ROLE OF ACCOUNTING IN BUSINESS Expected Learning Outcome After studying the chapter, you should be able to... 1. 2. Explain the nature of “accounting” Discuss why accounting information is considered “A Means to an End’. . Describe the overall objective of accounting. Enumerate and explain the types of accounting information. Explain how accounting information links economic activities to decision-making. . Be familiar with the users and uses of accounting information, both internal and external. . Appreciate the need for an accountant's ethical behavior in fulfiling his mandate . Explain the relationship between bookkeeping and accounting. LOGSCHAPTER 2 ROLE OF ACCOUNTING IN BUSINESS INTRODUCTION Accounting is the information system that measures business activities, processes that information into reports and communicates the results to decision makers. For this reason, it is called "the language of business." The better one understands accounting, the better one can marfage the financial aspects of living and the better the financial decisions will be. The information about the business activities are communicated to the users through the financial statements. Financial statements are the documents that tell us how well a business is performing and where it stands. This information allows people to make informed business decisions. The accounting professions own definition of accounting is as follows: Accounting is a service activity. Its function is to provide quantitative information, primarily financial’ in nature, about economic entities that is intended to be useful in making economic decisions. Quantitative refers to numbers and financial means having to do with money. Thus, accounting information involves the numbers (primarily those dealing with money) used to make economic decisions. Accounting is a social science, developed in a world of scarce resources. It is influenced by, and interacts with, economic, social and political environments. Business is conducted by investor-owned enterprises managed and controlled by professional managers, who are held responsible for providing reports to absentee owners, creditors and other external interested parties. In this environment,‘ financial accounting communicates information about the economic effects of accounting transactions and other events on a business entity to these external user groups. Thus, accounting is principally the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information.24 Chapter 2 Stakeholders require periodic information that the managers ‘are accounting Properly the resources under their control. This information helps the stakeholders to evaluate the performance of the managers. The performance measured by the accountant shows the extent to which the economic resources of the business have grown or diminished during the year. The stakeholders also require information to predict future performance. Many stakeholders use the report of past performance when making their prediction. OVERALL OBJECTIVE OF ACCOUNTING The overall objective of accounting is to provide ipformation that can be,used in making economic decisions. Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions — in making reasoned choices among alternative courses of action. Several key features of this definition should be noted. * Accounting provides a vital service in today's business environment. The study of accounting should not be viewed as a theoretical exercise — accounting is meant to be a practical tool. * Accounting is concerned primarily with quantitative financial information that is used in conjunction with qualitative evaluations in making judgments. * Accounting information is used in making decisions about how to allocate scarce resources. Economists and environmentalists remind us constantly that we live in a world with limited resources. The better the accounting system that measures and reports the costs of using these resources, the better decisions can be made for allocating them. * Although accountants place mush emphasis on reporting what has ‘occurred, this past information is intended to be useful in making economic decisions about the future.Role of Accounting in Business 28 TYPES OF ACCOUNTING INFORMATION Just_as there are many types of economic decisions, there are many types of accounting information. The terms financial accounting, management accounting, tax accounting and not-for-profit accounting often are used in describing four types of accounting information that are widely used in the business community. Financial Accounting Financial accounting refers to information describing the financial resources, obligations, and activities of an economic entity (either an organization or an individual). Accountants use the term financial position to describe an entity's financial resources and obligations at one point in time and the term results of operations to describe its financial activities during the year. Financial accounting information is designed primarily to assist investors and creditors in deciding where to place their scarce investment resources. Such decisions are important to society, as they determine which companies and industries will receive the financial resources necessary for growth, and which will not. Financial accounting information also is used by managers in income tax returns. In fact, financial accounting information is used for so many different purposes that it often is called "general-purpose" accounting information. Management Accounting Management (or managerial) accounting involves the development and interpretation of accounting information intended specifically to aid management in running the business. Managers use this information in setting the company's overall goals, evaluating the performance of departments