The Accounting Environment

Learning objectives

After studying this introduction, you should be able to:
Define accounting.
Describe the functions performed by accountants.
Describe employment opportunities in accounting.
Differentiate between financial and managerial accounting.
Identify several organizations that have a role in the development of financial accounting standards.

You have embarked on the challenging and rewarding study of accounting—an old and timehonored discipline. History indicates that all developed societies require certain accounting records. Record-keeping in an accounting sense is thought to have begun about 4000 BCE

The record-keeping, control, and verification problems of the ancient world had many characteristics similar to those we encounter today. For example,ancient governments also kept records of receipts and disbursements and used procedures to check on the honesty and reliability of employees.

A study of the evolution of accounting suggests that accounting processes have developed primarily in response to business needs. Also, economic progress has affected the development of accounting processes. History shows that the higher the level of civilization, the more elaborate the accounting methods.

The emergence of double-entry bookkeeping was a crucial event in accounting history. In 1494, a Franciscan monk, Luca Pacioli, described the double-entry Method of Venice system in his text called Summa de Arithmetica, Geometric, Proportion et Proportionate (Everything about arithmetic, geometry, and proportion). Many consider Pacioli's Summa to be a reworked version of a manuscript that circulated among teachers and pupils of the Venetian school of commerce and arithmetic.

Since Pacioli's days, the roles of accountants and professional accounting organizations have expanded in business and society. As professionals, accountants have a responsibility for placing public service above their commitment to personal economic gain. Complementing their obligation to society, accountants have analytical and evaluative skills needed in the solution of ever-growing world problems. The special abilities of accountants, their independence, and their high ethical standards permit them to make significant and unique contributions to business and areas of public interest.

You probably will find that of all the business knowledge you have acquired or will learn, the study of accounting will be the most useful. Your financial and economic decisions as a student and consumer involve accounting information. When you file income tax returns, accounting information helps determine your taxes payable. Understanding the discipline of accounting also can influence many of your future professional decisions. You cannot escape the effects of accounting information on your personal and professional life.

Every profit-seeking business organization that has economic resources, such as money, machinery, and buildings, uses accounting information. For this reason, accounting is called the language of business. Accounting also serves as the language providing financial information about not-for-profit organizations such as governments, churches, charities, fraternities, and hospitals. However, this text concentrates on accounting for business firms.

The accounting system of a profit-seeking business is an information system designed to provide relevant financial information on the resources of a business and the effects of their use. Information is relevant if it has some impact on a decision that must be made. Companies present this relevant information in their financial statements. In preparing these statements, accountants consider the users of the information, such as owners and creditors, and decisions they make that require financial information.

As a background for studying accounting, this Introduction defines accounting and lists the functions accountants perform. In addition to surveying employment opportunities in accounting, it differentiates between financial and managerial accounting. Because accounting information must conform to certain standards, we discuss several prominent organizations contributing to these standards. As you continue your study of accounting in this text, accounting—the language of business —will become your language also. You will realize that you are constantly exposed to accounting information in your everyday life.

Accounting Defined

The American Accounting Association—one of the accounting organizations discussed later in this Introduction—defines accounting as "the process ofidentifying, measuring, and communicating p. 15 of 433 economic information to permit informed judgments and decisions by the users of the information". This information is primarily financial—stated in money terms. Accounting, then, is a measurement and communication process used to report on the activities of profit-seeking business organizations and not-for-profit organizations. As a measurement and communication process for business, accounting supplies information that permits informed judgments and decisions by users of the data.

The accounting process provides financial data for a broad range of individuals whose objectives in studying the data vary widely. Bank officials, for example, may study a company's financial statements to evaluate the company's ability to repay a loan. Prospective investors may compare accounting data from several companies to decide which company represents the best investment. Accounting also supplies management with significant financial data useful for decision making.

Reliable information is necessary before decision makers can make a sound decision involving the allocation of scarce resources. Accounting information is valuable because decision makers can use it to evaluate the financial consequences of various alternatives. Accountants eliminate the need for a crystal ball to estimate the future. They can reduce uncertainty by using professional judgment to quantify the future financial impact of taking action or delaying action.

