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: