Chapter 1

• The Nature & Purpose of Accounting

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 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.

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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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