978-0134728391 Chapter 15 Part 1

Chapter 15: The Role of Accountants and Accounting Information

Chapter Overview

Every organization relies on accounting information and financial statements in order to gauge

business activity over periods of time. Accounting information can be thought of as a measuring

stick of an organization’s performance in specific periods of time.

This chapter unfolds with a discussion of the role of accountants and an explanation of the types

of accountants in the U.S. business system—public accountants, private accountants, management

accountants, and forensic accountants. In addition, the chapter discusses the accounting equation

as well as the three basic financial statements, showing how they reflect the activity and financial

condition of a business. It also looks at the key standards and principles for reporting financial

statements and describes how computing financial ratios can help users get more information

from financial statements to determine the financial strengths of a business. Finally, the chapter

ends with a discussion of the role of ethics in accounting—a subject that has received much press

in recent years.

Learning Objectives

15-1. Explain the role of accountants and distinguish among the kinds of work done by public

accountants, private accountants, management accountants, and forensic accountants.

15-3. Describe the three basic financial statements and show how they reflect the activity and

financial condition of a business.

15-5. Describe how computing financial ratios can help users get more information from

financial statements to determine the financial strengths of a business.

15-7. Describe the purpose of the International Accounting Standards Board and explain why

it exists.

LIST OF IN-CLASS ACTIVITIES: INSTRUCTOR’S CHOICE

Activity

Description

Time Limit

1. Ice–Breaker: Do You Use

Accounting?

Students think about ways in which they

use accounting in their personal lives.

20 min.

2. Class Discussion:

Interpreting Financial

Statements

Students determine in which financial

statement specific pieces of information are

included.

20 min.

3. Small-Group Discussion:

Annual Reports

Students review financial information from

annual reports of real companies.

45 min.

4. Class Discussion:

Choose an Investment

Students calculate financial ratios and

interpret their results.

30 min.

CHAPTER OUTLINE

Learning Objective 15-1

Explain the role of accountants and distinguish among the kinds of work done by public

accountants, private accountants, management accountants, and forensic accountants.

What is Accounting, and Who Uses Accounting Information?

Accounting is a comprehensive system for collecting, analyzing, and communicating financial

information that is used to prepare financial statements and management reports. Bookkeeping is

The controller manages a firm’s accounting activities. As chief accounting officer, the controller

ensures that the AIS provides the reports and statements needed for planning, controlling,

decision making, and other management activities.

A. Financial versus Managerial Accounting

1. Financial Accounting. A firm’s financial accounting system is concerned with external

information users—the firm’s external stakeholders: consumer groups, unions,

2. Managerial Accounting. Managerial (management) accounting serves internal users.

Managers at all levels need information to make departmental decisions, monitor projects,

and plan future activities. Other employees also need accounting information. Engineers

B. Certified Public Accountants (CPAs)

Certified public accountants (CPAs) offer accounting services to the public, whether a

business or individual client. They are independent from the clients they serve. They are

licensed by a state after passing an exam prepared by the American Institute of Certified

Public Accountants (AICPA).

1. The “Big Four” Public Accounting Firms. The “Big Four” public accounting firms,

Deloitte Touche Tohmatsu (United States), Ernst & Young (United Kingdom),

15-4

PricewaterhouseCoopers, PwC (United Kingdom), and KPMG (Netherlands) account for

one-half of the total revenue generated by accounting firms active in the United States.

2. CPA Services. Most CPA firms provide auditing services, tax services, and management

services.

a. Auditing. An audit examines a company’s AIS to determine whether financial reports

3. Noncertified Public Accountants. This category includes accountants who do not take the

CPA exam, who are preparing for it, or who are waiting for state certification.

4. The CPA Vision Project. The CPA Vision Project is a profession-wide program that was

established to assess the future of accounting; a prime reason for the project is the decline

in the number of people who have entered the profession in recent years. The CPA Vision

Project identifies core competencies for accounting that will be necessary for the future

CPA.

