Accounting—Present and Past PDF

Final PDF to printer Accounting— 1 Present and Past The worldwide financial and credit crisis that came to a head in the fall of 2008 was precipitated...

Final PDF to printer Accounting— 1 Present and Past The worldwide financial and credit crisis that came to a head in the fall of 2008 was precipitated by many factors. Not the least of these factors were greed, inadequate market regulatory supervi- sion, and an excess of “financial engineering” involved in the creation of financial instruments that almost defied understanding even by sophisticated investors. This crisis was preceded in the first decade of the century by the bankruptcy filings of two large, publicly owned corporations, which resulted in billions of dollars of losses by thousands of stockholders. In 2001, it had been Enron Corporation, and a few months later, WorldCom Inc. In each case, a number of factors caused the precipitous fall in the value of the firms’ stock. The most significant factor was probably the loss of investor confidence in each company’s financial reports and other disclosures reported to stock- holders and regulatory bodies, including the Securities and Exchange Commission (SEC). The Enron and WorldCom debacles, and other widely publicized breakdowns of corporate financial reporting, resulted in close scrutiny of such reporting by the accounting profession itself and also by the U.S. Congress and other governing bodies. The accounting practices that were criticized generally involved complex transactions. Also contributing to the issue were aggressive attempts by some executives to avoid the spirit of sound accounting, even though many of the financial reporting practices in question were not specifically forbidden by existing accounting pronouncements at that time. To be sure, the financial reporting requirements faced by companies whose securities are publicly traded have since become more strenuously scrutinized under the Sarbanes–Oxley Act of 2002 (SOX) and the watchful eye of the Public Company Accounting Oversight Board (PCAOB), which is the regulatory body created under SOX to oversee the activities of the auditing profession and fur- ther protect the public interest. These enhanced regulatory efforts have helped to increase the transparency of the financial reporting process and the understandability of financial statements. Although the financial crisis that disrupted the financial world in 2008 was not directly blamed on financial accounting or auditing weaknesses, some accounting and financial reporting practices that existed at that time were severely criticized. This book briefly addresses some of the more troublesome technical issues still faced by the accounting profession today, but the elaborate attempts to embellish the financial image of those companies in question certainly went beyond the fundamentals described in the following pages. mar26743_ch01_002-027.indd 2 11/08/21 09:10 AM  Final PDF to printer Chapter 1 Accounting—Present and Past 3 The objective of this text is to present enough of the fundamentals of accounting to permit the nonaccountant to understand the financial statements of an organization operating in our soci- ety and to understand how financial information can be used in the management planning, control, and decision-making processes. Although usually expressed in the context of profit-seeking busi- ness enterprises, most of the material presented here is equally applicable to not-for-profit social service and governmental organizations. Accounting is sometimes called the language of business, and it is appropriate for people who are involved in the economic activities of our society—and that is just about everyone—to know at least enough of this language to be able to make decisions and informed judgments about those economic activities. LE A RN I N G O BJ E C TI V E S After studying this chapter, you should understand and be able to LO 1-1 Explain the definition of accounting. LO 1-2 Identify who the users of accounting information are and explain why they find accounting information useful. LO 1-3 Identify the variety of professional services that accountants provide. LO 1-4 Summarize the development of accounting from a broad historical perspective. LO 1-5 Explain the role that the FASB plays in the development of financial accounting standards. LO 1-6 Generalize about how financial reporting standards evolve. LO 1-7 Identify the key elements of ethical behavior for a professional accountant. LO 1-8 Summarize the reasons for the FASB’s Conceptual Framework project. LO 1-9 Summarize the objective of general-purpose financial reporting. LO 1-10 Describe the plan of the book. What Is Accounting? In a broad sense, accounting is the process of identifying, measuring, and communi- LO 1-1 cating economic information about an organization for the purpose of making deci- Explain the definition of sions and informed judgments. (Accountants frequently use the term entity instead of accounting. organization because it is more inclusive.) This definition of accounting can be expressed schematically as follows: Accounting is the process of Identifying Communicating} Economic information For decisions and Measuring → about an entity informed judgments mar26743_ch01_002-027.indd 3 11/08/21 09:10 AM  Final PDF to printer 4 Chapter 1 Accounting—Present and Past Exhibit 1-1 User Decision/Informed Judgment Made Users and Uses of Accounting Information Management When performing its functions of planning, directing, and controlling, management makes many decisions and informed judgments. For example, when considering the expansion of a product line, planning involves identifying and measuring costs and benefits; directing involves communicating the strategies selected; and controlling involves identifying, measuring, and communicating the results of the product line expansion during and after its implementation. Investors/shareholders When considering whether to invest in the common stock of a company, investors use accounting information to help assess the amounts, timing, and uncertainty of future cash returns on their investment. LO 1-2 Creditors/suppliers When determining how much merchandise to ship to a customer before Identify who the users receiving payment, creditors assess the probability of collection and the of accounting informa- risks of late (or non-) payment. Banks also become creditors when they tion are and explain why make loans and thus have similar needs for accounting information. they find accounting Employees When planning for retirement, employees assess the company’s ability information useful. to offer long-term job prospects and an attractive retirement benefits package. SEC (Securities and When reviewing for compliance with SEC regulations, analysts Exchange Commission) determine whether financial statements issued to investors fully disclose all required information. Who makes these decisions and informed judgments? Users of accounting infor- mation include the management of the entity or organization; the owners of the orga- nization (who are frequently not involved in the management process); potential investors in and creditors of the organization; employees; and various federal, state, and local governmental agencies that are concerned with regulatory and tax matters. Exhibit 1-1 describes some of the users and uses of accounting information. Pause, and try to think of at least one other decision or informed judgment that each of these users might make from the economic information that could be communicated about an entity. Accounting information is required for just about every kind of organization. When accounting is mentioned, most people initially think of the information needs and reporting requirements of business firms, but not-for-profit social service organi- zations, governmental units, educational institutions, social clubs, political commit- tees, and other groups all require accounting for their economic activities as well. Accounting is frequently perceived as something that others who are good with numbers do, rather than as the process of providing information that supports deci- sions and informed judgments. Relatively few people become accountants, but almost all people use accounting information. The principal objective of this text is to help you become an informed user of accounting information, rather than to prepare you to become an accountant. However, the essence of this user orientation provides a solid foundation for students who choose to seek a career in accounting. If you haven’t already experienced the lack of understanding or confusion that results from looking at a set of financial statements, you have been spared one of life’s frustrations. Certainly during your formal business education and early during your employment experience, you will be presented with financial data. Being an informed user means knowing how to use those data as information. The following sections introduce the major areas of practice within the account- ing discipline and will help you understand the types of work done by professional mar26743_ch01_002-027.indd 4 11/08/21 09:10 AM  Final PDF to printer Chapter 1 Accounting—Present and Past 5 accountants within each of these broad categories. In a similar way, the accompanying Business in Practice discussion highlights career opportunities in accounting. 1. What does it mean to state that the accounting process should support decisions and informed judgments? Q What Does It Mean? Answer on page 27 Career Opportunities in Accounting Because accounting is a profession, most entry-level positions require at least a bachelor’s degree with a major in accounting. Individuals are encouraged to achieve Certified Public Accountant (CPA) licensure as quickly as feasible and/or to attend graduate school to pursue an area of specialization. Persons who work hard and smart can expect to attain high professional Business in levels in their careers. The major employers of accountants include public accounting firms, Practice industrial firms, government, and not-for-profit organizations. Public Accounting The work done by public accountants varies significantly depending on whether they are employed by a local, regional, or international CPA firm. Small local firms concentrate on the book- keeping, accounting, tax return, and financial planning needs of individuals and small businesses. These firms need generalists who can adequately serve in a variety of capacities. The somewhat larger, regional firms offer a broad range of professional services but concentrate on the per- formance of audits (frequently referred to as attestation or compliance services), corporate tax returns, and management advisory services. They often hire experienced financial and industry specialists to serve particular client needs, in addition to recruiting well-qualified recent graduates. The large, international CPA firms also perform auditing, tax, and consulting services. Their principal clients are large domestic and international corporations. The “Big 4” CPA firms are Deloitte Touche Tohmatsu (Deloitte), PricewaterhouseCoopers (known as PwC), EY (formerly Ernst & Young), and KPMG International (KPMG). These firms dominate the market in terms of total revenues; number of corporate audit clients; and the number of offices, partners, and staff members. The Big 4 international firms generally recruit outstanding graduates and highly expe- rienced CPAs and encourage the development of specialized skills by their personnel. (Visit any of the Big 4 websites for detailed information regarding career opportunities in public accounting: deloitte.com, pwc.com , ey.com, or kpmg.com.) Industrial Accounting More accountants are employed in industry than in public accounting because of the vast num- ber of manufacturing, merchandising, and service firms of all sizes. In addition to using the ser- vices of public accounting firms, these firms employ cost and management accountants, as well as financial accountants. Many accountants in industry start working in this environment right out of school; others get their start in public accounting as auditors but move to industry after getting at least a couple of years of experience. Government and Not-for-Profit Accounting Opportunities for accounting professionals in the governmental and not-for-profit sectors of the economy are constantly increasing. In the United States, literally thousands of state and local government reporting entities touch the lives of every citizen. Likewise, accounting specialists are employed by colleges and universities, hospitals, and voluntary health and welfare organiza- tions such as the Salvation Army, American Red Cross, United Way, and Goodwill. mar26743_ch01_002-027.indd 5 11/08/21 09:10 AM  Final PDF to printer 6 Chapter 1 Accounting—Present and Past Financial Accounting LO 1-3 Financial accounting generally refers to the process that results in the preparation Identify the variety of and reporting of financial statements for an entity. As will be explained in more detail, professional services financial statements present the financial position of an entity at a point in time, the that accountants results of the entity’s operations for some period of time, the cash flow activities for provide. the same period, and other information (the notes to the financial statements or finan- cial review) about the entity’s financial resources, obligations, owners’/stockholders’ interests, and operations. Financial accounting is primarily oriented toward the external user. The financial statements are directed to individuals who are not in a position to be aware of the day-to-day financial and operating activities of the entity. Financial accounting is also primarily concerned with the historical results of an entity’s performance. Financial statements reflect what has happened in the past. Although readers may want to proj- ect past activities and their results into future performance, financial statements are not a crystal ball. Many corporate annual reports refer to the historical nature of finan- cial accounting information to emphasize that users must make their own judgments about a firm’s future prospects. Bookkeeping procedures are used to accumulate the financial results of many of an entity’s activities, and these procedures are part of the financial accounting and process. Bookkeeping procedures have been thoroughly systematized using manual, mechanical, and computer techniques. Although these procedures support the finan- cial accounting and reporting process, they are only a part of the process. Financial accounting is done by accounting professionals who have generally earned a bachelor’s degree with a major in accounting. The financial accountant is employed by an entity to use her or his expertise, analytical skills, and judgment in the many activities that are necessary for the preparation of financial statements. The title controller is used to designate the chief accounting officer of a corporation. The con- troller is usually responsible for both the financial and managerial accounting func- tions of the organization (as discussed later). Sometimes the title comptroller (the Old English spelling) is used for this position. An individual earns the Certified Public Accountant (CPA) professional des- ignation by fulfilling certain education and experience requirements and passing a comprehensive four-part examination. A uniform CPA exam is given nationally, although it is administered by individual states.1 Some states require that candidates have accounting work experience before sitting for the exam. Each of the 55 U.S. juris- dictions, including all 50 states, have now enacted legislation increasing the educa- tional requirements for CPA candidates from 120 semester hours of college study, or a bachelor’s degree, to a minimum of 150 semester hours of college study to be granted licensure as a CPA. Thirty-two of these states allow candidates to sit for the CPA exam with 120 hours, but require 150 hours for certification.2 The American Institute of Certified Public Accountants (AICPA), the national professional organization of CPAs, has also endorsed this movement by requiring that an individual CPA wanting to become a member must have met the 150-hour requirement. This increase in the educational requirements for becoming a CPA and for joining the AICPA reflects the 1 Since 2004, CPA candidates have been allowed to schedule their own exam dates; they may sit for one part at a time because the examination is now computer-based. The former “pencil and paper” CPA exam has become a relic of the past. 2 See becker.com/cpa-review/requirements to learn about the requirements for your state. mar26743_ch01_002-027.indd 6 11/08/21 09:10 AM  Final PDF to printer Chapter 1 Accounting—Present and Past 7 increasing demands placed on accounting professionals to be both broadly educated and technically competent. Practicing CPAs work in all types of organizations, but as explained later, a CPA who expresses an auditor’s opinion about an entity’s financial statements must be licensed by the jurisdiction/state in which she or he performs the auditing service. Managerial Accounting/Cost Accounting Managerial accounting is concerned with the use of economic and financial informa- tion to plan and control many activities of the entity and to support the management decision-making process. Cost accounting is a subset of managerial accounting that relates to the determination and accumulation of product, process, or service costs. Managerial accounting and cost accounting have primarily an internal orientation, in contrast to the primarily external orientation of financial accounting. Many of the same data used in or generated by the financial accounting process are used in mana- gerial and cost accounting, but the data are more likely to be used in a future-oriented way, such as in the preparation of budgets. A detailed discussion of the similarities and differences between financial and managerial accounting is provided in Chapter 12 and highlighted in Exhibit 12-1. Managerial accountants and cost accountants are professionals who have usually earned a bachelor’s degree with a major in accounting. Their work frequently involves close coordination with the production, marketing, and finance functions of the entity. The Certified Management Accountant (CMA) designation can be earned by a management accountant or cost accountant by passing a broad two-part examination. Each part of the CMA examination is given in a computer-based format and con- sists of three hours of descriptive (multiple-choice) questions and two 30-minute essay questions. Auditing—Public Accounting