Chapter: The Nature and Purpose of Accounting

The Nature and Purpose of Accounting

Organizations are groups of people cooperating to achieve common goals, utilizing diverse resources that require funding and adequate compensation for financiers.

Organizations need to know the quantity of resources used and their economic convenience.
External stakeholders need similar information to judge and legitimize organizations.
Accounting is a system providing this information.

Organizations are classified as:

For-profit (enterprises).
Non-profit (non-profit organizations).
- The primary goal of for-profit organizations is to achieve satisfactory profit.
- Non-profits have other goals like governance, social services, security, and education.

Accounting is similar in both types, though structure, content, and measurement criteria may vary. This text primarily refers to company balance sheets.

The Need for Information

Organizations require diverse information. Summarized, information needs are similar and classifiable into categories.

The term "company" refers to an economic entity producing goods (manufacturing) and services (commerce, finance, insurance, transport, healthcare, etc.).
A company is an organization aiming to create wealth for its investors.
The terms "company" and "organization" are used interchangeably.

To describe an organization’s information needs, consider Alba Motori SpA, a car dealership. Alba Motori SpA achieves its economic goals by:

Selling new and used cars.
Selling spare parts and accessories.
Providing repair and maintenance services.

It employs 52 people, led by President Enrico Fonti. The company owns a building housing the showroom, parts sales, warehouse, workshop, and offices. It also owns new and used cars for sale, spare parts, accessories, and liquid assets. These are resources needed for business operations. Information can be quantitative and non-quantitative:

Quantitative information is expressed numerically.
Non-quantitative information comes from observations, conversations, news, internet, books, TV, etc.
Accounting systems primarily deal with quantitative information, mostly in monetary terms.

Data like employee age and tenure are quantitative but not typically accounting information. However, the boundary isn't strict.

A sales report might show revenue and the number of cars sold, including non-monetary data.
Non-monetary information is included in the balance sheet's explanatory notes for better understanding.

Central questions:

What information is needed to know Alba Motori SpA's invested resources at a given time?
What are the financial sources enabling possession?
How to examine the company's economic performance over a period using these resources?

This information is classified into four categories:

Operational accounting information.
Balance sheet information.
Management accounting information.
Tax information.

Operational Accounting Information

Operational accounting information is needed to carry out daily activities. For example:

Employees must receive correct monthly salaries.
Accounting records must detail earned and paid amounts, plus tax and contribution calculations.
Salespeople need to know the cost and price of each car.
Revenue recognition is necessary when a car is sold.
Warehouse staff needs to know available parts, costs, and sales prices.
Purchase department needs to know when parts are running low to reorder them.
The company needs to know customer account balances and payment statuses.
The company must track debts to creditors and payment deadlines.

Operational accounting information is the bulk of all accounting information and the primary source for balance sheets, management information, and tax payments.

Balance Sheet Information

Balance sheet information is used by management and external parties like shareholders, banks, creditors, the Ministry of Finance, financial observers, employees, and the community. The balance sheet informs on the company's performance.

Shareholders use it to assess their investment's value when deciding to sell shares.
Potential investors use it to decide whether to buy shares.
Lenders use it to assess the company's solidity and ability to repay loans.

External parties typically rely on public balance sheets and disclosed information. Understanding balance sheet rules is crucial for proper interpretation. These rules are consistent across companies and regulated by the Civil Code and accounting practices.

Information for Management

Managers rely on summarized information, combined with other data, to make decisions. Accounting information prepared to assist management is called management accounting.

This information supports three management functions:

Planning.
Implementation.
Control.

Tax Information

Alba Motori SpA must file tax returns. Taxable income rules differ from accounting income rules. Specific information is needed for tax declarations, separate from balance sheet information.

Definition of Accounting

Accounting emphasizes using information to improve decision-making. Managers and external stakeholders use accounting information to make decisions affecting the organization.

Accounting is defined as the process of:

Recognition.
Measurement.
Analysis.
Interpretation.
Communication of information that enables users to develop judgments, evaluations, and informed decisions about their relationships with the company.

Balance sheets, summarizing accounting data, share the same objective.

The Book's Approach

Accounting can be approached from the accountant's or the information recipient's perspective. This text focuses on the latter. Accountants need to know how information will be used to collect, interpret, and report it effectively. Information users need to understand accounting practices to fully grasp the information's meaning and limitations.

Users should know the meaning of accounting items, limits, ambiguities, and context-dependent interpretations.
Users don't need to design or manage accounting systems; they need to understand the information produced.

Prejudices About Accounting

Readers have encountered accounting information through receipts, checks, bank statements, and bills. News covers company profits, losses, dividends, and public works investments. All this information comes from accounting systems.

