Financial Accounting and Its Environment
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LEARNING OBJECTIVES :
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1. Define accounting and identify its objectives.
2. Distinguish among the three major types of accounting.
3. List the three primary financial statements and briefly summarize the information
contained in each.
4. Identify financial statement users and the decisions they make.
5. Define generally accepted accounting principles and explain how they are
determined.
6. Describe the role of auditing.
7. List the economic consequences of accounting principle choice.
8. Assess the importance of ethics in accounting.
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INTRODUCTION
Jane Johnson is considering selling T-shirts in the parking lot during her university’s
football games. Jane, of course, will do this only if she expects to make a profit. To estimate
her profits, Jane needs certain pieces of information, such as the cost of a shirt,
the university’s charge for the right to conduct business on its property, the expected
selling price, and the expected sales volume. Suppose Jane has developed the following
estimates:
Sales price per shirt $ 12
Cost per shirt $ 7
Number of shirts sold per game day 50
University fee per game day $100
Although developing estimates is tricky, let’s take these estimates as given. Based
on the estimates, Jane would earn a profit of $150 per game day.
Sales ($12 50) $600
Less expenses:
Cost of merchandise ($7 50) $350
University fee 100
Total expenses 450
Net income $150
Since this looks like a reasonable profit, Jane puts her plan into action. After her
first game day, Jane needs to assess her success (or failure). Based on her actual results,
Jane prepares the following information:
Sales ($12 40) $480
Less expenses:
Cost of merchandise ($7 40) $280
University fee 100
Total expenses 380
Net income $100
Jane’s business was profitable, but not as profitable as she planned. This is because
Jane sold fewer shirts than she hoped, but Jane is confident that she can sell any remaining
shirts on the next game day.
The preceding illustration shows two ways in which accounting can be used.
First, Jane used accounting to help plan her business. That is, she used accounting to
project her expected profit. Second, after Jane operated her business for a day, she
used accounting to determine if, in fact, she had made a profit. In general, accounting
is used during all phases of planning and operating a business.
ACCOUNTING
Accounting is the systematic process of measuring the economic activity of a business
to provide useful information to those who make economic decisions. Accounting
information is used in many different situations. The illustration in the introductory
section shows how a business owner (Jane) can use accounting information.
Bankers use accounting information when deciding whether or not to make a loan.
Stockbrokers and other financial advisers base investment recommendations on accounting
information, while government regulators use accounting information to determine
if firms are complying with various laws and regulations.
TYPES OF ACCOUNTING
The examples mentioned in the last section explained how accounting information
can be helpful in a number of situations. In fact, the field of accounting consists of several
specialty areas that are based on the nature of the decision. The following sections
describe the three major types of accounting, which are summarized in Exhibit 1-1.
Financial Accounting
Financial accounting provides information to decision makers who are external
to the business. To understand the role of financial accounting, consider a large corporation
such as IBM. The owners of corporations are called shareholders, and IBM
has more than 600,000 shareholders. Obviously, each shareholder cannot participate
directly in the running of IBM, and because IBM needs to maintain various trade
secrets, its many thousands of shareholders are not permitted access to much of the
firm’s information. Because of this, shareholders delegate most of their decisionmaking
power to the corporation’s board of directors and officers. Exhibit 1-2 contains
an organizational chart for a typical corporation. Shareholders, however, need
information to evaluate (1) the performance of the business and (2) the advisability
of retaining their investment in the business. Financial accounting provides some of
the information for this purpose; such information is also used by potential shareholders
who are considering an investment in the business.
Creditors and potential creditors are also served by financial accounting. Firms often
seek loans from banks, insurance companies, and other lenders. Although creditors
are not internal parties of those firms, they need information about them so that
funds are loaned only to credit-worthy organizations. Financial accounting will usually
provide at least some of the information needed by these decision makers.
Managerial Accounting
Managers make numerous decisions. These include (1) whether to build a new plant,
(2) how much to spend for advertising, research, and development, (3) whether to
lease or buy equipment and facilities, (4) whether to manufacture or buy component
parts for inventory production, or (5) whether to sell a certain product. Managerial accounting
provides information for these decisions. This information is usually more detailed
and more tailor-made to decision making than financial accounting information.
It is also proprietary; that is, the information is not disclosed to parties outside the firm.
Sterling Collision Centers, Inc. provides a good illustration of managerial accounting
at work. Although Sterling only has 18 shops, it hopes to put a major dent in
the automotive body shop business through aggressive expansion and the introduction
of innovative management techniques. One of its strategies is to use computers
to better track repair times, which will provide both standards for different types of
repair jobs as well as measures of how individual workers perform relative to the standards.
By tying pay to performance, Sterling hopes to improve worker productivity.
Knowledge of repair times will also help Sterling to determine estimated bids for its
repair jobs. Managerial accountants play a major role in all these activities.
Although distinguishing between financial and managerial accounting is convenient,
the distinction is somewhat blurred. For example, financial accounting provides information
about the performance of a firm to outsiders. Because this information is essentially
a performance report on management, managers are appropriately interested in and influenced
by financial accounting information. Accordingly, the distinction between financial
and managerial accounting depends on who is the primary user of the information.