Accounting is a system for producing information about an entity and communicating that information to people who want or need it for making decisions.
Crucial in this definition is communication. If accounting does not effectively communicate with the people using the information it is not serving a useful purpose.
Accounting systems accumulate data about an entity’s economic activities and convert them so that they can be useful for making decisions. There are a number of complexities involved in this process:
There are many people with different interests and different decisions to make about an entity. It is not likely that the same information will be best for all these different people.
It is not always obvious how an entity’s various economic activities should be accounted for. Economic activity can be very complex and summarizing it in an accounting system can require judgment and interpretation by the people who prepare the accounting information.
The people who manage an entity and who are responsible for preparing the accounting information can be affected economically by the information. As a result, these people are not likely neutral in how they approach the preparation of the information. This is not to say that these people are dishonest or unethical. Rather, like most people, their personal interests affect their choices. These interests can include such things as the amount of compensation they receive, their personal wealth, and the amount of tax they pay.
These three factors help explain why accounting is full of mystery and intrigue and why it can take detective work to fully make sense of accounting information. At this early stage these points may be confusing or unclear. This is understandable since we haven’t even begun to look at actual accounting information. However, these points are important and they are repeated throughout the book because they are so fundamental to being able to understand and use accounting information.
Why do People Need and Want Information?
People need and want information so that they can make better decisions. Without information a “decision” is nothing more than a guess.
Not all information is equivalent. Information will vary in quality depending on its source and appropriateness for the decision at hand. Information that is relevant for one decision may not be relevant for another.
This general point about the usefulness of any particular piece of information depending on the intended use is very important for accounting. Accounting information, for example the information contained in financial statements, will not be equally useful for all decisions and all decision makers.
Accounting is an important source of information for decision makers. However, accounting is not the only source of information. There are many different sources and types of information that can provide valuable input into a decision. Some examples of other sources of information include newspapers, press releases by an entity, and information about the economy can be important sources of information.
There are limits to the amount of information that people will gather.
Information will only be gathered if the benefit exceeds the cost. If the cost of gathering information is greater than the benefit, the decision maker will actually be worse off by having gathered the information. In economic terms this cost benefit tradeoff means that information will be acquired until the marginal cost of the information equals the marginal benefit.
There are also limits to the amount of information a decision maker can process and manage. Too much information, or information overload, can impair a decision maker’s ability to make decisions.
Information will only be gathered if the benefit exceeds the cost. If the cost of gathering information is greater than the benefit, the decision maker will actually be worse off by having gathered the information. In economic terms this cost benefit tradeoff means that information will be acquired until the marginal cost of the information equals the marginal benefit.
There are also limits to the amount of information a decision maker can process and manage. Too much information, or information overload, can impair a decision maker’s ability to make decisions.
Top The Two Fields of Accounting: Financial and Managerial Accounting
Accounting is usually divided into two fields, financial and managerial.
Financial accounting refers to the field of accounting that provides information to people who are external to an entity. These external users include investors, lenders, taxation authorities (Canada Revenue Agency), competitors, and many more. Usually users of financial accounting information do not have direct access to information about the entity and must rely on the entity to provide information to them.
Managerial accounting refers to the field of accounting that provides information to the managers of the entity and other decision makers who work for the entity. This information assists them in making decisions related to operating the entity, including setting the price of products, deciding whether the company should expand, determining which products are successful and which are not, figuring out how much should be produced, and so on. Managerial accounting information is often much more detailed than financial accounting information, and its content and organization is more flexible.
While these two fields of accounting are described separately and are usually taught as separate courses, they are not independent. Entities usually collect and organize information in a single accounting system, so that even though the information is presented differently for the two fields, “financial” and “managerial” accounting information usually comes from the same pool of data.
The preparation of accounting information does not take place in a vacuum. The accounting environment affects what and how information is presented to stakeholders. The accounting environment represents the context in which accounting operates. The figure emphasizes a number of important factors:
The nature of a society—its political, cultural, economic, competitive, regulatory, and legal institutions and traditions—will significantly impact its accounting. The society’s accounting evolves from these institutions and traditions, and differences among different societies help explain why accounting is different in different countries.
An entity is an economic unit of some kind. An entity can be an individual, a business, part of a business, a charity, a school, a government, a club, or an industry, and so on. Whether an entity will provide information to a decision maker depends on the characteristics of the entity and the relationship the decision maker has with the entity.
There are three types of business entities:
Corporations—Corporations are separate legal entities created under the corporation laws of Canada or of a province, or of some other jurisdiction in the world. A corporation has many of the rights and responsibilities that an individual has (they must file tax returns, can be sued, and can enter into contracts). Corporations provide limited liability to their shareholders. It is relatively easy to transfer ownership of a corporation from one shareholder to another. The shares of public corporations can be purchased by anyone who is interested in owning a piece of the entity and has the money to buy the shares. The shares of public corporations can usually be purchased or sold on a stock exchange. A private corporation is one whose shares and other securities are not available for purchase without agreement by the private corporation or its shareholders.
Proprietorships—A proprietorship is an unincorporated business that has one owner.
Partnerships—A partnership is an unincorporated business owned by two or more individuals called partners.
