Accounting in Action: Activities, Users, and the Accounting Foundations, and Equations

Accounting Activities and Users

Accounting is a financial information system that provides insights into the financial activities of an organization. It is one of the top career opportunities in business and a popular academic major because it provides the skills needed to understand internal financial operations. To understand an organization, one must know the numbers.

Three Basic Activities of Accounting

Accounting consists of three foundational activities intended to identify, record, and communicate economic events.

• Identification: A company selects the economic events relevant to its business. Examples include:
  • Sale of food and snacks by Unilever (GBR and NLD).
  • Provision of telephone services by Chunghwa Telecom (TWN).
  • Manufacture of motor vehicles by Tata Motors (IND).
• Recording: Once economic events are identified, they are recorded to provide a history of financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in monetary units. During this phase, the entity (e.g., Unilever) classifies and summarizes economic events.
• Communication: Collected information is communicated to interested users via accounting reports, the most common of which are financial statements. To ensure clarity, information is reported in the aggregate, meaning thousands of similar transactions (such as sales over a period) are accumulated and reported as a single amount to simplify the data.
  • Analysis: Involves using ratios, percentages, graphs, and charts to highlight significant financial trends and relationships.
  • Interpretation: Involves explaining the uses, meaning, and limitations of the reported data.

Users of Financial Information

The information needed depends on the decisions the user must make. Users are categorized into two groups:

Internal Users

Internal users are managers who plan, organize, and run the business (e.g., marketing managers, production supervisors, finance directors, and company officers). They ask specific questions:

• Finance: "Is cash sufficient to pay dividends to SAP shareholders?"
• Marketing: "What price should Nokia charge for a cell phone to maximize net income?"
• Human Resources: "Can Toyota afford to give its employees pay raises this year?"
• Management: "Which PepsiCo product line is the most profitable? Should any product lines be eliminated?"

Managerial Accounting provides the internal reports needed for these decisions, such as financial comparisons of alternatives, income projections for sales campaigns, and cash flow forecasts.

External Users

External users are individuals and organizations outside the company. The two most common types are:

• Investors (owners): Use information to decide whether to buy, hold, or sell ownership shares (e.g., "Is Lenovo earning satisfactory income?" or comparing Disney to Time Warner).
• Creditors (suppliers and bankers): Use information to evaluate risks of granting credit or lending money (e.g., "Will Singapore Airlines be able to pay its debts as they come due?").
• Taxing Authorities: (e.g., State Administration of Taxation in CHN) Ensure compliance with tax laws.
• Regulatory Agencies: (e.g., Financial Services Authority of Indonesia (IDN)) Ensure operation within prescribed rules.
• Customers: (e.g., customers of Tesla Motors, Inc. (USA)) Interested in whether the company will honor warranties.
• Labor Unions: (e.g., Indian National Trade Union Congress (IND)) Interested in the company's ability to pay increased wages and benefits.

Financial Accounting provides the economic and financial information required by these external users.

Questions & Discussion: DO IT! 1 Basic Concepts

Task: Indicate whether the statements are true or false. If false, correct them.

1. Statement: The three steps in the accounting process are identification, recording, and communication.
   • Solution: True.
2. Statement: Bookkeeping encompasses all steps in the accounting process.
   • Solution: False. Bookkeeping involves only the recording step.
3. Statement: Accountants prepare, but do not interpret, financial reports.
   • Solution: False. Accountants analyze and interpret information in reports as part of the communication step.
4. Statement: The two most common types of external users are investors and company officers.
   • Solution: False. The two most common types of external users are investors and creditors.
5. Statement: Managerial accounting activities focus on reports for internal users.
   • Solution: True.

The Building Blocks of Accounting

Reporting relies on building blocks consisting of ethics, principles, and assumptions.

Ethics in Financial Reporting

Ethics are the standards of conduct by which actions are judged as right or wrong, honest or dishonest, fair or not fair. Effective financial reporting depends on sound ethical behavior to maintain the credibility of information and the trust of investors in the economy.

