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Accounting
Information:
Users and Uses

chapter



1
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learning objectives After studying this chapter, you should be able to:


1 Describe the purpose of 3 Describe the environment of 4 Analyze the reasons for
accounting and explain its accounting, including the studying accounting.
role in business and society. effects of generally accepted
accounting principles,
2 Identify the primary users of international business,
accounting information.
ethical considerations, and
technology.
2 chapter f1
Accounting Information: Users And Uses


In 1987, IBM was the most valuable com- just 32 employees in 1981 when IBM
pany in the world, worth an estimated elected to use Microsoft s DOS to 31,575 as
$105.8 billion. By the end of 1992, IBM had of the June 30, 1999, fiscal year. In terms
an estimated value of $28.8 billion. This of social impact, Microsoft and its employ-
decline in value can be traced to a strate- ees donate millions of dollars each year to
gic error made by IBM in the early 1980s. such charitable causes as Special Olympics,
Prior to 1981, IBM was the major player in Boys and Girls Clubs, and the United Negro
the computer market and was the primary College Fund. Microsoft also supports ele-
provider of computers for government, mentary and high schools throughout the
universities, and businesses. At this time, country in their efforts to in-
fyi
believe it or not, virtually no computers corporate technology into
were available at an affordable price for in- the curriculum, and the com- In fact, many people are of the
dividuals. Then, in 1981, IBM introduced pany has established schol-
opinion that Microsoft has suc-
its personal computer (IBM PC), and it arship programs to encour-
ceeded too well. Several of Mi-
quickly established the standard by which age minorities and women
crosoft s competitors allege
other PCs would be measured. However, to pursue careers in com-
IBM elected to leave the software devel- puter science and related that Microsoft is involved in
opment for PCs to other companies. In- technical fields. In addition, monopolistic practices that sti-
stead of developing its own disk operating Bill Gates and his wife fle competition. As this book
system (DOS), IBM elected to use a DOS Melinda have started a foun-
goes to press, the government
developed by a small company located in dation dedicated primarily to
is considering several options
S e a t t l e MICROSOFT.1 health and education. Thus
far they have contributed
Microsoft was founded in 1975 by Bill relating to Microsoft s business
Gates and Paul Allen.2 When they founded several billion dollars to their practices including breaking
foundation.
Microsoft, Gates and Allen envisioned that the company into several
In terms of stock price,
computers would eventually find their way
smaller entities.
Microsoft s per share stock
into everyday life (contrary to IBM s pre-
price (adjusted for stock
diction in the 1950s when one IBM execu-
splits) has gone from $0.17 in 1986 to over
tive forecast the total worldwide demand
$70 in April of 2000 (see Exhibit 1-1). On
for computers to be about five). While
setting the stage
virtually every dimension you can think of,
IBM s performance floundered in the mid-
Microsoft has succeeded. But most of
and late-1980s, Microsoft demonstrated an
these dimensions are a by-product of Mi-
amazing ability to become a major player
crosoft s ability to produce products that
in practically every aspect of the computer
are valued by the market. If Microsoft were
software market from operating systems
unable to produce and sell quality prod-
to the Internet to networks to spreadsheets
ucts, the company would not be in a posi-
and word processors.
tion to employ so many people, to give so
With Microsoft s many accomplish-
much money to charities, to dominate
ments comes the question: Just how suc-
(some would say monopolize) its markets,
cessful is the company? The answer to
or to experience such an incredible in-
that question depends on how you define
crease in stock price. And this is where ac-
success. Measured in terms of number
counting enters the picture.
of employees, Microsoft has grown from

1 The decision to have another company develop the software for its personal computer was not IBM s only
strategic error. At the same time, IBM decided to use another company s microprocessors the brains of the
computer. As a result, another successful company was born INTEL. IBM lost the opportunity to dominate the
software market as well as the computer chip market. By May 2000, Microsoft, Intel, and IBM had market val-
ues exceeding $364 billion, $398 billion, and $195 billion, respectively.
2 Everybody knows Bill Gates, but few people know about Paul Allen. Allen was Microsoft s head of research
and new product development until 1983 when a serious illness caused him to leave the company. He still re-
mains on the company s board of directors and is Microsoft s second largest shareholder. He now spends much
of his time investing in technology companies and watching the Seattle Seahawks, a professional football team,
and the Portland Trailblazers, a professional basketball team both of which he owns.
3
f4 Accounting Information: Users And Uses
Part 1 Financial Reporting and the Accounting Cycle



History of Microsoft s Stock Price Per Share
exhibit 1-1



Price History of Microsoft
(1/1/1986“4/30/2000)
120

110

100

90

80

70

$ 60

50

40

30

20

10

0
1995
1986 1990 2000
Year




In this textbook, you will begin your study of accounting. You will learn to speak and understand ac-
counting, the language of business. Without an understanding of accounting, business investments,
taxes, and money management will be like a foreign language to you. In brief, an understanding of
accounting facilitates the interpretation of financial information, which allows for better eco-
caution nomic decisions.
The major objectives of this text are to provide you with a basic understanding of the lan-
Don t be too concerned with all
guage of accounting and with the ability to interpret and use financial information prepared
the new and unfamiliar terms
using accounting techniques and procedures. With the knowledge you obtain from this expo-
you see in the first chapter of
sure to accounting, you will be able to read the financial statements of companies such as Mi-
the book. Learning a new lan-
crosoft, understand the information that is being conveyed, and use accounting information to
guage takes time. Be patient.
make good business decisions. Also, through discussion of the business environment in which
Before too long, you will be
accounting is used, you will increase your understanding of general business concepts such as
speaking the language of
corporations, leases, annuities, leverage, derivatives (the financial kind, not the calculus kind),
business (accounting) quite and so forth.
fluently. You will become convinced that accounting is not bean counting. Time after time you
will see that accountants must exercise judgment about how to best summarize and report the
results of business transactions. As a result, you will gain a respect for the complexity of accounting
and develop a healthy skepticism about the precision of any financial reports you see.
Finally, you will see the power of accounting. Financial statements are not just paper reports that
get filed away and forgotten. You will see that financial statement numbers, and, indirectly, the ac-
countants who prepare them, determine who receives loans and who doesn t, which companies attract
investors and which don t, which managers receive salary bonuses and which don t, and which com-
panies are praised in the financial press and which aren t.
So, let s get started.
4 f5
Accounting Information: Users And Uses Chapter 1
Accounting Information: Users and Uses



