CHAPTER 1 Introduction to accounting Lecturer: Hyungjin Cho Email: hcho@emp.uc3m.es / office: 6.0.23 1 Chapter outline 2 Economic activity and information needs Accounting: formal concept The flow of information Importance of accounting information Financial Accounting and Management accounting Users of accounting information How does accounting work? Requirements of accounting information Accounting regulation Economic activity and information needs Imagine that you run the business. You are not so rich, then you need to borrow from bank or to attract outside investor. Provide information to bank or investors Then, what information? -> Accounting info. 3 Information needs: Shareholders 4 Accounting – The basis of decision making Accounting is the “language of business” Accounting is the information system that Measures business activities Processes that information into reports Communicates the results to decision makers 5 Definition of accounting Working definition: A system providing information to managers and owners in order make business decisions Formal definition: The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information American Accounting Association (1966), Statement of Basic Accounting Theory, p. 1 6 Nature of Accounting Accounting is about recording, preparing and interpreting business transactions Enables key questions to be answered, such as how much profit have we made? In small businesses, managers and owners are the same people In large businesses, managers and owners will be different 7 The Accounting System: The Flow of Information 1. People make decisions 2. Business transactions occur 3. Businesses prepare reports to show the results of their operations 8 The Notion of Accounting Accountants: measure, record Economic environment 9 communicate USERS Beliefs & Perceptions Accounting as Communication of Financial Information Remember that managers and owners will be different in large businesses because professional managers tend to work for the benefit of owners. Academics call this as the “separation of ownership and control.” Through accounting information, managers report their performance to owners, and owners evaluate managers. 10 Accounting as Communication of Financial Information Management is the steward to whom capital suppliers entrust control over a portion of their financial resources Purpose of financial statements is to provide a report to capital suppliers to facilitate their evaluation of management’s stewardship Income measurement Financial data have to facilitate contracting between parties such as management and investors Financial data have to facilitate decisions makers in selecting the best action among available alternatives Informational approach 11 Importance of Accounting Information 12 Money makes the world go round Businesses depend on cash and profit Unless you understand accounting, you will never understand business Need to know basic terminology such as: Income Assets Expenses Liabilities Profit Capital Cash flow Internal vs. External Users Internal : management accounting More focused and detailed information No need to follow accounting regulation External : financial accounting (financial statements) Global information Need to follow accounting regulation 13 Financial and Management accounting Financial accounting Provision of financial information on a business’s recent financial performance targeted at external users such as shareholders Backwards-looking Double-entry bookkeeping Profit and loss account (income statement) and balance sheet 14 Financial and Management accounting Management accounting Internal needs of business Not required by law (unlike financial accounting) Management accounting can be split into cost accounting and decisionmaking 15 Overview Financial and Management Accounting Accounting Financial Profit and loss Account 16 Balance sheet Management Cash flow statement Cost making Decision making Financial vs. Management accounting 17 Financial accounting serves outsiders while management accounting serves insiders The main work of financial accounting is to prepare the financial statements Financial accounting is based upon doubleentry bookkeeping while management accounting is not Financial accounting looks backwards while management accounting looks forwards The product of each accounting is different Users of Accounting Information Outsiders: regulators consumers lenders Financial markets suppliers FIRM Insiders: 18 Tax officials Management Employees User Information Requirements User group Information requirements Internal users: 1. Management Information for costing, decision-making, planning and control 2. Employees Information about job security and for collective bargaining External users 1. Shareholders and analysts advisers Information for buying and selling shares 2. Lenders Information about assets and the company’s cash position 3. Suppliers, and customers Information about long-term prospects and survival of the business 4. Government and tax authorities Information on profits to use as a basis for calculating tax 5. Public Information about the social and environmental impact of corporate activities 19 Financial Statements 20 Understanding the Financial Statements 21 The income statement reports net income or net loss for the period. It reflects the wealth generated by the company in a given period The balance sheet reflects the financial position of the company at the end of a period (assets and liabilities). The financial statements help managers take decisions about the company (although they may have different incentives) Hewlett-Packard