CHAPTER 1

Introduction to accounting

Dr. Bing Guo Email: bguo@emp.uc3m.es Office: 6.0.18

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Chapter outline
Economic activity and information needs Accounting: formal concept The flow of information Importance of accounting information Financial Accounting and Management accounting Users of accounting information How does accounting work? Requirements of accounting information Accounting regulation
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Information Needs

Accounting The basis of decision making

Accounting is the language of business Accounting is the information system that
Measures business activities Processes that information into reports Communicates the results to decision makers

Definition of accounting
Working definition: A system providing information to managers and owners in order make business decisions Formal definition: The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information
American Accounting Association (1966), Statement of Basic Accounting Theory, p. 1
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Nature of Accounting
Accounting is about recording, preparing and interpreting business transactions Enables key questions to be answered, such as how much profit have we made? In small businesses, managers and owners are the same people In large businesses, managers and owners will be different
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The Accounting System: The Flow of Information

1. People make decisions

2. Business transactions occur

3. Businesses prepare reports to show the results of their operations

The Notion of Accounting

DECISION- MAKING DECISION-MAKING

Accountants: measure, record

communicate

USERS

Economic environment

Beliefs & Perceptions

Accounting as Communication of Financial Information

Management is the steward to whom capital suppliers entrust control over a portion of their financial resources Purpose of financial statements is to provide a report to capital suppliers to facilitate their evaluation of managements stewardship

Income measurement

Financial data have to facilitate contracting between parties such as management and investors

Financial data have to facilitate decisions makers in selecting the best action among available alternatives

Informational approach

Importance of Accounting Information

Money makes the world go round Businesses depend on cash and profit Unless you understand accounting, you will never understand business Need to know basic terminology such as: Income Assets Expenses Liabilities Profit Capital Cash flow
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Hewlett-Packard shares fall by 10% on lacklustre results

By Scott Morrison in San Francisco, Financial Times Published: Aug 20, 2003

Hewlett-Packard shares fell 10 per cent in late trading yesterday after the computer and printer maker reported disappointing third-quarter results. The failure to meet analysts' expectations was a setback for the company, which has reported several quarters of operational improvements following its $19bn (12bn) acquisition of Compaq Computer last year. HP blamed the results on overly aggressive pricing for personal computers and weak sales of its corporate computers. Carly Fiorina, chairman and chief executive, said: "The third quarter is always tough, but we still should have done better. Nevertheless, we are confident in our strategy and the actions we're taking. We expect to deliver a strong fourth quarter." The company reported a net profit of $297m, or 10 cents per share, for the quarter ended July 31, compared with a loss of $2bn, or 67 cents per share, last year which including hefty restructuring and acquisition charges. Excluding special items, the company reported earnings of $700m, or 23 cents per share, compared with a profit of $420m, or 14 cents per share, last year. Revenue totalled $17.35bn, up 5 per cent from $16.54bn last year and down 4 per cent from the previous quarter. Analysts had expected earnings of 26 cents per share on revenue of $17.5bn, according to Thomson First Call. HP's PC unit reported an operating loss of $56m, just one quarter after posting its first profit in years. The company said PC sales fell because of seasonal factors while gross margins were hit by aggressive pricing, aimed at fending off rival group Dell's bid for increased market share.

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Internal vs. External Users

Internal : management accounting
More focused and detailed information Feed back possible

External : financial accounting (financial statements)

Global information No influence on the reporting process
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Financial and Management accounting

Financial accounting Provision of financial information on a businesss recent financial performance targeted at external users such as shareholders Backwards-looking Double-entry bookkeeping Profit and loss account (income statement) and balance sheet
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Financial and Management accounting

Management accounting Internal needs of business Not required by law (unlike financial accounting) Management accounting can be split into cost accounting and decisionmaking
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Overview Financial and Management Accounting

Accounting

Financial

Management

Profit and loss Account

Balance sheet

Cash flow statement

Cost making

Accounting

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Financial vs. Management accounting

Financial accounting serves outsiders while management accounting serves insiders The main work of financial accounting is to prepare the financial statements Financial accounting is based upon doubleentry bookkeeping while management accounting is not Financial accounting looks backwards while management accounting looks forwards The product of each accounting is different
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Users of Accounting Information

Outsiders: regulators consumers suppliers FIRM Insiders:
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Tax officials lenders Financial markets

Management Employees

User Information Requirements

User group Internal users: 1. Management Employees External users: 1. Shareholders and analysts advisers 2. Lenders 3. Suppliers and other trade creditors 4. Customers
2. 5.

