An accountant is concerned with the provision and interpretation of financial information. He does not, as an accountant, make decisions. Many accountants do of course get directly involved in decision-making but when they do they are performing a different function.
Accounting is also concerned with reporting on the effects of past decisions. But one should consider whether this is done for its own sake or whether it is done in order to provide information which it is hoped will prove helpful in current and future decisions. We contend that knowledge of the past is relevant only if it can be used to help in making current and future decisions, for we can hope that we shall be able to influence the future by making appropriate decisions but we cannot redo the past. Thus the measurement of past results is a subsidiary role, but because of the historical development of accounting and, perhaps, because of the limitations of the present state of the art, 'backward looking' accounting sometimes appears to be an end in itself and not as a means that help in achieving a more fundamental objective.
WHY STUDY ACCOUNTING?
Considering the wide range of questions that are answered by referring to accounting information, perhaps every educated person in our society should be regarded as a user of accounting information. If you are to use accounting information effectively, you must have some understanding of how the data are gathered and the figures are put together. You must appreciate the limitations of the data and the extent to which portions are based on estimates rather than on precise measurement. And, you must understand accounting terms and concepts. Needless to say, this knowledge is gained in a study of accounting.
For the information provided in financial statements to be useful, ii must be capable of being understood by investors, creditors and other users. Investors, creditors and other users are assumed to have a reasonable understanding of business and economic activities and together with a willingness to study the information with reasonable diligence.
Another reason to study accounting is to make it one's lifework. A career in accounting can be very interesting and highly rewarding.
Accountancy as a profession
Over the past half century, accountancy as a profession has attained a stature comparability with that of law or medicine. Most provinces license public accountants just as they license doctors and lawyers. The licensing helps ensure a high standard of professional service. Only individuals who have passed a rigorous examination of their accounting and related knowledge, met other education and
experience requirements, and have received a license may designate themselves as public accountants.
There are a number of accounting organizations providing education and professional training. These include the provincial institutes of Chartered Accountants, the Certified General Accountants' Association, and the Society of Management Accountants (SMA). Successful completion of the prescribed courses of instruction and practical experience lead to the following appellations:
Chartered Accountant (CA)
Certified General Accountant (CGA)
Certified Management Accountant (CMA)
An activity of the three accounting organizations that has shaped accounting thought has been the education and the publication program. Each has an extensive educational program and has maintained the publication of journals which enjoy wide readership.
In the past decade reliance on post-secondary accounting education has become a significant part of the educational process and complements the extensive correspondence and lecture programs of both the Certified General Accountants' Association, and the Society of Management Accountants — The Institute of Chartered Accountants requires a university degree with specified course content.
Accountancy is the fastest growing of the professions. The growth is in response to the expansion and complexity of the economy, the increasing involvement of the accountant in the process of management decision making, and a growing number of financial reporting activities.
Short 9.BUSINESS TRANSACTIONS
Basic Terminology for Accounting Information
Money resources and economic or service resources are the assets of a company. Initially creditors and owners are the sources of the assets of a business. These sources of assets are known as the equities of a business. They represent claims upon the assets if the business is dissolved.
Expenses are the assets used up or spent to provide revenue. Revenue is the payment made by customers for the product or service purchased. Income is the excess of the assets received (revenue) over the assets used up to provide the revenue (expense); it is the net increase in assets. Income increases the owners' equity in the business because the owners' claim to assets is increased.
A distinct feature of traditional accounting information is that it relies heavily on a transfer or exchange between the business and outsiders and between areas within the company. Accountants tend to assume for recording purposes that an activity takes place when an exchange occurs. These exchanges are known as transactions. In a sense, traditional accounting information is information on either past or future transactions.
Transactions
A transaction provides a means for measuring activity. By a transaction is meant the flow of economic resources, or rights to the resources, from one accounting entity to another. Since substantially all business or economic activities culminate in an exchange rather than in consumption by the entity, a record of an entity's transactions will reveal its significant activities, for the idea of an exchange underlies the concept of a transaction.
There are limitations to the transaction concept, for not all business activities are immediately reflected in a transaction. Specifically, changes in the market price of economic resources often occur without regard to business activities aimed at a future transaction. Similarly, some business activities are directed toward objectives which cannot be related to a specific future transaction, such as the production of a product having an unknown future sales (transaction) price. In an effort to overcome limitations such as these, the accounting discipline has stretched the concept of a transaction to include the concept of an accrued transaction which, as we shall see, includes meas-urements of changes in wealth and rights to wealth prior to the time the exchange transaction occurs.
Types of Transactions
The procedures of accounting largely represent means for measuring and communicating information on transactions. The development of these procedures involves problems of measuring and communicating information on three types of transactions. It is important to distinguish them, for different measurement and communication methods are appropriate for each type.
Future Transactions. By measuring and communicating information on possible future transactions, accounting reveals those activities which appear to be the most desirable for the entity to carry out in the future. By measuring and communicating information on planned future transactions, accounting reveals those actions which will have to be taken at appropriate times to carry out the plans most effectively.
