Chapter 1: What is Accounting?

Chapter 1 \| What is Accounting: The Vital Role of Accounting in Modern Society Fundamentally, accounting a process of aggregating (or bringing together) information so that people can use this information to make good decisions. You've made a great choice to study accounting because accounting is...

Chapter 1 \| What is Accounting: The Vital Role of Accounting in Modern Society Fundamentally, accounting a process of aggregating (or bringing together) information so that people can use this information to make good decisions. You've made a great choice to study accounting because accounting is the language of business and touches every facet of business: operations, marketing, human resources, entrepreneurship, and finance. Not only that, but studying accounting will help you make smart personal financial decisions. In our communities, knowledge of accounting is crucial to achieving financial success, both personally and commercially. With this in mind, let's dive in. Accounting is a language used to understand and communicate financial information. This language can help us understand our personal finances better, such as reading our bank account, buying a new pair of pants or a car, grocery shopping, or getting student loans. And accounting language is universally used by businesses. Let's look at two examples: one in personal accounting and the other in business accounting. Personal accounting: let's say that you buy a new pair of sneakers with your debit card. In this simple transaction, accounting gives us a framework to record that your bank balance has gone down, but your sneaker collection has increased. Essentially, you haven't lost any value, you've just moved that value from your bank account to your sneaker collection. Business accounting: let's use the example of a bookstore. The bookstore will buy books and pay with cash. Here again, the transaction causes the company's bank balance to go down, but their inventory of books has gone up. The company hasn't lost value, just moved the value from their bank account to their book collection. Accounting creates a common framework to create meaning. As such, accounting records transactions, convey meaningful information. In the examples above, we see value in \$\$ moving from the bank account to an inventory account -- sneakers or books. But how does information actually get recorded and put together? A whole world of accounting systems and processes are used to record transactions, aggregate them, and sort into a meaningful form. In this chapter we will discuss the purpose of accounting., why accountants are actually superheroes), figure out who uses financial information (everyone!), and discuss what financial information should look like so that it's easy to use for decision making. **[What does accounting tell us?]** Accounting gives us a way of talking money: where it goes and how it could be used in the future. This is important for every facet of business. In fact, accounting is crucial for marketing, HR, and finance professionals. It is probably the most important topic you can cover in business school. Before we move on, there are a few bits of terminology that we need to clarify: \(1) Who produces accounting information? Accounting information is recorded and aggregated for ***entities***. You may ask "What is an entity?". Typically we would think of an entity as a company, but it could also be a person. For example, you could (and should) keep your own accounts so you can make informed decisions about how to spend your money (a budget). In this class, our entity is typically a company because companies tend to engage in more complicated transactions. So if we can learn to work with company accounting information, you shouldn't find your personal accounting too complicated \(2) What is a transaction? A ***transaction*** is a business activity (or event) that an entity engages in. An accounting transaction takes place if an entity gives something up (e.g. makes a cash payment) and/or gets something (e.g. sneakers for your collection). Examples are: buying a car, taking out a student loan, paying back these student loans, paying salaries or year-end bonuses to employees. Of course, an entity will engage in activities that don't involve paying cash or getting something. An example of a non-transaction is hiring an employee, for example, is a business activity with an employment contract ! But it doesn't involve giving up anything (at least not until the employee has worked and earned a paycheque)[^1^](#fn1){#fnref1.footnote-ref} and the company doesn't get anything until the employee contributes their efforts by working. So hiring an employee isn't an accounting transaction because nothing is given up (i.e., no cash paid yet) and nothing is received (i.e., employee effort). \(3) How often is accounting information reported? A ***reporting period*** is the span of time covered by a set of financial statements. Accountants use the word 'periodicity' to describe how a company's life is divided into artificial time periods. For example, Sears Canada opened in 1952 and closed its doors in 2018. Sears' life was 1952-2018, but these 66 years were divided into artificial time periods (i.e., fiscal year of February 1 to January 31 annually). The most common time period is the ***fiscal year***. Companies have a year-long reporting cycle that is similar in nature to the January to December calendar year, but companies get to choose what day their year will end on. It's not necessarily December 31. This reporting cycle is referred to as a 'fiscal year'. The most common fiscal year end date is December 31 (i.e. fiscal year January 1 to December 31), but March 31 (i.e., April 1 to March 31) and September 30 (i.e., October 1 to September 30) are also common. The idea of periodicity will be important when we talk about accruals in a later chapter. In technical terms, accounting gives us information about how transactions have affected an entity during a reporting period. Or more specifically, accounting aggregates similar transactions (e.g. all money paid for telephone bills, or paid for office supplies, or money received from customers) over a given reporting period. For example, we could look up (1) how much money Nike made in sneaker sales during the fiscal year June 1, 2018 to May 31, 2019 (answer: \$25,880,000 U.S.); or (2) how much Nike paid for the merchandise (e.g., sneakers and clothing) in their stores at May 31, 2019 (answer: \$5,622,000 U.S.).[^2^](#fn2){#fnref2.footnote-ref} **[Who uses accounting information?]** Users of accounting information can be internal to the company or external. Internal users have another contract with the company, usually an employment contract, so they have a closer relationship with the company than external users. Let's take a look. *Internal information* Internal accounting, looks different in each company and depends on the decisions a particular company is trying to make. Essentially, financial information for internal users is flexible; this information is meant to answer a particular problem. For example, a marketing manager might be interested in making sure the company has enough cash in the bank to introduce and market a new product line. Or human resources may want to know how much money is available for employee training. Every department in a company uses accounting information on a regular basis to make decisions, so internal information users will likely need to understand accounting to progress in their careers. Although there is a distinct stream of accounting called 'management accounting' (you'll probably take an undergraduate course with the same name), all management decisions are firmly rooted in the financial accounting concepts that we discuss in this course. *Internal information users* When we refer to internal users, we usually mean ***managers*** such as the Chief Executive Officer (CEO), the Chief Financial Officer (CFO), Chief Operations Officer (COO), Controller, or Head of a Division. These managers use information to make decisions for the company. For example, a manager may ask whether the company should expand operations, how much to pay employees, whether to hire more employees, which supplier to purchase from, or how much to charge for a product or service. ***Employees*** are another internal user of financial information. Employees have information about a company's culture, processes, and other aspects related to their respective job position. How are managers and employees different? While managers have high-level leadership positions, employees deliver on the managers' decisions. If we use the example of a pharmaceutical company, employees may work in labs developing new drugs, or may visit physicians as salespersons (providing samples and information). Accountants, marketers, and product developers are also examples of employees. What decisions might an employee want to make? Consider that an employee, a lab technician for example, has many employment opportunities. A lab tech may work for a pharmaceutical company like GlaxoSmithKline, but there are many other companies in the industry where they could work (i.e., AstraZeneca, Merck, Pfizer, etc.). An employee will use the information available to her to decide whether to stay at her current employment or work elsewhere. This decision will hinge on salary, opportunities for career progression, corporate culture, vacation time, and office location among other considerations. What kind of information is important to make employment decisions? An employee might look at indicators of financial health such as profit to determine whether a company can sustain its workforce, and whether the company is able to increase wages over time. As an employee, maybe you'd want to know if you can negotiate a pay increase or if company can afford to pay you a performance bonus. Or maybe you'd be interested in how much the employer pays into your pension. Accounting information gives employees power to make good decisions about where to work, and power to negotiate better employment contracts. In truth, employees make decisions based on internal and external sources of information. They have internal information about the company they work for, and external information about potential employers. Now that we've discussed internal users and the financial information they might use, let's take a look at external information and users. *External information* External information is available publicly to anyone who requests it.[^3^](#fn3){#fnref3.footnote-ref} Most of the time, this information is on websites, in the news, or in social media. The most comprehensive source of financial information is a company's annual report. The annual report is in two parts: narratives and financial statements. Narratives: In this section, management gets to share their perspective on how the company performed and what their goals are for the next year. Sometimes this section is called the management discussion and analysis, or the MD&A. Narratives (MD&A) give context to the financial statements. This is important because the financial statements have a standard (rigid) format with no real capacity for explanation or illustration. Narratives allows management to describe their business model in their own words: to tell a story about how they create value in the market, their strategy, objectives, and current performance. For example, Sephora describes its business model and strategy as follows[^4^](#fn4){#fnref4.footnote-ref}: Business model and strategy are fundamental in accounting because they give us information on how the company evaluates itself and the types of financial information that are of particular interest to them. Look back at Sephora's business model. How might they evaluate how they're performing? They might be interested in the number of brands carried in-store, or how many new offerings are introduced each year. Looking at Sephora's annual report, we may expect to find financial information that is separated by offering: new products, classics, and the Sephora collection. Sephora may also want to benchmark against other beauty stores (i.e., their competition) to demonstrate the effectiveness of their "revolutionary beauty-retail concept". Business model and strategy is so important for financial information users! Financial statements: This section includes the audited financial statements and financial statement notes. Financial