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 mariage 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} ¢ off the into ion: .Role of Accounting in Business 23 Akey product of accounting is the set of financial statements, the documents that report fi nancial. information.about a business entity to decision makers. They tell us how well a business is performing in terms of profit and losses and where it stands in financial terms. The world of business surrounds us and accounting is the language spoken in the world of bissiness. ACCOUNTING INFORMATION: A MEANS TO AN END To provide information that is useful for decision-making purposes is the primary. objective of accounting. sceounting dl is not an end but rather is a means to an end. Accounting provides much of the information that people use to manage and evaluate businesses. A person can make a wiser business decision if he or she knows how to use the information. In fact, the chances are good that accounting provided the right information for the decision. The accounting information system produces the information about the business firm's financial position, profitability and cash flows. This information meets the needs of users of the information, investors, creditors, managers and so on — and supports many kinds of financial decisions, — performance evaluation and resource allocation, among others. The final output of accounting information is the decision that is enhanced by the use of accounting information whether made by owners, management, creditors, governmental regulatory bodies, labor unions or the many other groups that have an interest in the financial performance of an enterprise. Accountants are communicators. Accountancy is the art of communicating financial information about a business entity to users such as shareholders and managers.:The communication is generally in the form of financial statements that show in money terms the economic resources under the control of the management, The art:lies in selecting the information that is relevant to the user and is reliable. In addition to assisting in making economic decisions, financial statements also show the results of the stewardship of management: that is, the accountability of management for the resources entrusted to it. Users who assess the stewardship do so in order to make economic decisions,.e.g. whether to hold or sell shares in Avartioulan company\or change the management.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 information 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 already occurred, this past information is intended to be useful in making | economic decisions about the future.Role of Accounting in Business 25 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 thew 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 ‘inancial factors, such as political and environmental considerations, product lity, customer satisfaction, and worker productivity, 426 Chapter 2 Tax Accounting The preparation of income tax returns is a specialized field within accounting. To a great extent, tax retums 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 business transactions and structuring these transactions in a manner that will minimize the income tax burden. Not-for-Profit Accounting a 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 aad 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. External User External Decision 0 Internal User Internal Decision28 Chapter 2 USERS OF ACCOUNTING INFORMATION do they require to meet - Who uses accounting information and what information a rested in the financial their decision-making needs? In general, all parties inte1 health of a company are called stakeholders. Stakeholder users of accounting information are normally divided into two major classifications: uy © 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. is 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. 2) 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. é 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 dependent 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, enterprisés 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. 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. 3 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. i 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 ergunization-is) said to” actyethically 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 detisions of the company's employees, a In order to achieve the objectives of the accountancy profession, professional accountants have to observe a number of. prerequisites or fundamental priticiples. These are: . Integrity A professional accountant should be straightforward and honest in performing professional services. e © Objectivity A professional accountant should be fair and should not allow prejudice , oF bias, conflict of interest or influence of others to override objectivity. ¢ Professional Competence and due Care A professional accountant should perform proféssional 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 front 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 pereral public,32_Chapter 2 © ~ Compliance with Technical Standards. : oe 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 accountants in public practice, independence. In addition, they should conforth with the 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 (AASC). 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 Rs generate considerable pressure on the accountant to "improve the reported 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. ‘ c.. 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 behayior 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 smajl-but- importarit 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.