwnersV.P EthicsControllerTreasurerHere is a typical organizational chart for a company. The CEO reports to the board of directors and owners of the company. Senior managers report to the CEO.1-15
16 Objectives of Management Accounting Information To help achieve goals and missionsTo help evaluate and reward decision makersUnlike financial accounting information, managerial accounting information is developed to help managers achieve the goals and missions of an organization. The information can be used to evaluate the performance of managers responsible for decisions about directing and controlling resources.
17 Characteristics of Management Accounting Information TimelinessIdentify Decision MakerA Means to an EndThe accounting information created and used by management is intended primarily for planning and control decisions. In order to plan for and control ongoing business processes, accounting information needs to be timely. Information that is produced to monitor and control processes needs to be provided to those who have decision-making authority to correct problems. Although some accounting information, like financial accounting information, is historical in nature, the purpose in creating and generating it is to affect the future. Accounting information measures the efficiency and effectiveness of resource usage. As with financial accounting information, management accounting information is a means to an end, not an end in and of itself.Measures of Efficiency and EffectivenessOriented Toward Future
18 Institutional Features Generally Accepted Accounting Principles (GAAP)Financial Accounting Standards BoardInternational Accounting Standards BoardSecurities and Exchange CommissionPublic Company Accounting Oversight BoardAudits of Financial StatementsLegislationThe Financial Accounting Standards Board (FASB) is recognized as the group in the private sector that makes specific accounting principles. If an accountant departs from the principles established by the FASB, proper disclosure of the departure must be made.When an enterprise operates beyond the boarders of its own country, differences in financial reporting practices between countries can pose significant problems. Efforts are underway to harmonize accounting standards around the world and the International Accounting Standards Board is playing a leading role in this process.In the public sector, the Securities and Exchange Commission has the authority to establish accounting principles for companies reporting to the agency. Currently the Securities and Exchange Commission has accepted all pronouncements of the FASB for use by reporting companies.The Public Company Accounting Oversight Board is a quasi-governmental body charged with oversight of the public accounting profession.Audits of financial statements by a certified public accountant provides outsiders with an opinion on whether the financial statements are misleading.Congress passed the Sarbanes-Oxley Act in Among the more important provisions of this legislation is the creation of the Public Company Accounting Oversight Board mentioned earlier. Another important provision of the Act is to ban auditors from providing many nonaudit services for their audit clients on the assumption that those services interfere with the objectivity required of auditors.
19 Professional Organizations American Institute of Certified Public AccountantsInstitute of Management AccountantsInstitute of Internal AuditorsAmerican Accounting AssociationCommittee of Sponsoring Organizations of the Treadway Commission (COSO)Several professional accounting organizations play an active role in improving the quality of accounting information that is used by investors, creditors, management, and others. In addition to the SEC, FASB, and IASB discussed earlier, the American Institute of CPAs, the Institute of Management Accountants, the Institute of Internal Auditors, the American Accounting Association, and the Committee of Sponsoring Organizations of the Treadway Commission are particularly important.One of the most influential professional organizations in accounting is the American Institute of Certified Public Accountants or AICPA. It represents the interests of Certified Public Accountants (or CPAs). The Institute of Management Accountants, or IMA, and the Institute of Internal Auditors, or IIA, represent the interests of accountants and auditors working with an organization.The American Accounting Association is composed of members from academics. Your accounting instructor may be a member of the American Accounting Association.The Committee of Sponsoring Organizations of the Treadway Commission is a voluntary private sector organization dedicated to improving the quality of financial reporting through business ethics, effective internal controls, and corporate governance.
20 Competence, Judgment and Ethical Behavior Certified Public Accountant (CPA)Certified Management Accountant (CMA)Certified Internal Auditor (CIA)If the public is to have confidence in the judgment of professional accountants, these accountants must first demonstrate that they possess the characteristic of competence. Both the accounting profession and state governments have taken steps to assure the public of the technical competence of certified public accountants (CPAs). CPAs are licensed by the states, in much the same manner as states license physicians and attorneys. The licensing requirements vary somewhat from state to state, but in general, an individual must be of good character, have completed 150 semester hours of college work with a major in accounting, pass a rigorous examination, and have accounting experience. In addition, most states require at least 40 hours a year in continuing professional education throughout a CPA’s career.While management accountants are not required to be licensed as CPAs, they may voluntarily earn the Certified Management Accountant or the Certified Internal Auditor as evidence of their professional competence.Ethical behavior is the cornerstone of the accounting profession. Recently there have been many corporate scandals involving individuals who acted in an unethical, and often times illegal, way.Ethics is the belief system that permits us to distinguish right from wrong and identify good and bad behavior. Professional organizations have promulgated codes of ethics that must be followed by members of that organization.Ethical behavior is the cornerstone of the accounting profession.
21 Careers in Accounting Public Accounting Management Accounting Governmental AccountingAccounting EducationCareers in accounting can follow many paths.Certified public accountants (CPAs) offer a variety of accounting services to the public. The work consists primarily of auditing financial statements, income tax work, and management advisory services. To become a CPA, a person must meet several criteria, including an extensive university education requirement, passing the CPA examination, and meeting a practice experience requirement.The management accountant works for one enterprise and develops and interprets accounting information designed specifically to meet the various needs of management.Governmental agencies use accounting information in allocating their resources and in controlling their operations. Therefore, the need for management accountants in governmental agencies is similar to that in business organizations.Some accountants, including your instructor and the authors of this textbook, have chosen to pursue careers in accounting education. A position as an accounting faculty member offers opportunities for teaching, research, consulting, and an unusual degree of freedom in developing individual skills.
22 What About Bookkeeping? Bookkeeping is the clerical side of accounting—the recording of routine transactions and day-to-day record keeping.Bookkeeping is the clerical side of accounting—the recording of routine transactions and day-to-day record keeping. Professional accountants are involved more with the interpretation and use of accounting information than with its actual preparation. A person might become a proficient bookkeeper in a few weeks or months. To become a professional accountant, however, requires years of study, experience, and an ongoing commitment to keeping current.Professional accountants are involved more with the interpretation and use of accounting information than with its actual preparation.
23 I’m Not An Accounting Major Accounting is the language of business, and trying to run a business without understanding accounting information is analogous to trying to play sports without understanding the rules.Most students who use this book are not accounting majors. However, the study of accounting is still important to you. You need to understand accounting concepts, both for your professional careers and for many aspects of your personal life. Finance students need to understand accounting concepts if they seek positions in investment banking, consulting, or in corporate America as a financial analyst. A management student seeking a career as a management trainee—with the ultimate goal of running a corporation or a corporate division—needs to understand accounting in order to be able to run, control, and evaluate the performance of a business unit. Marketing students often take positions in sales where it is imperative that they understand the principles of revenue recognition, as well as the obligations of a public company under the U.S. securities law. Accounting is the language of business, and trying to run a business without understanding accounting information is analogous to trying to play sports without understanding the rules.
24 Ethics, Fraud & Corporate Governance Corporate governance entails corporate structures and processes for overseeing the company’s affairs to ensure that the company is being managed with the best interests of shareholders in mind.Earlier this decade was a time of unprecedented business failures amid allegations of fraudulent financial reporting that include corporations that have now become household names—Enron, WorldCom, HealthSouth, Adelphia Communications, Tyco and Qwest, among others. These problems are not exclusively a problem with financial reporting in the United States, as evidenced by fraud allegations at Parmalat, a large Italian company.Corporate governance entails corporate structures and processes for overseeing the company’s affairs, including oversight by the board of directors of the actions of top management to ensure that the company is being managed with the best interests of shareholders in mind.Dennis Kozlowski, the former CEO of Tyco, was sentenced to 8 1/3 to 25 years in prison for his conviction for conspiracy, securities fraud, and falsifying records.