Many entities have their financial statements reviewed or examined by an indepen- dent third party. In most cases, an audit (examination) is required by securities laws if the stock or bonds of a company are owned and publicly traded by investors. Public accounting firms and individual CPAs provide this auditing service, which consti- tutes an important part of the accounting profession. The result of an audit is the independent auditor’s report. The report usually has four relatively brief paragraphs. The first paragraph identifies the financial statements that were audited, explains that the statements are the responsibility of the company’s management, and states that the auditor’s responsibility is to express an opinion about the financial statements. The second paragraph explains that the audit was conducted “in accordance with the standards of the Public Company Accounting Oversight Board (United States)” and describes briefly what those standards require and what work is involved in performing an audit. (In effect, they require the application of generally accepted auditing standards, or GAAS.) The third paragraph contains the auditor’s opinion, which is usually that the named statements “present fairly, in all material respects” the financial position of the entity and the results of its operations and cash flows for the identified periods “in conformity with U.S. generally accepted account- ing principles.” This is an unqualified, or “clean,” opinion. Occasionally the opinion will be qualified with respect to fair presentation, departure from generally accepted accounting principles (GAAP), or the auditor’s inability to perform certain audit- ing procedures. Similarly, an explanatory paragraph may be added to an unqualified mar26743_ch01_002-027.indd 7 11/08/21 09:10 AM  Final PDF to printer 8 Chapter 1 Accounting—Present and Past opinion regarding the firm’s ability to continue as a going concern (that is, as a viable economic entity) when substantial doubt exists. An unqualified opinion is not a clean bill of health about either the current financial condition or the future prospects of the entity. Readers must reach their own judgments about these and other matters after studying the annual report, which includes the financial statements and the notes to the financial statements, as well as management’s extensive discussion and analysis. A final paragraph makes reference to the auditors’ opinion about the effectiveness of the company’s internal control over financial reporting. The entire auditors’ report is further discussed in Chapter 10. Auditors who work in public accounting are professional accountants who usually have earned at least a bachelor’s degree with a major in accounting. The auditor may work for a public accounting firm (a few firms have several thousand partners and pro- fessional staff) or as an individual practitioner. Most auditors seek and earn the CPA designation; the firm partner or individual practitioner who signs the audit opinion must be a licensed CPA in the state in which she or he practices. To be licensed, the CPA must satisfy the character, education, examination, and experience requirements of the state or other jurisdiction. To see an example of the independent auditors’ report, refer to pages 87–88 in Campbell’s the 2020 annual report of Campbell Soup Company, selected portions of which are reproduced in the appendix. Q What Does It Mean? Answers on page 27 2. What does it mean to work in public accounting? 3. What does it mean to be a CPA? Internal Auditing Organizations with many plant locations or activities involving many financial trans- actions employ professional accountants to do internal auditing. In many cases, the internal auditor performs functions much like those of the external auditor/public accountant, but perhaps on a smaller scale. For example, internal auditors may be responsible for reviewing the financial statements of a single plant or for analyzing the operating efficiency of an entity’s activities. The qualifications of an internal audi- tor are similar to those of any other professional accountant. In addition to having the CPA and the CMA designation, the internal auditor may have also passed the exami- nation to become a Certified Internal Auditor (CIA). Governmental and Not-for-Profit Accounting Governmental units at the municipal, state, and federal levels and not-for-profit enti- ties, such as colleges and universities, hospitals, and voluntary health and welfare organizations, require the same accounting functions to be performed as do other accounting entities. Religious organizations, labor unions, trade associations, perform- ing arts organizations, political parties, libraries, museums, country clubs, and many other not-for-profit organizations employ accountants with similar educational qualifi- cations as those employed in business and public accounting. mar26743_ch01_002-027.indd 8 11/08/21 09:10 AM  Final PDF to printer Chapter 1 Accounting—Present and Past 9 Income Tax Accounting The growing complexity of federal, state, municipal, and foreign income tax laws has led to a demand for professional accountants who are specialists in various aspects of taxation. Tax practitioners often develop specialties in the taxation of individuals, partnerships, corporations, trusts and estates, or in international tax law issues. These accountants work for corporations, public accounting firms, governmental units, and other entities. Many tax accountants have bachelor’s degrees and are CPAs; some have a master’s degree in accounting or taxation or are attorneys as well. How Has Accounting Developed? Accounting has developed over time in response to the needs of users of financial LO 1-4 statements for financial information to support decisions and informed judgments Summarize the devel- such as those mentioned in Exhibit 1-1 and others that you were challenged to identify. opment of accounting Even though an aura of exactness is conveyed by the numbers in financial statements, from a broad historical a great deal of judgment and approximation is involved in determining the numbers perspective. to be reported. Although broad, generally accepted principles of accounting exist, dif- ferent accountants may reach different but often equally legitimate conclusions about how to account for a particular transaction or event. A brief review of the history of the development of accounting principles may make this often confusing state of affairs a little easier to understand. Early History It is not surprising that evidence of record keeping for economic events has been found in the earliest civilizations. Dating back to the clay tablets used by Mesopotamians in about 3000 B.C. to record tax receipts, accounting has responded to the information needs of users. In 1494, Luca Pacioli, a Franciscan monk and mathematics professor, published the first known text to describe a comprehensive double-entry bookkeep- ing system. Modern bookkeeping systems (as discussed in Chapter 4) have evolved directly from Pacioli’s “method of Venice” system, which was developed in response to the needs of the Italian mercantile trading practices in that period. The Industrial Revolution generated the need for large amounts of capital to finance the enterprises that supplanted individual craftsmen. This need resulted in the cor- porate form of organization marked by absentee owners, or investors, who entrusted their money to managers. It followed that investors required reports from the corporate managers showing the entity’s financial position and results of operations. In mid-19th- century England, the independent (external) audit function added credence to financial reports. As British capital was invested in a growing U.S. economy in the late 19th cen- tury, British-chartered accountants and accounting methods came to the United States. However, no group was legally authorized to establish financial reporting standards. This led to alternative methods of reporting financial condition and results of opera- tions, which resulted in confusion and, in some cases, outright fraud. The Accounting Profession in the United States Accounting professionals in this country organized themselves in the early 1900s and worked hard to establish certification laws, standardized audit procedures, and other attributes of a profession. However, not until 1932–1934 did the American Institute of Accountants (predecessor of today’s American Institute of Certified Public mar26743_ch01_002-027.indd 9 11/08/21 09:10 AM  Final PDF to printer 10 Chapter 1 Accounting—Present and Past Accountants—AICPA) and the New York Stock Exchange agree on five broad prin- ciples of accounting. This was the first formal accounting standard-setting activity. The accounting, financial reporting, and auditing weaknesses related to the 1929 stock market crash gave impetus to this effort. The Securities Act of 1933 and the Securities Exchange Act of 1934 apply to securities offered for sale in interstate commerce. These laws had a significant effect on the standard-setting process because they gave the Securities and Exchange Commission (SEC) the authority to establish accounting principles to be followed by companies whose securities had to be registered with the SEC. The SEC still has this authority, but the standard-setting process has been delegated to other