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Introduction to Accounting :: Shyam V. Sunder :: University of Arizona 0
I have written these pre-
course notes for students
in ACCT 540: Introduction
to Accounting to
introduce you to the
content of the course.
The notes are written
assuming that you have
no prior exposure to
accounting and financial
reporting. If this is not
applicable in your case,
please use this reading as
a refresher.
The notes are not
intended to be a
substitute for the
textbook.
I have written these
notes in an informal and
conversational tone. So
please view these notes
as a starter-kit for the
class and we will use the
content as a starting
point to build-up in class.
Introduction to Accounting
An overview of key terms and concepts
Prof. Shyam V. Sunder
University of Arizona
Contents
1. What is accounting? Page 1 2. What is financial reporting? Page 4
3. Financial reports and the
firms operations Page 8
4. Contents of financial reports Page 11
5. Solutions to exercise problems Page 18
Introduction to Accounting :: Shyam V. Sunder :: University of Arizona 1
Accounting is an information system of a firm that captures
outcomes of economic activities resulting from decisions by
managers and influence of the environment
Chapter 1
What is accounting?
Let us understand each part of the definition.
Information system refers to the systematic
production and reporting of quantitative
information about the firm.
The information production is systematic since
the firm adheres to a set of accounting rules that
are applied consistently over time.
The information is quantitative to enable
interpretations about the performance and
financial health of the firm
outcomes of economic activities the system
generates information that aids in interpretation
of actions of the firm. The actions ultimately
impact value generation in the firm are therefore
referred to as economic transactions.
decisions by managers and the influence of the
environment economic transactions arise due to
conscious decisions of the managers or due to
forces in the environment. Managers are tasked
with operating the business of the firm and
managing the firms economic resources.
As a result managers enter into economic
transactions that increase firm value.
Forces from the environment, such as
regulators, competitors, weather, etc. can
also lead to economic transactions.
Lets look at an example to understand the
elements of the definition:
Sales in the last year are $1 million
What is the economic transaction?
Selling of products
What is the outcome?
Receipts from selling activities are $1 million
What are the decisions by the managers?
Produce, advertise and sell the product
How is this information useful?
The information helps in understanding value
generated from managerial actions to sell the
product.
Introduction to Accounting :: Shyam V. Sunder :: University of Arizona 2
Types of accounting information systems
Depending on the decision makers, accounting information systems are broadly of two types.
Financial Accounting: Financial accounting
information is used to communicate
information about a firms operations to
users who are outside of the firm.
Since the users are outside of the firm it is
important that the information produced by
the firm is credible. Users may not have the
ability discern if the information is correct
on a real time basis. In economics, this
problem is more generally referred to as
the information asymmetry between the
firm and the external users of the
information. In the next chapter we will see
how this information asymmetry problem
can be mitigated.
The outside users of the information and
the decisions they make is illustrated in Fig
1.1
Managerial Accounting: Managerial
accounting information is used to
communicate information about the firm to
users who are inside of the firm. The inside
users of information include the managers
at various levels who need the information
to make operating decisions.
Surprisingly, the problem of information
asymmetry can also exist in the managerial
accounting system too! This happens as
competing managers produce biased
information to support their point of view.
The inside users of the information and the
decisions they make is illustrated in Fig 1.2.
User Decision
Owner Add to ownership in the firm, referred to as equity owners Lender Lend money to the firm, referred to as creditors
Regulator Pass laws to regulate the firms activities including taxes, competition, etc. Supplier Whether to sell and at what terms such as price, quantity, payment, etc.
Employee Whether to seek a job, quit, or to determine compensation level
User Decision
Finance manager What amount of cash to hold to meet obligations? What would be an affordable rate of interest on loans?
Marketing manager
How to price a new product or service; how many units to sell in a sales territory?
Production manager
How many units to produce ensure that costs are met; whether to buy or rent a new machine?
Human resources manager
What should be salary level for employees; whether to hire more workers or subcontract work?
Divisional manager Which units to shut down? Which product lines are most profitable?
Fig 1.1 Users and decisions under financial accounting information system
Fig 1.2 Users and decisions under managerial accounting information system
Introduction to Accounting :: Shyam V. Sunder :: University of Arizona 3
The following graphic, summarizes the key differences between financial and managerial
accounting information.
Information System
Financial Accounting
Managerial Accounting
Decision Makers
External
Internal
Decisions
Invest? Lend?
Regulate?
Employment?
Invest in new equipment?
Launch in new
markets? How much to
produce?
Preparation Basis
All firms use generally accepted
accounting principles
(GAAP)
Firms use customized reporting systems
Exercise 1.1
Analyze the following statements from the accounting information system. What is the
outcome, economic transaction, and managerial decision?
1. Salaries paid to employees are $10,000
2. We spent $3 million for product innovation
Your answer should articulate four elements for each of the questions
- What is the economic transaction?
- What is the outcome?
- What are the decisions by the managers?
- How is this information useful?
Introduction to Accounting :: Shyam V. Sunder :: University of Arizona 4
Chapter 2
What is financial reporting?
Let us understand the definition,
process financial reporting is more than
accounting. It starts with recording of
economic transactions (accounting), then
classifying similar transactions in a
meaningful manner, tabulating their
economic effects, and finally reporting the
information in a format that is meaningful
to users.
aggregating economic transactions a
typical firm undertakes many transactions
so they are aggregated based on common
characteristics and the aggregate effects
are reported. For example, Nike Inc.
reported sales of $27,799 million for the
year 2014. Let us assume that they only sell
shoes and the average price of a pair of
shoes is $100. This would mean that on
average they sell 278 million pairs in a year
and would have 278 million sales
transactions alone! It would be herculean
task to report individual transactions and
even if it is accomplished, users may find it
hard to comprehend the information. Thus
Nike Inc. reports sales as an aggregate
number.
snapshots called financial reports - the
downside of aggregating economic
transactions is that there is an information
loss. For example, users of Nike Inc.
financial reports may wish to know how
many pairs of shoes were sold, where they
were sold and at what price or wish to
know if more shoes sell at particular times
in the year, etc. Aggregating sales would
lead to loss of such useful information. To
mitigate this information loss, reporting is
done after passage of a reasonable interval
of time, typically every 3 months and every
12 months. The reporting date is chosen by
the firm and is changed very rarely.
disclosed to external users the financial
reports are required to be disclosed in a
specific format, which will be discussed in
Chapter 4. The financial reports are
required to be disclosed publicly if the firm
has raised money from public owners or
borrowed from the general public.
We can illustrate the linkage between
economic transactions, accounting, and
financial reporting in the following way: