Chapter 1 Accounting: Information for Decision Making

FinancialAccounting

Professor Jane Kaplan

Professor Notes

Chapter 1 – Accounting: Information for Decision Making

Accounting and Organizations
Accounting information helps decision-makers determine:
Where they are
Where they have been
Where they are going
The purpose of accounting is to help people:
Make decisions about economic activities
Economic activities involve the allocation of scarce resources
Accounting provides information for managers, owners, members, and other stakeholders who make decisions about organizations
Stakeholders include those who have an economic interest in an organization and those who are affected by its activities
An organization is a group of people who work together to develop, produce, and/or distribute goods or services.
Major types of organizations:
Merchandising or retail companies sell goods to consumers that are produced by other companies and are finished goods.
Manufacturing companies produce goods that they sell to consumers, merchandising companies, or to other manufacturing companies.
Service companies sell services such as banking and consulting, rather than goods.
Organizations that sell their goods and services to make a profit are business organizations.
Governmental and non-profit organizations provide goods and services for a particular purpose without the intent of earning a profit.
Transformation of Resources
Resources include:
Natural resources, like ore and timber
Physical resources, like plant and equipment
Financial resources
Intangible resources like management and labor skills, and patents and copyrights
Value is added when an organization transforms resources from a less desirable form or location to a more desirable form or location.
The transformation creates value because people are better off after the transformation than before.
Accounting measures the increase in value created by a transformation as the difference between the total price of goods and services sold and the total cost of resources consumed in developing, producing, and selling the goods and services
Profit is the difference between the price a seller receives for goods or services and the total cost to the seller of all resources consumed in developing, producing, and selling these goods or services during a particular period.
Thus profits are the net resources generated from selling goods and services, that is, resources received from the sales minus resources used in making the sales.
The Role of Accounting in Business Organizations
Businesses earn profits by providing goods and services demanded by society. Owners invest in a business to receive a return on their investment from profits earned by their business.
Return on Investment (ROI) is the amount of profit earned by a business that could be paid to owners
Return on Investment often is expressed as a ratio:
To earn profits and pay returns to owners, businesses must also operation effectively and efficiently.
An effective business is one that is successful in providing goods and services demanded by customers.
An efficient business is one that keeps the costs of resources consumed in providing goods and services low relative to the selling prices of these goods and services
Accounting is an information system for the measurement and reporting of the transformation of resources into goods and services and the sale or transfer of these goods and services to customers.
Business Ownership
Corporation:
A corporation is a legal entity with the right to enter into contracts; the right to own, buy, and sell property; and the right to sell stock.
Stockholders or shareholders are the owners of a corporation
Proprietorships and Partnerships:
Business organizations that do not have legal identities distinct from their owners.
Proprietorships have only one owner
Partnerships have more than one owner
Advantages of Corporations:
Continuous lives apart from those of their owners
Limited liability of shareholders
Shareholders cannot enter into contracts that are binding on a corporation unless they are managers or directors
Investors in a corporation do not have to be concerned about the abilities of other stockholders to make sound business decisions
In selling shares to many investors, a corporation can obtain large amounts of financial resources
Disadvantages of Corporations
Most corporations must pay taxes on their income
Corporate taxes are separate from the taxes paid by shareholders on dividends received from the company
Corporations are regulated by various state and federal government agencies
Corporations must file many reports and publicly disclose their business activity
Compliance with these regulations can be costly
Some of the required disclosures can also be helpful to competitors
Managers’ personal interests sometimes conflict with the interests of shareholders.
This produces a condition known as moral hazard, which arises when one group, known as agents (such as managers) is responsible for serving the needs of another group, know as principals (such as investors)
The large size of corporations, which may make them difficult to manage, is another disadvantage of corporations.
Moral Hazard is the condition that exists when agents have superior information to principals and are able to make decisions that favor their own interests over those of the principals
Moral hazard imposes costs on corporations because managers must report to stockholders and generally these reports are audited
An audit verifies the reliability of reported information
Co-ordination among managers may be difficult to achieve
Moral hazard may exist among managers and employees
Employees and lower-level managers may not report reliable information about their activities to high level managers if the information is not in their best interests
The profits of corporations , except for subchapter S corporations are taxed separately from taxes paid by the owners of the corporation
The federal government and most state governments impose a corporate income tax on the profits of corporations, which is paid by the corporation
In addition, amounts distributed to shareholders are taxed as part of their income
Thus, the profits of corporations are subject to double taxation:
Taxation of the corporation and taxation of the shareholders
Creditors
A creditor is someone who loans financial resources to an organization
Creditors usually loan money for a specific period and are promised a specific rate of return (usually a fixed rate) on their investments
In contrast, owners invest for a non-specific period and receive a return that depends on the business’s profitability
Accounting and Business Decisions
Contracts are legal agreements for the exchange of resources and services
Contract terms establish the rights and responsibilities of the contracting parties
Contracts establish “give and get” relationships
Each party to the contract expects to receive something in exchange for something given
Contracts require information that the contracting parties accept as reliable and sufficient for determining if the terms of the contract have been met
Therefore, accounting information is important for forming and evaluating contracts
Accounting information helps investors evaluate the risk and return they can expect from their investments
It also helps them determine whether managers of companies they invest in are meeting the terms of their contracts.
Accounting information provides a means for owners and managers to determine the amount of compensation managers will receive
Accounting information is useful for identifying the types and locations of an organizations resources
Employees
Accounting information helps managers assess employee performance
Accounting information helps employees asses the risk and return of their employment contracts
Suppliers
Accounting information helps companies evaluate the abilities of their suppliers to meet their resource needs
Suppliers use accounting information about their customers to evaluate the risk of a buyer not being able to pay for acquired goods and services
Accounting information is used to assess the risks of buying from specific companies and selling to specific customers
Government agencies use accounting information to make taxation and regulatory decisions
The Regulatory Environment of Accounting
Financial accounting is the process of preparing, reporting, and interpreting accounting information that is provided to external decision-makers.
It is a primary source of information for investors and auditors
Generally Accepted Accounting Principals (GAAP) are standards developed by professional accounting organizations to identify appropriate accounting and reporting procedures
GAAP establish minimum disclosure requirements and increase the comparability of information from one period to the next and among difference companies
Accounting information reported by corporations to investors must be audited
An audit is a detailed examination of an organization’s financial reports
The purpose of an audit is to evaluate whether information reported to external decision-makers is a fair presentation of an organization’s economic activities
Certified Public Accountants (CPAs) examine this information to confirm that it is prepared in accordance with GAAP
The Importance of Ethics
Ethical behavior is important for accounting because the reliability of accounting information depends on the honesty of those who prepare, report, and audit this information

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