Although accounting information plays a significant role in reducing uncertainty within the organization, it also provides financial data for persons outside the company. This information tells how management has discharged its responsibility for protecting and managing the company's resources. Stockholders have the right to know how a company is managing its investments. In fulfilling this obligation, accountants prepare financial statements such as an income statement, a statement of retained earnings, a balance sheet, and a statement of cash flows. In addition, they prepare tax returns for federal and state governments, as well as fulfill other governmental filing requirements.

Accounting is often confused with bookkeeping. Bookkeeping is a mechanical process that records the routine economic activities of a business. Accounting includes bookkeeping but goes well beyond it in scope. Accountants analyze and interpret financial information, prepare financial statements, conduct audits, design accounting systems, prepare special business and financial studies, prepare forecasts and budgets, and provide tax services.

Employment opportunities in accounting

During the last half-century, accounting has gained the same professional status as the medical and legal professions. Today, the accountants in the United States number well over a million. In addition, several million people hold accounting-related positions. Typically, accountants provide services in various branches of accounting. These include public accounting, management (industrial) accounting, governmental or other not-for-profit accounting, and higher education. The demand for accountants will likely increase dramatically in the future. This increase is greater than for any other profession. You may want to consider accounting as a career.

Public accounting firms offer professional accounting and related services for a fee to companies, other organizations, and individuals. An accountant may become aCertified Public Accountant (CPA) by passing an examination prepared and graded by the American Institute of Certified Public Accountants (AICPA). The exam is administered by computer. In addition to passing the exam, CPA candidates must meet other requirements, which include obtaining a state license. These requirements vary by state.

A number of states require a CPA candidate to have completed specific accounting courses and earned a certain number of college credits (five years of study in many states); worked a certain number of years in public accounting, industry, or government; and lived in that state a certain length of time before taking the CPA examination. As of the year 2000, five years of course work were required to become a member of the AICPA.

After a candidate passes the CPA examination, some states (called one-tier states) insist that the candidate meet all requirements before the state grants the CPA certificate and license to practice. Other states (called two-tier states) issue the CPA certificate immediately after the candidate passes the exam. However, these states issue the license to practice only after all other requirements have been met. CPAs who want to renew their licenses to practice must stay current through continuing p. 17 of 433 professional education programs and must prove that they have done so. No one can claim to be a CPA and offer the services normally provided by a CPA unless that person holds an active license to practice.

The public accounting profession in the United States consists of the Big-Four international CPA firms, several national firms, many regional firms, and numerous local firms. The Big-Four firms include Deloitte & Touche, Ernst & Young, KPMG, and Pricewaterhouse Coopers. At all levels, these public accounting firms provide auditing, tax, and, for nonaudit clients, management advisory (or consulting) services.

Auditing A business seeking a loan or attempting to have its securities traded on a stock exchange usually must provide financial statements to support its request. Users of a company's financial statements are more confident that the company is presenting its statements fairly when a CPA has audited the statements. For this reason, companies hire CPA firms to conduct examinations (independent audits) of their accounting and related records. Independent auditors of the CPA firm check some of the company's records by contacting external sources. For example, the accountant may contact a bank to verify the cash balances of the client.

After completing a company audit, independent auditors give an independent auditor's opinion or report. (For an example of an auditor's opinion, see The Limited, Inc. annual report in the Annual report appendix at the end of the text.) This report states whether the company's financial statements fairly (equitably) report the economic performance and financial condition of the business. As you will learn in the next section, auditors within a business also conduct audits, which are not independent audits. Currently auditing standards are established by the Public Company Accounting Oversight Board.

In 2002 The Sarbanes-Oxley Act was passed. The Act was passed as one result of the large losses to the employees and investors from accounting fraud situations involving companies such as Enron and WorldCom. The Act created the Public Company Accounting Oversight Board. The Board consists of five members appointed and overseen by the Securities and Exchange Commission. The Board oversees and investigates the audits and auditors of public companies and can sanction both firms and individuals for violations of laws, regulations, and rules.

The Chief Executive Officer and Chief Financial Officer of a public company must now certify the company's financial statements. Corporate audit committees, rather than the corporate management, are now responsible for hiring, compensating, and overseeing the external auditors.

Tax services CPAs often provide expert advice on tax planning and preparing federal, state, and local tax returns. The objective in preparing tax returns is to use legal means to minimize the taxes paid. Almost every major business decision has a tax impact. Tax planning helps clients know the tax effects of each financial decision.

