1.3 Accounting and Financial Reporting

The overall objective of accounting is to provide information that can be used in making economic decisions.

Several key features of this definition should be noted.

• Accounting provides a vital service in today’s business environment. The study of accounting should not be viewed as a theoretical exercise—accounting is meant to be a practical tool.

• Accounting is concerned primarily with quantitative financial information that is used in conjunction with qualitative evaluations in making judgments.

• Accounting information is used in making decisions about how to allocate scarce resources. Economists and environmentalists remind us constantly that we live in a world with limited resources. The better the accounting system that measures and reports the costs of using these resources, the better decisions can be made for allocating them.

• Although accountants place much emphasis on reporting what has already occurred, this past information is intended to be useful in making economic decisions about the future.

Users of Accounting Information

Who uses accounting information and what information do they require to meet their decision-making needs? In general, all parties interested in the financial health of a company are called stakeholders. Stakeholder users of accounting information are normally divided into two major classifications:

• Internal users, who make decisions directly affecting the internal operations of the enterprise

• External users, who make decisions concerning their relationship to the enterprise

Major internal and external stakeholder groups are listed in Figure 1.1.

Internal users need information to assist in planning and controlling company operations and managing company resources. The accounting system must provide timely information needed to control day-to-day operations and to make major planning decisions such as:

• Do we make this product or another one?

• Do we build a new production plant or expand existing facilities?

Management accounting (sometimes referred to as managerial or cost accounting) is concerned primarily with financial reporting for internal users. Internal users, especially management, have control over the accounting system and can specify precisely what information is needed and how the information is to be reported.

Financial accounting focuses on the development and communication of financial information for external users. As a company grows and expands, it often finds its need for cash to be greater than that provided from profitable operations. In this situation, it will turn to people or organizations external to the company for funding. These external users need assurances that they will receive a return on their investment. Thus, they require information about the company’s past performance because this information will allow them to forecast how the company can be expected to perform in the future.

Companies compete for external funding because external users have a variety of investment alternatives. The accounting information provided to external users aids in determining (1) whether a company’s operations are profitable enough to justify additional funding and (2) how risky a company’s operations are in order to determine what rate of return is necessary to compensate capital providers for the investment risk.

The types of decisions made by external users vary widely; therefore, their information needs are highly diverse. As a result, two groups of external users, creditors and investors, have been identified as the principal external users of financial information. Creditors need information about the profitability and stability of the company to decide whether to lend money to the company and, if so, what interest rate to charge. Investors (both existing stockholders and potential investors) need information concerning the safety and profitability of their investment.

Incentives

As mentioned, companies often need external funding if they are to compete in the marketplace. Thus, the managers of these companies have an incentive to provide information that will attract external funding. They want to present information to external users that will make it appear as though their companies will be profitable in the future.

In their pursuit of external funding, management may not be as objective in evaluating and presenting accounting information as external users would like. As a result, care must be taken to ensure that accounting information is neutral. Standards have been established and safeguards have been implemented in an attempt to ensure that accounting information is neutral and objective.

Financial Reporting

Most accounting systems are designed to generate information for both internal and external reporting. The external information is much more highly summarized than the information reported internally. Understandably, a company does not want to disclose every detail of its internal financial dealings to outsiders. For this reason, external financial reporting is governed by an established body of standards or principles that are designed to carefully define what information a firm must disclose to outsiders. Financial accounting standards also establish a uniform method of presenting information so that financial reports for different companies can be more easily compared. The development of these standards is discussed in some detail later in this chapter.

This textbook focuses on financial accounting and external reporting. The general-purpose financial statements are the centerpiece of financial accounting. These financial statements include the balance sheet, income statement, and statement of cash flows.

The three major financial statements, along with the explanatory notes and the auditor’s opinion, are briefly described here.

• The balance sheet reports, as of a certain point in time, the resources of a company (the assets), the company’s obligations (the liabilities), and the net difference between its assets and liabilities, which represents the equity of the owners. The balance sheet addresses these fundamental questions: What does a company own? What does it owe?

• The income statement reports, for a certain interval, the net assets generated through business operations (revenues), the net assets consumed (expenses), and the difference, which is called net income. The income statement is the accountant’s best effort at measuring the economic performance of a company for the given period.

FYI
The cash flow statement is the most recent of the primary financial statements. It has been required only since 1988.

• The statement of cash flows reports, for a certain interval, the amount of cash generated and consumed by a company through the following three types of activities: operating, investing, and financing. The statement of cash flows is the most objective of the financial statements because it is somewhat insulated from the accounting estimates and judgments needed to prepare a balance sheet and an income statement.

• Accounting estimates and judgments are outlined in the notes to the financial statements. In addition, the notes contain supplemental information as well as information about items not included in the financial statements. Using financial statements without reading the notes is like preparing for an intermediate accounting exam by just reading the table of contents of the textbook—you get the general picture, but you miss all of the important details. Each financial statement routinely carries the following warning printed at the bottom of the statement: “The notes to the financial statements are an integral part of this statement.”

• Auditors, working independently of a company’s management and internal accountants, examine the financial statements and issue an auditor’s opinion about the fairness of the statements and their adherence to proper accounting principles. The opinion is based on evidence gathered by the auditor from the detailed records and documents maintained by the company and from a review of the controls over the accounting system. Obviously, management is motivated to present the financial information in the most favorable manner possible. It is the responsibility of the auditors to review management’s reports and to independently decide whether the reports are indeed representative of the actual conditions existing within the enterprise. The auditor’s opinion adds credibility to the financial statements. The types of opinions issued by auditors, along with their relative frequencies, are outlined in Figure 1.2. As you can see, the audit opinion is almost always “unmodified.”

The financial statements and accompanying notes (certified by the auditor’s opinion) have historically been the primary mode of communicating financial information to external users.