Common, potentially misleading ideas about accounting:

Accounting systems reveal a company's worth.
Balance sheets don't aim to provide this information.
Assets include all valuable things a company possesses.
Employee skills are not accounting assets, even though valuable.

Accounting systems differ from preconceived notions. Understanding these differences and their rationales is important. Users need sufficient knowledge to comprehend the nature and limitations of accounting information.

The Conceptual Framework Regulating Accounting and Financial Statements

To track and provide useful information about an organization, one method could be to write events down in a diary, similar to a ship captain's log. Gradually, rules evolve to make the activity more effective. It isn’t feasible to document events of every individual inside the organization. Standardization allows outsiders to understand the notations better and enable others to perform recordings reliably. Selecting one of several ways to describe an event is necessary to be able to have a shared base of understanding.

These considerations are central to the development of accounting. Balance sheets, rules, terminology, and principles evolved over centuries. Understanding these conventions and purposes is vital.

Accounting as a Language

Accounting is the language of business. Learning accounting is learning a technical language but can be difficult since many terms overlap with colloquial language with different meanings.

Accountants use "profit" for a specific balance sheet value, while colloquially, "profit" describes something valuable.

Accounting is guided by shared and disputed rules. Accountants may differ on recording events, similar to varying preferences in language. However, some accounting practices are inappropriate.

The general principles are in use today but will evolve to meet new informational needs. Balance sheets are artificial systems with changing information purposes.

The Nature of Principles

Accounting norms and concepts are termed principles. Principles guide action, but don't prescribe exact recording methods. Therefore, accounting issues can be handled differently by different companies.

A single, detailed rule set cannot apply to all businesses.
Managers have some discretion within principles to express their views.
Readers need to know the choices made when preparing the documents.

Understanding also requires knowledge of the company's context.

Three General Criteria for Formulating Accounting Principles

Accounting principles are formulated by people and are not deduced from fundamental axioms, nor can they be falsified through observations or experiments. They evolve over time, it is a dynamic process. Acceptance requires respecting general norms:

Relevance.
Objectivity.
Feasibility.

A principle is relevant if it produces important and useful information that can influence economic decisions. It's objective if information is not influenced by the provider's judgment, implying reliability and verifiability. Finally, a principle is feasible if implemented without excessive costs or complexity.

These criteria conflict. The most relevant solution may be less objective and feasible. Valuing new product development is useful for investors, but management's estimates are subjective. Accounting sacrifices relevance for objectivity.

The market value of Genentech was $26.4$ billion, while its book value was $6.8$ billion. Thus, this difference isn't an error; accounting doesn't aim to represent market value.

Balancing relevance, objectivity, and feasibility is essential. Critiques that accounting information isn't relevant enough often underestimate the trade-off required. The balance sheet is a man-made system with specific goals, so its rules change over time.

Until the 1970s, business-environment interaction was limited. The main purpose of financial statements was to report on administrators' actions to shareholders and protect creditors by applying prudence, risking results that were not fully representative of real performance.

The emphasis has gradually shifted from protecting assets and guaranteeing third parties to providing current and potential equity investors with information on business performance that is not excessively conditioned by caution and that is useful for a prospective valuation of the business. The legislator has repeatedly amended the rules governing financial statements to reflect these new informational needs and to provide performance measures that are more suited to the needs of growth and fundraising in national and international markets.

Sources of Accounting Principles

In Italy, financial statement principles are defined by the Civil Code (articles $2423$ to $2435$ bis) and accounting practices. The Civil Code applies to capital companies conducting industrial or commercial activities. However, further technical guidance and specific rules are required due to the synthesis and generality of the Civil Code.

The Italian Accounting Body (OIC) clarifies and supplements the Civil Code. Internationally, the IASB (International Accounting Standards Board) issues new valuation criteria and accounting principles aiming to harmonize accounting rules.

IASB principles are called IFRS (International Financial Reporting Standards), while older IASC (International Accounting Standards Committee) principles are called IAS (International Accounting Standard). Since 2005, Italy has moved towards international accounting practices.

Companies listed on financial markets must prepare consolidated and separate financial statements according to IASB principles (IFRS). Insurance companies must use IAS/IFRS for consolidated statements and IFRS for separate statements. Non-listed capital companies can optionally use IFRS, excluding small companies. The OIC is harmonizing Italian and international accounting principles.

Speaking the same "language" promotes internationalization, facilitates capital raising, and fosters economic development. Harmonization increases transparency and develops common skills across countries. For example, companies operating in the United States face high reconciliation costs to conform to US accounting rules, thus the principles will continue to evolve to align with international standards.

Small businesses primarily refer to the Civil Code and OIC for their balance sheets.

