What Is Accounting, and Who Uses Accounting Information?

Learning Objective 15-1 Explain the role of accountants in business and distinguish among the kinds of work done by public accountants, private accountants, management accountants, and forensic accountants.

Accounting is a comprehensive system for collecting, analyzing, and communicating financial information to a firm’s owners and employees, to the public, and to various regulatory agencies. To perform these functions, accountants keep records of taxes paid, income received, and expenses incurred, a process historically called bookkeeping, and they assess the effects of these transactions on business activities. By sorting and analyzing such transactions, accountants can determine how well a business is being managed and assess its overall financial strength.

Accountingcomprehensive system for collecting, analyzing, and communicating financial information

Bookkeepingrecording of accounting transactions

Because businesses engage in thousands of transactions, ensuring consistent, dependable financial information is a necessity. This is the job of the accounting information system (AIS), an organized procedure for identifying, measuring, recording, and retaining financial information so that it can be used in accounting statements and management reports. The system includes all of the people, reports, computers, procedures, and resources that are needed to compile financial transactions.5

Accounting Information System (AIS)organized procedure for identifying, measuring, recording, and retaining financial information for use in accounting statements and management reports

Many different individuals, groups, and other entities use accounting information:

Managers use it to develop goals and plans, set budgets, and make decisions about market opportunities.

Employees and unions use it to plan for and receive compensation and such benefits as health care, vacation time, and retirement pay.

Investors and creditors use it to estimate returns to shareholders, determine growth prospects, and decide whether a firm is a good credit risk.

Tax authorities use it to plan for tax inflows (revenues), determine the tax liabilities of individuals and businesses, and ensure that correct amounts are paid on time.

Government regulatory agencies rely on it to fulfill their duties toward the public. The Securities and Exchange Commission (SEC), for example, requires firms to file financial disclosures so that potential investors have valid information about their financial status.

The controller, or chief accounting officer, manages a firm’s accounting activities by ensuring that the AIS provides the reports and statements needed for planning, decision making, and other management activities. This range of activities requires different types of accounting specialists. In this section, we begin by distinguishing between the two main fields of accounting: financial and managerial. Then, we discuss the different functions and activities of certified public accountants, private accountants, management accountants, and forensic accountants.

Controllerperson who manages all of a firm’s accounting activities (chief accounting officer)

Financial Versus Managerial Accounting

In any company, two forms of accounting—financial and managerial—can be distinguished by the users they serve: those outside the company and those within.6

Financial Accounting

A firm’s financial accounting system is concerned with external information users: consumer groups, unions, shareholders, suppliers, creditors, and government agencies. It prepares reports such as income statements and balance sheets that focus on the activities of the company as a whole rather than on individual departments or divisions or internal projects and operations.7

Financial Accountingfield of accounting concerned with external users of a company’s financial information

Managerial Accounting

Managerial accounting, on the other hand, serves internal users. Managers at all levels need information to make departmental decisions, monitor projects, and plan future activities. Other employees also need accounting information. Engineers must know certain costs, for example, before making product or operations improvements, purchasing agents use information on materials costs to negotiate terms with suppliers and to set performance goals, and salespeople need historical sales data for each geographic region and for each of its products.

Managerial (Management) Accountingfield of accounting that serves internal users of a company’s financial information

Certified Public Accountants

Public accountants offer accounting services to the public and are distinguished by their independence from the clients they serve. That is to say, they typically work for an accounting firm providing services for outside client firms in which the public accountant has no vested interest, thus avoiding any potential biases in conducting their professional services. Among public accountants, certified public accountants (CPAs) are licensed by a state after passing an exam prepared by the American Institute of Certified Public Accountants (AICPA). Preparation for certification begins with majoring in a college program studying the theory, practices, and legal aspects of accounting. In addition to the CPA exam, certification in most states requires some practice (experience), varying up to two years, in a private company or government entity under the direction of a CPA. Once certified, the CPA can perform services beyond those allowed by non-CPAs.8 Whereas some CPAs work as individual practitioners, many form or join existing partnerships or professional corporations.

Certified Public Accountant (CPA)accountant licensed by the state and offering services to the public

The “Big Four” Public Accounting Firms

Although thousands of CPA companies of various sizes, ranging from small one-person local operations to large multinationals, operate in the United States, about one-half of total revenues for public accounting services are generated by the four biggest CPA firms (listed with their headquarters):

Deloitte (United Kingdom)

Ernst & Young (United Kingdom)

PricewaterhouseCoopers, PwC (United Kingdom)

KPMG (Netherlands)

In addition to prominence in the United States, international operations are important for all four of these companies. For instance, they have experienced especially rapid growth in recent years for CPA services in Asia and Latin America. Each of the Big Four firms has more than 200,000 employees worldwide.9

Accountants help monitor and analyze a firm’s financial information to make sure that it is accurate and that proper reporting procedures are being followed. In 2017, accountants uncovered fraudulent activities at Tesco, a large British retailer, resulting in jail time for these three former Tesco executives. All told, accountants discovered that they had inaccurately reported over $400 million in revenues and expenses in order to falsely boost Tesco stock prices.

Hannah McKay/PA Images/Alamy Stock Photo

CPA Services

Virtually all CPA firms, whether large or small, provide auditing (sometimes called assurance), tax, and management services. Larger firms such as Deloitte Touche Tohmatsu and Ernst & Young earn much of their revenue from auditing and tax services and consulting (management advisory) services. For instance, in 2022 Ernst & Young earned $4.4 billion in revenues, with 31.7 percent from auditing/assurance, 24.9 percent from tax services, and 30.5 percent from consulting services.10 Smaller firms earn most of their income from tax and management services.

Auditing

An audit examines a company’s AIS to determine whether financial reports reliably represent its operations.11 Organizations must provide audit reports when applying for loans, selling stock, or going through a major restructuring. Independent auditors who do not work for the company must ensure that clients’ accounting systems follow generally accepted accounting principles (GAAP), which are formulated by the Financial Accounting Standards Board (FASB) of the AICPA and govern the content and form of financial reports.12 The auditing of a firm’s financial statements is one of the services that can be performed only by a CPA. The Securities and Exchange Commission (SEC) is the U.S. government agency that legally enforces accounting and auditing rules and procedures. Ultimately, the CPA performing the audit is expected to certify whether or not the client’s reports comply with GAAP.

Auditsystematic examination of a company’s accounting system to determine whether its financial reports reliably represent its operations

Generally Accepted Accounting Principles (GAAP)accounting guidelines that govern the content and form of financial reports

Tax Services

Tax services include assistance not only with tax-return preparation but also with tax planning. A CPA’s advice can help a business structure (or restructure) operations and investments and perhaps save millions of dollars in taxes. Staying abreast of tax-law changes is no simple matter. Some critics charge that the changing of tax regulations has become a full-time vocation among some state and federal legislators, who add increasingly complicated laws and technical corrections on taxation each year.

Tax Servicesassistance provided by CPAs for tax preparation and tax planning

Management Advisory Services

As consultants, some accounting firms also provide management advisory services ranging from personal financial planning to planning corporate mergers. Other services include production scheduling, information systems studies, AIS design, and even executive recruitment. The staffs of the largest CPA firms sometimes include engineers, architects, mathematicians, and psychologists, all of whom are available for consulting on relevant issues, challenges, and initiatives.

Management Advisory Servicesassistance provided by CPA firms in areas such as financial planning, information systems design, and other areas of concern for client firms

Noncertified Public Accountants

Many accountants don’t take the CPA exam; others work in the field while getting ready for it or while meeting requirements for state certification. Many small businesses, individuals, and even larger firms rely on these non-CPAs for basic income-tax preparation, payroll accounting, and financial-planning services so long as they abide by local and state laws. Non-CPAs often put together financial statements that are used in the firm for internal purposes, based on information provided by management. These statements may include a notification that auditing methods were not used in their preparation.

The CPA Vision Project

A continuing talent shortage in accounting has led the profession to rethink its culture and lifestyle.13 With grassroots participation from CPAs, educators, and industry leaders, the AICPA, through its CPA Vision Project, is redefining the role of the accountant for today’s world economy. The Vision Project identifies a unique combination of skills, technology, and knowledge, called core competencies for accounting, that will be necessary for future CPAs. The AICPA summarizes the project’s core purpose as follows: “CPAs . . . Making sense of a changing and complex world.”14 As Table 15.1 shows, those skills, which include communication, critical thinking, and leadership, go far beyond the ability to “crunch numbers.” They include certain communications skills, along with skills in critical thinking and leadership. Indeed, the CPA Vision Project foresees CPAs who combine specialty skills with a broad-based orientation to communicate more effectively with people in a wide range of business activities.

Table 15.1 AICPA’s Competencies for Success in Accounting

Skills in Strategic Thinking and Critical Problem Solving

The accountant can combine data with reasoning and professional knowledge to recognize and help solve critical problems for better strategic action.

Communications, Interpersonal Skills, and Effective Leadership

The accountant can communicate effectively in various business situations using meaningful communications skills that provide interpersonal effectiveness and leadership.

Dedication to Meeting Customer Needs

The accountant surpasses the competition in understanding each client’s unique needs, in meeting those needs, and in visualizing the client’s future needs.

Ability to Integrate Diverse Information

The accountant can combine financial and other kinds of information to gain new meaning that provides clients with useful insights and understanding for solving problems.

Proficiency with Information Technology

The accountant can use information technology (IT) in performing services for clients and can identify IT applications that the client can adopt for added value to the business.

Source: Based on “The CPA Vision Project,” The American Institute of Certified Public Accountants, accessed July 25, 2023, https://us.aicpa.org/content/dam/aicpa/research/cpahorizons2025/cpavisionproject/downloadabledocuments/cpavisionproject-finalreport.pdf.

Core Competencies for Accountingthe combination of skills, technology, and knowledge that will be necessary for the future CPA

Private Accountants and Management Accountants

To ensure integrity in reporting, CPAs engaged in auditing activities are always independent of the firms they audit. However, many businesses also hire their own private accountants as salaried employees to perform day-to-day activities. These accountants may also be CPAs but cannot engage in the external audit process.

Private Accountantsalaried accountant hired by a business to carry out its day-to-day financial activities

Private accountants perform numerous jobs. An internal auditor at ConocoPhillips, for example, might fly to the North Sea to confirm the accuracy of oil-flow meters on offshore petroleum drilling platforms. A supervisor responsible for $2 billion in monthly payouts to vendors and employees may never leave the executive suite, with duties such as hiring and training, assigning projects, and evaluating performance of accounting personnel. Large businesses employ specialized accountants in such areas as budgeting, financial planning, internal auditing, payroll, and taxation. In small businesses, a single person may handle all accounting tasks.

Although private accountants may be either CPAs or non-CPAs, most are what are called management accountants, who provide services to support managers in various activities (marketing, production, engineering, and so forth). Many hold the certified management accountant (CMA) designation, awarded by the Institute of Management Accountants (IMA), recognizing qualifications of professionals who have passed IMA’s experience and examination requirements. With more than 150,000 members in 150 countries, IMA is dedicated to supporting accounting professionals to create quality internal controls and financial practices in their companies.15

Management Accountantprivate accountant who provides financial services to support managers in various business activities within a firm

Certified Management Accountant (CMA)professional designation awarded by the Institute of Management Accountants (IMA) in recognition of management accounting qualifications

Forensic Accountants

One of the fastest-growing areas in accounting is forensic accounting, the use of accounting for legal purposes.16 Sometimes known as “the private eyes of the corporate culture,” forensic accountants must be good detectives. They look behind the corporate façade instead of accepting financial records at face value. In combining investigative skills with accounting, auditing, and the instincts of a detective, they assist in the investigation of business and financial issues that may have application to a court of law. Forensic accountants may be called on by law enforcement agencies, insurance companies, law firms, private individuals, and business firms for both investigative accounting and litigation support in crimes against companies, crimes by companies, and civil disagreements. They may conduct criminal investigations of online scams and misuse of government funds. Civil cases often require investigating and quantifying claims of personal injury loss as a result of negligence and analyzing financial issues in divorce proceedings. Forensic accountants also assist business firms in tracing and recovering lost assets from employee business fraud or theft.

Forensic Accountingthe practice of accounting for legal purposes

Investigative Accounting

Law enforcement officials may ask a forensic accountant to investigate a trail of financial transactions behind a suspected crime, as in a money-laundering scheme or an investment swindle. The forensic accountant, being familiar with the legal concepts and procedures of the case, would then identify and analyze pertinent financial evidence—documents, bank accounts, phone calls, computer records, and people—and present accounting conclusions and their legal implications. They also develop reports, exhibits, and documents to communicate their findings.

Litigation Support

Forensic accountants assist in the application of accounting evidence for judicial proceedings by preparing and preserving evidence for these proceedings. They also assist by presenting visual aids to support trial evidence, by testifying as expert witnesses, and, especially, by determining economic damages in any case before the court. A divorce attorney, for example, may suspect that the assets of one party are being understated and request financial analysis by a forensic accountant. A movie producer may need help in determining damages for breach of contract by an actor who quits before a film is completed.

Certified Fraud Examiners

One specific area within forensic accounting, the Certified Fraud Examiner (CFE) designation, is administered by the ACFE. The CFE’s activities focus specifically on fraud-related issues, such as fraud detection, evaluating accounting systems for weaknesses and fraud risks, investigating white-collar crime on behalf of law enforcement agencies, evaluating internal organizational controls for fraud prevention, and expert witnessing. Many CFEs find employment in corporations seeking to prevent fraud from within. The CFE examination covers four areas:

Fraud prevention and deterrence. Includes why people commit fraud, theories of fraud prevention, and professional code of ethics

Financial transactions. Examines types of fraudulent financial transactions incurred in accounting records

Fraud investigation. Pertains to tracing illicit transactions, evaluating deception, and interviewing and taking statements

Legal elements of fraud. Includes rules of evidence, criminal and civil law, and rights of the accused and accuser

Certified Fraud Examiner (CFE) professional designation administered by the ACFE in recognition of qualifications for a specialty area within forensic accounting

Eligibility to take the exam includes both educational and experience requirements. Although a minimum of a bachelor’s degree is required, it does not have to be in accounting or any other specific field of study. Candidates without a bachelor’s degree, but with fraud-related professional experience, may substitute two years of experience for each year of academic study. Experience requirements for certification include at least two years in any of several fraud-related areas, such as auditing, criminology, fraud investigation, or law.

Entrepreneurship and New Ventures Skimming Off the Top

Jennifer Mayberry runs a respectable coffee shop in a small Pacific Northwest town. For years she’s dropped her daily receipts off in the night deposit slot at the local Chase bank, where her friend works, but Jennifer, trusting the banking system, never reconciled her deposit slips to her accounting records. In fact, she never reconciled her checking account to the bank statement. But when her accountants started tallying up revenues for tax reporting, they found a $1,000 discrepancy in the November deposit. That led to the hiring of a forensic accountant, who discovered that, despite internal controls at the bank, Jennifer’s friend had been skimming the cash from the deposits, changing the deposit slips, and then making the smaller deposit into the account. Over the course of 18 months, the friend skimmed $42,828.96. Jennifer could have prevented this had the coffee shop had some simple accounting procedures in place.17

Meanwhile, down in Texas at the Collin Street Bakery, world famous for its delectable fruitcakes, owner Bob McNutt was unraveling a decade of embezzlement. It had started when the head accountant, feeling underpaid, bought himself a new Lexus and paid for it with a company check, covering his tracks by voiding that check in the system and writing another check to a legitimate vendor, which he then never sent. In the bank account, a check cleared for $20,000, and the accounting records showed a payment of $20,000. Since there were no other accountants and the business owner didn’t audit the records, no one caught the theft. Soon, the accountant was taking up to $98,000 a month from the bakery and he and his wife were living a lavish lifestyle, explaining it away as the result of an inheritance. No one much questioned the fine cars, vacations, jewelry, country club membership, home remodeling, and other obviously expensive purchases. Eventually McNutt, who had been scratching his head now for years trying to figure out how his business, which seemed so outwardly successful, was cash poor and struggling year after year, examined labor expenses, product expenses, prices, and everything he could think of but found nothing helpful. But one day, a new hire in the accounting department found a curious voided check in the system. That was the beginning of the end for the thief. As the story unfolded, McNutt found that this one accountant had managed to skim over $17 million from Collin Street Bakery, using an unsophisticated scheme that could have been prevented by a few simple internal control procedures.18

The Fort Worth Star-Telegram/Ron Jenkins/AP Images

Small and medium-sized businesses aren’t the only ones who get hit by embezzlers. Cargill Inc. is a global agribusiness corporation based in Minnesota, and although it’s privately held, on the Fortune 500 list it would rank ahead of AT&T. In 2016, one of the accounting managers pled guilty to skimming over $3 million from the company by depositing customer payments into her personal account.19 In 2021, Cargill lost $45 million when two employees conspired with a vendor, Women’s Distribution Services, or WDS, of South Carolina, to overcharge Cargill for their own benefit.20

It’s not just high-tech scams that these businesses need to watch out for. All three of these instances occurred because the business owners took a relaxed view of the kinds of accounting policies and procedures that protect one of the most valuable and easily lifted assets—cash. That’s why it pays to become educated in basic financial accounting and human resource management as you move your way up in business.

Federal Restrictions on CPA Services and Financial Reporting: Sarbox

The financial wrongdoings associated with firms such as ImClone Systems, Tesco, Tyco, WorldCom, Enron, Arthur Andersen, and others have not gone unnoticed in legislative circles. Federal regulations, primarily the Sarbanes-Oxley Act of 2002 (Sarbox or SOX), have been enacted to restore and maintain public trust in corporate accounting practices.

Sarbanes-Oxley Act of 2002 (Sarbox or SOX)enactment of federal regulations to restore public trust in accounting practices by imposing new requirements on financial activities in publicly traded corporations

Sarbox restricts the kinds of nonaudit services that CPAs can provide. Under the Sarbox law, for example, a CPA firm can help design a client’s financial information system, but not if it also does the client’s auditing. Hypothetically, an unscrupulous accounting firm’s audit might intentionally overlook a client’s false financial statements if, in return, the client rewards the accounting firm with a contract for lucrative nonaccounting services, such as management consulting. This was a core allegation in the Enron–Arthur Andersen scandal several years ago. Arthur Andersen, one of the world’s largest accounting firms at the time, filed audits that failed to disclose Enron’s shaky financial condition, which eventually led to the massive energy company’s bankruptcy and to Andersen’s dissolution. Andersen’s auditors gained more money from consulting at Enron than from the actual auditing work.22 By prohibiting auditing and nonauditing services to the same client, Sarbox encourages audits that are independent and unbiased.

Sarbox imposes requirements on virtually every financial activity in publicly traded corporations, as well as severe criminal penalties for persons committing or concealing fraud or destroying financial records. CFOs and CEOs, for example, have to pledge that the company’s finances are correct and must personally vouch for the methods and internal controls used to get those numbers. Companies have to provide a system that is safe for all employees to anonymously report unethical accounting practices and illegal activities without fear of retaliation. Table 15.2 provides brief descriptions of several of Sarbox’s many provisions.

Table 15.2 Selected Provisions of the Sarbanes-Oxley Act21

The Accounting Equation

Learning Objective 15-2 Explain the accounting equation and how it is used.

All accountants rely on record keeping to enter and track transactions. Underlying all record-keeping procedures is the most basic tool of accounting, the accounting equation:

Assets = Liabilities + Owner’sEquity

Accounting EquationAssets = Liabilities + Owners’Equity; used by accountants to balance data for the firm’s financial transactions at various points in the year

After each financial transaction (e.g., payments to suppliers, sales to customers, wages to employees), the accounting equation must be in balance. If it isn’t, then an accounting error has occurred. To better understand the importance of this equation, we must understand the terms assets, liabilities, and owners’ equity.

Assets and Liabilities

An asset is any economic resource that is expected to benefit a firm, its owner(s), or both. Assets for accounting purposes include land, buildings, equipment, inventories, and payments due the company (accounts receivable). Apple, for example, held total assets amounting to $352,755 million at year end 2022.23 A liability, in contrast, is a debt that a firm owes to an outside party. The total of Apple’s liabilities—all the debt owed to others—was $302,083 million at the end of 2022.

Assetany economic resource expected to benefit a firm or an individual who owns it

Liabilitydebt owed by a firm to an outside organization or individual

An asset is an economic resource that benefits the firm. Apple’s assets include retail outlets and the inventories of Apple products that the stores keep on hand to sell to customers.

Peregrine/Alamy Stock Photo

Owners’ Equity

You may be familiar with the concept of equity that a homeowner has in a house—the amount of money that could be made (or lost) by selling the house and paying off the mortgage. Similarly, owners’ equity in a business is the amount of money that owners would theoretically receive if they sold all of a company’s assets at their presumed value and paid all of its liabilities. Apple’s financial reports for 2022 declared shareholders’ equity of $50,672 million. At Apple, then, we see that the accounting equation is in balance, as it should be.

Owners’ Equityamount of money that owners would receive if they sold all of a firm’s assets and paid all of its liabilities

Assets = Liabilities + Owner’sEquity$352,755 = $302,083 + $50,672million

We can also rewrite the equation to highlight how owners’ equity relates to assets and liabilities.

Assets−Liabilities = Owner’sEquity

Another term for this is net worth: The difference between what a firm owns (assets) minus what it owes (liabilities) is its net worth, or owners’ equity. If a company’s assets exceed its liabilities, owners’ equity is positive. At Apple, owners’ equity is $50,672 million (=$362,755million−$302,083million). If the company goes out of business, the owners may receive some cash (a gain) after selling assets and paying off liabilities. However, if liabilities outweigh assets, owners’ equity is negative; assets are insufficient to pay off all debts, and the firm is insolvent. If the company goes out of business, the owners will get no cash, and some creditors won’t be paid.

Owners’ equity is meaningful for both investors and lenders. Before lending money to owners, for example, lenders want to know the amount of owners’ equity in a business. A larger owners’ equity indicates greater security for lenders. Owners’ equity consists of two sources of capital:

The amount that the owners originally invested (this is also referred to as contributed capital)

Profits (also owned by the owners) earned by and then reinvested in the company (legally called retained earnings)

When a company operates profitably, its assets increase faster than its liabilities. Owners’ equity, therefore, will increase if profits are retained in the business instead of paid out as dividends to stockholders. Owners’ equity also increases if owners invest more of their own money to increase assets. However, owners’ equity can shrink if the company operates at a loss or if owners withdraw assets.

Managing in Turbulent Times United States Versus the World

The International Financial Reporting Standards (IFRS) set of accounting rules is used in more than 168 countries around the world, including the European Union and many Asian and South American countries. The generally accepted accounting standards (GAAP) set of guidelines, set by the Financial Accounting Standards Board (FASB), is used only in the United States.