Management advisory (or consulting) services Before Sarbanes-Oxley management advisory services were the fastest growing service area for most large and many smaller CPA firms. Management frequently identifies projects for which it decides to retain the services of a CPA. However, the Sarbanes-Oxley Act specifically prohibits providing certain types of consulting services to a publiclyheld company by its external auditor.

These services include bookkeeping, information systems design and implementation, appraisals or valuation services, actuarial services, internal audits, management and human resources services, broker/dealer and investment services, and legal or expert services related to audit services. Accounting firms can perform many of these services for publicly held companies they do not audit. Other services not specifically banned are allowed if pre-approved by the company's audit committee.

In contrast to public accountants, who provide accounting services for many clients, management accountants provide accounting services for a single business. In a company with several management accountants, the person in charge of the accounting activity is often the controller or chief financial officer.

Management accountants may or may not be CPAs. If management accountants pass an examination prepared and graded by the Institute of Certified Management Accountants (ICMA) and meet certain other requirements, they become Certified Management Accountants (CMAs). The ICMA is an affiliate of the Institute of Management Accountants, an organization primarily consisting of management accountants employed in private industry.

A career in management accounting can be very challenging and rewarding. Many management accountants specialize in one particular area of accounting. For example, some may specialize in measuring and controlling costs, others in budgeting (the development of plans for future operations), and still others in financial accounting and reporting. Many management accountants become specialists in the design and installation of computerized accounting systems. Other management accountants are internal auditors who conduct internal audits.

They ensure that the company's divisions and departments follow the policies and procedures of management. This last group of management accountants may earn the designation of Certified Internal Auditor (CIA). The Institute of Internal Auditors (IIA) grants the CIA certificate to accountants after they have successfully completed the IIA examination and met certain other requirements.

Many accountants, including CPAs, work in governmental and other not-for-profit accounting. They have essentially the same educational background and training as accountants in public accounting and management accounting.

Governmental agencies at the federal, state, and local levels employ governmental accountants. Often the duties of these accountants relate to tax revenues and expenditures. For example, Internal Revenue Service employees use their accounting backgrounds in reviewing tax returns and investigating tax fraud. Government agencies that regulate business activity, such as a state public service commission that regulates public utilities (e.g. telephone company, electric company), usually employ governmental accountants. These agencies often employ governmental accountants who can review and evaluate the utilities' financial statements and rate increase requests. Also, FBI agents trained as accountants find their accounting backgrounds useful in investigating criminals involved in illegal business activities, such as drugs or gambling.

Not-for-profit organizations, such as churches, charities, fraternities, and universities, need accountants to record and account for funds received and disbursed. Even though these agencies do not have a profit motive, they should operate efficiently and use resources effectively.

Approximately 10,000 accountants are employed in higher education. The activities of these academic accountants include teaching accounting courses, conducting scholarly and applied research and publishing the results, and performing service for the institution and the community. Faculty positions exist in two-year colleges, four-year colleges, and universities with graduate programs. A significant shortage of accounting faculty has developed due to the retirement beginning in the late 1990s of many faculty members. Starting salaries will continue to rise significantly because of the shortage.

You may want to talk with some of your professors about the advantages and disadvantages of pursuing an accounting career in higher education. A section preceding each chapter, entitled "Careers in accounting", describes various accounting careers. You might find one that you would like to pursue.

Financial accounting versus managerial accounting

An accounting information system provides data to help decision makers both outside and inside the business. Decision makers outside the business are affected in some way by the performance of the business. Decision makers inside the business are responsible for the performance of the business. For this reason, accounting is divided into two categories: financial accounting for those outside and managerial accounting for those inside.

Financial accounting information appears in financial statements that are intended primarily for external use (although management also uses them for certain internal decisions). Stockholders and creditors are two of the outside parties who need financial accounting information. These outside parties decide on matters pertaining to the entire company, such as whether to increase or decrease their investment in a company or to extend credit to a company. Consequently, financial accounting information relates to the company as a whole, while managerial accounting focuses on the parts or segments of the company.

Management accountants in a company prepare the financial statements. Thus, management accountants must be knowledgeable concerning financial accounting and reporting. The financial statements are the representations of management, not the CPA firm that performs the audit.