The Economic-Financial Reports

The final goal of accounting is producing economic-financial reports summarizing general accounting data. The Civil Code mandates four documents for listed companies:

Statement of financial position (balance sheet).
Income statement.
Cash flow statement.
Explanatory notes.

Together, these documents constitute the financial statement.

Many reports are classified into:

Stock reports.
Flow reports.

The amount of water in a reservoir at a given time is a stock measure, while the outflow over a period is a flow measure. Stock reports refer to an instant, while flow reports cover a period. Stock reports provide snapshots, and flow reports provide movies.

The statement of financial position is a stock report showing a company's resources and the rights to those resources at a specific moment. The income statement and cash flow statement are flow reports showing results of activities over a period, like a year or quarter.

Listed companies publish annual and quarterly financial statements online.

The Statement of Financial Position

The statement of financial position shows Moretti SpA's financial position as a snapshot. It has two sections:

Assets (left).
Liabilities and equity (right).

Assets

Companies need cash, machinery, websites, and other resources. These resources are its assets. Assets are possessions of value. The asset section shows the amount at a specific date. For example, Moretti SpA's cash on December 31, 2014, was € 1 449 000. Employees are not assets because the company does not own them.

Liabilities and Equity

The right section shows the financial sources that enabled the possession of assets. The primary sources are:

Liabilities.
Equity.

Liabilities are obligations to third parties who provided resources. Third parties are creditors. For example, suppliers provided € 5 302 000 credit to Moretti SpA on December 31, 2014. Creditors have claims on assets for the amount of the liability. For example, a bank loaned Moretti SpA € 1 000 000 and has a claim for that amount. Since assets are used to settle liabilities, creditor claims are against the assets.

Equity is the other financial source, consisting of:

Capital contributed by owners.
Retained earnings generated through operations and not distributed as dividends.

Creditors can legally pursue the company if obligations are not met. Equity investors have a residual claim and are only entitled to what remains after liabilities are settled. The right side of the statement of financial position shows:

The amount of funding provided by creditors and owners.
The total claims of creditors and owners on company assets.

The Principle of the Double Aspect

Deducting the value of creditor claims (liabilities) from asset values yields the equity amount. If assets are € 10 000 and liabilities are € 4000, then equity is € 6000. Since:

Equity holders claim assets not claimed by creditors.
Total claims cannot exceed assets.

Then total assets must always equal total liabilities plus equity. This equality justifies the Anglo-Saxon name of the statement as "Balance Sheet."

This doesn't imply anything about a company's financial position. This equality is always verified unless there are accounting errors. This is the basis of the double-entry principle: assets = liabilities + equity. This equation is fundamental to accounting and highlights that equity is a residual value: equity = assets - liabilities. If Rossi Srl has assets of $€ 19 000$ and liabilities of $€ 3000$ , then equity is $€ 16 000$ . Each accounting transaction is described by its effects on this equation.

For example, if Rossi Srl buys a car for $€ 15 000$ in cash, cash decreases by $€ 15 000$ and vehicles increase by $€ 15 000$ . A company's asset and liability amounts vary daily, so the statement of financial position reports amounts at a specific instant and must be dated, with close of business as being the implicit moment the financial report is referencing.

The Income Statement

The increase in equity from operations over a period is called net income. The income statement explains how income was generated. The basic income statement equation is: revenues - expenses = income.

The first income statement item is sales revenue from goods or services delivered to customers. The second item is the expenses, including the cost of goods sold, operating expenses, and income taxes. Cost of goods sold represents the cost of resources directly attributable to the goods or services sold. The difference between sales revenue and cost of goods sold is gross margin: gross margin = revenues - cost of goods sold.

Operating expenses are subtracted from gross margin, determining income before taxes: gross margin - operating expenses = income before taxes. Operating expenses include:

Costs directly associated with sales transactions.
Costs associated with management activities.
Costs that provide no future benefit.

Income taxes are shown separately and are a particularly important cost item.

The last line on the income statement is net income or loss.

A "Package" of Economic-Financial Reports

A financial reporting "package" consists of two statements of financial position and an income statement (and a cash flow statement). The statement of financial position, statement of changes in retained earnings, and income statement are linked through retained earnings. The income statement summarizes the changes in retained earnings that occurred during the period.

A reporting package that is effective at communicating economic-financial performance consists of the statement of financial position at the beginning of the accounting period, the income statement for the period, and the statement of financial position at the end of the period. The statement of changes in retained earnings shows the retained earnings at the beginning of the year with additions and deductions. Earnings are added and dividends are deducted to calculate the retained earnings at the end of the year.

Cash dividends reduce retained earnings and cash, as they are a distribution of cash to shareholders. Dividends are not an expense.

The Purpose of Financial Statements

The main purpose of financial statements is to provide relevant information to third parties, even though they are useful for management and the property to which the third-party actors belong.