Differences between the two standards can be significant. Samsung, maker of the Galaxy phones, is a Korean company, and its financial statements are prepared according to Korea’s version of IFRS and stated in won, the Korean currency. Apple is a U.S. company with GAAP-based financials. GAAP requires companies to report research and development (R&D) costs as expenses as they are incurred, under the theory that most R&D doesn’t result in a viable product, but IFRS allows companies to record R&D as an asset on the balance sheet and to then spread the costs out over subsequent years. For two hypothetically identical companies, this would mean that the U.S. financials would show less profit in the current year but slightly more in subsequent years, as the international company spread the costs out. And that’s only one of the many divergent practices.

Although the FASB and the London-based International Accounting Standards Board (IASB) have agreed in principle to work together toward a more unified set of standards, progress on this “convergence” has been slow for several reasons. First, IFRS are principle based, offering more philosophical guidance rather than the more definitive rule-based provisions of GAAP. Regulators and professionals in the United States argue that in our litigious society, we need stricter guidance, not looser. In addition, the FASB and the SEC are unlikely to concede their long-established standard-setting authority to the relatively new IASB. Third, U.S. companies and investors alike have a long-standing investment of both time and money in GAAP, and changing could be disruptive and expensive.

Even though Samsung and Apple compete in the smartphone market, they use different accounting standards.

Lukmanazis/Shutterstock

Even though the U.S. accounting profession shows no sign of adopting IFRS in the near future, recent work around a conceptual framework for GAAP, an overall trend toward more and more globalization, and the flexibility and adaptability of a more principle-based system of accounting are just some of the forces pushing the convergence process onward. In the meantime, savvy investors understand the differences between various systems and rely on the disclosures to the audited financial statement to explain accounting practices and choices.

Financial Statements

Learning Objective 15-3 Describe the three basic financial statements and show how they reflect the activity and financial condition of a business.

As noted previously, accountants summarize the results of a firm’s transactions and compile reports to help managers make informed decisions. Among the most important reports are financial statements, which fall into three broad categories: balance sheets, income statements, and statements of cash flows. Together, these reports indicate the firm’s financial health and what affected it. In this section, we discuss these three financial statements as well as the function of the budget as an internal financial statement.

Financial Statementany of several types of reports summarizing a company’s financial status to stakeholders and to aid in managerial decision making

Balance Sheets

Balance sheets supply detailed information about the items that constitute the accounting equation: assets, liabilities, and owners’ equity. Because they also show a firm’s financial condition at one specific point in time, they are sometimes called statements of financial position. Figure 15.1 is a simplified presentation of the balance sheet for Apple, Inc. on the last day of its 2022 fiscal year.

Figure 15.1 Apple’s Balance Sheet

Source: Apple, Inc., Fourth-Quarter 2022 10-K.

Figure 15.1 Full Alternative Text

Balance Sheetfinancial statement that supplies detailed information about a firm’s assets, liabilities, and owners’ equity

Assets

From an accounting standpoint, most companies have major three types of assets: current, fixed, and intangible.

Current Assets

Current assets include cash and assets that can be converted into cash within a year. The act of converting something into cash is called liquidating. Assets are normally listed in order of liquidity, the ease of converting them into cash. Debts, for example, are usually paid in cash. A company that needs but cannot generate cash—a company that’s not “liquid”—may be forced to sell assets at reduced prices or even to go out of business.

Current Assetasset that can or will be converted into cash within a year

Liquidityease with which an asset can be converted into cash

By definition, cash is completely liquid. Marketable securities purchased as short-term investments are slightly less liquid but can be sold quickly. These include stocks or bonds of other companies, government securities, and money market certificates. Many companies hold other nonliquid assets such as merchandise inventory, the cost of merchandise that’s been acquired for sale to customers and is still on hand. Apple keeps very little inventory on hand. For instance, as new iPhones are manufactured, they are shipped directly to retailers like AT&T or Verizon and are then carried as inventory on the balance sheets of those companies. However, because Apple generates so much cash, it does maintain robust investments in long-term marketable assets.

Fixed Assets

Fixed assets (such as land, buildings, and equipment) have long-term use or value, but as buildings and equipment wear out or become obsolete, their value decreases. Accountants use depreciation to spread the cost of an asset over the years of its useful life. To reflect decreasing value, accountants calculate an asset’s expected useful life in years, divide its worth by that many years, and subtract the resulting amount each year. Every year, therefore, the remaining value (or net value) decreases on the firm’s records. In Figure 15.1, Apple shows fixed assets of $42,117 million after depreciation.

fixed assetasset with long-term use or value, such as land, buildings, and equipment

depreciationaccounting method for distributing the cost of an asset over its useful life

Intangible Assets

Although their worth is hard to calculate, intangible assets have monetary value in the form of expected benefits, which may include fees paid by others for obtaining rights or privileges—such as patents, trademarks, copyrights, and franchises—to your products. Goodwill is the amount that a buyer would be expected to pay for an existing business beyond the value of its other assets. A purchased firm, for example, may have a particularly good reputation or location. Apple declares both intangible assets and goodwill in its expanded balance sheet.

Intangible assetnonphysical asset, such as a patent or trademark, that has economic value in the form of expected benefit

Goodwillamount paid for an existing business above the value of its other assets

Liabilities

Like assets, liabilities are often separated into different categories. Current liabilities are debts that must be paid within 1 year. These include accounts payable (payables), unpaid bills to suppliers for materials as well as wages and taxes that must be paid in the coming year. Apple has current liabilities of $153,982 million. Long-term liabilities are debts that are not due for at least a year. These normally represent borrowed funds on which the company must pay interest. The long-term liabilities of Apple are $148,101 million.

Current Liabilitydebt that must be paid within one year

Accounts Payable (Payables)current liability consisting of bills owed to suppliers, plus wages and taxes due within the coming year

Long-Term Liabilitydebt that is not due for at least one year

Owners’ Equity

The final section of the balance sheet in Figure 15.1 shows owners’ equity (shareholders’ equity) broken down into paid-in capital and retained earnings. When Apple was first formed, it sold a small amount of common stock that provided its first paid-in capital. Paid-in capital is money invested by owners. This includes both the original infusion of capital as well as additional capital raised when a firm issues additional stock as it grows.

Paid-In Capitalmoney that is invested in a company by its owners

Retained earnings are net profits kept by a firm rather than paid out as dividend payments to stockholders. As businesses earn profits, they can divide those profits to shareholders in the form of dividends (discussed in Chapter 17) or retain them to finance future growth.

Retained Earningsearnings retained by a firm for its use rather than paid out as dividends

The balance sheet for any company, then, is a barometer for its financial condition at one point in time. By comparing the current balance sheet with those of previous years, creditors and owners can better interpret the firm’s financial progress and future prospects in terms of changes in its assets, liabilities, and owners’ equity.

Income Statements

The income statement is sometimes called a profit-and-loss statement because its description of revenues and expenses results in a figure showing the firm’s annual profit or loss. In other words,

Profit(or Loss) = Revenues−Expenses

Income Statement (Profit-and-Loss Statement)financial statement listing a firm’s annual revenues and expenses so that a bottom line shows annual profit or loss

Commonly known as the bottom line, profit or loss is probably the most important figure in any business enterprise. Figure 15.2 shows the 2022 income statement for Apple, whose bottom line was $99,803 million in profit. The income statement includes four major categories: (1) revenues, (2) cost of revenues, (3) operating expenses, and (4) net income. Unlike a balance sheet, which shows the financial condition at a specific point in time, an income statement shows the financial results that occurred across a period of time, such as a month, quarter, or year.

Figure 15.2 Apple’s Income Statement

Source: Apple, Inc., 2022 Annual Report (Mountain View, CA: Author, 2022.)