1 WHAT S THE PURPOSE OF ACCOUNTING?
Describe the purpose of
Imagine a long distance telephone company with no system in place to document who calls
accounting and explain its
role in business and whom and how long they talk. Or a manager of a 300-unit apartment complex who has for-
society.
gotten to write down which tenants have and have not paid this month s rent. Or an account-
ing professor who, the day before final grades are due, loses the only copy of the disk contain-
ing the spreadsheet of all the homework, quiz, and exam scores. Each of these scenarios illustrates
a problem with bookkeeping, the least glamorous aspect of accounting. Bookkeeping is the
bookkeeping The preserva-
tion of a systematic, quanti- preservation of a systematic, quantitative record of an activity. Bookkeeping systems can be very
tative record of an activity. primitive cutting notches in a stick to tally how many sheep you have or moving beads on a
string to track the score in a billiards game. But the importance of routine bookkeeping cannot
be overstated; without bookkeeping, business is impossible.
To evaluate the importance of bookkeeping records, we ll use a thought experiment. Sup-
pose that sometime during the night, every copy of every novel ever written were to disappear.
Could life proceed normally the next day? While the cultural loss would be incalculable, the
normal activities of the next day would not be noticeably affected. What if television were sud-
denly gone when we woke up? While we might wander around wondering what to do with our
time, life would go on. But what if we woke up tomorrow morning to find the bookkeeping
records of all businesses worldwide destroyed during the night? Businesses that rely on up-to-
the-minute customer account information, such as banks, simply could not open their doors.
Retailers would have to insist on cash purchases, since no credit records could be verified. Man-
ufacturers would have to do a quick count of existing inventories of raw materials and compo-
nents to find out whether they could keep their production lines running. Suppliers would have
to call all their customers, if they could remember who they were, to renegotiate purchase or-
ders. Attorneys would find themselves in endless arguments about their fees because they would
have no record of billable hours. Routine and dry as bookkeeping may seem, the world simply
could not function for one day without it.
Rudimentary bookkeeping is ancient, probably predating both language and money. The
modern system of double-entry bookkeeping still in use today (described in Chapter 3) was de-
veloped in the 1300s 1400s in Italy by the merchants in the trading and banking centers of Flo-
rence, Venice, and Genoa. The key development in accounting in the last 500 years has been
the use of the bookkeeping data, not just to keep track of things, but to evaluate the perfor-
mance and health of a business.
This use of bookkeeping data as an evaluation tool may seem obvious to you, but it is a step
that is often not taken. Let s consider a bookkeeping system with which most of us are familiar
a checking account. Your checking account involves (or should involve) careful recording of the
dates and amounts of all checks written and all deposits made, the maintenance of a running ac-
count total, and reconciliations with the monthly bank statement. Now, assume that you have a
perfect checking account bookkeeping system. Will the system answer the following questions?
Are you spending more for groceries this year than you did last year?
What proportion of your monthly expenditures are fixed, meaning that you can t change
them except through a drastic change in lifestyle?
You plan to study abroad next year; will you be able to save enough between now and then
to pay for it?
In order to answer these kinds of evaluation questions, each check must be analyzed to de-
termine the type of expenditure, your checks must then be coded by type of expenditure, the
accounting system The pro-
data must be boiled down into summary reports, and past data must be used to forecast future
cedures and processes
patterns. How many of us use our checking account data like this? Not many. We do the book-
used by a business to ana-
lyze transactions, handle keeping (usually), but we don t structure the information to be used for evaluation.
routine bookkeeping tasks,
In summary, an accounting system is used by a business to (1) analyze transactions, (2)
and structure information
handle routine bookkeeping tasks, and (3) structure information so it can be used to evaluate
so it can be used to evalu-
the performance and health of the business. Exhibit 1-2 illustrates the three functions of the ac-
ate the performance and
counting system.
health of the business.
5
f6 Accounting Information: Users And Uses
Part 1 Financial Reporting and the Accounting Cycle



Functions of an Accounting System
exhibit 1-2

Analysis Bookkeeping Evaluation




Use summary information
Analyze business events
Day-to-day keeping to evaluate the financial
to determine if information
track of things health and performance
should be captured by the
of the business
accounting system




Accounting is formally defined as a system for providing quantitative information, pri-
accounting A system for
providing quantitative, fi- marily financial in nature, about economic entities that is intended to be useful in making eco-
nancial information about nomic decisions. 3 The key components of this definition are:
economic entities that is
useful for making sound Quantitative. Accounting relates to numbers. This is a strength because numbers can be eas-
economic decisions. Ac- ily tabulated and summarized. It is a weakness because some important business events, such
counting is often called the
as a toxic waste spill and the associated lawsuits and countersuits, cannot be easily described
language of business be-
by one or two numbers.
cause it provides the means
Financial. The health and performance of a business are affected by and reflected in many
of recording and communi-
cating business activities dimensions financial, personal relationships, community and environmental impact, and
and the results of those ac- public image. Accounting focuses on just the financial dimension.
tivities.
Useful. The practice of accounting is supported by a long tradition of theory. U.S. accounting
rules have a theoretical conceptual framework. Some people actually make a living as ac-
counting theorists. However, in spite of its theoretical beauty, accounting exists only be-
cause it is useful.
Decisions. Although accounting is the structured reporting of what has already occurred, this
past information can only be useful if it impacts decisions about the future.
Making good decisions is critical for success in any business enterprise. When an impor-
tant decision must be made, it is essential to use a rational decision-making process. The process
is basically the same no matter how complex the issue. First, the issue or question must be clearly
identified. Next, the facts surrounding the situation must be gathered and analyzed. Then, sev-
eral alternative courses of action should be identified and considered before a decision is finally
reached. This decision-making process is summarized in Exhibit 1-3.
One must be careful to make a distinction between a good decision and a good outcome.
Often, many factors outside the control of the decision maker affect the outcome of a decision.
The decision-making process does not guarantee a certain result; it only ensures that a good de-
cision is made. To illustrate this process, let s consider an example. It s Friday afternoon, the
sun is shining, your homework is done, and you have the rest of the afternoon and evening
ahead of you. What to do? You check the movie listings in the newspaper to see if there are any
new movies you haven t seen, you call several of your friends to see what they are doing, and
you review your list of things you always wanted to organize around your apartment but never
had the time. With this information, you decide that you could either (1) go to the new Tom
Hanks movie with a group of friends or (2) go over to your friend s house and watch TV. (Spend-
ing time at home organizing your sock drawer on a Friday night is out of the question.) You


3 Statement of the Accounting Principles Board No. 4, Basic Concepts and Accounting Principles Underlying
Financial Statements of Business Enterprises, New York: American Institute of Certified Public Accountants,
1970, par. 40.
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Accounting Information: Users And Uses Chapter 1
Accounting Information: Users and Uses



The Decision-Making Process
exhibit 1-3

Step Step Step Step
Select the




1234
option that
Gather Identify
Identify will most
information. alternatives.
the issue. likely result
in the desired
objective.




decide to go to the movies. You get to the movie theater, buy your ticket, your popcorn, and
your drink, then select a seat. The lights dim, the movie starts, and the only empty seat left in
the theater is right in front of you. It turns out you have the best seat in the house until
Shaquille O Neal (7 2 , 300 pounds) comes in and sits in that seat. Good decision, bad out-
come.
The four steps of the decision-making process lead to the best decision under the circum-
stances, but the outcome always has an element of chance. Part of business is learning how to
protect yourself against bad outcomes. The first step in achieving a favorable outcome begins
with making a good decision.
Accounting plays a vital role in the decision-making process. An accounting system pro-
vides information in a form that can be used to make knowledgeable financial decisions. The
information supplied by accounting is in the form of quantitative data, primarily financial in
nature, and relates to specific economic entities. An economic entity may be an individual, a
business enterprise, or a nonprofit organization. A business, such as a grocery store or a car deal-
business An organization
operated with the objective ership, is operated with the objective of making a profit for its owners. The goal of a nonprofit
of making a profit from the
organization, such as a city government or a university, is to provide services in an effective and
sale of goods or services.
efficient manner. Every entity, regardless of its size or purpose, must have a way to keep track
of its economic activities and to measure how well it is accomplishing its goals. Accounting pro-
nonprofit organization An
entity without a profit ob- vides the means for tracking activities and measuring results.
jective, oriented toward
Without accounting information, many important financial decisions would be made
providing services effi-
blindly. Investors, for example, would have no way to distinguish between a profitable company
ciently and effectively.
and one that is on the verge of failure; bankers could not evaluate the riskiness of potential loans;
corporate managers would have no basis for controlling costs, setting prices, or investing the
company s resources; and governments would have no basis for taxing income. No list of ex-
amples could fully represent the pervasive use of accounting information throughout our eco-
nomic, social, and political institutions. When accounting information is used effectively as a
basis for making economic decisions, limited resources are more likely to be allocated efficiently.
From a broad perspective, the result is a healthier economy and a higher standard of living.
The value of accounting information can also be illustrated on a personal level. Since very
few of us will ever make more money than we can spend, we each will be making choices as
to what to do with our limited incomes. For example, assume you have a job that results in
take-home pay of $2,000 per month. What do you do with the money? If you are making
monthly payments on a home and/or an automobile, you previously made choices to use part
of your monthly income for these two items. How about a trip around the world, season tick-
ets for your favorite basketball team, or a new home entertainment system? You could spend
your money on these items, but that might not be the best use of your income. After all, you
haven t eaten yet. Routine expenditures for food, clothing, and utilities must be made. How
much money will you need for these and other everyday expenditures? By collecting financial
information relating to prior months inflows and outflows of cash, you will be able to ap-
proximate how much money you will need for this month. This process called budgeting (dis-
cussed later) is often used by individuals (and businesses) to ensure that monthly income is
used in the best manner possible. While it is true that budgeting is not necessary, budgeting is
part of good decision making.
7
f8 Accounting Information: Users And Uses
Part 1 Financial Reporting and the Accounting Cycle