Current Transactions. By measuring and communicating information on current transactions, accounting reveals the current state of the entity's activities. When these current transactions are compared with the budgeted or planned transactions, the information disclosed will enable management to take actions which will bring current activities in line with planned activities and thus control the activities of the entity.
Past Transactions. Measurement and communication of past transactions provide a description of the entity's activities over a period of time. Systematic study and analysis of these descriptions afford insights into the nature of an entity's operations which enable governments to establish tax collection methods, owners to control general managerial direction of the entity, and creditors to evaluate managerial performance over a period of time and in varying situations.
Classification of Transactions
Transactions may be classified in a number of ways. Possibly the most useful classification for accounting purposes is the following:
1. External transactions involve activities between an entity and someone outside the entity. They are of two main types:
a. Exchange transactions, wherein there is an exchange of economic resources or rights between the company or other entity and someone outside the entity, such as the sale of merchandise to a customer for cash.
b. Accrued transactions, wherein there is continuous gradual transfer or receipt of economic rights or services by the company to or from an outside party with the understanding that payment for the services will be made later. An example is the continuous transfer of electricity to a customer by an electric utility company, for which payment is made at the end of the month. 2. Internal transactions involve the activities within the company. These activities also are of two main types:
a. Transfer transactions, wherein there is a transfer of economic resources or rights from one area of the company to another in exchange for relief from responsibility for the resources or rights. The transfer of material from the storeroom to the factory is an example.
b. Accrued transactions, wherein the transfer of economic resources or rights is a continuous process. An example is the gradual using up of a machine over a period of time to make a product. The daily wearing out of the machine would be an accrued transaction.
Transactions and Accounting Data Collection Procedures
The study of accounting procedures is largely the study of means for collecting data on transactions. A record of data on past, present, and future transactions provides a means for describing business activities. Since business activities are directed toward the objectives of acquiring and using economic resources, traditional accounting procedures normally measure transactions in terms of the monetary worth of the resources involved in the transactions. They provide for the classification of the transactions in such a way as to reveal the nature of the business activity involved. In communicating measured information to others, accounting procedures represent means for disclosing transactions in terms of business efforts and business accomplishments and the resulting economic resources and rights in the entity. While the following discussion is primarily a description of historically conventional methods for collecting data on external exchange transactions, it is applicable to all types of transactions.
Transactions and Business Activity
The validity of the assumption that business activities of all types ultimately result in transactions is most important to the double-entry recording process. If the «lag» between a business activity (e.g., making shoes for a customer) and the transaction (delivery of the shoes to the customer) were substantial, the criticism could be made that the accounting recording process is inadequate and should abandon the transaction concept. However, there is no reason to think that the lag between a business activity and the resulting transaction is so great that the transaction concept cannot be used. Undoubtedly, as electronic data processing develops, it will be possible by the accrual process to eliminate much of the lag when it does exist.
To prevent the development of a «lag» between a business activity and a transaction, accountants have defined a transaction in a special way: they have adopted the concept of an accrued transaction and use it to record business activity prior to the date the actual transaction occurs. External Exchange Transactions
The idea of an exchange, or a trading between two parties, underlies the concept of a transaction. While the description is satisfactory for most general purposes, for accounting purposes a transaction is defined in several special ways. One way, an external exchange transaction, refers to the exchange between the company and someone outside of the company.
External Accrued Transactions
The concept of an accrued (external) transaction, refers to those activities which result in a continuous transfer of services from one company to another.
Internal Transfer Transactions
To expand on the concept of internal transactions^ note that it does not refer to an exchange with another company; it refers to the transfer of resources from one internal area to another internal area. Typically, internal transfer transactions refer to the transfer of resources from one department to another, or of responsibility for them from one person to another.
Internal Accrued Transactions
Internal accrued transactions represent the continuous transfer of resources from one area to another within the company. They are recognized periodically, generally at the end of each month, in the manually maintained accounting record.
Summary
Relying on the observation that business activities ultimately result in an exchange of some type, the accounting discipline for recording data on business activity uses the concept of a transaction to indicate when an activity has occurred.
THE ANALYSIS OF FINANCIAL STATEMENTS
The objective of public accounting reports is to reveal or describe the economic activities of a company. In this sense, accounting reports represent raw material to be used in developing an understanding of a company and its operations. The statements provide much useful information, but by analysis, and study of them additional relationships and activities may be revealed. The underlying principles of accounting analysis are to be found in information theory and communication theory. But the practice is best revealed by a study of what analysts do, and in practice ratio analysis and trend studies are widely used analytical techniques. While analysis of all types of accounting reports is desirable for disclosure of information on a company's activities, the process can best be explained by emphasizing methods of analyzing the public accounting.
The purposes for which information is needed will indicate the types of analyses to be made. In broad terms, there are three types of analyses:
1. General-purpose analysis, which aims merely to reveal more completely the information in accounting statements, and to relate it to other factors in the company and the economy.
2. Analysis for credit or investment, which aims to disclose relationships which bear upon the financial effectiveness of the company.