Figure 15.2 Full Alternative Text

Revenues

When a law firm receives $250 for preparing a will or a supermarket collects $65 from a grocery shopper, both are receiving revenues, the funds that flow into a business from the sale of goods or services. In 2022, Apple reported revenues of $394,328 million from the sale of iPhones, iPads, computers, digital music, watches, and other products.

Revenuesfunds that flow into a business from the sale of goods or services

Cost of Revenues (Cost of Goods Sold)

In the Apple income statement, the cost of revenues section shows the costs of obtaining the revenues from other companies during the year. These are the costs that Apple pays manufacturers for producing its hardware products like phones, tablets, and computers and the licensing fees it pays for the right to distribute music, movies, and so forth. Other costs include expenses arising from the operation of Apple’s data centers, including labor, energy, and costs of processing customer transactions. The cost of revenues for Apple in 2022 was $223,546 million.

Cost of Revenuescosts that a company incurs to obtain revenues from other companies

We should also note that Apple does very little of its own manufacturing—most of its manufacturing is outsourced to low-cost producers in Asia. Traditional manufacturing companies, however, like Ford and Procter & Gamble, use a different reporting category, cost of goods sold, which are the costs of obtaining and transforming materials to make physical products sold during the year.

Cost of Goods Soldcosts of obtaining materials for making the products sold by a firm during the year

Gross Profit

Managers are often interested in gross profit, a preliminary, quick-to-calculate profit figure that considers just two pieces of data—revenues and cost of revenues (the direct costs of getting those revenues)—from the income statement. To calculate gross profit, simply subtract cost of revenues from revenues obtained by selling the firm’s products.

Gross Profitpreliminary, quick-to-calculate profit figure calculated from the firm’s revenues minus its cost of revenues (the direct costs of getting the revenues)

Operating Expenses

In addition to costs directly related to generating revenues, every company has general expenses ranging from office supplies to the CEO’s salary. Like cost of revenues and cost of goods sold, operating expenses are resources that must flow out of a company if it is to earn revenues. As shown in Figure 15.2, Apple had operating expenses of $51,345 million in 2022.

Operating Expensescosts, other than the cost of revenues, incurred in producing a good or service

Research development expenses are associated with exploring new services and technologies that might be introduced in the future. Selling expenses result from activities related to selling goods or services, such as sales-force salaries and advertising expenses. Administrative and general expenses, such as management salaries and maintenance costs, are related to the overall management of the company.

Operating and Net Income

Operating income compares the gross profit from operations against operating expenses. This calculation for Apple ($170,782 million − $51,345) yields an operating income, or income before taxes, of $119,437 million. Apple also earned $2,825 million from interest on investments (this is not considered to be operating income) and incurred tax liabilities of $19,300 million. Adding the interest revenue and subtracting estimated income taxes from operating income ($119,437million + $2,825million−$19,300million) yields net income (net profit or net earnings). Apple’s net income for 2022 was $99.803 million. The step-by-step detail in an income statement shows how a company obtained its net income for the period, making it easier for shareholders and other stakeholders to evaluate the firm’s financial performance.

Operating Incomegross profit minus operating expenses

Net Income (Net Profit or Net Earnings)gross profit minus operating expenses and income taxes

Statements of Cash Flows

Some companies prepare only balance sheets and income statements. However, the SEC requires all firms whose stock is publicly traded to issue a third report, the statement of cash flows. This statement summarizes yearly cash receipts and cash payments. Because it provides the most detail about how the company generates and uses cash, some investors and creditors consider it one of the most important statements of all. It shows the effects on cash of three aspects of a business: operating activities, investing activities, and financing activities. Apple’s (simplified) 2022 statement of cash flows is shown in Figure 15.3.

Cash flows from operations. The first set of information presented in the statement concerns primary operating activities: cash transactions involved in buying and selling goods and services. For Apple, it reveals how much of the year’s cash balance results from the firm’s primary business, sales of iPhones, iPads, computers, watches, and music. At the beginning of 2022, Apple had $35,929 million in cash on hand. During the year, it generated an additional $99,803 million in cash from the sales of its primary product lines.

Cash flows from investing. A second set of information in the statement reports net cash used in or provided by investing. It includes cash receipts and payments from buying and selling stocks, bonds, property, equipment, and other productive assets. These sources of cash are not the company’s main business. Apple generated $37,446 million from sales of marketable securities but also spent $76,923 million on other marketable securities.

Cash flows from financing. The third set of information reports net cash from all financing activities. It includes cash inflows from borrowing or issuing stock, as well as outflows for payment of dividends and repayment of borrowed money. Apple’s financing activities included $1,175 million in proceeds from the issuance of common stock but also $89,402 million spent on the repurchase of common stock at different times during the year.

The overall change in cash from all of these sources, as well as a few other minor sources, was a decrease in cash from $35,929 million at the beginning of 2022 to $24,977 million at the end of 2022. When creditors and stockholders know how a firm obtained and used funds during the course of a year, it’s easier for them to interpret year-to-year changes in the balance sheet and income statement.

Figure 15.3 Apple’s Statement of Cash Flows

Source: Apple, Inc., 2022 Annual Report (Mountain View, CA: Author, 2022.)

Figure 15.3 Full Alternative Text

Statement of Cash Flows financial statement describing a firm’s yearly cash receipts and cash payments

The Budget: An Internal Financial Statement

For planning, controlling, and decision making, the most important internal financial statement is the budget, a detailed report on estimated receipts and expenditures for a future period of time. Although that period is usually 1 year, some companies also prepare longer-term projections, most commonly three- or five-year budgets, especially when considering major capital expenditures. The budget differs from the other statements we have discussed in that it is not shared outside the company (hence the “internal financial statement” term). During the 2020 COVID-19 pandemic, many firms found it necessary to revise their existing budgets due to dramatic and unexpected declines in revenue.

Budgetdetailed statement of estimated receipts and expenditures for a future period of time

Although the accounting team coordinates the budget process, it needs input from many other managers in the organization about proposed activities and required resources. Figure 15.4 is a sales budget for a hypothetical wholesaler, Perfect Posters. In preparing next year’s budget, accounting must obtain from the sales group projections for units to be sold and expected expenses for the coming year. Then, accounting draws up the final budget and, throughout the year, compares the budget to actual expenditures and revenues. Discrepancies signal potential problems and spur action to improve financial performance.

Figure 15.4 Perfect Posters’ Sales Budget

Figure 15.4 Full Alternative Text

Reporting Standards and Practices

Learning Objective 15-4 Explain the key standards and principles for compiling and reporting financial statements.

Accountants follow standard reporting practices and principles when they prepare external reports. The common language dictated by standard practices and spelled out in GAAP is designed to give external users confidence in the accuracy and meaning of financial information. GAAP cover a range of issues, such as when to recognize revenues from operations and how to make full public disclosure of financial information. Without such standards, users of financial statements wouldn’t be able to compare information from different companies and would misunderstand—or be led to misconstrue—a company’s true financial status. Forensic accountants, such as Al Vondra from the opening case, watch for deviations from GAAP as indicators of possible fraudulent practices.

Revenue Recognition and Activity Timing

The reporting of revenue inflows, and the timing of other transactions, must abide by accounting principles that govern financial statements. Revenue recognition, for example, is the formal recording and reporting of revenues at the appropriate time. Although a firm earns revenues continuously as it makes sales, earnings are not reported until the earnings cycle is completed. This cycle is complete under two conditions:

The sale is complete and the product delivered.

The sale price has been collected or is collectible (accounts receivable).

Revenue Recognitionformal recording and reporting of revenues at the appropriate time

The end of the earnings cycle determines the timing for revenue recognition in a firm’s financial statements. Suppose a toy company signs a sales contract in January to supply $1,000 of toys to a retail store with delivery scheduled in February. Although the sale is completed in January, the $1,000 revenue should not then be recognized (that is, not be reported in the firm’s financial statements) because the toys have not been delivered and the sale price is not yet collectible, so the earnings cycle is incomplete. Revenues are recorded in the accounting period—February—in which the product is delivered and collectible (or collected). This practice ensures that the statement gives a fair comparison of what was gained (revenues) in return for the resources that were given up (cost of materials, labor, and other production and delivery expenses) for the transaction.