• Scandals: Questionable practices at companies like Satyam Computer Services (IND), Toshiba (JPN), Pou Sheng International (HKG), and Siwei (CHN) have previously damaged investor faith.
• Case Study: Dewey \u0026 LeBoeuf LLP: Employees at this now-defunct law firm overstated revenue and used "accounting tricks" to hide losses. One employee noted: "I was instructed by the CFO to create invoices, knowing they would not be sent to clients." Another admitted: "I intentionally gave the auditors incorrect information."
• Steps in Analyzing Ethics Cases:
  1. Recognize an ethical situation and the ethical issues involved.
  2. Identify and analyze the principal elements/stakeholders (persons/groups harmed or benefited).
  3. Identify alternatives and weigh the impact on stakeholders, then select the most ethical alternative.

Accounting Standards and Principles

Accountants present statements in conformity with standards issued by standard-setting bodies:

• International Accounting Standards Board (IASB): Headquartered in London (15 board members). Issues International Financial Reporting Standards (IFRS), followed by more than $130$ countries.
• Financial Accounting Standards Board (FASB): Primary body in the United States. Issues Generally Accepted Accounting Principles (GAAP).
• Convergence: The effort by IASB and FASB to reduce differences between IFRS and U.S. GAAP to increase global comparability.

Measurement Principles

1. Historical Cost Principle: Dictates that companies record assets at their cost. This cost must be maintained even if value increases. For example, if Great Wall Manufacturing buys land for $\text{¥}300,000$, it must continue to report it at $\text{¥}300,000$ even if the fair value rises to $\text{¥}400,000$.
2. Fair Value Principle: Dictates assets and liabilities should be reported at the price received to sell an asset or settle a liability. This is generally used only for actively traded assets like investment securities.

Qualities of Useful Information:

• Relevance: Financial information is capable of making a difference in a decision.
• Faithful Representation: Numbers and descriptions match what actually happened (factual).

Foundational Accounting Assumptions

1. Monetary Unit Assumption: Only transaction data that can be expressed in money terms is included. Non-quantifiable info (owner health, employee morale) is excluded. Currencies used globally include:
   • Australia: dollar (A\)
   • Brazil: real (R\)
   • China: yuan renminbi ($\text{¥}$)
   • Europe: euro ($€$)
   • Hong Kong: dollar (HK\)
   • India: rupee ($₹$)
   • Indonesia: rupiah ($Rp$)
   • Japan: yen ($\text{¥}$)
   • Russia: ruble ($\text{RUB}$)
   • South Africa: rand ($R$)
   • South Korea: won ($\text{₩}$)
   • Switzerland: Swiss franc ($CHF$)
   • Taiwan: New dollar (NT\)
   • Turkey: lira ($₺$)
   • United Kingdom: pound ($£$)
   • United States: dollar (\)
2. Economic Entity Assumption: Requires entity activities to be kept separate from the owner and other entities.
   • Ethics Note: The Adelphia (USA) scandal involved senior employees blurring this line by having the company guarantee over $\$\$2\,\text{billion}$ in loans to the founding family.
   • Global Insight: "The Korean Discount": International investors previously mistrusted South Korean financial reports due to inaccuracy/lack of transparency, leading to lower share prices. In response, Korean regulators moved toward international standards to increase transparency.

Forms of Business Ownership

• Proprietorship: Owned by one person (the proprietor). The proprietor receives all profits, suffers all losses, and has unlimited personal liability for debts. There is no legal distinction between the business and the owner, though accounting records are kept separate.
• Partnership: Owned by two or more persons. Terms are set in a partnership agreement. Partners usually have unlimited personal liability. Common in professional practices (lawyers, doctors).
• Corporation: A business organized as a separate legal entity under jurisdiction corporation law. Ownership is divided into transferable shares. Shareholders enjoy limited liability (not personally liable for debts). Corporations enjoy unlimited life. Major examples: ING (NLD), Royal Dutch Shell (GBR and NLD), Apple Inc. (USA), Fortis (BEL), and Toyota (JPN).

Questions & Discussion: DO IT! 2 Building Blocks

Task: Indicate whether the statements are true or false. If false, correct them.

