Chapter 1

The Nature
and Purpose of
Accounting

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. 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 for payroll
purposes.
– Automobiles available for sale to customers.
– Amounts owed by customers.
– Parts and accessories on hand.

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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 company.
• Primary financial statements:
– Balance sheet.
– Income statement.
– Statement of cash flows.
• Common rules used so investors can compare
with other companies’ financial statements.

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 Management Accounting
Information
• For internal users such as president,
marketing manager and production
manager.
• Used for three functions of managers:
– Planning.
– Implementation.
– Control.

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 Planning
• Deciding what actions should be taken. Decision
making involves:
– Identify problem or opportunity.
– Specify and rank criteria.
– Identify alternatives.
– Use accounting and other information to analyze.
– Compare alternatives and select best.
• Budgeting = process of planning for a specified
time, often for one year.

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 Implementation
• Actions to provide human and other
resources to achieve planned results.
• Requires supervision of managers.
• Managers must change plans as
conditions require.

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 Control
• Process to ensure employees perform properly.
• Accounting information is used to:
– Communicate. Inform employees of plans.
– Motivate. Encourage employees to act consistently
with organization’s goals.
– Direct attention. Provide feedback, that is, signal
when a problem may exist.
– Appraise. Provide information to appraise
performance of managers and other employees.

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 Tax Accounting Information
• Preparation of federal, state, and other
taxes.
• 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.
• Large and small firms.
• American Institute of CPAs (AICPA).

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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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 Responsibilities of Controller
• Manage professionals; prepare reports.
– Management accounting.
– Financial accounting.
– Tax accounting.
• 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.
• Authors emphasize perspective of current and
potential future users, recognizing need for
some knowledge of how accounting reports are
prepared.

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 Misconceptions about
Accounting
• Not all resources of organizations can be
measured and reported.
– Knowledge and skills of employees.
• Actual value or “worth” of a business may
not be included in usual financial reports.

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 Plan of Book/Course
• Part One Financial Accounting
– Chapters 2,3 and 4: Includes 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.
– Management can establish whatever rules, and
analysis it believes to be useful.

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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
• Many words have similar, but not same,
meaning as in common English.
• Similar to English, some rules are definite
others are not.
• Rules continue to evolve.
• XBRL (extensible business reporting
language): a digital business language.

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 Accounting Principles
• General rule or law.
• Convention.
• 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 members, diverse accounting backgrounds.
– Supported by professional staff.
– Private organization.
– Due process.
• Not legally required.
• Emerging Issues Tax Force.
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 Securities Exchange
Commission (SEC)
• U.S. agency empowered by congress to
protect investors.
• Jurisdiction over publicly traded company.
• Influences accounting rules through
Regulation S-X, Financial Reporting
Series Releases, and Staff Bulletins.
• Delegated authority for GAAP to FASB.

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 American Institute of CPAs
(AICPA)
• Members include auditors.
• Statements of Position (SOP).
• Accounting Trends & Techniques
summarizes practices of 600 companies.

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 International Accounting
Standards Board (IASB)
• International Financial Reporting Standards
(IFRS)
– Include International Accounting Standards (IAS)
developed by predecessor, International Accounting
Standards committee (IASC).
• Based in London, England.
• No authority to require compliance.
• Required by European Union (EU) for listed
companies.
• 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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 Stock vs. Flow
• Stock/resources and obligations at a point
in time:
– Balance sheet.
• Flow/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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 Dual Aspect: Balance Sheet
(Fundamental Accounting Equation)
• Assets = Liabilities + Owners’ equity.
• LHS = RHS.
• Resources = Obligations to creditors or claims
on resources + Residual claim.
• Amounts invested in resources = how these
amounts were financed.
• Resources = financed by creditors + financed
by owners.

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 Owners’ Equity
• Equivalently net assets (i.e. = A -L).
• 2 sources of OE:
– 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
• Net Assets = Owners’ Equity
• Every accounting transaction has an equal affect
on both sides of equation.
• Purchase a $20,000 car for cash.
– Increase asset car and decrease asset cash by
$20,000. No net change to assets.
• Purchase a $20,000 car on credit.
– Increase asset car and increase liabilities by $20,000.

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 Income Statement
• Shows changes in Owners’ Equity or Retained
Earnings from operations of business.
• Reconciles Retained Earnings from beginning to
end of period resulting from operations of
business.
• Revenues – Expenses = Net Income
– Sales Revenue = amount for product sold to
customers during accounting period.
– Gross margin = Sales revenue – Cost of sales

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 Financial Statement
Objectives
• Useful for investment decisions. (All financial
statements)
• Comprehensible. (All financial statements)
• About economic resources and claims on
resources (Balance Sheet).
• About financial performance during a period
(Income Statement).
• About cash flows (Statement of Cash Flows).

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 Sarbanes-Oxley Act (2002)
• Chief executives and chief financial
officers 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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 Chapter 1

End of
Chapter 1

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.