Objectives of external communication:

Useful for current and potential creditors in making informed decisions.
Understandable to those with sufficient business knowledge.
Relate to the organization's economic resources and claims, and the effects of transactions that change them.
Report on an enterprise’s performance over a period.
Help users assess the amount, timing, and uncertainties of dividends, interest payments, and debt reduction.

The first two objectives apply to all financial statement documents. It is assumed that users have adequate preparation. Objective 3 refers to the statement of financial position, 4 to the income statement, and 5 to the cash flow statement.

Despite providing past information, the financial statements aim to help users predict future performance.

Which Financial Statement?

The purpose of the financial statement is its informative function. Depending on the main addressee (property and management or creditors and other stakeholders), the financial statement lends itself to different reclassifications, i.e., different ways of representing the values contained therein. The main distinction is between the internal financial statement - aimed at property and management - and the external financial statement, the official financial statement intended for publication and addressed to external parties.

The internal financial statement does not have to comply with specific rules and can, therefore, have a form, periodicity (and sometimes also content and measurement criteria) established by the individual company according to its needs. In this case, the problem of the comprehensibility of the reports would not arise, since the documents are produced by the subject that uses them and can be modified at will. The management board uses this data to examine any economic effects (such as sales variations that have impacted on income modifications). The issue regarding intelligibility is, therefore, resolved, being that the addressee of such document is the one that creates it.

The external financial statement, to be published, has its form, content, and measurement requirements regulated by the Civil Code (articles 2423 and 2435a) and by accounting practices in order to:

Protect the interests of creditors by removing them from the discretion or discretion of the directors.
Make the reading of the reports understandable to an external person.
Avoid that each financial statement of a new company requires the learning of a new body of rules.
Allow the comparability of financial statements of different companies and of the same company over time, facilitating the raising of capital.
Provide useful information also for a prospective evaluation of the company.

All external parties interested in the life and performance of the company must, therefore, be able to obtain "codified" information from a public financial statement, so the document becomes a real official information package, pre-defined in form and content.

An important clarification to make is that the body of civil law and accounting practice governs, in reality, multiple categories of external financial statement. External financial statements change, depending on:

The legal form of the company.
The sector to which the company belongs (banks, insurance companies, and financial companies present financial statements prepared according to different rules and principles from production or commercial companies).
How capital is raised (listed companies are subject to specific legislation based on international accounting principles).
The size of the company (for small companies it is possible to prepare financial statements in simplified form).

Finally, different financial statements also exist according to the stage of life of the company, i.e., whether the company operates in a condition of continuity of operation or not. In the first case, the company must produce the ordinary financial statement for the year. If, on the other hand, it were in a phase of termination of activity, then it should prepare the (special) liquidation balance sheet, while if it were about to be acquired, it should produce the (special) transfer balance sheet. These financial statements also have an informational function, but different from that addressed to those who observe a company in the condition of ordinary operation. The text does not deal with liquidation and transfer financial statements. The text focuses, instead, on the ordinary financial statement of capital companies (with the exception of those banking, insurance, or financial for which reference is made to specialized texts) with specific references to companies listed on the stock exchange. Furthermore, the text illustrates mainly financial statement schemes for internal use, aimed at property and management, but with reference to the contents and valuation criteria dictated by the rules of the Civil Code and accounting principles. In other words, the text presents structures (reclassifications) of financial statements particularly suitable for management but with contents and valuation criteria typical of a financial statement for external use. Chapter 11, on the other hand, presents the structure of the civil law financial statement (the external financial statement intended for publication) of a capital company.

Summary

Accounting information is classified into:

Operational information.
Balance sheet information.
Management information.
Tax information.

Accounting and balance sheets follow general rules that balance information relevance with objectivity and feasibility. The final product is four financial statements: the statement of financial position, income statement, cash flow statement, and explanatory notes.

The statement of financial position is a stock report, and the income statement and cash flow statement are flow reports. The fundamental accounting equation is: assets = liabilities + equity.

Internal balance sheets do not need to follow specific rules and can have reclassification structures defined by individual companies. External balance sheets must adhere to the Civil Code and accounting practices, which vary by legal form, sector, size, and other factors.

Problems

(Solutions on www.ateneonline.it/anthony)

Problem 1.1: Preparing a partial statement of financial position with provided sums.
Problem 1.2: Determining the missing figures in a statement of financial position from four different time periods.
Problem 1.3: Determining the missing figures in an income statement from four different time periods.
Problem 1.4: Understanding, listing changes to the statement of financial position and preparing the income statement for a company in a given month.
Problem 1.5: Record journal entries for specific transactions. Calculate ending account balances. Prepare an income statement and statement of financial position. Determine the cash flow from operations. Explain the importance of the first accounting equation.