and individuals, deciding whether to introduce a new line of products, and in making virtually all types of managerial decisions. ‘A company’s managers and employees constantly need such information in order to run and control daily business operations. For example, they need to know the amount of money in the company's bank accounts, the types and quantities of merchandise in the company's warehouse, and the amounts owned to specific creditors, Much management accounting information is financial in nature but has been organized in a’ manner relating directly to the decision at hand. However, management accounting information often includes evaluations of nonfinancial factors, such as political and environmental considerations, product quality, customer satisfaction, and worker productivity.26 Chapter 2 Tax Accounting The preparation of income tax returns is a specialized field within accounting. To 4 great extent, tax returns are based on financial accounting information. However, the information often is adjusted or reorganized to conform with income tax reporting requirements. The most challenging aspect of tax accounting is not the preparation of an income tax return, but tax planning. Tax. planning means anticipating the tax effects of bi ss transactions and structuring these transactions in a manner that will minimize the income tax burden, Not-for-Profit Accounting . Not-for-profit accounting is used for government agencies, churches, non- government organizations (NGO's), charitable institutions, and schools. Accountants for these organizations prepare budgets and maintain records of revenues and expenses. It should be noted however that some not-for-profit organizations do in fact make a profit; however, the profit is kept in the organization and not distributed. For example, a hospital makes a profit and then reinvests the profit in modern equipment. National and local government bodies ‘employ a vast number of people in accounting positions. In this textbook, we introduce the basic concepts of financial accounting. These discussions emphasize both the process of financial reporting to investors and creditors and the usefulness of financial information to an organization's management and employees.Role of Accounting in Business 27 ACCOUNTING INFORMATION: ECONOMIC ACTIVITIES AND DECISION MAKING The illustration below shows the interactive nature of the accounting process; that is, accounting information about economic entities is accumulated (identified, measured, recorded, and retained) and communicated to both internal and external users to assist them in decision making. Their decisions, in turn have ‘an impact on the economic entity, and the accounting information accumulation and communication process is repeated. For example, a company intends to apply for a bank loan to supplement their current working capital needs. Prior to such decision, the company will have to get information as'to their other current debts. Based on its analysis of the company's financial position, it may decide not to pursue the bank loan anymore but instead sell some other properties which it does not need in their operations. By doing so, it may be able to generate cash without incurring additional debts. After the decision, future activities of the business will change and in turn, result in different accounting information about the business. Furthermore, as these people evaluate alternative investment opportunities, they try to determine whether they will be paid and if so, when the payment will occur and how much will it be. It has also been mentioned that this assessment begins with an evaluation of an alternative's present condition and its past performance. Over time, financial tools have been developed to convey information about the present condition and past performance of a business entity. These financial tools include financial statements from which investors, creditors and other users might obtain information useful in decision making. Company's Economic Activities {impact}28 Chapter 2 USERS OF ACCOUNTING INFORMATION Who uses accounting information and what information do they require to meet their decision-making needs? In general, all parties interested in the financial health of a company are called stakeholders. Stakeholder users. of accounting information are normally divided into two major classifications: * External users, who make decisions concerning their relationship to the enterprise. Internal users, who make decisions directly affecting the internal operations of the enterprise. The basic role of accountants is to provide useful economic information to external and internal decision makers (users) as explained below: a. External decision makers include present and potential stockholders, investors, creditors, suppliers, customers, legislators, trade associations and others, who lack direct access to the information generated by the internal operations of the business and must rely on general-purpose financial statements to make their investment, credit and public policy decisions. “The process of developing general-purpose financial statements and reporting general-purpose accounting information to external decision makers is called financial accounting, the focus of Intermediate Accounting. 1) Investors. The providers of risk capital and their advisers are concerned with the risk inherent in, and return provided by, their investments. They need information to help them determine whether they should buy, hold or sell. Shareholders are also interested in information which enables them to assess the ability of the enterprise to pay dividends. y Employees. Employees and their representative groups are interested in information about the stability and profitability of their employers. They are also interested in information which enables them to assess * the ability of the enterprise to provide remuneration retirement benefits and employment opportunities.Role of Accounting in Business. 