The types of accounting information that a company must develop vary with such factors as the size of the organization, whether-it is publicly owned, and the philosophy of management. The needfor some types of accounting information may be prescribed by law. For example,incomc tax regulations require every business to have an accounting system that can measure the company’s taxable income and explain the nature and source of every item in the company’s income tax return. Federal securities laws require publicly owned companles to’ prepare financial statements in conformity with generally accepted accounting principles. These statements must be filed with the Securities and Exchange Commission. distributed to stockholders.and made available to the public.
Other types of accounting information are required as matters of practical necessity. For example, every business needs to know the amounts receivable from each customer and the amounts owed to each creditor.
Although much accounting information clearly is essential to business operations, management still has many choices as to the types and amount of accounting information to be developed. For example, should the accounting system of a department store measure separately the sales of each department and of different types of merchandise? The answer to such questions depends on how useful management considers the information to be and the cost “of developing the information.
The Cost of Producing Accounting Information
Accounting systems should be c()st~effective-that is, the value of the information produced should exceed the cost of producing it. Management has no choice button produce the types of accounting reports required by law. In other cases, however, management may use cost-effectiveness as the criterion for deciding whether or not to produce the information.
In recent years. the development and installation of computer-based accounting systems have increased greatly the types and amount of accounting information that can be produced in a cost-effective manner
Basic Functions of an Accounting System
In developing information about the financial position of its business and the results of its operations, every accounting system performs the following basic functions:
1. Interpret and record the effects of business transactions.
2. Classify the effects of similar transactions in 11 manner that permits determfnatlon of the various to~~/s and subtotals useful to manalement and used in accounting reports.
3. Summarize and communicate. the Information contained in the system to decision makers
The differenccs in, accounting sYlitcms arise primarily in the manner and speed with which these functions arc performed.
In our illustrations, we often assume thc use of a simple manual nccountlng system. Such a sysrem is useful in illustrating basic accounting concepts, but it is too slow und cumbersome to mect the needs of most business organizations. In n large buslness, transactions may occur at a, rate of scvcral hundred or several thousand per hour. To keep , pace with such a rapid flow of accounting information, these companlcs must use nccounting systems thalt arc lurgely computer-based.
Many small businesses continue to use manual accounting systems, but they modify these systems to meet thcir needs as efficiently as possible.
DECISION MAKING BY EXTERNAL PARTIES
Financial accounting is the primary subject of Chapters 2-14 of this textbook. It is an important subject for students who need only an introduction to the field of accounting, us well as students w.ho will pursue accounting as a major and take many additional accounting courses’. Financial accounting provides information about tbe financial resources, obligations, and activities of ad enterprise that is intended for use primarily by external decision makers-investors and creditors
External Users of Acconting Information
What do we mean by external users and who are they? External users of accounting information are, individuals and other enterprises that have a financial interest in the re-‘porting enterprise, but they are not involved in the day-to-day operations of that enter-
, priseExternal users offinanciil information include the following
• Labor unions
• Trade associations
•. General public
Each of these groups ‘of external decision makers has unique information needs to be .able to make their decisions about the reporting enterprise. For example, customers who purchase from the enterprise-need information to allow them to assess the quality of the products they buy and the faithfulness of the enterprlse.in fulfilling obligations.
Governmental agencies such, as the Federal Trade Commission may have an interest in whether the enterprise meets certain governmental regulations that apply. The general public may be interested in th,e extent to which the reporting enterprise is ‘socially responslble (for example, does ‘not pollute the environment). ” . Provldlng lnformation that !l1eets the needs of such a large set of diverse users is dif· flcult, if not impossible, in a single set of financial information. Therefore, external financiill reporting is directed toward the information needs of two primary groups-investors and creditors, As you will soon see, investors are individuals and other enterprises that own the reporting enterprise. Creditors, on the other hand, are Individuals and other enterprises Ihllt have provided credit to the reporting enterprise. For example, a cornmerclal bunk may have loaned money to the reporting enterprise, or-a supplier may have permitted the reporting enterprise to purchase goods and to pay for those goods later.
Our assumption is that by meeting the financial information needs of investors and credo , itors, we provide information that is also useful to many other users of financial information. In addition, certain external users of financial information;.such as government agencies like the Federal Trade Commission. can require information that is not generally available to the public. All a result. they are not us dependent on publicly available information as are investors and creditors.
For .these reasons. we sometimes refer to investors and creditors as the primary external financial information users. When you see references like these. you should keep in mind that we are talking about both current investors and creditors and those individuals and other enterprises that may become investors-and creditors 111 the future:
Objectives of External Financial Reporting
be your primary financial interest in the company? You probably would be interested in two things, both of which make up the company’s cash flow prospects. You would be interested in the return to you at some future date of the amount you had invested or
loaned. We refer to this as the return of your investment. In addition, you would expect the company to pay you something for the use of your funds, either as an owner or a creditor. We refer to this as the return on your investment. Information that is useful to you in making judgments about the company’s ability to provide you’ with what , you expect in terms of the return of your funds in the future and the return on your funds while you do not have use of them is what we mean by information ‘about cash flow prospects. .
Assume, for example. that you loan $100,000 to a company that is owned by a friend .Your intent is not to be a long-term investor (owner). but simply to help the company financially through its difficult startup phase. Management of the company agrees In pay you interest at 12% and to repay your loan in one year. Before making this loan, you are interested in seeing information that will allow you to assess the company’s ability to provide the following cash flows to you in the future
While there is always some risk in entering into 11 trunsactlon or this type, before making this loan you need to feel reasonably secur’1 that the company will be in-a position to pay you these amounts.
Similarly, assume you have an opportunity to invest in u company by becoming one of a large number of owners. As un external owner, ruther than an owner-manager, you will not be involved in the daily operations of the com puny. Before making such un investment.
you want to see evidence that the company wilJ be lib Ie to pay you a perlodlc return on your investment (called a dividend if the company is organized as a corporation) and that at some future date you can expect to soli your investment to another owner at n favorable price-in other words, that you can expect the return of your investment.
Providing information about these cash flow prospects essentially is what financial accounting is all about. For the primary external users of financial information-c-investors and creditors-this information is summarized in the following table
The accounting profession has identified certain objectives of external financial reporting to guide its efforts to refine and improve the reporting of information to external decision makers. These general objectives are displayed.below and are best understood i fstudled from the bottom up-from general to specific.
The first objective is the most general and is to provide information that is useful in making investment and credit decisions. As we indicated earlier, investors ‘and creditors are the primary focus of external financial reporting. We believe that by meeting the information needs of investors and creditors, we provide information that is also useful to many other important financial statement users.
The second objective, -which is more. specific than the first, is to provide information that is useful in, assessing the amount, timing. and uncertainty of future cash flows. As
Financial reporting. and financial statements in particular. ‘tan be thought of as a lens through which you can view a business. (Seethe figure on page 13.) A lens allows you , to see things from a distance that you would not otherwise be able to see; it also allows
you to focus in greater detail on certain aspects of what you arc, looking at. Financial information, and particularly financial statements, allows you to do just that.,-focus in on certain financial aspects of the enterprise that are of particular interest to you in making important investing and credit decisions. Because financial statements are only one source of financial accounting information, financial reporting provides a broader view’ of the business than that provided by financial statements only. In other words. financial reporting encompasses financial statements, but it is not limited to financial statements. Precisely how the financial statements identified earlier provide information to external users is introduced in and is the major subject of several chapters thereafter.