The external users of accounting information fall into six groups; each has different interests in the company and wants answers to unique questions. The groups and some of their possible questions are:

Owners and prospective owners . Has the company earned satisfactory income on its total investment? Should an investment be made in this company? Should the present investment be increased, decreased, or retained at the same level? Can the company install costly pollution control equipment and still be profitable?
Creditors and lenders . Should a loan be granted to the company? Will the company be able to pay its debts as they become due?
Employees and their unions . Does the company have the ability to pay increased wages? Is the company financially able to provide long-term employment for its workforce?
Customers . Does the company offer useful products at fair prices? Will the company survive long enough to honor its product warranties?
Governmental units . Is the company, such as a local public utility, charging a fair rate for its services?
General public . Is the company providing useful products and gainful employment for citizens without causing serious environmental problems?

General-purpose financial statements provide much of the information needed by external users of financial accounting. These financial statements are formal reports providing information on a company's financial position, cash inflows and outflows, and the results of operations. Many companies publish these statements in annual reports. (See The Limited, Inc., annual report in the Annual report appendix.) The annual report also contains the independent auditor's opinion as to the fairness of the financial statements, as well as information about the company's activities, products, and plans.

Financial accounting information is historical in nature, reporting on what has happened in the past. To facilitate comparisons between companies, this information must conform to certain accounting standards or principles called generally accepted accounting principles (GAAP). These generally accepted accounting principles for businesses or governmental organizations have developed through accounting practice or been established by an authoritative organization. We describe several of these authoritative organizations in the next major section of this Introduction.

Managerial accounting information is for internal use and provides special information for the managers of a company. The information managers use may range from broad, long-range planning data to detailed explanations of why actual costs varied from cost estimates.

Managerial accounting information should:

Relate to the part of the company for which the manager is responsible. For example, a production manager wants information on costs of production but not of advertising.
Involve planning for the future. For instance, a budget would show financial plans for the coming year.
Meet two tests: the accounting information must be useful (relevant) and must not cost more to gather and process than it is worth.

Managerial accounting generates information that managers can use to make sound decisions. The four major types of internal management decisions are:

Financial decisions —deciding what amounts of capital (funds) are needed to run the business and whether to secure these funds from owners (stockholders) or creditors. In this sense, capital means money used by the company to purchase resources such as machinery and buildings and to pay expenses of conducting the business.
Resource allocation decisions —deciding how the total capital of a company is to be invested, such as the amount to be invested in machinery.
Production decisions —deciding what products are to be produced, by what means, and when.
Marketing decisions —setting selling prices and advertising budgets; determining the location of a company's markets and how to reach them.

Development of financial accounting standards

Several organizations are influential in the establishment of generally accepted accounting principles (GAAP) for businesses or governmental organizations. These are the American Institute of Certified Public Accountants, the Financial Accounting Standards Board, the Governmental Accounting Standards Board, the Securities and Exchange Commission, the American Accounting Association, the Financial Executives Institute, and the Institute of Management Accountants. Each organization has contributed in a different way to the development of GAAP.

The American Institute of Certified Public Accountants (AICPA) is a professional organization of CPAs. Many of these CPAs are in public accounting practice. Until recent years, the AICPA was the dominant organization in the development of accounting standards. In a 20-year period ending in 1959, the AICPA Committee on Accounting Procedure issued 51 Accounting Research Bulletins recommending certain principles or practices.

From 1959 through 1973, the committee's successor, the Accounting Principles Board (APB), issued 31 numbered Opinions that CPAs generally are required to follow. Through its monthly magazine, the Journal of Accountancy, its research division, and its other divisions and committees, the AICPA continues to influence the development of accounting standards and practices. Two of its committees—the Accounting Standards Committee and the Auditing Standards Committee—are particularly influential in providing input to the Financial Accounting Standards Board (the current rule-making body) and to the Securities and Exchange Commission and other regulatory agencies.

In 1973, an independent, seven-member, full-time Financial Accounting Standards Board (FASB) replaced the Accounting Principles Board. The FASB has issued numerous Statements of Financial Accounting Standards. The old Accounting Research Bulletins and Accounting Principles Board Opinions are still effective unless specifically superseded by a Financial Accounting Standards Board Statement. The FASB is the private sector organization now responsible for the development of new financial accounting standards.