organizations over the years. Between 1939 and 1959, the Committee on Accounting Procedure of the American Institute of Accountants issued 51 Accounting Research Bulletins that dealt with accounting principles. This work was done without a common conceptual framework for financial reporting. Each bulletin dealt with a specific issue in a rela- tively narrow context, and alternative methods of reporting the results of similar trans- actions remained. In 1959, the Accounting Principles Board (APB) replaced the Committee on Accounting Procedure as the standard-setting body. The APB was an arm of the AICPA, and although it was given resources and directed to engage in more research than its predecessor, its early efforts intensified the controversies that existed. The APB issued 39 Opinions on serious accounting issues, but it failed to develop a con- ceptual underpinning for accounting and financial reporting. Financial Accounting Standard Setting at the Present Time LO 1-5 In 1973, as a result of congressional and other criticism of the accounting standard- Explain the role that the setting process being performed by an arm of the AICPA, the Financial Accounting FASB plays in the devel- Foundation (FAF) was created as a more independent entity. The foundation estab- opment of financial lished the Financial Accounting Standards Board (FASB) as the authoritative stan- accounting standards. dard-setting body within the accounting profession. The FASB embarked on a project called the Conceptual Framework of Financial Accounting and Reporting and had issued eight Statements of Financial Accounting Concepts by February 2021. Concurrently with its Conceptual Framework project, the FASB issued 168 Statements of Financial Accounting Standards (SFAS) that established standards of accounting and reporting for particular issues, much as its predecessors did. Effective in July 2009, however, all such FASB standards were superseded by the FASB Accounting Standards Codification (FASB Codification). Essentially, the FASB Codification reor- ganized divergent sources of U.S. GAAP in a more accessible and researchable format. The FASB Codification now represents a single source of U.S. GAAP. Changes to the Codification are communicated through an Accounting Standards Update (Update or ASU), regardless of the form in which such guidance may have been issued prior to the release of the FASB Codification. Although such Updates do in fact amend the FASB Codification, the FASB does not consider ASUs as authoritative in their own right. A total of 192 ASUs had been issued by February 2021. Alternative ways of accounting for and reporting the effects of similar transactions still exist. In many aspects of financial reporting, the accountant still must use judg- ment in selecting between equally acceptable alternatives. To make sense of financial statements, one must understand the impact of the accounting methods used by a firm, relative to alternative methods that were not selected. Subsequent chapters describe many of these alternatives and the impact that various accounting choices have on mar26743_ch01_002-027.indd 10 11/08/21 09:10 AM  Final PDF to printer Chapter 1 Accounting—Present and Past 11 financial statements. As examples, Chapter 5 discusses the effects of the first-in, first-out inventory cost flow assumption in comparison to the last-in, first-out and the weighted-average assumptions; similarly, Chapter 6 discusses the difference between the straight-line and accelerated methods of depreciating long-lived assets. Although such terminology may not be meaningful to you at this time, you should understand that the FASB has sanctioned each of these alternative methods of accounting for inventory and depreciation, and that the methods selected can significantly affect a firm’s reported profits. The FASB does not set standards in a vacuum. An open, due process procedure is followed. The FASB invites input from any individual or organization who cares to pro- vide ideas and viewpoints about the particular standard under consideration. Among the many professional accounting and financial organizations that regularly present suggestions to the FASB, in addition to the AICPA and the SEC, are the International Accounting Standards Board (IASB), the American Accounting Association, the Institute of Management Accountants, Financial Executives International, and the Chartered Financial Analysts (CFA) Institute. The accounting and auditing standard-setting processes were heavily criticized as a result of the Enron and WorldCom collapses and the accounting and reporting problems of other companies that came to light in 2001 and early 2002. In July 2002, President George W. Bush signed into law the most significant legislation affect- ing the accounting profession since 1933: the Sarbanes–Oxley Act (SOX) of 2002. Essentially, the act created a five-member Public Company Accounting Oversight Board (PCAOB), which has the authority to set and enforce auditing, attestation, quality control, and ethics (including independence) standards for public companies. It is also empowered to inspect the auditing operations of public accounting firms that audit public companies and impose disciplinary sanctions for violations of the Board’s rules, securities laws, and professional auditing standards. The impact of SOX on financial reporting has been far reaching and will be explored in some detail in Chapter 10, which addresses corporate governance and disclosure issues. The point of this discussion is to emphasize that financial accounting and report- LO 1-6 ing practices are not based on a set of inflexible rules to be mastered and blindly Generalize about how followed. The reality is that financial reporting practices have evolved over time in financial reporting stan- response to the changing needs of society, and they are still evolving. In recent years, dards evolve. financial instruments and business transactions have become increasingly complex and are now being used with greater frequency by firms of all sizes. The FASB has thus been hard pressed to develop appropriate standards to adequately address emerg- ing accounting issues in a timely manner. Moreover, many recent ASUs appear to be more like rules than the judgmental application of fair guidelines. Don’t worry about any critical reviews you may read concerning new FASB Codification updates; instead, keep your eye on the big picture. Your objective is to learn enough about the fundamentals of financial accounting and reporting practices to be neither awed nor confounded by the overall presentation of financial data. 4. What does it mean to state that generally accepted accounting principles are not a set of rules to be blindly followed? 5. What does it mean when the Financial Accounting Standards Board issues a new Accounting Standards Update? Q What Does It Mean? Answers on page 27 mar26743_ch01_002-027.indd 11 11/08/21 09:10 AM  Final PDF to printer 12 Chapter 1 Accounting—Present and Past Standards for Other Types of Accounting Because managerial/cost accounting is oriented primarily to internal use, it is pre- sumed that internal users will know about the accounting practices being followed by their firms. As a result, the accounting profession has not regarded the develop- ment of internal reporting standards for use by management as an important issue. Instead, individual companies are generally allowed to self-regulate with respect to internal reporting matters. One significant exception is accounting for the cost of work done under government contracts. Over the years, various governmental agencies have issued directives prescribing the procedures to be followed by government contrac- tors. During the 1970–1980 period, the Cost Accounting Standards Board (CASB) operated as a governmental body to establish standards applicable to government contracts. Congress abolished the CASB in 1981, although its standards remained in effect. In 1988, Congress reestablished the CASB as an independent body within the Office of Federal Procurement Policy. The CASB now has authority to establish cost- accounting standards for government contracts in excess of $750,000, provided that the contractor or subcontractor is performing a total of $7.5 million or more in all such contracts. Since 1995, CASB standards also have applied to colleges and universities that receive major federal research funds. In the auditing/public accounting area, auditing, attestation, and quality control standards are established by the Auditing Standards Board, a technical committee of the AICPA, unless superseded or amended by the PCAOB. The SEC has had input into this process, and over the years a number of auditing standards and procedures have been issued. One of the most important of these standards requires the auditor to be independent of the client whose financial statements are being audited. Yet the auditor’s judgment is still very important in the auditing process. Because of this, crit- ics of the accounting profession often raise questions concerning the independence of CPA firms in the auditing process (see Business in Practice—Auditor Independence). It is worth repeating here that an unqualified auditor’s opinion does not constitute a clean bill of health about either the current financial condition of or the future pros- pects for the entity. It is up to the readers