The Relationship of Accounting to Business
Business is the general term applied to the activities involved in the production and distribution
of goods and services. Accounting is used to record and report the financial effects of business
activities. Thus, as mentioned earlier, accounting is often called the language of business. It
provides the means of recording and communicating the successes and failures of business or-
ganizations.
All business enterprises have some activities in common. As shown in Exhibit 1-4, one com-
mon activity is the acquisition of monetary resources. These resources, often referred to as cap-
ital, come from three sources: (1) investors (owners), (2) creditors (lenders), and (3) the busi-
ness itself in the form of earnings that have been retained. Once resources are obtained, they are
used to buy land, buildings, and equipment; to purchase materials and supplies; to pay em-
ployees; and to meet any other operating expenses involved in the production and marketing of
goods or services. When the product or service is sold, additional monetary resources (revenues)
are generated. These resources can be used to pay loans, to pay taxes, and to buy new materi-
als, equipment, and other items needed to continue the operations of the business. In addition,



Activities Common to Business Organizations
exhibit 1-4


Investments by owners Loans from creditors




contribute


Monetary resources
Business earnings
(capital)

used to




Buy land, buildings, and Purchase materials and Pay other
Pay employees
equipment supplies operating expenses




Produce and market
goods and services

results in


Monetary resources (revenues) from sale of
goods and services


used to




Pay a return to owners Continue business activity (buy
Pay taxes
Pay loans
on their investments materials, pay wages, etc.)
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Accounting Information: Users And Uses Chapter 1
Accounting Information: Users and Uses


some of the resources may be distributed to owners as a return on their investment. MI-
CROSOFT, for example, uses the earnings from its operations to fund research and develop-
ment and to purchase other companies. The developed (or purchased) products can then be sold
at a profit under the Microsoft name. This produces more funds that can then be used to pur-
chase more companies or develop more products. Microsoft currently does not distribute its re-
sources back to its owners. Owners receive a return on their investment through the growth in
value of the stock.
Accountants measure and communicate (report) the results of these activities. In order to
measure these results as accurately as possible, accountants follow a fairly standard set of proce-
dures, usually referred to as the accounting cycle. The cycle includes several steps, which in-
accounting cycle The proce-
dure for analyzing, record- volve analyzing, recording, classifying, summarizing, and reporting the transactions of a busi-
ing, classifying, summariz-
ness. These steps are explained in detail in Chapters 3 and 4.
ing, and reporting the
transactions of a business.



to summarize
Accounting is a service activity designed to accumulate, measure, and com-
municate financial information about economic entities businesses and non-
profit organizations. Its purpose is to provide information used to make informed
decisions about how to best use available resources. Accounting is often called
the language of business because it provides the means of recording and
communicating business activities and the results of those activities.




2 WHO USES ACCOUNTING INFORMATION?
Identify the primary users
The accounting system generates output in the form of financial reports. As shown in Exhibit
of accounting information.
1-5, there are two major categories of reports: internal and external. Internal reports are used by
those who direct the day-to-day operations of a business enterprise. These individuals are col-
lectively referred to as management, and the related area of accounting is called management
management accounting
The area of accounting con- accounting. Management accounting focuses on the information needed for planning, imple-
cerned with providing inter- menting plans, and controlling costs. Managers and executives who work inside a company have
nal financial reports to as-
access to specialized management accounting information that is not available to outsiders. For
sist management in making
example, the management of MCDONALD S CORPORATION has detailed management ac-
decisions.
counting data on exactly how much it costs to produce each item on the menu. Further, if
BURGER KING or WENDY S starts a local burger price war in, say, Missouri, McDonald s
annual report A document managers can request daily sales summaries for each store in the area to measure the impact.
that summarizes the results
Other examples of decisions made using management accounting information are whether
of operations and financial
to produce a product internally or purchase it from an outside supplier, what prices to charge,
status of a company for the
and which costs seem excessive. Consider those companies that produce computers. Most com-
past year and outlines
plans for the future. puters are shipped with an operating system already installed. Approximately 85% of comput-
ers have MICROSOFT s Windows pre-installed. The computer makers must decide whether to
financial statements Re-
develop their own operating system or pay Microsoft a licensing fee to use Windows. Most com-
ports such as the balance
puter manufacturers have determined it is cost effective to license from Microsoft. Companies
sheet, income statement,
and statement of cash such as SEARS and RADIO SHACK often use products produced by outside suppliers rather
flows, which summarize the than manufacture the products themselves. The products are then labeled with the Kenmore
financial status and results
or Realistic brand names and sold to customers. These are just two examples of decisions that
of operations of a business
must be made by management given available financial information.
entity.
External financial reports, included in the firm s annual report, are used by individuals
financial accounting The and organizations that have an economic interest in the business but are not part of its man-
area of accounting con-
agement. Information is provided to these external users in the form of general-purpose fi-
cerned with reporting finan-
nancial statements and special reports required by government agencies. The general-purpose
cial information to inter-
information provided by financial accounting is summarized in the three primary financial
ested external parties.
9
f10 Accounting Information: Users And Uses
Part 1 Financial Reporting and the Accounting Cycle



Output of the Accounting Cycle
exhibit 1-5

Internal Reporting External Reporting
(Management Accounting) (Financial Accounting)

The
Accounting
Cycle




Financial reports for internal use by General-purpose financial statements for
company management. use by creditors, investors, and other
external users.
Examples: G budgets
G cost analyses Examples: G balance sheet
G divisional performance G income statement

reports G statement of cash flows




Other external reports:
Special reports required by regulatory
agencies, such as the SEC.
Example: registration statements
Income tax forms required by the IRS
and state and local governments.
Example: corporate tax returns




statements: balance sheet, income statement, and statement of cash flows (more formally in-
troduced in Chapter 2).
The balance sheet reports the resources of a company (the assets), the company s obligations
(the liabilities), and the owners equity, which represents the difference between what is
owned (assets) and what is owed (liabilities).
The income statement reports the amount of net income earned by a company during a pe-
riod, with annual and quarterly income statements being the most common. Net income
is the excess of a company s revenues over its expenses; if the expenses are more than the
revenues, then the company has suffered a loss for the period. The income statement rep-
resents the accountant s best effort at measuring the economic performance of a company.
The statement of cash flows reports the amount of cash collected and paid out by a company
in the following three types of activities: operating, investing, and financing. The types of
activities in each of these three categories will be explained in Chapter 2. The statement of
cash flows is the most objective of the financial statements because, as you will see in sub-
sequent chapters, it involves a minimum of accounting estimates and judgments.
Examples of external users of the information contained in these three financial statements,
along with other available information, are described in the following paragraphs.

Lenders
Lenders (creditors) are interested in one thing being repaid, with interest. If you were to ap-
proach a bank for a large loan, the bank would ask you for the following types of information
in order to evaluate whether you would be able to repay the loan:
A listing of your assets and liabilities
Payroll stubs, tax returns, and other evidence of your income
10 f11
Accounting Information: Users And Uses Chapter 1
Accounting Information: Users and Uses



Details about any monthly payments (car, rent, credit cards, etc.) you are obligated to make
Copies of recent bank statements to document the flow of cash into and out of your ac-
count
In essence, the bank would be asking you for a balance sheet, an income statement, and a
statement of cash flows. Similarly, banks use companies financial statements in making deci-
sions about commercial loans. The financial statements are useful because they help the lender
predict the future ability of the borrower to repay the loan.
In the case of Microsoft, a review of its balance sheet indicates that the company has no
formal lenders. It does, however, report a balance in its accounts payable account. This amount
represents amounts owed to vendors from whom Microsoft has purchased on credit. Consider-
ing Microsoft s reputation, this lending is very low risk.