1. Statement: Convergence refers to efforts to reduce differences between IFRS and U.S. GAAP.
   • Solution: True.
2. Statement: The primary accounting standard-setting body headquartered in London is the International Accounting Standards Board (IASB).
   • Solution: True.
3. Statement: The historical cost principle dictates that companies record assets at their cost. In later periods, however, the fair value of the asset must be used if fair value is higher than its cost.
   • Solution: False. The historical cost principle dictates that companies record assets at their cost and continue to use cost in later periods.
4. Statement: Relevance means that financial information matches what really happened; the information is factual.
   • Solution: False. Faithful representation means the info matches what happened; relevance means it can make a difference in a decision.
5. Statement: A business owner's personal expenses must be separated from expenses of the business to comply with accounting's economic entity assumption.
   • Solution: True.

The Accounting Equation

The basic accounting equation provides the underlying framework for recording economic events.

$Assets = Liabilities + Owner's Equity$

Components of the Accounting Equation

Assets

Assets are resources a business owns used for production and sales. The common characteristic is the capacity to provide future services or benefits, resulting in cash inflows.

• Example (Taipei Pizza): Delivery truck, tables, chairs, sound system, cash register, oven, tableware, and cash.
• Example (adidas (DEU)): Total assets are approximately $€15,176\,\text{billion}$.

Liabilities

Liabilities are claims against assets—existing debts and obligations to creditors. Creditors have the legal right to force liquidation to pay claims before ownership claims.

• Accounts Payable: Obligations for purchases on credit (e.g., cheese, flour for Taipei Pizza).
• Note Payable: Money borrowed from a bank (e.g., First Bank).
• Salaries and Wages Payable: Money owed to employees.
• Tax Payable: Owed to local government.
• Example (adidas): Liabilities total $€8,721\,\text{billion}$.

Owner's Equity

The ownership claim on total assets. It is referred to as residual equity because it is what remains after liabilities are subtracted from assets ($Assets - Liabilities = Owner's Equity$).

• Example (adidas): Owner's equity totals $€6,455\,\text{billion}$.

Changes in Owner's Equity

• Increases:
  • Investments by Owner: Assets the owner puts into the business (recorded in Owner's Capital).
  • Revenues: Gross increase in equity from business activities (merchandise sales, services, rent, interest, dividends). For Taipei Pizza, this includes pizza sales and beverage sales.
• Decreases:
  • Drawings: Withdrawal of cash or other assets by the owner for personal use (Owner's Drawings).
  • Expenses: Cost of assets consumed or services used to earn revenue (e.g., cost of ingredients, utilities, delivery, rent, and property taxes).

Expanded Accounting Equation

$Assets = Liabilities + Owner's Capital - Owner's Drawings + Revenues - Expenses$

Questions & Discussion: DO IT! 3 Owner's Equity Effects

Task: Classify items and indicate if they increase or decrease owner's equity.

1. Rent Expense: Expense (E); Decreases owner's equity.
2. Service Revenue: Revenue (R); Increases owner's equity.
3. Drawings: Owner's drawings (D); Decreases owner's equity.
4. Salaries and Wages Expense: Expense (E); Decreases owner's equity.

Analyzing Business Transactions

The Accounting Information System

This system collects and processes transaction data and communicates it to decision-makers. Factors shaping it include company nature, transaction types, volume of data, and management demands.

• Electronic Data Processing (EDP): Computerized systems that handle the recording process. Tootsie Roll (USA) refers to information technology as a "key strategic tool."
• The Accounting Cycle: A series of steps beginning with analysis of business transactions and ending with a post-closing trial balance:
  1. Analyze business transactions.
  2. Journalize.
  3. Post.
  4. Trial Balance.
  5. Adjusting Entries.
  6. Adjusted Trial Balance.
  7. Financial Statements.
  8. Closing Entries.
  9. Post-Closing Trial Balance.

Accounting Transactions

Transactions are economic events recorded by accountants.

• External Transactions: Events between the company and an outside enterprise (e.g., Taipei Pizza buying equipment or paying rent).
• Internal Transactions: Events occurring entirely within one company (e.g., Taipei Pizza using cleaning supplies).
• Non-Transactions: Activities that do not change financial position and are not recorded (e.g., hiring employees, responding to emails, talking with customers, placing merchandise orders).

Criterion for Recording: "Is the financial position (assets, liabilities, or owner's equity) of the company changed?"

Dual Effect: Each transaction has a dual effect on the accounting equation. If an asset is increased, there must be a corresponding:

• Decrease in another asset, OR
• Increase in a specific liability, OR
• Increase in owner's equity.