C. Private Accountants and Management Accountants

Private accountants are hired as salaried employees of a firm who perform day-to-day

activities. Management accountants provide services to support managers in various

activities. Many hold the certified management accountant (CMA) designation.

D. Forensic Accountants

Forensic accounting is the use of accounting for legal purposes. Forensic accountants may be

called on by law enforcement agencies, insurance companies, or law firms for investigative

accounting and litigation support in crimes against companies, crimes by companies, and civil

disagreements.

2. Litigation Support. Forensic accountants assist in the application of accounting evidence

for judicial proceedings by preparing and preserving evidence for these proceedings,

focus specifically on fraud-related issues, including fraud prevention and deterrence,

financial transactions, fraud investigation, and legal elements of fraud.

E. Federal Restrictions on CPA Services and Financial Reporting: Sarbox

The Sarbanes-Oxley Act (2002) was enacted to restore public trust in corporate accounting

practices; Sarbox restricts the kinds of nonaudit services that CPAs can provide.

Sarbox Compliance Requirements. The CFO and CEO must pledge that the company’s

finances are correct and must vouch for the methods and internal controls used to get those

KEY TEACHING TIPS

 Remind students that accounting is a comprehensive system for collecting, analyzing, and

communicating financial information, whereas bookkeeping is the recording of

transactions.

 Point out that the controller manages a firm’s accounting activities.

 Make sure students keep these two points separate: Financial accounting is concerned

with external information users; managerial accounting serves internal users and is not

limited to managers.

 Make sure students understand the role of a CPA, who offers accounting services to the

public and who is licensed by a state after passing an exam.

may want to spend some time discussing these accountants to pique their interest.

QUICK QUESTIONS

 Who uses accounting information and for what purpose do they use it?

 Outside of the company, who might have an interest in a company’s financial situation?

 What types of services do CPAs perform?

 What has occurred in the business environment that has prompted the need for forensic

accountants and certified fraud examiners?

 The Sarbanes-Oxley Act of 2002 (Sarbox) is a critical piece of federal legislation enacted

to restore public trust in corporate accounting practices. What are some of Sarbox’s

provisions?

Use In-Class Activity 1: Ice-Breaker: Do You Use Accounting?

Time Limit: 20 minutes

Learning Objective 15-2:

Explain how the accounting equation is used.

The Accounting Equation

Underlying all record-keeping procedures is the most basic tool of accounting—the accounting

equation.

A. Assets and Liabilities

An asset is any economic resource that is expected to benefit a firm or an individual who

owns it; a liability is a debt that the firm owes to an outside organization.

B. Owners’ Equity

Owners’ equity refers to the amount of money that owners would receive if they sold all

assets and paid all debts. Assets – Liabilities = Owners’ Equity.

KEY TEACHING TIPS

 Make sure that students understand the accounting equation:

 An asset is any economic resource that is expected to benefit a firm that owns it; a liability

is a debt that the firm owes. What are some examples of assets and liabilities found in

organizations?

 Make sure students understand that owners’ equity is the money owners would receive if

they sold all of a company’s assets and paid all of its liabilities.

QUICK QUESTION

 In what way(s) do businesses benefit from intangible assets?

 How does the term net worth fit into the accounting equation?

 Why is owners’ equity meaningful to investors and lenders?

Learning Objective 15-3:

Describe the three basic financial statements and show how they reflect the activity and

financial condition of a business.

Financial Statements

Accountants summarize the results of a firm’s transactions and issue reports to help managers

make informed decisions. Among the most important reports are financial statements, which fall

into three broad categories—balance sheets, income statements, and statements of cash flows.

A. Balance Sheets

Balance sheets display a firm’s financial condition at one point in time. They supply

information about assets, liabilities, and owners’ equity.

1. Assets. An asset is any economic resource that a company owns and from which it

expects to get some future benefit.

a. Current Assets. Current assets include cash and assets that can be converted into cash

within a year. The act of converting something into cash is called liquidating. Assets

benefits. These usually include the cost of obtaining rights or privileges, such as

patents, trademarks, copyrights, and franchise fees. Goodwill is the amount paid for an

existing business beyond the value of its other assets.