Investors
Investors want information to help them estimate how much cash they can expect to receive in
the future if they invest in a business now. Financial statements, coupled with a knowledge of
business plans, market forecasts, and the character of management, can aid investors in
assessing these future cash flows. Many companies have broad ownership with a few in-
fyi
dividuals owning a large portion of the company s stock. At Microsoft, Bill Gates owns
One of the concerns with on-
787,055,600 shares (15.3% of total shares outstanding); Paul Allen, Microsoft s co-
line day trading is that in-
founder, owns 260,723,896 shares (5.1%); and Steve Ballmer, Microsoft s chief executive
vestors make significant in-
officer, owns 239,626,854 shares (4.7%).
vestment decisions without Obviously, millions of Americans invest in McDonald s, Microsoft, CISCO SYS-
ever seeing, or even thinking TEMS, and GENERAL ELECTRIC without ever seeing the financial statements of these
companies. Investors can feel justifiably safe in doing this because large companies are fol-
about, a company s reported fi-
lowed by armies of financial analysts who would quickly blow the whistle if they found
nancial position.
information suggesting that investors in these companies were at serious risk. But what
about investing in a smaller company, one that the financial press doesn t follow, or in a local
family business that is seeking outside investors for the first time? In cases such as these, invest-
ing without looking at the financial statements is like jumping off the high dive without look-
ing first to see if there is any water in the pool.

Management
In addition to using management accounting information available only to those within the
firm, managers of a company can use the general financial accounting information that is also
made available to outsiders. Company goals are often stated in terms of financial accounting
numbers, such as a target of sales growth in excess of 5%. Also, reported net income is fre-
quently used in calculating management bonuses. Finally, managers of a company can analyze
the general-purpose financial statements (using the techniques introduced in Chapter 2) in or-
der to pinpoint areas of weakness about which more detailed management accounting informa-
tion can be sought. Microsoft uses internally produced accounting reports to evaluate such things
as the profitability of product lines, the success of international operations, and the performance
of product and management teams.

Other Users of Financial Information
There are many other external users of financial information, including suppliers, customers,
employees, competitors, government agencies, and the press. These are described below.

In some settings, suppliers and customers are interested
SUPPLIERS AND CUSTOMERS
in the long-run staying power of a company. On the supplier side, if BOEING receives an or-
der from an airline for 30 new 747s over the next 10 years, Boeing wants to know whether the
airline will be around in the future to take delivery of and pay for the planes. On the customer
side, a homeowner who has foundation repair work done wants to know whether the company
making the repairs will be around long enough to honor its 50-year guarantee. Financial state-
11
f12 Accounting Information: Users And Uses
Part 1 Financial Reporting and the Accounting Cycle


ments provide information that suppliers and customers can use to assess the long-run prospects
of a company. Each version of a software release has a limited life, and part of Microsoft s suc-
cess has been its ability to provide product upgrades. Microsoft s customers can use financial in-
formation to help them ascertain the company s ability to survive and have the resources to fix
glitches and provide upgrades as the technology improves.

Employees are interested in financial accounting information for a variety of
EMPLOYEES
reasons. As mentioned earlier, financial statement data are used in determining employee bonuses.
In addition, financial accounting information can help an employee evaluate the likelihood that
the employer will be able to fulfill its long-run promises, such as pensions and retiree health-
care benefits. Financial statements are also important in contract negotiations between labor and
management.

If you were a manager at PEPSICO, would you be interested in knowing
COMPETITORS
the relative profitability of COCA-COLA s operations in the United States, Brazil, Japan, and
France? Of course you would, because that information could help you identify strategic op-
portunities for marketing pushes where potential profits are high or where your competitor is
weak. Microsoft can use the information in financial statements to track its competitors and
identify new opportunities to grow and use its market share in operating systems to increase its
revenues in other software ventures. For example, Microsoft s recent antitrust troubles relate, in
large part, to its competition with NETSCAPE, an Internet-browser alternative to Microsoft s
Explorer. In 1997 (the last year that Netscape provided publicly available financial information),
Netscape lost over $115 million on sales of almost $534 million. During that same period, Mi-
crosoft was earning a profit of almost $3.5 billion on sales of almost $12 billion.

Federal and state government agencies make frequent use of
GOVERNMENT AGENCIES
financial accounting information. For example, to make sure that investors have sufficient in-
formation to make informed investment decisions, the Securities and Exchange Commission
monitors the financial accounting disclosures of companies (both U.S. and foreign) whose stocks
trade on U.S. stock exchanges. The International Trade Commission uses financial accounting
information to determine whether the importation of Ecuadorian roses or Chinese textiles is
harming U.S. companies through unfair trade practices. The Justice Department uses financial
statement data to evaluate whether companies (such as Microsoft) are earning excess monopo-
listic profits. In Microsoft s case, from 1994 through 1999, it reported profits of $0.34 on every
dollar of sales. During that same period, General Electric, one of America s most admired com-
panies, generated profits of $0.09 on every dollar of sales.

Financial statements are a great place for a reporter to find background infor-
THE PRESS
mation to flesh out a story about a company. For example, a story about Microsoft can be en-
hanced by using the sales data shown in its annual report. In addition, a surprising accounting
announcement, such as a large drop in reported profits, is a trigger for an investigative reporter
to write about what is going on in a company. When the Justice Department proposed the
breakup of Microsoft, The Wall Street Journal reported analysts estimates of the value of the
company s various parts based on past revenue figures. For example, one analyst estimated that
Microsoft s consumer business would be worth 50 times its revenue.4
In summary, who uses financial accounting information? Everyone does, or at least every-
one should. External financial reports come within the area of accounting referred to as finan-
cial accounting. Most of the data needed to prepare both internal and external reports is pro-
vided by the same accounting system. A major difference between management and financial



4 Gregory Zuckerman, Figuring Worth of a Split-Up, Microsoft Leaves Analysts Scattered All Over Map, The
Wall Street Journal, May 2, 2000, p. C1.
12 f13
Accounting Information: Users And Uses Chapter 1
Accounting Information: Users and Uses


accounting is the types of financial reports prepared. Internal reports are tailored to meet the
needs of management and may vary considerably among businesses. General-purpose financial
statements and other external reports, however, follow certain standards or guidelines and are
thus more uniform among companies. The first thirteen chapters of Accounting: Concepts and
Applications focus on financial accounting, specifically on the primary financial statements (dis-
cussed and illustrated in Chapter 2). The remaining chapters, 14 through 23, focus on man-
agement accounting.




to summarize
Two major categories of reports are generated by the accounting cycle: inter-
nal and external. Management accounting focuses on providing reports for in-
ternal use by management to assist in making operating decisions and in plan-
ning and controlling a company s activities. Financial accounting provides
information to meet the needs of external users. General-purpose financial
statements are used by investors, creditors, and other external parties who are
interested in a company s activities and results.




3 WITHIN WHAT KIND OF ENVIRONMENT DOES
ACCOUNTING OPERATE?
Describe the environment
of accounting, including the
effects of generally
Accounting functions in a dynamic environment. Changes in technology as well as economic
accepted accounting
and political factors can significantly influence accounting practice. Four particularly important
principles, international
business, ethical factors are the development of generally accepted accounting principles (GAAP), international
considerations, and
business, ethical considerations, and technology.
technology.