shares fall by 10% on lacklustre results By Scott Morrison in San Francisco, Financial Times Published: Aug 20, 2003 Hewlett-Packard shares fell 10 per cent in late trading yesterday after the computer and printer maker reported disappointing third-quarter results. The failure to meet analysts' expectations was a setback for the company, which has reported several quarters of operational improvements following its $19bn (£12bn) acquisition of Compaq Computer last year. HP blamed the results on overly aggressive pricing for personal computers and weak sales of its corporate computers. Carly Fiorina, chairman and chief executive, said: "The third quarter is always tough, but we still should have done better. Nevertheless, we are confident in our strategy and the actions we're taking. We expect to deliver a strong fourth quarter." The company reported a net profit of $297m, or 10 cents per share, for the quarter ended July 31, compared with a loss of $2bn, or 67 cents per share, last year which including hefty restructuring and acquisition charges. Excluding special items, the company reported earnings of $700m, or 23 cents per share, compared with a profit of $420m, or 14 cents per share, last year. Revenue totalled $17.35bn, up 5 per cent from $16.54bn last year and down 4 per cent from the previous quarter. Analysts had expected earnings of 26 cents per share on revenue of $17.5bn, according to Thomson First Call. 22 HP's PC unit reported an operating loss of $56m, just one quarter after posting its first profit in years. The company said PC sales fell because of seasonal factors while gross margins were hit by aggressive pricing, aimed at fending off rival group Dell's bid for increased market share. The demand and supply of financial information The Demand for financial information will depend upon: Tastes and preferences (risk attitudes) Beliefs about the future Access to financial information The supply of financial information will depend upon: Incentives companies have to voluntarily disclose financial information Regulatory framework 23 Need for Regulation The role of capital markets as fund providers Economic consequences of financial information Managerial incentives to suppress unfavorable information Need for regulation 24 Financial Information and Financial Markets The relationship between financial information and security prices can influence investors’ direct demand for financial information Evidence shows: Annual earnings are not timely information and are preempted by alternative, more timely sources However, significant price reaction was found in the week of the anouncement of annual earnings Prices act as if earnings anouncements alter investors’ belief in such a way as to alter the price of security 25 Overview of Information Characteristics 26 Decision-Making 4. 1. Information Characteristics Content Relevance - Does it affect users’ decisions? Reliability - Is it representationally faithful, neutral, free from material error, prudent and complete? 2. Presentation Comparable - Inter-and intra-company comparisons Understandable - Presented as understandably as possible Information must also be: Material 27 Timely Accounting Principles and Concepts Generally accepted accounting principles (GAAP) are The rules that govern how accountants operate Based upon a conceptual framework 28 Key Spanish Accounting Organizations 29 ICAC Treasury Ministry Bank of Spain AECA UE Comission CNMV Accounting regulation in Spain There are two different regulatory regimes in place in Spain: INTERNACIONAL REGULATION For Group Accounts of listed companies. The international regulation is based on the rules issued by the IASB approved by the European Commission. 30 NACIONAL REGULATION For the rest of companies. These follow the National regulation. Regulatory Bodies Issuing Accounting Rules in Spain ICAC (Instituto de Contabilidad y Auditoría de Cuentas) Public organization linked to the Ministry of Economy. It issues regulation (compulsory for companies). http://www.icac.meh.es AECA (Asociación Española de Contabilidad y Administración de Empresas). Private body. Profesionals and academic are part of this organization which although it is influencial, it cannot regulate in accounting issues. http://www.aeca.es 31 International Accounting Standards Since 2005, all quoted companies within the EU have to prepare their accounts following the International Accounting Standards issued by the IASB. (CE 1606/2002) The IASB (International Accounting Standards Board) is the regulatory body of the IASC (International Accounting Standards Committee) http://www.iasb.org 32 International Accounting Standards Until 2001, the standards issued by the IASB are denominated IAS (or NIC in Spanish). Eg. IAS 2: Inventory From 2001 the new standards are denomnated IFRS (NIIF in Spanish). E.g. IFRS Insurance Contracts Benefits of IAS-General common standards Need to improve comparability of accounting information The objective is to have a common standard capital market Expand investment possibilities of European citizens Macroeconomic benefits: employment, economic growth, 33 prosperity Learning outcomes Nature and importance of accounting Main users of accounting and their information needs Different types of accountancy Requirements of accounting information Main accounting organizations 34 Bibliography Harrison and Horngren: Financial Accounting. 6th or 7th edition (Prentice Hall) Vilardell, Ortín and Solá: Introducción a la contabilidad general (McGraw-Hill) Jones (2006). Accounting. 2nd Edition. Ed. Wiley UK GAAP (2000). Ernst and Young, Butterworth 35