3. Analysis for management purposes, which aims to disclose successful and unsuccessful plans and operations.
Preliminary Arrangements
Regardless of the purpose for which an analysis is made, certain preliminary steps must be taken to arrange the data in suitable form. They include the following tasks:
1. Selecting and collecting relevant standards for evaluating an analysis.
2. Rounding off amounts, e.g., to the nearest hundreds or thousands of dollars.
3. Reclassifying accounts especially if comparative statements over a period of time are used, so that a uniform classification will be used in all analyses.
4. In some instances, segregating and grouping accounts according to different classification systems.
5. Selecting computing, and interpreting various statistical measures, economic indicators, ratios, comparisons, and relationships which reveal significant information.
Standards for Comparison. There is limited significance to any analysis which does not provide a basis for determining whether the information developed by the analysis is favorable or unfavorable. If comparative data are not available or cannot be developed, other analyses should be made for which comparative data will be available.
For every analysis, there should be some type of standard against which the resulting information may be compared. These standards maybe:
1. Informal — sometimes only a «feeling» on the part of the reader of the analyzed data.
2. Past results against which current results may be compared.
3. Results of other companies in the same industry (there are a number of limitations to this type of standard, because companies are seldom entirely comparable).
4. Budgeted or planned standards reflecting the stated objectives of management before the period was started.
Rounded Dollar Valuation. Computations are made easier by rounding off all amounts in the statements to the nearest $1,000 ($100 for a small company). While procedural in nature, this step is important in that it calls attention to the generalized nature of many of the results of data developed by analysis, for analysis involves reducing a mass of information to a generalized figure.
Reclassification of Amounts. If analyzed data are to be compared, a uniform classification system should be used for all amounts compared. For example, if depreciation has been computed on the assumption of an average 20-year life, this policy should be followed consistently; and if the current year's depreciation has been computed on a 10-year instead of the 20-year life, the excess depreciation should be reclassified as part of the asset, for purposes of comparison.
In developing a uniform classification system, all offsets — where liabilities are reduced by assets so that only the net liability is reported, or vice versa — should be removed and all assets and liabilities revealed., In the same way, all reductions in liabilities and assets which have occurred should be recorded. Thus, treasury stock should not be treated as an asset but as a reduction in the stockholders' equity, because it is a reduction in an equity and not an asset. Also, bond discount should be deducted from the liability.
In many instances, information will not be available to allow a satisfactory reclassification or even to know whether reclassification is appropriate. If the statements have been certified by a certified public accountant as a fair presentation of the accounting facts, it is appropriate to assume that for a particular company no material inconsistencies exist in the classification of amounts from period to period.
Classification for Different Purposes. For particular analyses, different classifications of amounts may be appropriate. That is, since the purpose of analysis is to reveal information, and since information enables a decision maker correct past actions or improve future decisions, only by analyzing reports in terms of different managerial objectives can the maximum amount of accounting information be transmitted. It follows, then, that analyses to develop information useful for different purposes will require different aggregations of the basic data. For example, the ratio of variable expenses to sales normally must be preceded by a reclassification of expenses into the categories of variable and fixed items, and this involves regroupings and rearrangements of the basic data.
Appropriate Ratios, Comparisons, Trends, and Relationships. The selection of the statistical measures, ratios, comparisons, trends, and relationships to be computed in analyzing statements and supporting data depends upon the specific purpose of the analysis. It is impossible to list all of the comparisons which may be made. Different situations and different purposes may require any number of different analyses. In general, the analyst should determine in detail the purpose for which the information is to be used before selecting the types of ratios and comparisons to be made.
Analysis for credit and investment purposes:
Typical analyses used in determining whether to loan or invest money in a company include:
1. Balance-sheet ratios.
2. Income-statement ratios.
3. Cross statement ratios.
4. Percentage statements.
5. Comparative statements.
Summary
The analysis of accounting reports is undertaken to achieve an understanding of a company and its activities. It is an involved process and the detailed study of this topic falls in the area of advanced accounting where statistical and mathematical methods and external, as well as internal, data are used. But this introduction to the subject provides a basic understanding of the process. It is based on the assumption that masses of data are often best understood when reduced to one significant figure. Consequently, a number of financial ratios may be used to reveal information in accounting reports. However, effective analysis of accounting reports can seldom be reduced to a process of computing 8 or 10 ratios. The more informative analyses depend upon the use that is to be made of the information. Broadly, accounting report analysis may develop information for either management or investors.
Effective analysis requires that the data available be unambiguously defined. Non-comparable data should be adjusted. If broad interpretations are to be made, data may be rounded off and reclassified to disclose only the significant information needed.
Selected ratios, comparisons, trends, and relationships which may be developed to reveal information to investors are:
1. Balance-sheet ratios: Current ratio, Acid-test ratio, Shareholders'-equity ratio, Book value per share of stock
2. Income-statement ratios: Operating ratio, Number of times fixed charges earned, Net income to sales ratio
3. Cross-statement ratios: Inventory turnover, Number of days' sales in receivables, Return on investment
4. Percentage statements
5. Comparative statements over time
For management purposes, analyses are usually more precise. Three conventional techniques used for these purposes are:
1. Analysis of rate of return on investment
2. Volume sensitivity analysis
3. Analysis of changes in income over time