The Significance and Development of Accounting Standards
Imagine a company that compensates a key employee in the following ways:
Paying a cash salary of $80,000.
Giving a new car with a value of $30,000.
Offering the option to become, a year from now, a 10% owner of the company in exchange
for an investment of $200,000.
If the company does well in the coming year, the company will increase in value, the
$200,000 price tag for 10% ownership will look like a great deal, and the employee will exer-
cise the option. If the company does poorly, it will decline in value, the $200,000 price will be
too high, and the employee will throw the option away and forget the whole thing. Assume the
company then sells the ownership option to interested outside investors for $25,000.
The accounting question is how to summarize in one number the company s compensa-
tion cost associated with this employee. We would probably all agree to include the $110,000
($80,000 $30,000) compensation cost from the cash salary and the new car. What about the
option? Both of the following arguments could be put forward:
1. If the employee were to buy the option from the company, just like any other outside in-
vestor, the employee would have to pay $25,000. Therefore, giving the option to the em-
ployee is just like paying him or her $25,000 cash. The $25,000 value of the option should
be added to compensation cost.
2. The option doesn t cost the company a thing. In fact, the option merely increases the prob-
ability that the employee will invest $200,000 in the company in the future. The option
doesn t add a penny to compensation cost.
13
f14 Accounting Information: Users And Uses
Part 1 Financial Reporting and the Accounting Cycle



business environment essay


The Evolution of Accounting It can be ing was invented not to write books but to
argued that accounting as a profession keep books. (Hoffer, p. 196)
is very young; as a service activity, how-
Among the earliest known records are those of the
ever, it dates back several thousand
Egyptians and Babylonians (from approximately 3000
years. Long before numerical figures
B.C.), who recorded on clay tablets such transactions
were invented, people designated pos-
as the payment of wages and taxes. Multiple clay
sessions and debts through natural
tablets listing valuable items in treasuries and tem-
means. Collections of pebbles, shells, or
ples have been found at excavation sites in Sumeria
bones were used to represent ex-
and Babylon. It makes sense that accountants of old
changes between people. Some main-
would only take the time to carve in these clay tablets
tained records of debt by carving notches in rods or
instead of writing on papyrus if they regarded the in-
canes. The ancient Peruvians used knotted strings be-
formation to be of great importance. As a result, we
fore numerical symbols were invented. Regardless of
have accurate knowledge of the wealth maintained in
the rudiments put into practice through the genera-
the treasuries, but little information relating to the per-
tions, it is obvious that accounting for ownership be-
sons who actually owned them.
tween parties drove ancient peoples to invent new
With the development of a written language came
methods of record keeping and communication. In
the ability to represent measures of tallied items with
fact, in his book The Temper of Our Times, Eric Hof-
a single symbol. Different numerical systems existed
fer argues that accounting was the driving force be-
throughout the world. As empires gained and lost
hind written language:
power, advances in culture and science spread among
the different nations. In order to maintain their em-
We are often told that the invention of writ-
pires, rulers would dictate the use of more unified
ing in the Middle East about 3000 B.C.
communication methods. Under Roman rule, people
marked an epoch in man s career because
living in territories in Europe, Africa, the Middle East,
it revolutionized the transmission of
and parts of Asia were forced to write and maintain
knowledge and ideas. Actually, for many
business communications in Latin. During the Roman
centuries after its invention, writing was
period (which lasted from approximately 500 B.C. to
used solely to keep track of the intake and
outgo of treasuries and warehouses. Writ- 500 A.D.), detailed tax records were maintained.




So, which argument is right? Should each company decide for itself whether to include the
$25,000 option value as part of compensation cost, or should there be an overall accounting
standard followed by all companies? And if there is a standard, who sets it?5
There are many situations in business, such as the option compensation case just described,
in which reasonable people can disagree about how certain items should be handled for ac-
counting purposes. And, since financial accounting information is designed to be used by peo-
ple outside a company, it is important that outsiders understand the rules and assumptions used
by the company in constructing its financial statements. This would be extremely difficult and
costly for outsiders to find out if every company formulated its own set of accounting rules. Ac-
cordingly, in most countries in the world there exists a committee or board that establishes the
accounting rules for that country.

The Financial Accounting Standards Board
Financial Accounting Stan-
In the United States, accounting standards are set by the Financial Accounting Standards
dards Board (FASB) The
Board (FASB). The FASB is based in Norwalk, Connecticut, and its seven full-time members
private organization respon-
sible for establishing the
standards for financial ac- 5 The answer to this surprisingly controversial question of the accounting for option compensation is given in
counting and reporting in Chapter 8. Just to show how influential accounting can be, this exact issue was debated on the floor of the U.S.
the United States. Senate.
14 f15
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Accounting Information: Users and Uses




accounting systems had to be developed to analyze
After the fall of Rome, trade continued to increase
and control the financial operations of these increas-
around the Mediterranean Sea. Italy found itself po-
ingly complex manufacturing processes.
sitioned between European consumers and Asian and
Governmental laws and requirements also have
Arabian producers. As trade increased in Italy s port
caused changes in the business environment and
cities, the need to borrow and purchase on credit also
have stimulated the growth of accounting services.
increased. In fact, the first bank of importance, Casa
For example, the Companies Act in England in the
di San Georgio, was founded in Genoa, Italy, during
1850s established compulsory independent audits by
the 12th century. During and after the era of the cru-
chartered accountants. In the United States, the 1913
sades from 1096 to about 1270, money from Italy s
Revenue Act instituted the personal federal income
European neighbors streamed into and out of Italian
tax, which created a need for income tax accounting.
cities. Credit transactions rose in volume as traders in
The 1934 Securities Exchange Act established the Se-
Florence, Pisa, and Venice became merchant-bankers.
curities and Exchange Commission, which monitors
Although accounting did not originate in Italy, its ge-
the reporting procedures of companies that sell stock
ographic location facilitated the formalization of a sys-
publicly.
tem of recording business transactions. In 1494, an
These and other factors have produced changes in
Italian Franciscan monk, Luca Pacioli, published a
the types of accounting services needed, and in many
treatise containing a small section titled Particularis
instances they have affected the accounting proce-
de Computis et Scripturis [Details of Accounting and
dures themselves. Thus, the profession of accounting
Recording], which contained the essential elements
has evolved to meet the needs of the people it serves
of the double-entry accounting system that is still in
in an ever-changing and increasingly complex busi-
use today.
ness environment.
But accounting has not remained static. The In-
As this brief history makes clear, accounting is not
dustrial Revolution brought about changes in busi-
a static science. It is constantly evolving, changing to
ness, and therefore in accounting. Beginning in Eng-
meet the needs of users and adapting itself to the eco-
land in the mid-1800s, manufacturing processes
nomic environment in which it operates.
started to evolve from individualized, handicraft sys-
tems to mass-production, factory systems. Techno-
logical advances not only provided new machinery Source: Eric Hoffer, The Temper of Our Times (New York: Harper &
but required new types of expenditures as well. Cost Row, 1966).




are selected from a variety of backgrounds professional accounting, business, government, and
academia. The FASB receives about one-third of its $20 million annual operating budget through
donations from the accounting profession and from businesses. The remaining two-thirds is gen-
erated through sales of publications and other services (e.g., a CD-ROM version of all the ex-
isting accounting standards). An important thing to note about the FASB is that it is not a gov-
ernment agency; the FASB is a private body established and supported by the joint efforts of
the U.S. business community, financial analysts, and practicing accountants. Because the FASB
is not a government agency, it has no legal power to enforce the accounting standards it sets.
The FASB gets its authority to establish rules from the Securities and Exchange Commission
(discussed later).
The FASB maintains its influence as the accounting standard setter for the United States
(and the most influential accounting body in the world) by carefully protecting its prestige and
reputation for setting good standards. In doing so, the FASB must walk a fine line between con-
stant improvement of accounting practices to provide more full and fair information for exter-
nal users and practical constraints on financial disclosure to appease businesses that are reluctant
generally accepted account- to disclose too much information to outsiders. To balance these opposing forces, the FASB seeks
ing principles (GAAP) Au-
consensus by requesting written comments and sponsoring public hearings on all its proposed
thoritative guidelines that
standards. The end result of this public process is a set of accounting rules that are described as
define accounting practice
being generally accepted accounting principles (GAAP). Without general acceptance by the
at a particular time.
15
f16 Accounting Information: Users And Uses
Part 1 Financial Reporting and the Accounting Cycle


business community, FASB standards would merely be theoretical essays by a powerless body,
and the FASB would be disbanded. This may sound overly dramatic, but the FASB was created
in 1973 to replace the previously existing accounting standards body (the Accounting Principles
Board or APB), which had lost credibility with the business community because it was seen as
being completely controlled by accountants.
As you study this text, you will be intrigued by the interesting conceptual issues the FASB
must wrestle with in setting accounting standards. The FASB has deliberated
Why is it important for over the correct way to compute motion picture profits, the appropriate treat-
ment of the cost of dismantling a nuclear power plant, the best approach for
the FASB to remain completely indepen-
reflecting the impact of changes in foreign currency exchange rates, and the
dent?
proper accounting for complex financial instruments such as commodity fu-
tures and interest rate swaps. And since U.S. companies are always suspicious that any change
in the accounting rules will make them look worse on paper, almost all FASB decisions are made
in the midst of controversy.


Other Organizations
In addition to the FASB, several other organizations affect accounting standards and are im-
portant in other ways to the practice of accounting. Some of these organizations are discussed
below.

In response to the Stock Market Crash
SECURITIES AND EXCHANGE COMMISSION
of 1929, Congress created the Securities and Exchange Commission (SEC) to regulate U.S.
Securities and Exchange
Commission (SEC) The gov- stock exchanges. Part of the job of the SEC is to make sure that investors are provided with full
ernment body responsible and fair information about publicly traded companies. The SEC is not charged with protecting
for regulating the financial
investors from losing money; instead, the SEC seeks to create a fair information environment
reporting practices of most
in which investors can buy and sell stocks without fear that companies are hiding or manipu-
publicly owned corpora-
lating financial data.
tions in connection with the
buying and selling of stocks As part of its regulatory role, the SEC has received from Congress specific legal authority
and bonds. to establish accounting standards for companies soliciting investment funds from the American
public. For now, the SEC refrains from exercising this authority and allows the FASB to set U.S.
accounting standards. The SEC has generally been content to be publicly supportive of the FASB
and to work out any disagreements privately. Remember, however, that the SEC is always loom-
certified public accountant
ing in the background, legally authorized to take over the setting of U.S. accounting standards
(CPA) A special designation
should the FASB lose its credibility with the public.
given to an accountant who
has passed a national uni-
form examination and has
The label CPA
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
met other certifying re-
has two different uses there are individuals who are CPAs and there are CPA firms. A cer-
quirements.
tified public accountant (CPA) is someone who has taken a minimum number of college-
American Institute of Certi-
level accounting classes, has passed the CPA exam administered by the American Institute
fied Public Accountants
of Certified Public Accountants (AICPA), and has met other requirements set by his or her
(AICPA) The national orga-
state. In essence, the CPA label guarantees that the person has received substantial account-
nization of CPAs in the
United States. ing training. Not all CPAs work as accountants, however. CPAs work in law firms, as busi-
ness consultants, as corporate managers, for the government, and even some as ac-
counting professors.
fyi
The second use of the label CPA is in association with a CPA firm. A CPA firm is
Other tasks accountants per-
a company that performs accounting services, just as a law firm performs legal services.
form are planning for acquisi-
Obviously, a CPA firm employs a large number of accountants, not all of whom have re-
tions and mergers, measuring ceived the training necessary to be certified public accountants. CPA firms also employ
efficiency improvements from attorneys, information technology specialists, experts in finance, and other business spe-
cialists. CPA firms help companies establish accounting systems, formulate business plans,
new technology, managing qual-
redesign their operating procedures, and just about anything else you can think of. A good
ity, and developing accounting
way to think of a CPA firm is as a freelance business-advising firm with a particular strength
software.
in accounting issues.
16 f17
Accounting Information: Users And Uses Chapter 1
Accounting Information: Users and Uses


CPA firms are also hired to perform independent audits of the financial statements
fyi
of a company. The important role of the independent audit in ensuring the reliability of
Other accounting-related certi- the financial statements is discussed in Chapter 5.
fications also exist. Examples
Imagine that you have a contract to design a com-
INTERNAL REVENUE SERVICE
include the Certified Manage-
puterized accounting system for a local business. Your fee is $100,000, which will be paid
ment Accountant (CMA), Certi-
in full when the job is finished. By the end of the year, you have collected nothing, but
fied Internal Auditor (CIA), and
you estimate that you have completed 80% of the work on the contract.
the Certified Fraud Examiner
If you are asked by a potential business partner how much money you have earned
(CFE).
during the past year, what will you say? To say that you made $0, the amount you ve col-
lected on the contract, significantly understates the value of the work you have completed.
If the 80% estimate is a fair reflection of the work you ve done, it would seem reasonable for
you to report to the potential partner that you ve earned $80,000 ($100,000 0.80) during
the year. And, as you ll see later in the text, this is exactly what you would report according to
financial accounting rules.
Now, if you are asked by the Internal Revenue Service (IRS) to state your income for the
Internal Revenue Service
(IRS) A government agency year, how much should you report? You don t have much leeway in the matter, because the IRS
that prescribes the rules
has very specific rules about what is considered taxable income. Assume that IRS rules state that
and regulations that govern
you must pay income tax on the $80,000 income from the estimated amount of the contract
the collection of tax rev-
that you have completed. Two practical problems would arise:
enues in the United States.
1. You don t have the money to pay the tax. You won t be able to pay the tax until the job is
completed and you have collected your entire fee.
2. You could have endless arguments with the IRS about the completion percentage. The IRS
could send an agent to dispute your estimate. The whole thing might end up in Tax Court.
This example illustrates that what works for financial accounting purposes does not necessar-
ily work for income tax purposes. Financial accounting reports are designed to provide information
about the economic performance and health of a company. Tax rules are designed to tax income
International Accounting when the tax can be paid and to provide concrete rules to minimize inefficient arguing between tax-
Standards Committee payers and the IRS. Accordingly, the IRS rules would probably allow you to report $0 income and
(IASC) The committee
delay paying income tax until you have actually collected the cash and could thus pay the tax.
formed in 1973 to develop
The implication of this separation between financial accounting and tax accounting is that
worldwide accounting stan-
companies must maintain two sets of books one set from which the financial statements can
dards.
be prepared and the other set to comply with income tax regulations. There is nothing
fyi shady or underhanded about this. Financial accounting and tax accounting involve dif-
ferent sets of rules because they are designed for different purposes.
Since international accounting
standards often differ from
International Business
GAAP, foreign companies may
One of the significant environmental changes in recent years has been the expansion of
be required to adjust their books
business activity on a worldwide basis. As consumers, we are familiar with the wide array
to be listed on the New York
of products from other countries, such as electronics from Japan and clothing made in
Stock Exchange. For example,
China. On the other hand, many U.S. companies have operating divisions in foreign coun-
when Germany s DAIMLER-
tries. Other American companies are located totally within the United States but have ex-
BENZ (makers of Mercedes
tensive transactions with foreign companies. The economic environment of today s busi-
Benz) became a NYSE-listed
ness is truly based on a global economy. As an example, in 1999 over 65% of
company in 1994, its GAAP-ad-
MICROSOFT S sales were to individuals and companies located outside the United States.
justed books showed a loss of
Accounting practices among countries vary widely. Attempts are being made to make
$748 million, whereas its Ger-
those practices more consistent among countries. In an attempt to harmonize conflicting
man standard books reported national standards, the International Accounting Standards Committee (IASC) was
earnings of $636 million. formed in 1973 to develop worldwide accounting standards. This body now represents
Note: Daimler-Benz subse- more than 142 accountancy bodies from 103 countries (including the United States). Like
the FASB, the IASC develops proposals, circulates them among interested organizations,
quently merged with CHRYS-
receives feedback, and then issues a final pronouncement.
LER to become DAIMLER-
The accounting standards produced by the IASC are referred to as International Ac-
CHRYSLER.
counting Standards (IAS). IAS are envisioned to be a set of standards that can be used by
17
f18 Accounting Information: Users And Uses
Part 1 Financial Reporting and the Accounting Cycle



