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CHAPTER 1Introduction to accounting

Chapter outline

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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 andinformation needs

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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.

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Information needs: Shareholders

Accounting – The basis ofdecision making

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Accounting is the “language of business” Accounting is the information system that

Measures business activitiesProcesses that information into reportsCommunicates the results to decision makers

Definition of accounting

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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

Nature of Accounting

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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

The Accounting System:The Flow of Information

1. People make decisions

2. Business transactions occur

3. Businesses prepare reports to show theresults of their operations

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The Notion of Accounting

Accountants:measure,

record

Economicenvironment

communicate

USERS

Beliefs &Perceptions

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Accounting as Communicationof Financial Information

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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.

Accounting as Communicationof 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

providea report to capital

suppliers to facilitate their evaluation of

management’s stewardship

Incomemeasurement

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

alternatives11

Informationalapproach

Importance of AccountingInformation

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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

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Internal : management accountingMore focused and detailed informationNo need to follow accounting

regulation External : financial accounting

(financial statements)Global informationNeed to follow accounting

regulation

Financial and Managementaccounting

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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

Financial and Managementaccounting

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Management accounting Internal needs of business Not required by law (unlike financial

accounting) Management accounting can be split

into cost accounting and decision- making

Overview Financial andManagement Accounting

Accounting

Financial

Profit and loss Account

Balance sheet

Cash flow statement

Management

Cost making

Decision making

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Financial vs. Managementaccounting

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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 double- entry bookkeeping while management accounting is not

Financial accounting looks backwards whilemanagement accounting looks forwards

The product of each accounting is different

Users of Accounting Information

FIRM

Management

suppliers

consumers

regulators

Tax officials

lenders

Financialmarkets

Outsiders:

Insiders: Employe

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User Information Requirements

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User group Information requirementsInternal users:1. Management Information for costing, decision-making,

planning and control

2. Employees Information about job security and for collective bargaining

External users1. 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 environmentalimpact of corporate activities

Financial Statements

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Understanding the FinancialStatements

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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

22 hit by aggressive pricing, aimed at fending off rival group Dell's bid for increased market share.

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.

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

The demand and supply of financialinformation

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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 dependupon: Incentives companies have to voluntarily disclose

financial information Regulatory framework

Need for RegulationThe role of capital

markets as fund providers

Economic consequences of financial information

Managerial incentives to suppress unfavorable information

Need for regulation24

Financial Information and FinancialMarkets

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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’ beliefin such a way as to alter the price of security

Overview of InformationCharacteristics

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Decision-Making

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4. Information Characteristics1. Content

Relevance - Does it affect users’ decisions?Reliability - Is it representationally faithful, neutral, freefrom material error, prudent and complete?

2. PresentationComparable - Inter-and intra-company comparisonsUnderstandable - Presented as understandably as possible

Information must also be:

Material Timely

Accounting Principles andConcepts

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Generally accepted accounting principles (GAAP) are The rules that govern how accountants

operate Based upon a conceptual framework

Key Spanish AccountingOrganizations

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ICAC Treasury Ministry Bank of Spain AECA UE Comission CNMV

Accounting regulation in SpainThere are two different regulatory regimes in place in

Spain:

NACIONAL REGULATION

For the rest of companies. These follow the National regulation.

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.

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Regulatory Bodies IssuingAccounting 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

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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

International AccountingStandards

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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 standardsNeed to improve comparability of accounting informationThe objective is to have a common standard capital market Expand investment possibilities of European citizensMacroeco33nomic benefits: employment, economic growth, prosperity

International AccountingStandards

Learning outcomes

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Nature and importance of accounting Main users of accounting and their

information needs Different types of accountancy Requirements of accounting

information Main accounting

organizations

Bibliography

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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