statements provide information on what the company owns (cash, buildings, equipment, and patents, for example), what it owes (to suppliers, the bank, or wages to employees), and how it uses its resources to create value. Financial statement notes give detailed information on items in the financial statements so that readers can get all the information they need without the financial statements themselves getting over-complicated. This is the place to look if you want to become intimately familiar with a company. If you are interested in finance, you will look to the financial statement notes to get an advantage in stock trading. This class focusses on financial statements, and this entire book is about preparing financial statements, so don't worry if some of these ideas are foreign to you now. We'll get there! *External information users* Now that we know the types of information that are disclosed, and where we might find them, let's turn back to users of financial information: who are our external users? This question is more difficult to answer comprehensively because there are so many potential external users. These users rely primarily on external financial information, although some (banks, analysts, large investors) may have internal information sources as well. External users include investors (shareholders, or the bank), customers, suppliers, the government, public interest groups, the community (whose resources a company shares), and society. Let's consider these in turn. ***Investors*** may own shares in a company (shareholder) or may own company debt (debtholder; such as a bank that loans a company money). A share is a percentage ownership stake in a company. That means if the company does well, the share is worth more; but if the company goes bankrupt, the share is worthless. If a company's shares are traded on a public exchange like the Toronto Stock Exchange (TSX), we say that the company is 'publicly traded'. Companies whose shares are not traded are called 'private companies'.[^5^](#fn5){#fnref5.footnote-ref} Try looking up the most recent annual report for a publicly traded company like The Second Cup by typing "The Second Cup, annual report" into your search engine. You should get results. Now try looking up a private company like Booster Juice. There isn't much financial information available for Booster Juice because it is privately held. What decisions are investors trying to make? Investors need to decide where to invest their money. Let's say there are two such possible companies, company A or company B. What information do investors need to decide which company to invest in Investors need financial information to determine (1) what the future return on investment will be (i.e. how much money do I expect to make from this investment), (2) how risky the investment is, and (3) the timing of cash flows. To predict how the company will perform in the future, we might look at historical trends: how has the company generated returns in the past, and is the trend likely to continue or how might it change? An investor might look at profit and company structure (including production facilities and intellectual property in place) to predict future returns on investment. Similarly, we can estimate risk by looking at volatility in stock price and profit. Industries like energy, financials, and technology tend to have volatile stock prices, meaning that the price fluctuates intensely and often.[^6^](#fn6){#fnref6.footnote-ref} Every investor is in a different position. Consider, for example, an investor who is close to retirement and wants to start withdrawing cash right away. This investor will likely consider a low-risk investment with high dividends. The opposite is true for a young investor saving for retirement who will choose higher risk and lower dividend investments to benefit from higher returns (which are only available as risk increases). And the investor doesn't care about dividends at early career; she'll just to re-invest them because she doesn't want money until retirement. I'm excited for you to learn more about investing in your Introduction to Finance class. Investing theories are exciting and there's much more to learn, but we'll stop here. Just know that to make profitable investments, you'll need good accounting skills. Now, what other external users are making decisions from financial information? ***Customers*** make decisions about what products and services to buy and from whom. Before a customer makes a major purchase, he may consider whether the company will be around to repair the product or take returns. To do this, this customer may look at cash flow to see if the company has enough cash coming in to support current operations. He may also look at profitability: is the company selling enough product at a reasonable price to cover their expenses (cost of product sold, utility bills, employee salaries, etc.)? The customer will most definitely look at the company business model and strategy to ensure that the company intends to continue selling and servicing the product in the future. Financial information is particularly important for corporate customers who buy and resell a product, or use the product in their manufacturing process. For example, if a car dealership can't buy vehicles (maybe because of backorder or supplier bankruptcy), then this dealership may not be able to generate enough cash to pay their rent or their employees, and may be forced to go out of business. ***Suppliers*** are providers of products. For example, Ford and Toyota supply cars to dealerships. Suppliers need information so they can forecast future sales. That is, suppliers need to know that their customer (e.g., a car dealership) will survive and continue purchasing into the future, and estimate how much the supplier will be able to purchase. Suppliers have to decide what products to sell, in what quantity, and at what price. And financial information helps suppliers to make these decisions. ***Government*** may be federal (e.g. Canadian government), provincial (e.g. Saskatchewan), or municipal (e.g. City of Regina). Government organizations use financial information for tax purposes. In Canada, companies pay income taxes, and the tax forms