business environment essay


Do You Have What It Takes? There are the Internal Revenue Service), and in commercial
many opportunities in the field of ac- banking. In addition to becoming accountants, many
counting. The Bureau of Labor Statistics accounting students use their undergraduate ac-
forecasts that the demand for account- counting education as a stepping-stone to law school
ing graduates will increase 10 to 20 per- or investment banking or to obtain other graduate de-
cent over the next decade. Accounting grees (like an MBA).
graduates use their education to obtain Many accounting students who go on to become
jobs in public accounting, for federal, accountants pursue the CPA designation. To be a CPA,
state and local governments (including specific requirements must be met. First, CPAs are re-




all companies regardless of where they are based. In the extreme, IAS could supplement or even
replace standards set by national standard setters such as the FASB. IASC standards are gaining
increasing acceptance throughout the world. For example, in April 2000, the IASC Web site
(http://www.iasc.org.uk) listed more than 958 companies around the world that prepare fi-
nancial statements according to IAS. Of these companies, 161 are located in
Why is it so difficult to Germany and 121 are located in China. Thus far, however, the SEC has not
make international accounting standards recognized IASC standards and has barred foreign companies from listing their
shares on U.S. stock exchanges unless those companies agree to provide finan-
consistent?
cial statements in accordance with U.S. accounting rules. Disclosure require-
ments in the United States are the strictest in the world, and foreign companies are reluctant to
submit to the SEC requirement. This conflict will be interesting to watch in the coming years:
Will the SEC maintain a hard line and ultimately force U.S. accounting rules on the rest of the
world? Or will the IASC standards gain increasing acceptance and become the worldwide stan-
dard? We ll see.
At numerous points throughout this text, we will point out certain international applications
of accounting as well as some differences that might exist in accounting rules between the United
States and other countries. In addition, each chapter includes a case in the end-of-chapter mate-
rial dealing with an international accounting issue.

Because of the expansion
of international business,
consumers are familiar
with products from other
countries, such as Hong
Kong.
18 f19
Accounting Information: Users And Uses Chapter 1
Accounting Information: Users and Uses




quired to have a formal education. For example, al- skills obtained from their education. This ensures that
though individual state laws vary, as of April 17, 2000, accountants are competent to perform independent
27 states require students to have completed 150 services for the community. In addition to the exam-
hours of college education to become CPAs. An ad- ination, field experience requirements must be met to
ditional 19 states have enacted legislation that will re- satisfy state licensing laws for CPAs.
quire 150 hours at some future date. Currently, only If you are interested in someday working in a busi-
California, Delaware, New Hampshire, and Vermont ness environment, a degree in accounting can help
have not enacted the 150-hour requirement. Next, as- you understand business issues, analyze accounting
piring CPAs must pass an examination based on the information, and make business decisions.




Ethics in Accounting
Another environmental factor affecting accounting, and business in general, is the growing con-
cern over ethics. This concern was highlighted in a speech given by the chairman of the SEC,
Arthur Levitt, in September 1998. In that speech, entitled The Number s Game, Chairman
Levitt identified several major accounting techniques that he believed were being used to
fyi undermine the integrity of financial reporting. As you will find, accounting involves sig-
nificant judgment. Chairman Levitt expressed concern that this accounting judgment was
The AICPA s Code of Profes-
giving way to pressure to meet the numbers. In other words, Wall Street s expectations
sional Conduct can be found on
about a company, rather than the company s actual business performance, were driving
its Web site at www.aicpa.org.
the reported accounting numbers.
The Code of Conduct spells out
In his speech, Chairman Levitt mentioned the standards of objectivity, integrity, and
what CPAs are famous for
judgment in reporting accounting numbers. These standards are an integral part of the
they are required to be inde-
public accounting profession s Code of Professional Conduct and form the foundation
pendent of their clients, to be
upon which audited financial statements are compiled and interpreted.
good at what they do, and to
The ethical dilemmas facing businesses and their accountants often revolve around
keep client information confi- pressures placed on companies by investors, creditors, and potential investors and credi-
dential. tors. As Chairman Levitt mentioned, these pressures can sometimes cause company offi-
cials to become involved in accounting hocus-pocus. Because accounting involves judg-
ment, the reported accounting numbers can differ significantly depending on the assumptions
made by those preparing the financial statements. As a simple example of how this can occur,
consider again the case of Microsoft. When a customer buys a Microsoft product, part of the
purchase price relates to promised customer service and future product upgrades. So the ques-
tion is this: How much of the sales price should Microsoft report as a sale on the date of the
sale, and how much relates to future services to be provided? As you can imagine, that is a dif-
ficult question to answer, and any answer will involve an estimate.
To quote again from Chairman Levitt s speech, accounting principles allow for flexibility
to adapt to changing circumstances. It is this flexibility that creates many of the ethical dilem-
mas faced by accountants. As businesses come under pressure to report favorable performance,
accountants may also come under pressure to flex the rules just a little too far.
Fortunately, the public accounting profession is guided by a Code of Professional Conduct.
Many other accounting organizations also have codes of conduct to provide guidance for their
members.
Don t let yourself naively think that ethical dilemmas in business are rare. Such issues arise
quite frequently. To help prepare you to enter the business world and to recognize and deal with
ethical issues, we have included at least one ethics case at the end of each chapter. Ethics is an
important topic that should be considered carefully, with the ultimate goal of improving indi-
vidual and collective behavior in society.
19
f20 Accounting Information: Users And Uses
Part 1 Financial Reporting and the Accounting Cycle



Technology
Few developments have changed the way business is conducted as much as computers have.
Computer technology allows businesses to do things that 20 years ago were unimaginable. Con-
sider being able to use your desktop computer to track the status of a package shipped from Los
Angeles to New York. Companies such as UPS and FEDEX incorporate this type of technol-
ogy as an integral part of their business. Financial institutions use computer technology to wire
billions of dollars each day to locations around the world.
So how have computers changed the way accounting is done? That question can be ad-
dressed on several levels. First, computer technology allows companies to easily gather vast
amounts of information about individual transactions. For example, information relating to the
customer, the salesperson, the product being sold, and the method of payment can be easily
gathered for each transaction using computer technology. Prior to today s technology, the cost
of gathering this information was prohibitive.
Second, computer technology allows large amounts of data to be compiled quickly and ac-
curately, thereby significantly reducing the likelihood of errors. As you will soon discover, a large
part of the mechanics of accounting involves moving numbers to and from various accounting
net work
records as well as adding and subtracting a lot of figures. Computers have made this process vir-
Access Microsoft s Web site tually invisible. What once occupied a large part of an accountant s time can now be done in
at http://www.microsoft.
an instant.
com. Identify the different
Third, in the precomputer world of limited analytical capacity, it was essential for lenders
kinds of information found
on Microsoft s home page, and investors to receive condensed summaries of a company s financial activities. Now, lenders
e.g., marketing, product in-
and investors have the ability to receive and process gigabytes of information, so why should the
formation, etc. Can you find
report of Microsoft s financial performance be restricted to three short financial statements? Why
any financial information?
can t Microsoft provide access to much more detailed information online? In fact, why can t Mi-
crosoft allow investors to directly tap into its own internal accounting database? Information
technology has made this type of information acquisition and analysis possible; the question ac-
countants face now is how much information companies should be required to make available
to outsiders. Ten years ago, the only way you could get a copy of Microsoft s financial state-
ments was to call or write to receive paper copies in the mail. Now you can download those
summary financial statements from Microsoft s Web site. How will you get financial informa-
tion 10 years from now? No one knows, but the rapid advances in information technology guar-
antee that it will be different from anything we are familiar with now.
Finally, and most importantly, although technology has changed the way certain aspects of
accounting are carried out, on a fundamental level the mechanics of accounting are still the same
as they were 500 years ago. People are still required to analyze complex business transactions
and input the results of that analysis into the computer. Technology has not replaced judgment.
So if you are asking Why do I need to understand accounting can t computers just do
it? the answer is a resounding No! You need to know what the computer is doing if you
are to understand and interpret the information resulting from the accounting process. You need
to understand that since judgment was required when the various pieces of information were
put into the accounting systems, judgment will be required to appropriately use that informa-
tion. We have included numerous end-of-chapter opportunities for you to experience how tech-
nology helps in the accounting process. These opportunities will illustrate the important role
that technology can play in the accounting process as well as emphasize the critical role that the
accountant plays as well.