2. Liabilities. Current liabilities are debts that must be paid within one year. Accounts

3. Owners’ Equity. Owners’ equity is broken down into paid-in capital and retained

earnings. Paid-in capital is additional money invested in the firm by its owners. Retained

earnings are net profits kept by a firm rather than paid out as dividend payments to

stockholders.

B. Income Statements

The income statement is sometimes called a profit-and-loss statement because its description

of revenues and expenses results in a figure showing the firm’s annual profit or loss.

1. Revenues. Revenues are funds that flow into a business from the sale of goods or services.

2. Cost of Revenues (Cost of Goods Sold). The cost of revenues section shows the costs of

obtaining the revenues from other companies during the year (used for service providers).

Cost of goods sold are costs of obtaining materials to make products sold during the year

3. Operating and Net Income. Operating income compares the gross profit from operations

against operation expenses. Net income (net profit or net earnings) is calculated by

subtracting income taxes from operating income.

C. Statements of Cash Flows

Required of all firms whose stock is publicly traded, the statement of cash flows shows a

company’s yearly cash receipts and cash payments. This statement shows cash flows from

operating, investing, and financing activities.

D. The Budget: An Internal Financial Statement

A budget is a detailed statement of estimated receipts and expenditures for a future period of

time.

KEY TEACHING TIPS

 Reinforce that financial statements include the summaries of a firm’s transactions and

help managers make informed decisions; financial statements include balance sheets,

income statements, and statements of cash flows. Go over each of the financial statements

carefully with students.

 Make sure that students understand the distinction between current assets and fixed assets

and that they can provide examples of each.

 Make sure students understand the difference between current liabilities and long-term

liabilities and that they can provide examples of each.

main areas of the income statement: revenues, cost of revenues, and operating expenses.

 Reinforce that revenues are the funds that flow into a business from the sale of goods or

services; the cost of revenues (or the cost of goods sold) are the costs of obtaining

materials to make products sold during the year (for goods) or the costs of obtaining the

revenues from other companies (for services).

 Point out that a statement of cash flows describes yearly cash receipts and cash payments;

it includes cash flows from operations, investing, and financing activities.

QUICK QUESTIONS

 What are some examples of operating expenses?

 Who might be interested in the information revealed in a statement of cash flows? Why?

 What might be included in a budget for a typical household in the United States?

HOMEWORK

Using a Budget

Now is a good time to assign Application Exercise 9 from the end-of-chapter materials as

homework. This assignment asks students to interview an accountant and ask how the firm uses

budgets.

At-Home Completion Time: 1 hour

Use In-Class Activity 2: Class Discussion: Interpreting Financial Statements

Time Limit: 20 minutes

Use In-Class Activity 3: Small-Group Discussion: Annual Reports

Time Limit: 45 minutes

Learning Objective 15-4:

Explain the key standards and principles for reporting financial statements.

Reporting Standards and Practices

Spelled out in GAAP, these practices and principles cover a range of issues. The purpose is to

give external users confidence in the accuracy and meaning of financial information.

A. Revenue Recognition and Activity Timing

Revenue recognition is the formal recording and reporting of revenues in financial statements,

B. Full Disclosure

This indicates that financial statements should not include just numbers; they should include

management’s interpretation and explanation of those numbers.

KEY TEACHING TIP

 Remind students that full disclosure requires that financial statements include both the

“numbers” and management’s interpretations/explanations of those numbers.

 Reinforce that two conditions must be met for an earnings cycle to be complete: the sale is

complete and the product delivered; and the sale price has been collected or is collectible.

Learning Objective 15-5:

Describe how computing financial ratios can help users get more information from financial

statements to determine the financial strengths of a business.

Analyzing Financial Statements

Financial statements provide data, which can reveal trends and be applied to create various ratios.

These trends and ratios can be used to evaluate a firm’s financial health, its progress, and its

prospects.

A. Solvency Ratios: Borrower’s Ability to Repay Debt

Solvency ratios provide measures of the firm’s ability to meet its debt obligations. They can

be used to estimate short-term and long-term risk.