Toys R Us was once the largest toy retailer in the world. However, the firm filed for bankruptcy in 2018 and closed all of its stores in 2021. Macy’s recently acquired the firm’s remaing assets and plan to open Toys R Us branded departments in over 400 of its stores. Investors in the original firm received mild warnings about the firm’s financial health before the 2018 bankruptcy.Champiofoto/Shutterstock

Full Disclosure

To help users better understand the numbers in a firm’s financial statements, GAAP requires that financial statements also include management’s interpretations and explanations of those numbers. The idea of requiring input from the manager is known as the full disclosure principle. Because they know about events inside the company, managers prepare additional information to explain certain events or transactions or to disclose the circumstances behind certain results.

Full Disclosureguideline that financial statements should not include just numbers but should also furnish management’s interpretations and explanations of those numbers

For example, a chain called Borders was once the second-largest brick-and-mortar bookseller in the United States (behind Barnes & Noble). However, the firm filed for bankruptcy in early 2011 and closed its last store in September of that same year. In its annual reports and financial statements beginning as early as 2008, the management of Borders had discussed the competitive and economic risks facing the company. These disclosures noted that consumer spending trends were shifting to online retailers and e-books and away from in-store purchasing, thus posing growing risks for Borders’s cash flows and overall financial condition. Management’s discussion noted there could be no assurance that Borders would muster adequate financial resources to remain competitive, and, indeed, it soon happened. On filing for bankruptcy, Borders’s liabilities of $1.29 billion had surpassed its assets of $1.28 billion.24 The previous disclosure information helped investors and other stakeholders make informed decisions about the risks associated with investing in or doing business with Borders. Therefore, they could not claim that they had no idea the firm was struggling. It would have been a far different story, however, had Borders’s managers been offering deceptively optimistic assessments of the business’s future.

Analyzing Financial Statements

Learning Objective 15-5 Describe how computing financial ratios can help investors and other stakeholders get more information from financial statements to determine the financial strengths of a business.

Financial statements present a lot of information, but how can it be used? How, for example, can statements help investors decide what stock to buy or help lenders decide whether to extend credit? Answers to such questions for various stakeholders—employees, managers, unions, suppliers, the government, customers—can be answered this way: Statements provide data, which can, in turn, reveal trends and be applied to create various ratios (comparative numbers). We can then use these trends and ratios to evaluate a firm’s financial health, its progress, and its prospects for the future.

Ratios are normally grouped into three major classifications:

Solvency ratios for estimating short-term and long-term risk

Solvency Ratiofinancial ratio, either short or long term, for estimating the borrower’s ability to repay debt

Profitability ratios for measuring potential earnings

Profitability Ratiofinancial ratio for measuring a firm’s potential earnings

Activity ratios for evaluating management’s use of assets

Activity Ratiofinancial ratio for evaluating management’s efficiency in using a firm’s assets

Depending on the decisions to be made, a user may apply none, some, or all of these ratios.

Solvency Ratios: Borrower’s Ability to Repay Debt

What are the chances that a borrower will be able to repay a loan and the interest due? This question is first and foremost in the minds of bank lending officers, managers of pension funds and other investors, suppliers, and the borrowing company’s own financial managers. Solvency ratios provide measures of a firm’s ability to meet its debt obligations.

The Current Ratio and Short-Term Solvency

Short-term solvency ratios measure a company’s liquidity and its ability to pay immediate debts. The most commonly used of these is the current ratio or “banker’s ratio.” This ratio measures a firm’s ability to generate cash to meet current obligations through the normal, orderly process of selling products and services and collecting revenues from customers. It is calculated by dividing current assets by current liabilities. The higher a firm’s current ratio, the lower the risk to investors. As a general rule, a current ratio is satisfactory at 2:1 or higher—that is, if current assets more than double current liabilities. A smaller ratio may indicate that a firm will have trouble paying its bills. Of course, a large, successful firm may be able to maintain a lower current ratio. By contrast, if the current ratio is too large, it suggests that the firm has a surplus of cash. This surplus, in turn, may prompt investors to question why the firm is not making investments for future growth (e.g., through research and development) or, alternatively, not paying case dividends.

Short-Term Solvency Ratiofinancial ratio for measuring a company’s ability to pay immediate debts

Current Ratiofinancial ratio for measuring a company’s ability to pay current debts out of current assets

Long-Term Solvency

Stakeholders are also concerned about long-term solvency. Has the company been overextended by borrowing so much that it will be unable to repay debts in future years? A firm that can’t meet its long-term debt obligations is in danger of collapse or takeover, a risk that makes creditors and investors quite cautious. To evaluate a company’s risk of running into this problem, creditors turn to the balance sheet to see the extent to which a firm is financed through borrowed money. Long-term solvency is calculated by dividing debt (total liabilities) by owners’ equity. The lower a firm’s debt, the lower the risk to investors and creditors. Companies with more debt may find themselves owing so much that they lack the income needed to meet interest payments or to repay borrowed money.

Long-Term Solvencyfinancial ratio for measuring a company’s ability to pay its long-term debt

Debtcompany’s total liabilities

Sometimes, manageably high debt can be not only acceptable but also desirable. Borrowing funds gives a firm leverage, the ability to make otherwise unaffordable investments. In leveraged buyouts, firms have willingly taken on sometimes huge debts to buy out other companies. If owning the purchased company generates profits above the cost of borrowing the purchase price, leveraging often makes sense. Unfortunately, many buyouts have caused problems because profits fell short of expected levels or because rising interest rates increased payments on the buyer’s debt. For instance, Elon Musk bought Twitter, starting firing people and cuttings costs, and quickly saw his investment decline in value by more than $10 billion.

Leverageability to finance an investment through borrowed funds

Profitability Ratios: Earnings Power for Owners

It’s important to know whether a company is solvent in both the long and the short term, but risk alone is not an adequate basis for investment decisions. Investors also want some indication of the returns they can expect. Evidence of earnings power is available from profitability ratios, such as earnings per share and the price earnings ratio.

Defined as net income divided by the number of shares of common stock outstanding (that is, shares in the hands of investors), earnings per share determines the size of the dividend that a firm can theoretically pay shareholders. As an indicator of a company’s wealth potential, investors might use this ratio to decide whether to buy or sell the firm’s stock. As the ratio goes up, stock value increases because investors know that the firm can better afford to pay dividends. Naturally, stock loses market value if financial statements report a decline in earnings per share. Another useful profitability ratio is the price earnings ratio, most commonly known as the P/E ratio. This ratio is the comparison of a firm’s current share price to its current earnings per share.

Earnings Per Shareprofitability ratio measuring the net profit that the company earns for each share of outstanding stock

Price Earnings Ratiomost commonly known as the P/E ratio, this ratio is the comparison of a firm’s current share price to its current earnings per share

Activity Ratios: How Efficiently Is the Firm Using Its Resources?

The efficiency with which a firm uses resources is linked to profitability. As a potential investor, you want to know which company gets more mileage from its resources. Information obtained from financial statements can be used for activity ratios to measure this efficiency. For example, two firms use the same amount of resources or assets to perform a particular activity. If Firm A generates greater profits or sales, it has used its resources more efficiently and so enjoys a better activity ratio. This may apply to any important activity, such as advertising, sales, or inventory management.