The Emerging Issues Task Force of the FASB interprets official pronouncements for general application by accounting practitioners. The conclusions of this task force must also be followed in filings with the Securities and Exchange Commission.

In 1984, the Governmental Accounting Standards Board (GASB) was established with a full-time chairperson and four part-time members. The GASB issues statements on accounting and financial reporting in the governmental area. This organization is the private sector organization now responsible for the development of new governmental accounting concepts and standards. The GASB also has the authority to issue interpretations of these standards.

Created under the Securities and Exchange Act of 1934, the Securities and Exchange Commission (SEC) is a government agency that administers important acts dealing with the interstate sale of securities (stocks and bonds). The SEC has the authority to prescribe accounting and reporting practices for companies under its jurisdiction. This includes virtually every major US business corporation. Instead of exercising this power, the SEC has adopted a policy of working closely with the accounting profession, especially the FASB, in the development of accounting standards. The SEC indicates to the FASB the accounting topics it believes the FASB should address.

Consisting largely of accounting educators, the American Accounting Association (AAA) has sought to encourage research and study at a theoretical level into the concepts, standards, and principles of accounting. One of its quarterly magazines, The Accounting Review, carries many articles reporting on scholarly accounting research. Another quarterly journal, Accounting Horizons, reports on more practical matters directly related to accounting practice. A third journal, Issues in Accounting Education, contains articles relating to accounting education matters. Students may join the AAA as associate members by contacting the American Accounting Association, 5717 Bessie Drive, Sarasota, Florida 34233.

The Financial Executives Institute is an organization established in 1931 whose members are primarily financial policy-making executives. Many of its members are chief financial officers (CFOs) of very large corporations. The role of the CFO has evolved in recent years from number cruncher to strategic planner. These CFOs played a major role in restructuring American businesses in the early 1990s. Slightly more than 14,000 financial officers, representing approximately 7,000 companies in the United States and Canada, are members of the FEI.

Through its Committee on Corporate Reporting (CCR) and other means, the FEI is very effective in representing the views of the private financial sector to the FASB and to the Securities and Exchange Commission and other regulatory agencies.

The Institute of Management Accountants (formerly the National Association of Accountants) is an organization with approximately 70,000 members, consisting of management accountants in private industry, CPAs, and academics. The primary focus of the organization is on the use of management accounting information for internal decision making. However, management accountants prepare the financial statements for external users. Thus, through its Management Accounting Practices (MAP) Committee and other means, the IMA provides input on financial accounting standards to the Financial Accounting Standards Board and to the Securities and Exchange Commission and other regulatory agencies.

Many other organizations such as the Financial Analysts Federation (composed of investment advisers and investors), the Securities Industry Associates (composed of investment bankers), and CPA firms have committees or task forces that respond to Exposure Drafts of proposed FASB Statements. Their reactions are in the form of written statements sent to the FASB and testimony given at FASB hearings. Many individuals also make their reactions known to the FASB.

Ethical behavior of accountants

Several accounting organizations have codes of ethics governing the behavior of their members. For instance, both the American Institute of Certified Public Accountants and the Institute of Management Accountants have formulated such codes. Many business firms have also developed codes of ethics for their employees to follow.

Ethical behavior involves more than merely making sure you are not violating a code of ethics. Most of us sense what is right and wrong. Yet get-rich-quick opportunities can tempt many of us. Almost any day, newspaper headlines reveal public officials and business leaders who did not do the right thing. Greed won out over their sense of right and wrong. These individuals followed slogans such as: "Get yours while the getting is good"; "Do unto others before they do unto you"; and "You have done wrong only if you get caught". More appropriate slogans might be: "If it seems too good to be true, it usually is"; "There are no free lunches"; and the golden rule, "Do unto others as you would have them do unto you".

An accountant's most valuable asset is an honest reputation. Those who take the high road of ethical behavior receive praise and honor; they are sought out for their advice and services. They also like themselves and what they represent. Occasionally, accountants do take the low road and suffer the consequences. They sometimes find their names mentioned in The Wall Street Journal and news programs in an unfavorable light, and former friends and colleagues look down on them. Some of these individuals are removed from the profession. Fortunately, the accounting profession has many leaders who have taken the high road, gained the respect of friends and colleagues, and become role models for all of us to follow.