of the financial statements to reach their own judgments about these and other matters after studying the firm’s annual report, which includes the financial statements and notes to the financial statements. In 1984, the Governmental Accounting Standards Board (GASB) was estab- lished to develop guidelines for financial accounting and reporting by state and local governmental units. The GASB operates under the auspices of the Financial Accounting Foundation, which is also the parent organization of the FASB. The GASB is attempting to unify practices of the nation’s many state and municipal entities, thus providing investors and taxpayers with a better means of comparing financial data of the issuers of state and municipal securities. In the absence of a GASB standard for a particular activity or transaction occurring in both the public and private sectors, gov- ernmental entities will continue to use FASB standards for guidance. The GASB had issued 97 standards and 6 concepts statements by February 2021. The U.S. Internal Revenue Code and related regulations and the various state and local tax laws specify the rules to be followed in determining an entity’s income tax liability. Although quite specific and complicated, the code and regulations provide rules of law to be followed. In income tax matters, accountants use their judgment and expertise to design transactions so that the entity’s overall income tax liability is mini- mized. In addition, accountants prepare or help prepare tax returns and may represent clients whose returns are being reviewed or challenged by taxing authorities. mar26743_ch01_002-027.indd 12 11/08/21 09:10 AM  Final PDF to printer Chapter 1 Accounting—Present and Past 13 Auditor Independence Certified public accountants have traditionally provided auditing, tax, and consulting services designed to meet a broad range of client needs. In recent years, the consultancy area of prac- tice has expanded considerably, especially among the Big 4 international CPA firms. Consulting services commonly offered include financial advisory services, assurance (risk management) Business in services, and information systems design and installation services. Until recent years, it was not Practice unusual for a CPA firm to provide such services to its audit clients. In the opinion of some observers, including the SEC, having the auditing firm involved in the development of information and accounting systems raises the possibility and appearance of a conflict of interest. Such a conflict might arise if the auditors are reluctant to challenge the results of a system from which the amounts shown on an audit client’s financial statements were derived. The appearance of independence could be further affected by the fact that consulting fees frequently exceed the auditing fees generated from many corporate clients. For several years prior to the Enron case, the SEC and the AICPA discussed the impact of auditors’ consulting practices on auditor independence. To help achieve independence in fact and in appearance, several auditing firms split off their consulting practices, thus making them separate entities. However, when it was learned that Arthur Andersen had earned consider- ably more in consulting fees from Enron than it had earned in auditing fees, and that this situa- tion prevailed for many auditing firms, there was strong pressure to require all auditing firms to divest their consulting practices. As discussed in Chapter 10, SOX now prohibits auditors from performing a variety of nonaudit services for financial statement audit clients. Clearly, the issue of auditor independence continues to have a “hot button” status, and it is likely to remain under close scrutiny for the foreseeable future. International Accounting Standards Accounting standards in individual countries have evolved in response to the unique user needs and cultural attributes of each country. Thus, despite the development of a global marketplace, accounting standards in one country may differ significantly from those in another country. In 1973, the International Accounting Standards Committee (IASC) was formed by accountancy bodies in Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom and Ireland, and the United States to create and promote worldwide acceptance and observation of accounting and financial reporting standards. In 2001, the International Accounting Standards Board (IASB) was formed in a restructuring effort and has since assumed all responsibili- ties previously carried out by the IASC, which was disbanded at that time. The IFRS Foundation, based in London, is the legal entity under which the IASB operates as an independent, not-for-profit private sector organization. The goal of the IASB is to develop a single set of high-quality, understand- able, enforceable, and globally accepted financial reporting standards based on clearly articulated principles. The IASB and its predecessor organization had issued 41 International Accounting Standards (IAS) and 17 International Financial Reporting Standards (IFRS) by February 2021, with much of this progress com- ing in recent years. As a result, all major nations except the United States have now established timelines to substantially converge with or fully adopt IFRS standards in the near future. The IASB and the FASB have been working together since 2002 to achieve con- vergence of IFRS and U.S. GAAP. The principal difference between IFRS and U.S. mar26743_ch01_002-027.indd 13 11/08/21 09:10 AM  Final PDF to printer 14 Chapter 1 Accounting—Present and Past GAAP is that U.S. financial reporting standards have been increasingly based on detailed rules, whereas IFRS standards require companies to follow broad principles, which can result in “situational” accounting that can lead to financial reporting differ- ences between companies having similar transactions. With this in mind, the boards agreed on a Memorandum of Understanding in 2006 (updated in 2008 and again in 2010) that identified several short-term and longer-term convergence projects that would bring the most significant improvements to IFRS and U.S. GAAP. Through these ongoing projects—some covering major components of the financial statements, such as leases, impairment of financial instruments, and insurance contracts—the boards intend to improve financial reporting to investors while also aligning U.S. and international standards. In November 2008, the SEC issued a “Roadmap” discussion paper for a possible path to the adoption of IFRS standards in the United States. In May 2011, the SEC released a more detailed proposal for the FASB to change U.S. GAAP over a defined period of perhaps five to seven years by endorsing, and thereby incorporating, indi- vidual IFRS standards into U.S. GAAP. Under this proposal, the FASB would have continued as the U.S. standard setter and would have participated in the development of new standards, but the nature of its role would have changed significantly. Rather than acting as the principal standard-setter for new standards, the FASB would have provided input and support to the IASB in its mission to develop high-quality, global standards. In more recent years, however, the FASB and IASB have backed away almost completely from the goal of a single global accounting language because of a lack of interest in accounting convergence on the part of U.S. investors and corporations. Yet, the boards did manage to agree as recently as January 2016 on another key area—lease accounting, which along with a revenue recognition standard issued in May 2014, was thought to be one of the crowning achievements of their mutual efforts in the ongo- ing convergence era. Moreover, the major goals of the highly successful convergence project clearly have been achieved, with substantially improved and fully aligned U.S. and international financial reporting for business combinations, segment reporting, stock compensation, fair value measurements, borrowing costs, and noncontrolling interests, as well as leases and revenue recognition. But at its core, the fatal flaw in the U.S. side of the complete convergence plan was the huge switching cost that domestic companies and auditors would have to pay for changing their reporting language from U.S. GAAP to IFRS. Thus, it would appear the U.S. GAAP and IFRS will continue to peacefully coexist indefinitely. Although it is appropriate to follow the progress of these convergence develop- ments, this text explains and illustrates only those current U.S. financial accounting and reporting standards that are necessary for you to gain a comprehension of the “big picture”—what the numbers mean from the perspective of financial statement users. However, where appropriate, IFRS standards currently in effect and under develop- ment are identified in text boxes titled “The IFRS Approach.” These text boxes contain brief explanations of the relevant international standards, particularly where they dif- fer significantly from their corresponding U.S. standards. A variety of hot topic issues affecting the accounting profession, such as those mentioned here, are discussed fur- The IFRS ther in the Epilogue: “Accounting—The Future.” Approach Exhibit 1-2 lists the website addresses of various accounting organizations. You are encouraged to visit these sites for more information about each one. mar26743_ch01_002-027.indd 14 