Information requirements
Information for costing, decision-making, planning and control Information about job security and for collective bargaining Information for buying and selling shares

Information about assets and the companys cash position Idem Information about long-term prospects and survival of the business Information on profits to use as a basis for Government and tax calculating tax

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authorities Public

Information about the social and environmental impact of corporate activities

Financial Statements

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Understanding the Financial Statements

The income statement reports net income or net loss for the period. It reflects the wealth generated by the company in a given period The balance sheet reflects the financial position of the company at the end of a period (assets and liabilities). The financial statements help managers take decisions about the company (although they may have different incentives)
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Hewlett-Packard shares fall by 10% on lacklustre results

By Scott Morrison in San Francisco, Financial Times Published: Aug 20, 2003

Hewlett-Packard shares fell 10 per cent in late trading yesterday after the computer and printer maker reported disappointing third-quarter results. The failure to meet analysts' expectations was a setback for the company, which has reported several quarters of operational improvements following its $19bn (12bn) acquisition of Compaq Computer last year. HP blamed the results on overly aggressive pricing for personal computers and weak sales of its corporate computers. Carly Fiorina, chairman and chief executive, said: "The third quarter is always tough, but we still should have done better. Nevertheless, we are confident in our strategy and the actions we're taking. We expect to deliver a strong fourth quarter." The company reported a net profit of $297m, or 10 cents per share, for the quarter ended July 31, compared with a loss of $2bn, or 67 cents per share, last year which including hefty restructuring and acquisition charges. Excluding special items, the company reported earnings of $700m, or 23 cents per share, compared with a profit of $420m, or 14 cents per share, last year. Revenue totalled $17.35bn, up 5 per cent from $16.54bn last year and down 4 per cent from the previous quarter. Analysts had expected earnings of 26 cents per share on revenue of $17.5bn, according to Thomson First Call. HP's PC unit reported an operating loss of $56m, just one quarter after posting its first profit in years. The company said PC sales fell because of seasonal factors while gross margins were hit by aggressive pricing, aimed at fending off rival group Dell's bid for increased market share.

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The demand and supply of financial information

The Demand for financial information will depend upon:
Tastes and preferences (risk attitudes) Beliefs about the future Access to financial information

The supply of financial information will depend upon:

Incentives companies have to voluntarily disclose financial information Regulatory framework
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Need for Regulation

The role of capital markets as fund providers

Economic consequences of financial information

Managerial incentives to suppress unfavorable information

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Need for regulation

Financial Information and Financial Markets

The relationship between financial information and security prices can influence investors direct demand for financial information Evidence shows:
Annual earnings are not timely information and are preempted by alternative, more timely sources However, significant price reaction was found in the week of the anouncement of annual earnings Prices act as if earnings anouncements alter investors belief in such a way as to alter the price o security
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Overview of Information Characteristics

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Decision-Making
4. 1. Information Characteristics Content Relevance - Does it affect users decisions? Reliability - Is it representationally faithful, neutral, free from material error, prudent and complete? Presentation Comparable - Inter-and intra-company comparisons Understandable - Presented as understandably as possible

2.

Information must also be: Material Timely

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Accounting Principles and Concepts

Generally accepted accounting principles (GAAP) are
The rules that govern how accountants operate Based upon a conceptual framework

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Key Spanish Accounting Organizations

ICAC Treasury Ministry Bank of Spain AECA UE Comission CNMV

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Accounting regulation in Spain

There are two different regulatory regimes in place in Spain:

INTERNACIONAL REGULATION For Group Accounts of listed companies. The international regulation is based on the rules issued by the IASB approved by the European Commission.

NACIONAL REGULATION For the rest of companies. These follow the National regulation.

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Regulatory Bodies Issuing Accounting Rules in Spain

AECA (Asociacin Espaola de Contabilidad y Administracin de Empresas). Private body. Profesionals and academic are part of this organization which although it is influencial, it cannot regulate in accounting issues. http://www.aeca.es
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ICAC (Instituto de Contabilidad y Auditora de Cuentas) Public organization linked to the Ministry of Economy. It issues regulation (compulsory for companies). http://www.icac.meh.es

International Accounting Standards

Since 2005, all quoted companies within the EU have to prepare their accounts following the International Accounting Standards issued by the IASB. (CE 1606/2002)

The IASB (International Accounting Standards Board) is the regulatory body of the IASC (International Accounting Standards Committee) http://www.iasb.org

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Learning outcomes
Nature and importance of accounting Main users of accounting and their information needs Different types of accountancy Requirements of accounting information Main accounting organizations
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Bibliography
Harrison and Horngren: Financial Accounting. 6th or 7th edition (Prentice Hall) Vilardell, Ortn and Sol: Introduccin a la contabilidad general (McGraw-Hill) Jones (2006). Accounting. 2nd Edition. Ed. Wiley UK GAAP (2000). Ernst and Young, Butterworth

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