start with accounting profit (followed by lots of fun adjustments that you'll see in your accounting for income tax course!). Companies also withhold and submit sales tax to the government (GST, PST, and HST) which is calculated and reported through a company's accounting system. The other decision government makes is whether to offer subsidies. We can think of subsidies as the opposite of taxation. Subsidies are cash paid from the government to companies in targeted industries to keep prices low and competitive for consumers. Examples of industries given subsidies include oil, agriculture, and housing; industries that provide important public goods/services. Government looks at profit figures (and other economic factors) to determine whether an industry requires bolstering to continue operating at low cost to consumers. ***Communities** are places where people work, live, and (hopefully!) get along. Companies are closely tied with communities and need community support to exist. After all, communities share their natural resources (e.g., water, land, air), time (e.g., as employees), and infrastructure (e.g., roadways) with companies. And it is likely that the community forms a supply chain, particularly in small companies (where buyers and purchasers live in the same communities). So communities are inextricably linked and members have to get along in order to function. Companies are part of communities, and many companies share how their operations affect the community in their financial reports.* *Perhaps you can think of other financial information users. It is fascinating that so many of the processes we take for granted: our work, shopping, taxes, buying a house, and operating a community and society are all based on an intricate web of accounting. Even the university: your tuition, government grants, community research, the university bookstore, the cafeteria and restaurants, rely on accounting to relate and communicate to internal users (like the president's office) and externally (to the government, or to you!).* ***[Accountants as Truth-Telling Superheroes]*** *You may be thinking, "this is all well and good, but what do accountants actually do?". Great question. What is the role of accountants? **Accountants are truth-tellers about the economic reality of an entity.** This means that accountants are responsible for communicating useful and transparent information to managers, employees, shareholders, debtholders, government, suppliers, customers, community, and any other users of financial information. In brief, accountants are society's protectors, defending investors, employees, and communities from potential harms caused by companies.* *The role of accountants is to hold companies to account. If companies communicate through financial information, and accountants are responsible for the production and verification of this information, then the accounting profession (and the ethics, skill, and professionalism of accountants) is the glue that holds markets and society together. I hope that whatever role you find yourself in, in business and in life, that you can see the importance of accounting. Whether or not you agree with capitalism or the role of business in society; whether your focus is finance, marketing, HR, starting a business, managing a personal budget, charity work, or community activism; you engage with accounting information. Let's take this time, in this course (and hopefully many others!), to become acquainted with accounting information and the people and processes that create useful, transparent information.* ***[Review]*** *Before we move on to the process of financial information production, here's a chance to see how much you've learned. Answer the following questions using the space provided, then go back into the chapter to find the answer. Be sure to write your answers down -- this process is super helpful when preparing for an exam! If you struggle to answer without referring to the chapter, re-read the chapter and try again.* *Test your comprehension by writing your answer to these questions:* 1. What two primary internal users rely on financial information? How do they use this information? 2. How do governments use financial information? What types of decisions to they make? 3. Give three examples of economic transactions. Why does it matter that accountants tell the truth about these transactions? 4. What types of economic entities use accounting? Is knowledge of accounting only useful for corporate accounting? 5. Why is an accountant's job important? Who do accountants protect? 6. Accountants specialize in recording and reporting financial information. Is accounting only important to accountants? What other business professionals need to understand accounting? What is an example of a decision other business professionals need accounting information to make? ::: {.section.footnotes} ------------------------------------------------------------------------ 1. ::: {#fn1} Paying employees is a transaction: the company gives up cash from its account; similarly every hour of employee effort is a transaction: as an employee works the company gets some benefit.[↩](#fnref1){.footnote-back} ::: 2. ::: {#fn2} See [↩](#fnref2){.footnote-back} ::: 3. ::: {#fn3} All companies listed on a stock exchange (i.e. publicly listed companies) are mandated to report annually, but most also disclose quarterly reports.[↩](#fnref3){.footnote-back} ::: 4. ::: {#fn4} See [↩](#fnref4){.footnote-back} ::: 5. ::: {#fn5} And the process of a publicly listed company buying back its shares for private ownership is called "going private". If the shares are not traded on an exchange, they are usually closely held (i.e. the CEO and his/her family own the shares).[↩](#fnref5){.footnote-back} ::: 6. ::: {#fn6} Risk and reward go hand in hand, meaning that on average risky stocks yield the highest returns. I mean, investors have to be compensated for the risk somehow! On the other hand, investments in treasury bonds (or your savings account at the bank) have very low returns because there's virtually no risk associated with them. You're pretty much guaranteed that the cash you deposited will be available to withdraw in the future.[↩](#fnref6){.footnote-back} ::: :::