11/08/21 09:10 AM  Final PDF to printer Chapter 1 Accounting—Present and Past 15 Exhibit 1-2 American Institute of Certified Public Accountants: aicpa.org Financial Accounting Standards Board: fasb.org Websites for Accounting Organizations Government Accounting Standards Board: gasb.org Institute of Internal Auditors: theiia.org Institute of Management Accountants: imanet.org IFRS Foundation and the International Accounting Standards Board: ifrs.org Public Company Accounting Oversight Board: pcaob.org Securities and Exchange Commission: sec.gov 6. What does it mean that the FASB and IASB have been working together to achieve convergence? Q What Does It Mean? Answer on page 27 Ethics and the Accounting Profession One characteristic frequently associated with any profession is that those practicing the LO 1-7 profession acknowledge the importance of an ethical code. This is especially impor- Identify the key ele- tant in the accounting profession because so much of an accountant’s work involves ments of ethical behav- providing information to support the decisions and informed judgments made by users ior for a professional of accounting information. accountant. The American Institute of Certified Public Accountants (AICPA) and the Institute of Management Accountants (IMA) both have published ethics codes. The Code of Professional Conduct, most recently amended in 2014, was adopted by the member- ship of the AICPA. The organization’s bylaws state that members shall conform to the rules of the Code or be subject to disciplinary action by the AICPA. Although it doesn’t have the same enforcement mechanism, the IMA’s Statement of Ethical Professional Practice calls on management accountants to maintain the highest stan- dards of ethical conduct as they fulfill their obligations to the organizations they serve, their profession, the public, and themselves. Both codes of conduct identify integrity and objectivity as two key elements of ethical behavior for a professional accountant. Having integrity means being honest and forthright in dealings and communications with others; objectivity means impar- tiality and freedom from conflict of interest. An accountant who lacks integrity and/ or objectivity cannot be relied on to produce complete and relevant information with which to make a decision or informed judgment. Other elements of ethical behavior include independence, competence, and accep- tance of an obligation to serve the best interests of the employer, the client, and the pub- lic. Independence is related to objectivity and is especially important to the auditor, who must be independent both in appearance and in fact. Having competence means having the knowledge and professional skills to adequately perform the work assigned. Accountants should recognize that the nature of their work requires an understanding of the obligation to serve those who will use the information communicated by them. In the recent past, incidents involving allegations that accountants have violated their ethical codes by being dishonest, biased, and/or incompetent have been highly publicized. mar26743_ch01_002-027.indd 15 11/08/21 09:10 AM  Final PDF to printer 16 Chapter 1 Accounting—Present and Past That some of these allegations have been proved true should not be used to condemn all accountants. The profession has used these rare circumstances to reaffirm that the public and the profession expect accountants to exhibit a very high level of ethical behavior. In this sense, are accountants really any different from those involved in any other endeavor? Q What Does It Mean? Answer on page 27 7. What does it mean to state that ethical behavior includes being objective and independent? The Conceptual Framework LO 1-8 Various accounting standards have existed for many years. But it wasn’t until the mid- Summarize the rea- 1970s that the FASB began the process of identifying a structure or framework of sons for the FASB’s financial accounting concepts. New users of financial statements can benefit from Conceptual Framework an overview of these concepts because they provide the foundation for understand- project. ing financial accounting reports. The FASB issued eight Statements of Financial Accounting Concepts through February 2021, the first six of which were issued between 1978 and 1985. These statements represented a great deal of effort by the FASB, and progress made on this project did not come easily. In concert with their efforts to converge U.S. and international accounting stan- dards, the FASB and IASB have undertaken a project to improve and converge their respective Conceptual Frameworks as well. In September 2010, FASB Concepts Statement No. 8, “Conceptual Framework for Financial Reporting,” was issued; it included two chapters of the new Conceptual Framework and superseded FASB Concepts Statements No. 1 and No. 2. In Concepts Statement No. 8, the FASB made the following assertions:3 Concepts Statements are not part of the FASB Accounting Standards Codification, which is the source of authoritative GAAP recognized by the FASB to be applied by nongovern- mental entities. Rather, Concepts Statements describe concepts that will underlie guidance on future accounting practices and in due course will serve as a basis for evaluating exist- ing guidance and practices. Establishment of objectives and identification of fundamental concepts will not directly solve accounting and reporting problems. Rather, objectives give direction, and concepts are tools for solving problems. The Board itself is likely to be the most direct beneficiary of the guidance provided by Concepts Statements. They will guide the Board in developing accounting and reporting guidance by providing the Board with a common foundation and basic reasoning on which to consider merits of alternatives.4 Summary of Concepts Statement No. 8, Chapter 1: “The Objective of General Purpose Financial Reporting” LO 1-9 To set the stage more completely for your study of financial accounting, it is appro- Summarize the objec- priate to have an overview of the foundational building blocks of financial reporting, tive of general-purpose as expressed in Chapter 1 of Concepts Statement No. 8. (To gain a comprehensive financial reporting. 3 FASB, Statement of Financial Accounting Concepts No. 8, Preface (Stamford, CT, 2010). Copyright the Financial Accounting Foundation, High Ridge Park, Stamford, CT 06905, U.S.A. Excerpted with permission. Copies of the complete document are available from the FASB. 4 FASB, Statement of Financial Accounting Concepts No. 8, Preface. mar26743_ch01_002-027.indd 16 11/08/21 09:10 AM  Final PDF to printer Chapter 1 Accounting—Present and Past 17 Business Ethics Events like the 2008–2009 global economic crisis highlight the necessity of sound ethical prac- tices across the business world. An indication of the breadth of this concern was the develop- ment of the term stakeholder to refer to the many entities—owners/stockholders, managers, employees, customers, suppliers, communities, and even competitors—who have a stake in the Business in way an organization conducts its activities. Another indicator of this concern is that business eth- Practice ics and corporate social responsibility issues have merged into a single broad area of interest. This concern is international in scope and is attracting political attention. In 2020, the Caux Round Table (CRT) for Moral Capitalism celebrated its 26th year of leadership in corporate busi- ness ethics after publishing its Principles for Business in 1994, which attempts to express a worldwide standard for ethical and socially responsible corporate behavior. Another influen- tial organization is Business for Social Responsibility (BSR), a U.S.-based global resource for companies seeking to sustain their commercial success in ways that demonstrate respect for ethical values and for people, communities, and the environment. For more information, visit cauxroundtable.org or bsr.org. The Foreign Corrupt Practices Act of 1977, as amended by the International Anti-Bribery and Fair Competition Act of 1998, has certainly contributed to a management focus on ethical behavior—although government regulation, in and of itself, tends to curtail only the most abusive ethical violations. As early as 1987, a private-sector commission was convened in response to perceived weaknesses in corporate financial reporting practices. This resulted in a series of rec- ommendations to the SEC that publicly owned corporations include in their annual reports dis- closures about how the company fulfills its responsibilities for achieving a broadly defined set of internal control objectives related to safeguarding assets, authorizing transactions, and report- ing properly. (See the Business in Practice discussion of internal control in Chapter 5.) Section 404 of the Sarbanes–Oxley Act of 2002 requires all SEC-regulated companies to include in their annual reports a report by management on the effectiveness of the company’s internal control over financial reporting. The auditor that audits the company’s financial statements included in the annual report is also required to attest to and report on management’s assessment of internal controls. Many companies provide further disclosures in their annual reports concerning their corporate code of conduct or ethics and whistleblower systems. Within the accounting