Many chapters in the text include an ethics case entitled, "An ethical perspective". We know you will benefit from thinking about the situational ethics in these cases. Often you will not have much difficulty in determining "right and wrong". Instead of making the cases "close calls", we have attempted to include situations business students might actually encounter in their careers.

Critical thinking and communication skills

Accountants in practice and business executives have generally been dissatisfied with accounting graduates' ability to think critically and to communicate their ideas effectively. The Accounting Education Change Commission has recommended that changes be made in the education of accountants to remove these complaints.

To address these concerns, we have included a section at the end of each chapter entitled, "Beyond the numbers—Critical thinking". In that section, you are required to work relatively unstructured business decision cases, analyze real-world annual report data, write about situations involving ethics, and participate in group projects. Most of the other end-of-chapter materials also involve analysis and written communication of ideas.

In some of the cases, (analysis, ethics situations, and group projects), you are asked to write a memorandum regarding the situation. In writing such a memorandum, identify your role (auditor,consultant), the audience (management, stockholders, and creditors), and the task (the specific assignment). Present your ideas clearly and concisely. The purpose of the group projects is to assist you in learning to listen to and work with others.

These skills are important in succeeding in the business world. Team players listen to the views of others and work cohesively with them to achieve group goals.

Internet skills

The Internet is a fact of life. It is important for accountants and students to be able to use the Internet to find relevant information. Thus, each chapter contains approximately two Internet projects related to accounting. Your instructor might assign some of these, or you could pursue them on your own.

How to study the chapters in this text In studying each chapter:

Begin by reading the learning objectives at the beginning of each chapter.
Read "Understanding the learning objectives" at the end of the chapter for a preview of the chapter content.
Read the chapter content. Each exercise at the end of the chapters identifies the learning objective(s) to which it pertains. If you learn best by reading about a concept and then working a short exercise that illustrates that concept, work the exercises as you read the chapter.
Reread "Understanding the learning objectives" to determine if you have achieved each objective.
Study the Key terms to see if you understand each term. If you do not understand a certain term, refer to the page indicated to read about the term in its original context.
Take the Self-test and then check your answers with those at the end of the chapter.
Work the Demonstration problem to further reinforce your understanding of the chapter content. Then, compare your solution to the correct solution that follows immediately.
Look over the questions at the end of the chapter and think out an answer to each one. If you cannot answer a particular question, refer back into the chapter for the needed information.
Work at least some of the exercises at the end of the chapter.
Work the Problems assigned by your instructor, using the forms available.
Study the items in the "Beyond the numbers—Critical thinking" section and the "Using the Internet—A view of the real world" section at the end of each chapter to relate what you have learned to real-world situations.
Work the Study guide for the chapter. The Study guide is a supplement that contains (for each chapter) Learning objectives; Demonstration problem and solution (different from the one in the text); Matching, Completion, True-false, and Multiple-choice questions; and Solutions to all questions and exercises in the study guide.

If you perform each of these steps for each chapter, you should do well in the course. Remember that a knowledge of accounting will serve you well regardless of the career you pursue.

International accounting standards

In recent years, there has been a movement to develop a single set of global accounting standards for use around the world. Proponents of this movement say that it will boost cross-border investment, deepen international capital markets and save multinational companies, who must currently report under multiple systems, a lot of time and money.

The International Accounting Standards Committee (IASC) Foundation was established as an independent, not-for profit, private sector organisation to work towards this goal. It seeks to develop a globally accepted set of financial reporting standards (IFRSs) under the direction of its standards-setting body, the International Accounting Standards Board (IASB). The AICPA (as well as the other entities mentioned above) supports this effort and, as of early 2010, states on its website that: “The growing acceptance of International Financial Reporting Standards (IFRS) as a basis for U.S. financial reporting represents a fundamental change for the U.S. accounting profession.

Today approximately 113 countries require or allow the use of IFRS for the preparation of financial statements by publicly held companies. In the United States, the Securities and Exchange Commission (SEC) has been taking steps to set a date to allow U.S. public companies to use IFRS, and perhaps make its adoption mandatory. In fact, on November 14, 2008, the SEC released for public comment a proposed roadmap with a timeline and key milestones for adopting IFRS beginning in 2014”. Clearly, many new issues can emerge between now and 2014, but the direction seems to be clear.

The AICPA has a link on its website to a page with current p. 28 of 433 information on the planned migration to IFRS.