29 3) Lenders. Lenders are interested in information that enables them to determine whether their loans, and the interest attaching to them will be paid when due. 4) Suppliers and other trade creditors. Suppliers and other creditors are interested in information that enables them to determine whether amounts owing to them will be paid when due. Trade creditors are likely to be interested in an enterprise over a shorter period than lenders unless they are depeident upon the continuation of the enterprise as a major customer. 5) Customers. Customers have an interest in information about the continuance of an enterprise, especially when they have a long-term involvement with, or are dependent on, the enterprise. 6) Governments and their agencies. Governments and their agencies are interested in the allocation of resources and, therefore, the activities of enterprises. They also require information in order to regulate the activities of enterprises, determine taxation policies and as the basis for national income and similar statistics. 7). Public. Enterprises affect members of the public in a variety of ways. For example, enterprises may make a substantial contribution to the local economy in many ways, including the number of people they employ and their patronage of local suppliers. Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the enterprise and the range of its activities. b. Internal decision makers are the managers of a business entity, responsible for managing efficiently and effectively, and who have the power and authority to obtain whatever economic information they need. The process of providing accounting information to internal decision makers is called management accounting. While managers have an interest in the information reported to external “users, managers also require various other types of information, such as the cost of its products, estimates of the income to be earned from a sales campaign, cost comparisons of alternative courses of action, and long- range budgets. Because of the strategic nature of much of this information, it is usually only available to a company's top-level management.30_Chapter 2 PROFESSIONAL VALUES AND ETHICS OF ACCOUNTANTS Users of accounting information - both external and internal — recognize that the usefulness, reliability of accounting information is affected by the personal attributes of competence, professional judgment, and ethical behavior of accountants. In general, the accountant should be able to recognize and understand ethical issues to identify and evaluate the possible consequences of each of the alternative solutions and to select the best alternative which will ensure relevant, reliable, comparable and consistent financial information-to serve the best of the users’ interests as a whole. ‘s Ethics'is a term that refers to a code or moral system that provides criteria for evaluating right and wrong. One of the elements that many believe distinguishes a profession from other occupations is the acceptance by its members of a responsibility for the interests of those it serves. Because of the important role of accounting in society, accountants must maintain high ethical standards. Facing pressures and influence of numerous groups with conflicting interests, the accountant should always be alert about ethical behavior. The Code of Ethics promulgated by the Board of Accountancy provides guidelines for practicing accountants. However, the code does not present a structured approach to resolving ethical dilemmas and conflicts. CPAs as well as other accountants are expected to make unswerving commitment to honorable behavior, even at the sacrifice of personal advantage, Ethical considerations pervade all areas of accounting and business. The ethical challenge for accountants-was to provide investors, creditors, and other interested Parties with enough information to enable them to make informal judgments about the business enterprise. Ethics is a code of conduct that applies to everyday life. It addresses the question of whether actions are right or wrong. Ethical actions are the product of individual decisions. You are faced with many ethical situations every day. Some may be potentially illegal — the temptation to take office supplies from your employer to use when you do homework, for example, Others are not illegal but are equally unethical — for example, deciding not to tell a fellow student who missed class that a test has been announced for the next class meeting. When an organization is said to act ethically or unethically, it means that individualsRole of Accounting in Business_31 within the organization have made a decision to act ethically: or unethically. When a company uses false advertising, cheats customers, pollutes the environment, treats employees poorly, or misleads investors by presenting false financial statements, members of management and other employees have made a conscious decision to act unethically. In the same way, ethical behavior within a company is a direct result of the actions and decisions of the company's employees. In order to achieve the objectives of the accountancy profession, professional accountants have to observe a number of prerequisites or fundamental priftciples. These are: Integrity ‘A professional accountant should be straightforward and honest in performing professional services. Objectivity A professional accountant should be fair and should not allow prejudice or bias, conflict of interest or influence of others to override objectivity. Professional Competence and due Care {A professional accountant should perform professional services