Retailers, for example, often focus on inventory turnover ratios. Suppose an appliance retailer expects to sell an average of 30 refrigerators per month over the next year. One strategy would be to order 360 refrigerators to arrive on January 1. This would be an ill-advised strategy, however, for many different reasons: The retailer would need to maintain and pay for a huge warehouse space, there would be increased risk of damage to the refrigerators that will not be sold for several months, and the retailer will have to pay for refrigerators now that will not generate revenue for several months. A better option would be to order fewer refrigerators so that they arrive in smaller quantities but more frequent intervals.

Bringing Ethics into the Accounting Equation

Learning Objective 15-6 Discuss the role of ethics in accounting.

Ethics plays a critical role in accounting. While ethical conduct should be expected of all managers and employees regardless of their roles, ethics is particularly important in accounting as a basis to maintain public confidence in business institutions, financial markets, and the products and services of the accounting profession. Without ethics, all of accounting’s tools and methods would be meaningless because their usefulness depends, ultimately, on veracity in their application.

In addition to the business world’s many favorable opportunities and outcomes, there have also been instances of misconduct. Amid public reports of unscrupulous activity, ethics remains an area in which one person who is willing to “do the right thing” can make a difference—and people do, every day. The role of ethics in the ground-breaking scandal from several years ago remains a classic example: Refusing to ignore unethical accounting around her at Enron, the now-failed giant energy corporation, Lynn Brewer tried to alert people inside about misstatements of the company’s assets. When that failed, she, along with colleagues Sherron Watkins and Margaret Ceconi, talked with the U.S. Committee on Energy and Commerce to voice concerns about Enron’s condition. To Brewer, maintaining personal and professional integrity was an overriding concern, and she acted accordingly.

AICPA’s Code of Professional Conduct

The code of professional conduct for public accountants in the United States is maintained and enforced by the AICPA. The institute identifies six ethics-related areas—listed in Table 15.3—with which accountants must comply to maintain certification. Comprehensive details for compliance in each area are spelled out in the AICPA Code of Professional Conduct. The IMA maintains a similar code to provide ethical guidelines for the management accounting profession.

Table 15.3 Highlights from the Code of Ethics for CPAs

By voluntarily accepting Certified Public Accountant membership, the accountant also accepts self-enforced obligations, listed here, beyond written regulations and laws.

Responsibilities as a Professional

The CPA should exercise duties with a high level of morality and in a manner that is sensitive to bringing credit to the profession.

Serving the Public Interest

The CPA should demonstrate commitment to the profession by respecting and maintaining the public trust and serving the public honorably.

Maintaining Integrity

The CPA should perform all professional activities with highest regard for integrity, including sincerity and honesty, so as to promote the public’s confidence in the profession.

Being Objective and Independent

The CPA should avoid conflicts of interest, and the appearance of conflicts of interest, in performing professional responsibilities. The CPA should be independent from the client when certifying to the public that the client’s statements are true and genuine.

Maintaining Technical and Ethical Standards Through Due Care

The CPA should exercise “due care,” through professional improvement, abiding by ethical standards, updating personal competence through continuing accounting education, and improving the quality of services.

Professional Conduct in Providing Services

The CPA in public practice should abide by the meaning and intent of the Code of Professional Conduct when deciding on the kinds of services and the range of actions to be supplied competently and diligently for clients.

Source: Based on “Code of Professional Conduct,” AICPA, accessed April 19, 2020, www.aicpa.org/Research/Standards/CodeofConduct/Pages/sec50.aspx.

Code of Professional Conductcode of ethics for CPAs as maintained and enforced by the AICPA

In reading the AICPA’s code, you can see that it forbids misrepresentation and fraud in financial statements. Deception certainly violates the call for exercising moral judgments (in “Responsibilities”), is contrary to the public interest (by deceiving investors), and does not honor the public trust (in “The Public Interest”). Misleading statements destroy the public’s confidence in the accounting profession and in business in general. Although the code prohibits such abuses, its success depends, ultimately, on its acceptance and use by the professionals it governs.

Violations of Accounting Ethics and GAAP

Unethical and illegal accounting violations have dominated the popular press in recent years. Some of the more notorious cases, listed in Table 15.4, violated the public’s trust, ruined retirement plans for tens of thousands of employees, and caused business shutdowns and significant job loss.25 As you read each case, you should be able to see how its violation relates to the presentation of balance sheets and income statements in this chapter. In each case, adversity would have been prevented if employees had followed the code of professional conduct. In each case, nearly all of the code’s six ethics-related areas were violated, and “professionals” willingly participated in unethical behavior. Such unscrupulous behavior was the impetus for passage of the Sarbanes-Oxley (Sarbox) Act.

Table 15.4 Examples of Unethical and Illegal Accounting Actions

Corporation

Accounting Violation

Kraft Foods Inc.

In 2019, Kraft Foods had to pay a fine of $16 million in settlement after the CFTC (Commodities Futures Trading Commission) accused Kraft of using manipulative market strategies to force the market to sell wheat to the company at lower prices in order to earn Kraft an illicit profit.

Steinhoff

In 2019, PwC found that Steinhoff, a South African retailer, recorded fictitious transactions that totaled $7.4 billion over a 10-year period.

Huawei

Huawei’s Chief Financial Officer Meng Wanzhou was arrested in December 2018 after the United States charged Meng and Huawei with bank and wire fraud in violation of American sanctions on Iran.

Wells Fargo

Wells Fargo admitted having opened over 2 million fraudulent customer accounts to meet cross-selling target goals over the course of five years. A settlement of $185 million was paid in September 2016.

Theranos

Theranos was charged with civil securities fraud after it made fraudulent and misleading statements about revenue projection and technology, among other things, while raising over $700 million from private investors. It is estimated that investors lost nearly $1 billion when the company dissolved in 2018. The firm’s founder began a 13-year prison sentence in 2023.

Caldwell & Smith

In 2018, the SEC charged Caldwell, pastor at the largest Methodist church in Houston, and Smith, a self-proclaimed financial planner, with fraud after they collected $3.4 million from elderly investors and promised a huge return on fraudulent bonds.

Wirecard AG

In 2020, investigative journalists and short sellers alleged that the German fintech company had inflated the value of its cash assets by $2.1 billion. The scandal led to Wirecard’s bankruptcy and the arrest of several executives, including its CEO, who had previously been a consultant with KPMG. (One executive fled the country and remained on the run until 2023.)

Nikola

In 2021, Nikola, an electric truck company, was charged with securities fraud after it made false claims about its products to raise more than $500 million from investors. The company released a video of the Nikola One truck, which it claimed was close to release. But the vehicle was not nearly functional, and the video had been created by towing it up a hill and letting it roll back down.

Sources: Matthew Heller, “Kraft Settles Futures Market Manipulation Case,” CFO, https://www.cfo.com/fraud/2019/08/kraft-settles-futures-market-manipulation-case/, accessed November 4, 2019; Tiisetso Motsoeneng, “PwC Investigation Finds $7.4 Billion Accounting Fraud at Steinhoff, Company Says,” Reuters, March 15, 2019, https://www.reuters.com/article/us-steinhoff-intln-accounts/pwc-investigation-finds-74-billion-accounting-fraud-at-steinhoff-company-says-idUSKCN1QW2C2; BBC News, “Huawei Faces US Charges: The Short, Medium and Long Story,” May 7, 2019, https://www.bbc.com/news/world-us-canada-47046264; Arjun Kharpal, “The Extradition Trial of Huawei’s CFO Starts This Month—Here’s What to Watch,” January 9, 2020, https://www.cnbc.com/2020/01/10/huawei-cfo-meng-wanzhou-extradition-trial-explained.html; Brian Tayan, “The Wells Fargo Cross-Selling Scandal,” https://corpgov.law.harvard.edu/2019/02/06/the-wells-fargo-cross-selling_scandal-2/; “Theranos Founder Elizabeth Holmes Charged with Massive Fraud,” press release, https://www.sec.gov/news/press-release/2018-51; “Houston, Texas Pastor Pleads Guilty to His Role in a Multimillion-Dollar Investment Scheme,” March 11, 2020, https://www.justice.gov/usao-wdla/pr/houston-texas-pastor-pleads-guilty-his-role-multimillion-dollar-investment-scheme; https://www.reuters.com/article/us-germany-wirecard-inquiry-timeline-idUSKBN2B811J; https://www.theverge.com/2021/7/29/22599726/nikola-founder-securities-fraud-charge-milton.