1. The Current Ratio and Short-Term Solvency. Short-term solvency ratios measure a

company’s liquidity and its ability to pay immediate debts. The most commonly used of

2. Long-Term Solvency. Long-term solvency is calculated by dividing debt—total

liabilities—by owners’ equity; this ratio illustrates the extent to which a firm is

financed through borrowed money. The lower the debt, the lower the risk to investors and

creditors.

B. Profitability Ratios: Earnings Power for Owners

Profitability ratios are used for measuring potential earnings.

Earnings per Share. This ratio is calculated by dividing net income by the number of shares

outstanding; this determines the size of the dividend that a firm can pay shareholders. As the

ratio goes up, stock value increases because investors know that the firm can better afford to

pay dividends.

C. Activity Ratios: How Efficiently Is the Firm Using Its Resources?

Activity ratios reveal the efficiency with which firms have used resources; an example is

when annual sales revenues can increase without an increase in operating costs. These ratios

are used for evaluating management’s use of assets.

KEY TEACHING TIPS

 Reinforce that the current ratio measures a company’s ability to meet current obligations

out of current assets. The formula is Current Assets/Current Liabilities.

 Reinforce that long-term solvency indicates a company’s ability to repay debts in future

years; the formula is Total Liabilities/Owners’ Equity.

 Point out earnings per share determines the size of the dividend a firm can pay

shareholders; this can be determined using the formula Net Income/Number of Shares of

Stock Outstanding.

QUICK QUESTIONS

 What do solvency ratios measure?

 How can high debt be desirable for a company?

 Of what value is earnings per share to an investor in analyzing the quality of the

investment?

Use In-Class Activity 4: Class Discussion: Choose an Investment

Time Limit: 30 minutes

HOMEWORK

Interview a Manager

Now is a good time to assign Application Exercise 10 from the end-of-chapter materials as

homework. This assignment asks students to interview the manager of a local retailer, wholesale

business, or manufacturing firm about the role of ethics in that company’s accounting practices.

At-Home Completion Time: 1 hour

Learning Objective 15-6:

Discuss the role of ethics in accounting.

Bringing Ethics into the Accounting Equation

A. Why Accounting Ethics?

1. AICPA’s Code of Professional Conduct. The code of professional conduct for public

2. Violation of Accounting Ethics and GAAP. The majority of recent accounting

thing” can make a difference.

KEY TEACHING TIP

 It is critical that students recognize the purpose of ethics in accounting: to maintain public

confidence in business institutions, financial markets, and the products and services of the

accounting profession.

QUICK QUESTIONS

 What are the six ethics-related areas outlined by the AICPA in its Code of Professional

Conduct?

 What is the connection between the Sarbanes-Oxley Act of 2002 and the recent

widespread violations of accounting ethics?

Learning Objective 15-7:

Describe the purpose of the International Accounting Standards Board and explain why it

exists.

Internationalizing Accounting. By the late twentieth century, it was apparent that the upsurge in

multinational organizations and the global economy demanded more uniformity among

accounting practices. The development of “universal” procedures would allow governments and

investors in, say, China, Brazil, and Italy to read, interpret, and compare financial statements from

all those countries, whereas such comparisons even today are difficult if not sometimes

impossible.

A. International Accounting Standards Board

Established in 2001 and housed at London, England, the International Accounting Standards

Board (IASB) is an independent, nonprofit organization responsible for developing a set of

global accounting standards, and for gaining the support and cooperation of the world’s

various accounting organizations to implement those standards.

B. Why One Set of Global Practices?

Although more than 138 countries have adopted IASB’s accounting practices, nearly 50

1. Example Areas Targeted for Aligning U.S. GAAP and IASB

Among the many differences between the practices of U.S. GAAP and IASB—some

reports identify more than 400 such discrepancies—the following examples illustrate

some discrepancies and proposals for convergence toward universal standards in financial

reporting.

2. Timetable for Implementation

The U.S. Securities and Exchange Commission originally targeted 2015 as the earliest