with due care, competence and diligence and has a continuing duty to. maintain professional knowledge and skill at a level required to ensure that a client or employer receives the advantage of competent professional service based on up-to-date developments in practice, legislation and techniques. Confidentiality ‘A. professional accountant should respect the confidentiality of information acquired during the course of performing professional services and should not use or disclose any such information without proper and specific authority or unless there is a legal or professional right or duty to disclose. Professional Behavior ‘A professional accountant should act in a manner consistent with the good reputation of the profession and refrain from any conduct which might bring discredit to the profession. The obligation to refrain from any conduct which might bring discredit to the profession requires professional organizations to consider, when developing ethical requirements, the responsibilities of a professional accountant to clients, third parties, other members of the accountancy profession, staff, employers, and the general public.32_Chapter 2 + Compliance with Technical Standards A Professional accountant should carry out professional services in accordance with the relevant technical and professional standards. Professional accountants have a duty to carry out with care and skill, the instructions of the client or employer insofar as they are compatible with the requirements of integrity, objectivity and, in the case of professional aceountants in public practice, independence. In addition, they should conform withthe technical and professional standards of the following: * Board of Accountancy (BOA)/Professional Regulation Commission (PRC); : Financial Reporting Standards Council (FRSC); Relevant legislation. . Securities and Exchange Commission (SEC); Auditing and Assurance Standards Council (ASC). Ethical Issues Accountants face several unique ethical dimensions as a result of their work. These dimensions include the following: 1, The financial statements produced by accountants have financial implications for individuals as well as businesses. These situations generate considerable pressure on the accountant to "improve the feported results". Examples of situations in where the financial implications can lead to efforts to influence the outcome are: a. The amount of taxes to be paid by the business. b. The amount of a bonus to be received by top management and employees. ©. The price to be paid by the customer. d. The amount to be distributed to a business's owners. Ethical behavior mandates that the accountants ignore these pressures, 2, Accountants have access to confidential sensitive information. Tax returns, salary data, details of financial arrangement and proposed price changes are examples of these type of information, Ethical behavior mandates that accountants respect the confidentiality information.Role of Accounting in Business 33 RELATIONSHIP OF BOOKKEEPING AND ACCOUNTING Some people do mistake bookkeeping for accounting. Bookkeeping is a procedural element of accounting just as arithmetic is a procedural element of mathematics. Bookkeeping is the process of recording financial transactions and keeping financial records. Mechanical repetitive bookkeeping is only a small-but- important part of accounting. An accountant takes that information and prepares the financial statements that are used to analyze the company’s financial position. Accounting on the other hand, includes the design of an information system that meets the user's needs. Accounting involves many complex activities. Often, it includes the preparation of tax and financial reports, budgeting and analyses of financial information. . Accounting cannot exist independently of bookkeeping. An accountant must know the principles and mechanics of bookkeeping but a person may be a bookkeeper even if he does not know the analytical and interpretative functions of accounting. Hence, those who study accounting are taught first the fundamentals of bookkeeping. Today, computers are used for routine bookkeeping operations that used to take weeks or months to complete, Basic accounting knowledge though is needed even though computers can do routine tasks.34 Chapter 2 REVIEW QUESTIONS, EXERCISES AND PROBLEMS Questions lL Pox vos ™ 2 Explain briefly the statement, "Accounting is a means rather than an end." Define accounting and explain the purpose of accounting information. Why has society as a whole become one of the largest users of accounting information? Identify the uses of financial information. * What is the primary difference between financial accounting and ' managerial accounting? ‘What organizations other than businesses use accounting information? Outline how accounting information might contribute to one decision that each major user group might make. Give examples of nonfinancial information that users of accounting information often need. ‘What is the role of accounting in the decision-making process and what broad business goals and activities does it help management to achieve and manage? * What role do transactions play in accounting? ~ Discuss the importance of professional ethics in the accounting profession. . Give examples of unprofessional and unethical behavior of accountants. How do they affect the reliability and credibility of accounting data that they provide? + Ethical conduct and professional judgment each play important roles in the accounting process. In general terms, explain why it is important to society that people who prepare accounting information act in an ethical manner. b. Identify at least three areas in which accountants must exercise professional judgment, rather than merely relying in written rules.Role of