1.8 Review of Key Points

Accounting is the recording of the day-to-day financial activities of a company and the organization of that information into summary reports used to evaluate the company’s financial status.

Bookkeeping is the preservation of a systematic, quantitative record of an activity. Without bookkeeping, good business is impossible. An accounting system is used by a business to handle routine bookkeeping tasks and to structure the information so it can be used to evaluate the performance and financial status of the business. Accounting information is intended to be useful in making decisions about the future.

The focus of financial accounting is the three primary financial statements: the balance sheet, the income statement, and the statement of cash flows.

Financial accounting information is provided for, and used by, external users. Managerial accounting is the name given to accounting systems designed for internal users. The information provided by financial accounting is summarized in the financial statements:

  • The balance sheet reports a company’s assets, liabilities, and owners’ equity.

  • The income statement reports the amount of net income earned by a company during a period. Net income is the excess of a company’s revenues over its expenses.

  • 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.

Among the users of financial accounting information are lenders, investors, company management, suppliers, customers, employees, competitors, government agencies, politicians, and the press.

Financial accounting information helps lenders evaluate the cash flows a business can be expected to generate in the future in order to repay loans. Investors use the same type of information to assess the attractiveness of companies as investments. Managers use financial accounting data to formulate company goals, to compute bonuses for employees, and to illuminate company weaknesses. Suppliers, customers, and employees use financial statements to tell them about the long-run prospects of a company. Competitors use financial accounting information to reveal strategic opportunities within their industry. Government agencies and politicians use financial statement data to bolster political and regulatory positions for and against companies. Reporters use financial accounting data as background information and to indicate which companies are undergoing significant changes in financial status.

The practice of accounting involves adherence to the established accounting rules as well as the use of judgment. U.S. accounting rules are established by the FASB.

It would be extremely difficult and costly for users to evaluate financial statements if every company formulated its own set of accounting rules. In the United States, accounting standards are set by the Financial Accounting Standards Board (FASB). The FASB is not a government agency; it is a private body established and supported by the joint efforts of the U.S. business community, financial analysts, and practicing accountants.

The FASB has no legal power to enforce the accounting standards it sets but maintains its influence by carefully protecting its prestige and reputation.

In addition to the FASB, other important accounting-related organizations are the SEC, the AICPA, the PCAOB, the IRS, and the IASB.

  • The Securities and Exchange Commission (SEC) regulates U.S. stock exchanges and seeks to create a fair information environment in which investors can buy and sell stocks without fear that companies are hiding or manipulating financial data.

  • The American Institute of Certified Public Accountants (AICPA) is the professional organization of certified public accountants (CPAs) in the United States. A CPA is someone who has taken a minimum number of college-level accounting classes, has passed the CPA exam, and has met other requirements set by his or her state. A CPA firm is a company that provides freelance business advice, particularly in connection with accounting issues.

  • The Public Company Accounting Oversight Board (PCAOB) inspects the audit practices of registered audit firms and has statutory authority to investigate questionable audit practices and to impose sanctions such as barring an audit firm from auditing SEC-registered companies.

  • The Internal Revenue Service (IRS) establishes rules to define exactly when income should be taxed. It has no role in setting financial accounting rules; and a company’s financial statements are not used in determining how much tax the company must pay.

  • The International Accounting Standards Board (IASB) was formed to develop a common set of worldwide accounting standards. IASB standards are increasingly accepted worldwide, but FASB rules are still the standard in the United States.

Three factors have combined to make right now a time of significant change in accounting. The three factors are the rapid advance in information technology, the international integration of worldwide business, and the increased scrutiny associated with the large corporate accounting scandals.

Investors are complaining that the financial statements they use to evaluate investments across the world are not prepared according to a common set of standards. Diverse national accounting practices must be harmonized, and, in fact, this historic harmonization is happening right now.

Information technology has made it possible for financial statement users to receive and process gigabytes of information. The question accountants face right now is how much information companies should be required to make available to outsiders.

A wave of accounting scandals starting in 2001 resulted in the Sarbanes-Oxley Act, which increases U.S. federal government scrutiny of the production of financial statements.

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