Finding a Better Way Integrated Profit and Loss

T. Schneider/Shutterstock

Natura&Co is a cosmetics company headquartered in São Paolo, Brazil. The company’s mission statement reads: “Since 1969, Natura’s reason for being has been to create and sell products and services that promote the harmonious relationship of the individual with oneself, with others and with nature.”26 Like many multinational businesses, Natura started out as a small shop that grew gradually in the early years. By 2023, it had grown to operate more than 3,200 stores and locations and include subsidiaries such as Avon and The Body Shop.

In 2021, the company adopted an integrated profit and loss (IP&L) approach to reporting the results of operations and quickly became a leader in impact accounting, using its IP&L and underlying methodology to quantify the impacts and net value of its corporate performance on environmental, social, and human capital.27 As part of the IP&L initiative, the company established a cross-functional committee responsible for the development and strategy of the IP&L methodology, which includes the controllership and technical accounting team as well as members of the financial planning and analysis (FP&A) team.28

Natura promotes itself as eco-friendly and sustainable, and the IP&L model provides quantitative information about all business activities, not just financial results. For instance, the IP&L takes into account the impact of corporate performance in the environmental, social, and human dimensions. In addition to traditional financial results, the IP&L work considers several other fronts of the company’s performance, such as carbon emission and offsetting, circularity, regeneration and conservation of biomes, income generation for the network (and its impacts on health and welfare). According to the model’s application, based on 2021 results, for every $1 of Natura revenue, the brand generated a net return of $1.5 in benefits for society.29 In essence, the IP&L connects what the business sells with what it accomplishes and the impacts it has on people and communities.

Internationalizing Accounting

Learning Objective 15-7 Describe the purpose of the International Accounting Standards Board and explain why it exists.

Accounting in its earliest forms is known to have existed more than 7,000 years ago in Mesopotamia and Egypt for recording trade transactions and keeping track of resources. With the passage of time, each country’s or region’s accounting practices were refined to meet its needs in commerce while also accommodating local cultural traditions and developments in the region’s laws. Although unique practices served each region well, they later posed problems as international business became prominent. By the late twentieth century, it was apparent that the upsurge in multinational organizations and the global economy demanded more uniformity among accounting practices. The development of “universal” procedures would allow governments and investors in, say, China, Brazil, and Italy to read, interpret, and compare financial statements from all those countries, whereas such comparisons even today are difficult if not sometimes impossible.

International Accounting Standards Board

Established in 2001 and housed in London, England, the International Accounting Standards Board (IASB) is an independent, nonprofit organization responsible for developing a set of global accounting standards and for gaining the support and cooperation of the world’s various accounting organizations to implement those standards.

International Accounting Standards Board (IASB)organization responsible for developing a set of global accounting standards and for gaining implementation of those standards

IASB’s 14 board members from various countries are full-time accounting experts with technical and international business experience.30 Because the board cannot command sovereign nations to accept its recommended standards, its commitment to gaining cooperation around the world is a continuing task. Yet international acceptance is essential for success. Accordingly, the board’s task is a long-term process that requires working with various countries to design proposed standards. As an example, for any IASB proposal to be accepted in the United States, it must first be approved by the U.S.-based FASB and by the U.S. SEC. However, IASB’s efforts extend beyond the United States, to all nations. For years IASB has been working toward convergence in consistent accounting practices across many local GAAPs into one global set of practices.

Why One Set of Global Practices?

Although more than 138 countries have adopted IASB’s accounting practices, over 50 others continue to use their national GAAP.31 U.S.-based global companies such as Google, Caterpillar, and Microsoft may prepare different financial reports using local accounting practices for each country in which they conduct business. They also report the company’s overall performance in a set of consolidated statements that combines the financial results of all its global affiliates, using U.S. GAAP. Using different accounting standards, however, can result in very different pictures of a firm’s financial health. Income statements, balance sheets, and statements of cash flows using local GAAPs versus IASB practices, for example, may contain conflicting information with inconsistencies leading to confusion and misunderstandings among investors and other constituents. To emphasize this point, Hans Hoogervorst, chairman of the IASB, notes that a company using IASB standards can report balance sheet figures that are twice the size of those using U.S. GAAP accounting standards.32 Which of the reports tells how well the company is doing? Such inconsistencies in reporting are unacceptable in a global economy, and accordingly, protection against them is a goal of IASB.

Example Areas Targeted for Aligning U.S. GAAP and IASB

Among the many differences between the practices of U.S. GAAP and IASB—some reports identify more than 400 such discrepancies—the following examples illustrate some discrepancies and proposals for convergence toward universal standards in financial reporting.

In valuing assets (reported on the balance sheet), U.S. GAAP allows an asset to be written down if for some reason its value decreases. However, the value cannot later be rewritten up, even if its actual value has increased. IASB standards, in contrast, do allow such write-ups reflecting increased market value, so the reported value of a company’s assets can be quite different, depending on the chosen accounting system.33 For instance, suppose a firm buys land for future expansion. The price paid for that land is initially used on the balance sheet to reflect its value. Suppose, though, that in five years the firm has still not expanded but the land value has dropped by half. Both IASB and U.S. GAAP allow the firm to lower its value on the balance sheet. But what happens if the value of the undeveloped land doubles? IASB allows firms to reflect this increase on the balance sheet, but U.S. GAAP does not.

In revenue recognition, when revenues from customers should be recognized (reported), and in what amounts on the income statement, the U.S. GAAP and IASB procedures differ from each other. A current joint proposal, if approved, would remove existing inconsistencies and provide a single standard that recognizes revenue at the time the goods and services are transferred to the customer, and in the amounts that are expected to be received (or are received) from the customer.34

In devaluing of financial assets, such as writing down bad loans in the financial crisis, both U.S. GAAP and IASB currently use the same procedure: After a loss occurs (but not until after the fact), the loan’s value can be written down in the firm’s financial statements, reflecting its lower value. Both groups, however, believe an “expected loss model” that recognizes (and reports) likely loan losses ahead of time will provide more timely information for investors and financial planners. A joint proposal for such a procedure has been presented but is still being discussed.35

In fair value disclosure, the FASB and IASB jointly propose new standards for improving the comparability of fair value disclosures in financial statements. Unlike dissimilar disclosure practices among many local GAAPs, both groups want the reported “fair value” for an asset, a liability, and an item in shareholders’ equity to have the same meaning under both FASB and IASB procedures. The disclosure should identify the techniques and inputs used to measure fair value so that users can more clearly assess and compare financial statements.36

Timetable for Implementation

The U.S. SEC originally targeted 2015 as the earliest date that U.S. companies would be required to use IASB procedures for financial reporting, and some procedures were indeed implemented that year. However, others were deferred or set to be phased in over a period of several years. But, as of 2020, the United States did not have an IFRS mandate.37 To fully implement any given procedure, IASB must first demonstrate that its standards are developed adequately for use in the U.S. financial reporting system. Doing so includes ensuring that investors have developed an understanding of and education in using IASB standards. Accounting education, too, is being updated to prepare U.S. accounting students for IASB as well as updating practitioners in CPA firms. The AICPA has begun a process of introducing international standards in the CPA examinations. A number of the exam’s questions now address some areas of difference between U.S. GAAP and International Financial Reporting Standards.