pro- fession, it is generally accepted that an organization’s integrity and ethical values bear directly on the effectiveness of its internal control system. Researchers have demonstrated that well-constructed ethical and social programs can contribute to profitability by helping to attract customers, raise employee morale and produc- tivity, and strengthen trust relationships within the organization. Indeed, organizations that are committed to ethical quality often institute structures and procedures (such as codes of conduct) to encourage decency. Ethics codes vary from generalized value statements and credos to detailed discussions of global ethical policy. Johnson & Johnson’s “Our Credo” is perhaps the most frequently cited corporate ethics statement, and rightfully so (see jnj.com/credo). For a list of the 100 Best Corporate Citizens as determined by one observer of the cor- Campbell’s porate scene, see 100best.3blmedia.com. Incidentally, Campbell’s was ranked 35th on the 2020 list, which was led by Owens Corning, Citi, General Mills, Cisco, HP, Intel, Ecolab, General Motors, Hess, and Accentuate as the top 10. For additional guidance, check out US SIF (The Forum for Sustainable and Responsible Investment), which offers comprehensive information, contacts, and resources on socially responsible investing (see ussif.org). It is never too early to understand and refine your own value system and to sharpen your awareness of the ethical dimensions of your activities, and don’t be surprised if you are asked to literally “sign on” to an employer’s code of conduct. The following websites reference other sites dealing with business ethics: scu.edu/ethics (then click on Business Ethics in the Focus Areas drop down menu). ethics.org mar26743_ch01_002-027.indd 17 11/08/21 09:10 AM  Final PDF to printer 18 Chapter 1 Accounting—Present and Past At this point, it is unlikely that you will fully grasp and retain all of the details expressed here. Don’t try to memorize these summary highlights! Instead, read through this material to get a basic understanding of what the accounting profession is “gearing toward.” That way, as specific applications of these concepts are presented later in the course, you will have a basis for com- Study parison, and you won’t be surprised very often. Suggestion understanding of the author summary that follows, you may want to download the full text of Concepts Statement No. 8 from the FASB’s website.) Financial reporting is done for individual firms, or entities, rather than for indus- tries or the economy as a whole. It is aimed primarily at meeting the needs of external users of accounting information who would not otherwise have access to the firm’s records. Investors, creditors, and financial advisers are the primary users who create the demand for accounting information. Financial reporting is designed to meet the needs of users by providing information that is relevant to making rational investment and credit decisions and other informed judgments. The users of accounting informa- tion are assumed to be reasonably astute in business and financial reporting practices. However, each user reads the financial statements with her or his own judgment and biases and must be willing to take responsibility for her or his own decision making. Most users are on the outside looking in. For its own use, management can pre- scribe the information it wants. Reporting for internal planning, control, and deci- sion making need not be constrained by financial reporting requirements—thus the Concepts Statements are not directed at internal (i.e., managerial) uses of accounting information. Financial accounting is historical scorekeeping; it is not future oriented. Although the future is unknown, it is likely to be influenced by the past. To the extent that accounting information provides a fair basis for the evaluation of past performance, it may be helpful in assessing an entity’s future prospects. However, financial reports are not the sole source of information about an entity. For example, a potential employee might want to know about employee turnover rates, which are not disclosed in the financial reporting process. The information reported in financial accounting relates primarily to past transactions and events that can be measured in dollars and cents. Financial accounting information is developed and used at a cost, and the benefit to the user of accounting information should exceed the cost of providing it. Many of the objectives of financial reporting relate to the presentation of earn- ings and cash flow information. Investors and creditors are interested in making judg- ments about the firm’s profitability and whether they are likely to receive payment of amounts owed to them. The user may ask, “How much profit did the firm earn during the year ended December 31, 2022?” or “What was the net cash inflow from operating the firm for the year?” Users understand that cash has to be received from somewhere before the firm can pay principal and interest to its creditors or dividends to its inves- tors. A primary objective of financial reporting is to provide timely information about a firm’s earnings and cash flow. Financial reporting includes detailed notes and other disclosures. Accrual accounting—to be explained in more detail later—involves accounting for the effect of an economic activity, or transaction, on an entity when the activity has occurred, rather than when the cash receipt or payment takes place. Thus, the company mar26743_ch01_002-027.indd 18 11/08/21 09:10 AM  Final PDF to printer Chapter 1 Accounting—Present and Past 19 you work for reports a cost for your wages in the month in which you do the work, even though you may not be paid until the next month. Earnings information is reported on the accrual basis rather than the cash basis because past performance can be measured more accurately under accrual accounting. In the process of measuring a firm’s accrual accounting earnings, some costs applicable to one year’s results of operations may have to be estimated; for example, product warranty costs applicable to 2022 may not be finally determined until 2023. Reporting an approximately correct amount in 2022 is obviously preferable to recording nothing at all until 2023, when the precise amount is known. In addition to providing information about earnings and cash flows, financial reporting should provide information to help users assess the relative strengths and weaknesses of a firm’s financial position. The user may ask, “What economic resources does the firm own? How much does the firm owe? What caused these amounts to change over time?” Financial accounting does not attempt to directly measure the value of a firm, although it can be used to facilitate the efforts of those attempting to achieve such an objective. The numbers reported in a firm’s financial statements do not change just because the market price of its stock changes. Financial accounting standards are still evolving; with each new update to the FASB Codification, accounting procedures are modified to mirror new developments in the business world as well as current views and theories of financial reporting. At times, the FASB finds it difficult to keep pace with the ever-changing economic activities addressed by its ASUs. Fortunately, however, such efforts have resulted in improved financial reporting practices each step along the way. Students of accounting should be aware that the how-to aspects of accounting are not static; the accounting discipline is relatively young in comparison to other profes- sions and is in constant motion. Perhaps the most important outcome of the conceptual framework project is the sense that the profession now has a blueprint in place that will carry financial reporting into the future. 8. What does it mean to state that the objectives of financial reporting given in Statement of Financial Accounting Concepts No. 8 provide a framework for this text? Q What Does It Mean? Answer on page 27 Objectives of Financial Reporting for Nonbusiness Organizations At the outset of this chapter, it was stated that the material to be presented, although usually to be expressed in the context of profit-seeking business enterprises, would also be applicable to not-for-profit social service and governmental organizations. The FASB’s “Highlights” of Concepts Statement No. 4, “Objectives of Financial Reporting by Nonbusiness Organizations,” states, “Based on its study, the Board believes that the objectives of general-purpose external financial reporting for government-spon- sored entities (e.g., hospitals, universities, or utilities) engaged in activities that are not unique to government should be similar to those of business enterprises or other non- business organizations engaged in similar activities.”5 Statement 6 amended Statement 2 by affirming that the qualitative characteristics described in Statement 2 apply to the information about both business enterprises and not-for-profit organizations. 