to summarize
Accounting functions in a dynamic environment. Generally accepted account-
ing principles (GAAP) have developed over time. The primary standard-setting
body for the private sector is the Financial Accounting Standards Board (FASB).
The accounting environment includes business activity that is conducted on an
international basis. Consequently, accounting practices often must be modified
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Accounting Information: Users and Uses



to reflect the accounting standards of different countries. Attempts are being made
to establish comparable international accounting practices. There is increasing
concern in society over ethics. High standards of ethical conduct are important,
especially for accountants who assume a special responsibility to the public. CPAs
have adopted standards of conduct that contain principles and rules as guide-
lines for the performance of accounting services. Technology has changed the
way accounting information is collected, analyzed, and used. The use of com-
puters in the accounting process has increased significantly, and although they
allow more information to be gathered and used, computers have not re-
placed the accountant nor eliminated the need for qualified decision makers.




4 SO, WHY SHOULD I STUDY ACCOUNTING?
Analyze the reasons for
You may still be asking, But why do I need to study accounting? Even if you have no desire
studying accounting.
to be an accountant, at some point in your life you will need financial information to make cer-
tain decisions, such as whether to buy or lease an automobile, how to budget your monthly in-
come, where to invest your savings, or how to finance your (or your child s) college education.
You can make each of these decisions without using financial information and then hope every-
thing turns out okay, but that would be bad decision making. As noted in the discussion of Ex-
hibit 1 3, a good decision does not guarantee a good outcome, but a bad decision guarantees
one of two things a bad outcome or a lucky outcome. And you cannot count on lucky out-
comes time after time. On a personal level, each of us needs to understand how to collect and
use accounting information.
Odds are that each of you will have the responsibility of providing some form of income
for yourself and your family. Would you prefer to work for a company that is doing well and
has a promising future or one that is on the brink of bankruptcy? Of course we all want to work
for companies that are doing well. But how would you know? Accounting information will al-
low you to evaluate your employer s short- and long-term potential.
When you graduate and secure employment, it is almost certain that accounting informa-
tion will play some role in your job. Whether your responsibilities include sales (where you will
need information about product availability and costs), production (where you will need infor-
mation regarding the costs of materials, labor, and overhead), quality control (where you will
need information relating to variances between expected and actual production), or human re-
sources (where you will need information relating to the costs of employees), you will use ac-
counting information. The more you know about where accounting information comes from,
how it is accumulated, and how it is best used, the better you will be able to perform your job.
Everyone is affected by accounting information. Saying you don t need to know account-
ing doesn t change the fact that you are affected by accounting information. Ignoring the value
of that information simply puts you at a disadvantage. Those who recognize the value of ac-
counting information and learn how to use it to make better decisions will have a competitive
advantage over those who don t. It s as simple as that.




review of learning objectives

Describe the purpose of accounting and explain its role to allocate scarce resources and reach their financial objectives. It
1 in business and society. Accounting is a service activity is used to accumulate, measure, and communicate economic data
designed to assist individuals and organizations in deciding how about organizations and to assist in the decision-making process.
21
f22 Accounting Information: Users And Uses
Part 1 EOC Financial Reporting and the Accounting Cycle


Identify the primary users of accounting informa- mary standard-setting body for accounting principles in the
2 tion. The primary users of accounting information are private sector.
lenders, investors, management, and other interested individ- Accounting is practiced in an international environment.
uals and organizations. Management accounting deals pri- Accounting procedures in the United States sometimes must
marily with the internal accounting functions of planning, be modified to accommodate foreign operations. Attempts are
implementing, and control. Financial accounting is concerned being made to establish consistent and comparable accounting
with reporting business activities and results to external par- practices throughout the world, primarily through the efforts
ties. The objectives of both areas of accounting are measure- of the International Accounting Standards Committee (IASC).
ment and communication of information for decision- Ethical considerations affect society and are particularly
making purposes. important for accountants, who have a special responsibility
to the public. CPAs have adopted standards of conduct to
Describe the environment of accounting, including guide them in the performance of their duties.
3 the effects of generally accepted accounting princi- Technology has changed the way accounting information
ples, international business, ethical considerations, and is accumulated and analyzed. What once occupied a large part
technology. Accounting functions in a dynamic environment. of an accountant s time is now done quickly by computers,
The principles of accounting have evolved over time to meet thereby freeing the accountant to be involved in more pro-
the changing demands of the business environment. They are ductive tasks. But computer technology has not removed the
therefore not absolute. Only if they prove useful do they be- accountant from the decision-making process. Accounting
come generally accepted. Accounting principles provide com- judgment is still essential.
parable data for external users and need to be applied with
judgment. Analyze the reasons for studying accounting. Know-
4
Since the 1930s, several organizations have been involved ing how to use accounting information will help indi-
in the development of accounting principles in the United viduals make better decisions in their personal life as well as
States. The American Institute of Certified Public Accountants in their employment. Whatever the job, it is likely that ac-
(AICPA), the Securities and Exchange Commission (SEC), counting information plays a part. Knowing where informa-
and the Financial Accounting Standards Board (FASB) are tion comes from, how it is accumulated, and how it is best
among the most prominent. The FASB is currently the pri- used will result in better decision making.




key terms and concepts

certified public accountant (CPA) 16 International Accounting Standards
accounting 6
Committee (IASC) 17
accounting cycle 9 financial accounting 9
management accounting 9
accounting system 5 Financial Accounting Standards
nonprofit organization 7
Board (FASB) 14
American Institute of Certified
Securities and Exchange
Public Accountants (AICPA) 16 financial statements 9
Commission (SEC) 16
annual report 9 generally accepted accounting
principles (GAAP) 15
bookkeeping 5
Internal Revenue Service (IRS) 17
business 7




discussion questions

1. What are the three functions of an accounting system? 3. What types of personal decisions have required you to
2. What are the essential elements in decision making, and use accounting information?
how does accounting fit into the process? 4. What does the term business mean to you?
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Accounting Information: Users And Uses EOC Chapter 1
Accounting Information: Users and Uses


5. Why is accounting often referred to as the language of 10. For you as a potential investor, what is the problem
business ? with different countries having different accounting
6. In what ways are the needs of internal and external standards? For you as the president of a multinational
users of accounting information the same? In what ways company, what is the problem with different countries
are they different? having different accounting standards?
7. What are generally accepted accounting principles 11. Ethical considerations affect all society. Why are ethi-
(GAAP)? Who currently develops and issues GAAP? cal considerations especially important for accoun-
What is the purpose of GAAP? tants?
8. Why is it important for financial statements and other 12. Given significant technological advances, can we expect
external reports to be based on generally accepted ac- to see less demand for accountants and accounting-type
counting principles (GAAP)? services?
9. What are the respective roles of the Securities and Ex- 13. Other than that it is a requirement for your major or
change Commission (SEC) and the Internal Revenue that your mom or dad is making you, why should you
Service (IRS) in the setting of accounting standards? study accounting?




discussion cases

CASE 1-1 TO LEND OR NOT TO LEND THAT IS THE QUESTION
Sam Love is vice president and chief lending officer of the Meeker First National Bank. Re-
cently, Bill McCarthy, a new farmer, moved to town. Sam has not dealt with Bill previously
and knows little about the Mountain Meadow Ranch that Bill operates. Bill would like to bor-

. 1
( 29)



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