Non-business entities include not-for-profit organizations, governments, and individuals.
Stakeholders are groups or individuals that have an interest or a “stake” in an entity. The interests of the various stakeholders are different and they have different decisions to make. Different stakeholders may require different information to make their decisions. Examples of stakeholders include owners, lenders, suppliers, governments, taxation authorities, and consumers.
Characteristics of entities—Each entity has a set of characteristics that make it unique. An entity’s characteristics may influence the accounting choices its managers make. Characteristics include size, industry, ownership, risk, and stage in the life cycle.
Constraints—How an entity does its accounting and what information it reports are not entirely up to the people who prepare the information. Often, the choices available are constrained by contracts, laws, accounting rules, and the information needs and demands of powerful users of accounting information.
Stakeholders versus preparers
The preparers of accounting information are the people responsible for deciding what, how, and when information is going to be presented in an entity’s financial statements and other accounting reports. The preparers (or managers) are not likely to be neutral in how they approach preparing financial statements.
This perspective may be surprising to people new to the study of accounting. The reality of accounting is that there can often be more than one way to report an entity’s economic activity. This does not mean that there is fraud or misrepresentation occurring (although this does happen). There are often legitimate alternative ways of accounting. The textbook devotes considerable space to exploring the existence and implications of these alternatives.
There are two main explanations for why preparers of accounting information are not neutral:
Entities usually have many stakeholders with different information needs. It is usually not possible or practical to provide separate information to each stakeholder. Therefore, the preparers must choose among the competing interests of the different stakeholders.
Preparers have their own interests and these interests may conflict with those of the stakeholders. An entity’s financial statements can have economic consequences for the entity’s managers and these consequences may influence how they choose to account. These economic consequences probably explain many of the corporate scandals that have occurred in recent years.
The implication of this imperfect relationship between stakeholders and preparers is that the accounting information that a stakeholder receives from an entity may not be fully appropriate for the decision that stakeholder has to make. This means that stakeholders must be able to critically evaluate the information in financial statements and other accounting reports so that they can assess its appropriateness.
Accounting systems are designed to allow measurement of various attributes of an entity. Attributes that accounting information can help measure include performance of an entity and its managers, the amount of tax an entity should pay, and the value of the entity.
Two characteristics of accounting information make it useful for measuring the attributes of an entity.
Accounting information is quantitative.
The accounting information that is produced by an accounting system is presented in terms of a single unit of measure, usually money.
There are often many ways to measure the same “thing.” For example, a car can be measured in terms of its cost, what it would cost to replace, what it could be sold for, and the amount for which it should be insured. These measures are stated in terms of dollars. There are many other measurements one could make for a car. Examples include its fuel efficiency, how fast it can go, its cargo capacity, and the number of people it can seat.
The measurements a decision maker needs will depend on the decision being made. This point is important. Accounting information that is presented by an entity may not necessarily provide appropriate measurements for every stakeholder. Stakeholders usually do not have the right to obtain or demand the exact information they require so it is important for them to understand the usefulness and limitations of the information they receive.
Accounting is a tool that has been developed by people as a means of providing information for decision making. Unlike gravity, accounting has no natural laws that define how it should be done. As a result, it is necessary to establish rules of the game. If there were no rules it would be much more costly and difficult to make sense of the information contained in accounting reports because it would be necessary to learn and understand the rules that each entity was using.
The rules in accounting are known as generally accepted accounting principles or GAAP. GAAP are the principles, conventions, practices, procedures, and rules that define acceptable accounting practices and guide the preparation of financial statements in certain situations. In other words, GAAP provide a structure for preparing financial statements.
There are a few limitations worth noting about GAAP:
GAAP are not universal. GAAP in each country differs.
Not every entity follows GAAP or has to follow GAAP.
GAAP are flexible. Preparers often have many choices that can affect the information contained in financial statements.
The CICAHandbook, which lays out the conceptual groundwork for Canadian GAAP and is the source of some specific GAAP, describes four qualitative characteristics that financial statement information must have if it is to be useful to users. The four characteristics are:
Understandability: Users must be able to understand information if it is to be useful to them.
Relevance: The information provided to users must be relevant or useful for the decisions they have to make.
Reliability: The information provided to users must be a reasonable measure of what it is intended to measure. In other words, the information must be precise and unbiased.
Comparability: Users should be able to compare the accounting information provided by different entities and the information of a particular entity from period to period.
In practice these characteristics often conflict so that trade-offs are often made in setting GAAP. Because of these trade-offs the information available under GAAP will not satisfy all users in all situations.
It is essential for any user or preparer of accounting information to know and understand GAAP. No user or preparer of accounting information can afford not to have an understanding of the concepts, principles, and rules that underlie GAAP. However, every user, preparer, and accountant must also understand that GAAP have significant problems and limitations. GAAP are not applicable to every user and every decision in every situation. Sophisticated users of financial statements will know when not to rely on GAAP-based statements, when to adjust the GAAP statements, and when to look elsewhere for information. Sophisticated users will also understand the flexibility that preparers of financial statements have even under GAAP and understand that this flexibility can have a significant effect on the appearance of the statements. We will explore these issues as we progress through the book.