5 FASB, Statement of Financial Accounting Concepts No. 4. mar26743_ch01_002-027.indd 19 11/08/21 09:10 AM  Final PDF to printer 20 Chapter 1 Accounting—Present and Past The objectives of financial reporting for nonbusiness organizations focus on pro- viding information for resource providers (such as taxpayers to governmental entities and donors to charitable organizations), rather than investors. Information is provided about the economic resources, obligations, net resources, and performance of an orga- nization during a period of time. Thus, even though nonbusiness organizations have unique characteristics that distinguish them from profit-oriented businesses, the infor- mation characteristics of the financial reporting process for each type of organization are similar. It will be appropriate to remember the gist of the preceding objectives as individ- ual accounting and financial statement issues are encountered in subsequent chapters and are related to real-world situations. Plan of the Book LO 1-10 This text is divided into two main parts. Chapters 2 through 11, which compose the Describe the plan of the first part of the book, are devoted to financial accounting topics. The remaining chap- book. ters, Chapters 12 through 16, provide an in-depth look at managerial accounting. As you study the topics that lie ahead, the authors believe it will be to your advan- tage to be aware of the organizational strategy that we followed in writing this book. In general, the coverage of each topic begins with a “big picture” designed to put the topic in perspective relative to its role in financial accounting and reporting (Chapters 2 through 11) and managerial analysis and decision making (Chapters 12 through 16). The text coverage is limited in detail and is designed to provide a broad “high spot” understanding of the material and a foundation for further learning in a more advanced academic environment or experiential setting. You are quite likely to encounter certain situations in practice that do not follow exactly this textbook’s descriptions of account- ing practices. Yet we are confident that your own thoughtful study, and practical input from others who do accounting-related work and use its results, will permit you to refine your knowledge and use this material effectively. Chapter 2, which kicks off our discussion of financial accounting, describes financial statements, presents a model of how they are interrelated, and briefly sum- marizes key accounting concepts and principles. This is a “big picture” chapter; later chapters elaborate on most of the material introduced here. This chapter also includes four Business in Practice features. As you have seen from the features in this chapter, these are brief explanations of business practices that make some of the ideas covered in the text easier to understand. Chapter 3 describes some of the basic analytical tools that allow financial state- ment users to make fundamental interpretations of a company’s financial position and results of operations. This is a “big picture” chapter that merely scratches the sur- face of financial statement analysis; a more complete explanation of the key financial statement relationships is presented in subsequent chapters. Understanding the basic relationships presented here permits better comprehension of the impact of alternative accounting methods discussed in Chapters 4 through 10. However, because Chapter 11 presents a more comprehensive treatment of financial statement analysis, some instructors may prefer to cover the Chapter 3 material with that of Chapter 11. Chapter 4 describes the bookkeeping process and presents a powerful transac- tion analysis model. Using this model, the financial statement user can understand mar26743_ch01_002-027.indd 20 11/08/21 09:10 AM  Final PDF to printer Chapter 1 Accounting—Present and Past 21 the effect of any transaction on the statements, and many of the judgments based on the statements. You will not be asked to learn detailed bookkeeping procedures in this chapter. Chapters 5 through 9 examine specific financial statement elements. Chapter 5 describes the accounting for short-term (current) assets, including cash, accounts and notes receivable, inventory, and prepaid items. Chapter 6 describes the accounting for long-term assets—including land, buildings and equipment—and a variety of intan- gible assets and natural resources. Chapter 7 discusses the accounting issues related to current and long-term liabilities, including accounts and notes payable, bonds pay- able, and deferred income taxes. Chapter 8 deals with the components of stockhold- ers’ equity, including common stock, preferred stock, retained earnings, and treasury stock. Chapter 9 presents a comprehensive view of the income statement and the state- ment of cash flows. Chapter 10 covers corporate governance issues as well as the notes to the finan- cial statements, and Chapter 11 concludes our look at financial accounting with a detailed discussion of financial statement analysis. The financial accounting chap- ters frequently make reference to Campbell Soup Company’s 2020 annual report, Campbell’s appropriate elements of which are reproduced in the appendix. You should refer to those financial statements and notes, as well as other company financial reports you may have, to get acquainted with actual applications of the issues being discussed in the text. Following Chapter 11, we turn our focus to managerial accounting topics. Chapter 12 presents the “big picture” of managerial accounting. It contrasts financial and man- agerial accounting; introduces key managerial accounting terminology; and illustrates cost behavior patterns by describing various applications of cost–volume–profit analy- sis, including the calculation of a firm’s breakeven point in units and sales dollars. Chapter 13 describes the principal cost accounting systems used in business today, with emphasis on the cost accumulation and assignment activities carried out by most firms. Chapter 14 illustrates many aspects of a typical firm’s operating budget, includ- ing the sales forecast, production and purchases budgets, and the cash budget, as well as the development and use of standard costs for planning purposes. Chapter 15 con- centrates on cost analysis for control; it highlights a number of performance reporting techniques and describes the analysis of variances for raw materials, direct labor, and manufacturing overhead. Chapter 16 concludes our discussion of managerial account- ing with an overview of short-run versus long-run decision making, including a dem- onstration of the payback, net present value, and internal rate of return techniques used to support capital budgeting decisions. An epilogue titled “Accounting—The Future” (read only, with no homework assignments!) reemphasizes the evolutionary nature of the accounting discipline and the relationships between financial and managerial accounting, and calls students’ attention to a world of possibilities that remain to be explored in the future. Use each chapter’s learning objectives, “What Does It Mean?” questions, sum- mary, and glossary of key terms and concepts to help manage your learning. With reasonable effort, you will achieve your objective of becoming an effective user of accounting information to support the related decisions and informed judgments you will make throughout your life. mar26743_ch01_002-027.indd 21 11/08/21 09:10 AM  Final PDF to printer 22 Chapter 1 Accounting—Present and Past Summary Accounting is the process of identifying, measuring, and communicating economic information about an entity for the purpose of making decisions and informed judg- ments. (LO 1-1) Users of financial statements include management, investors, creditors, employ- ees, and government agencies. Decisions made by users relate to, among other things, entity operating results, investment and credit questions, employment characteristics, and compliance with laws. Financial statements support these decisions because they communicate important financial information about the entity. (LO 1-2) The major classifications of accounting include financial accounting, managerial accounting/cost accounting, auditing/public accounting, internal auditing, govern- mental and not-for-profit accounting, and income tax accounting. (LO 1-3) Accounting has developed over time in response to the information needs of users of financial statements. Financial accounting standards have been established by dif- ferent organizations over the years. These standards have become increasingly com- plex in recent decades and, in some cases, are now extremely specific almost to the point of being statute-like. As a result, interest in converging U.S. financial reporting standards with International Financial Reporting Standards, which are more general and flow from broad principles, increased greatly beginning in the late 1990s. The Securities and Exchange Commission, the Financial Accounting Standards Board, and the International Accounting Standards Board have made substantial progress on the so- called convergence project that promises to make the existing financial reporting stan- dards fully compatible as soon as possible. Currently in the United States, the FASB is the standard-setting body for financial accounting and is likely to remain so indefinitely. Other organizations are involved in establishing standards for cost accounting, auditing, governmental accounting, and income tax accounting. (LO 1-4, 1-5, 1-6) Integrity, objectivity, independence, and competence are several characteristics of ethical behavior required of a professional accountant. High standards of ethical conduct are appropriate for all people, but profess