Accounting in Business_35 Exercises Exercise 1 Match the terms on the left with the descriptions on the right. Each description should be used only once. Term Description __ Financial accounting a. The procedural aspect of accounting ___ Management accounting that involves keeping detailed Financial reporting records of business transactions. Financial statements = b._A_ broad “term that describes all ——: General-purpose assumption information provided to external —— Integrity 2 users, including but not limited to Public accounting financial statements. Bookkeeping c. An important quality of accounting information that allows investors, creditors, management and other users to rely on the information. d. The segment of the accounting profession that relates to providing audit, tax, and consulting services to clients. i . Statement of financial position (statement of financial position), income statement, statement of cash flows. £. The fact that the same information is provided to various external users, including investors and creditors. g. The area of accounting that refers to providing information to support internal management decisions. h, The area of accounting that refers to providing information to support external and credit decisions.4 ata etnias eae 36 Chapter 2 Exercise 2 The major focus of accounting information is to facilitate decision making. a. Asan investor in a company, what would be your primary objective? b. Asamanager of a company, what would be your primary objective? ©. Is the same accounting information likely to be equally useful to you in these two different roles? Exercise 3 Management accounting information is used primarily for internal decision making by an enterprise's management. a What are the three primary purposes of management accounting information? b. Which of these are the most general and which is the most specific? ©. Give several examples of the ‘kinds of decisions that management accounting information supports. Problems Problem 1 Romeo Garcia practiced law with a large firm, a partnership, for five years after graduating from law school. Recently, he resigned his position to open his own law office, which he operates as proprietorship. The name of the new entity is Romeo Gareia, Attorney. Garcia experienced the following events during the organizing phase of his new business and its first month of operations. Some of the events were personal and did not affect his law Practice. Others were business transactions and should be accounted for by the business. Feb.4 Garcia received P800,000 cash from his former Partners in the law firm from which he resigned. 5 Garcia deposited: P600,000 cash in a new business bank account entitled Romeo Garcia, Attorney. 6 Garcia paid P3,000 cash for letterhead stationary for his new law office. 7 Garcia purchased office furniture for his law office. He agreed to pay the ‘account payable, P70,000, within six months. 10 Garoia sold 500 shares of IBM stock, which he and his wife had owned for Several years, receiving P750,000 cash from his stockbroker, 11 Garcia deposited the P750,000 cash from sale of the IBM stock in his Personal bank account.Role of Accounting in Business_37 12. A representative of a large company telephoned Garcia and told him of the companys intention'to transfer is legal business to the new enfity of Romeo Garcia, Attomey. 18 Garcia finished court hearings on behaif of a client and submitted his bill for legal services, P40,000. Garcia expected to collect from this client within two weeks. 25 Garcia paid office rent, P10,000 28 Garcia withdrew 20,000 cash from the business for personal living ‘expenses. Required: 1. Classify each of the preceding events as one of the following: a. A business transaction to be accounted for by the proprietorship of Romeo Gareia, Attorney. b. A business-related event but not a transaction to be accounted for by the proprietorship of Romeo Garcia, Attorney. c. A personal transaction not to be accounted for by proprietorship of Romeo Garcia, Attorney. 2. Analyze the effects of the above events on the personal equity of Romeo Garcia. Problem 2 Discuss the ethical choices in the situation below. In each instance, describe the ethical dilemma, and what your cause of action will be. 1. You are the payroll accountant for a small business. A friend asks you how much another employee is paid per hour. 2. As an accountant for the branch office of a wholesale supplier, you discover that several of the receipts the branch manager has submitted for reimbursement as selling expense actually stem from nights out with his spouse. % 3. You are an accountant in the purchasing department of a construction company. When you arrive home from work on December 22, you find a large ham in a box marked "Happy Holidays — It’s a pleasure to wok with you." The gift is from a supplier who has bid on a contract your employer plans to award next week.38 Chapter 2 4. As an auditor with one year's experience at a local CPA firm, you are expected to complete a certain part of an audit in twenty hours. Because of your lack of experience, you know you cannot finish the job wi that time. Rather than admit this, you are thinking about working late to finish the job and not telling anyone, 5. You are a tax accountant at a local CPA firm. You help your neighbor fill out her tax return, and she pays you P200 in cash. Because there is no record of this transaction, you are considering not reporting it on your tax return. 6. The accounting firm for which you workvas a CPA has just won a new client, a firm in which you own 200 shares of stock that you received as an inheritance from your grandmother. Because it is only a small number of shares and you think the company will be very successful, you are considering not disclosing the investment. ‘