CHAPTER 1

Users of Accounting and Financial Information

Accounting is often referred to as the language of business; unfortunately, many business professionals lack fluency in this unique language, making it difficult for them to perform basic financial analysis, prepare budgetary forecasts, or compare competing capital investment alternatives. Although there is no shortage of well-written accounting textbooks, budgeting handbooks, or finance publications, most require that readers have educational backgrounds and/or professional experience in accounting and financial management.

This book targets individuals in management positions with limited exposure to—or formal training in—the disciplines of accounting and finance. These professionals include engineers, information technology specialists, entrepreneurs, marketing managers, construction contractors, attorneys, and even bankers who have transitioned from consumer-lending positions to become commercial loan officers.

Throughout this book, accounting and financial reporting subjects are addressed from a user’s perspective. Thus, topics such as transaction analysis, journal entries, and numerous other recordkeeping procedures associated with financial statement preparation are avoided. Its purpose is to help managers from diverse professional and educational backgrounds to: (1) converse more effectively with their accounting and finance colleagues, (2) appreciate the usefulness and limitations of general purpose financial statements, (3) use accounting information in decision-making processes, (4) develop short- and long-term financial forecasts, and (5) make sense of commonly used decision-making models.

The Role of Accounting in Organizations and Society

A primary objective of accounting is to communicate relevant and reliable information to decision makers that is useful in managing economic resources. This book addresses the role of accounting as it relates to for-profit corporations; however, accounting plays an important role in all types of enterprises—including partnerships, family-owned businesses, nonprofit organizations, and governmental entities.

Users of accounting information include investors, creditors, managers, regulatory agencies, tax authorities, and anyone else interested in financial issues related to a company’s efficiency, performance, competitive advantage, and sustainability. When accounting information is prepared for users external to an organization (such as investors, creditors, and regulators), it is often referred to as financial accounting or financial reporting. When it is prepared for users inside of an organization (including managers, chief financial officers, board members, and controllers), it is generally referred to as managerial accounting. Chapters 2 through 4 devote coverage to external reporting topics, whereas Chapters 5 through 8 focus on internal accounting issues.¹

Financial Management Systems

It is useful to frame a preliminary discussion of accounting in the context of financial management systems.² Figure 1.1 illustrates the function of a financial management system as it relates to external and internal decision makers.

Figure 1.1 Financial management systems

Organizations engage in a multitude of economic events and transactions every day. Most of these activities result in the creation of what is referred to in Figure 1.1 as unprocessed “raw” financial data. This information often takes the form of source documents such as sales receipts, utility bills, property tax notices, employee timecards, bank statements, purchase orders, insurance policies, and lease contracts. Financial management systems convert raw financial data into relevant and reliable information useful to external and internal decision makers.

Financial management systems are composed of numerous modules and reporting applications unique to the environments in which they function; however, common to all financial information systems is general ledger software. General ledger software is used to record economic events, accumulate activities in specific accounts, analyze accounts receivable, manage payments to creditors, track inventory, maintain depreciation schedules, and streamline financial reporting processes.

Most financial management systems also include payroll software for distributing paychecks, transferring withholdings to tax authorities, and performing the year-end filings of required IRS forms, such as W-2s and 1099s. Other components may include cost accounting software, budgeting applications, simulation packages, and forecasting modules. Functioning as an integrated set of specialized subroutines, these components convert raw data into uniquely formatted reports for dissemination to a diverse group of stakeholders and decision makers.

As Figure 1.1 illustrates, the users of accounting information are both internal and external to the reporting entity. The needs and characteristics of each user group are discussed next.

Internal Users of Accounting Information

Accounting information provided to internal users can be highly confidential and company-specific. Thus, internal accounting reports are often custom-designed and uniquely tailored for specific user groups. For instance, the following internal decision makers rely upon accounting information for very specific purposes:

• Boards of directors and CEOs use accounting information to support strategic planning decisions, such as acquiring subsidiaries, distributing dividends, and shifting manufacturing operations abroad.
• Treasurers and CFOs use accounting information to make financial management decisions, such as investing excess cash reserves, determining annual bonuses, and financing expansion with debt or with equity.
• Controllers use accounting information to analyze cost behaviors, to measure operating efficiency, and to determine breakeven points.
• Human resources officers use accounting information to make hiring decisions, to measure health care costs, and to forecast retirement fund requirements.
• Engineers and researchers use accounting information to estimate the cost of improving quality, to measure manufacturing efficiency, and to prepare budgets supporting the R&D pipeline.
• Marketing and sales managers use accounting information to forecast sales, to make product mix decisions, and to support brand management decisions.

The second half of this book is devoted entirely to the use of accounting information by internal decision makers. Chapter 5 discusses long-term forecasting, whereas Chapter 6 addresses short-term forecasting and operational budgeting. Chapter 7 examines cost behavior and its impact on profitability, and Chapter 8 focuses on the importance of accounting information for evaluating capital investment decisions. The remaining portion of this chapter and the three chapters that follow pertain to accounting information used by external decision makers, in particular the investors and creditors of publicly owned, for-profit corporations.

External Users of Accounting Information

Investors and creditors are generally considered the primary external users of accounting information. Other external users include regulatory bodies (such as the Federal Trade Commission and the Public Utilities Commission), tax authorities (including the Internal Revenue Service and the Social Security Administration), and a host of other stakeholders with vested interests in the financial affairs of a particular business entity (common examples include labor unions, suppliers, and customers).

Investors (Shareholders)

Investors are the owners of for-profit corporations. Many privately owned corporations are so small that there is no separation between owners and management—in other words, they are one and the same. Publicly owned corporations can have millions of external shareholders, few of whom actually take part in managing the daily operations of the company whose shares they own. Thus, in publicly owned corporations, a separation exists between owners and managers.³ The shareholders of these corporations are on the outside looking in, and they depend heavily upon financial accounting information to keep them informed.

Existing and potential investors require a basic level of financial literacy in order for accounting information to be useful to them. As their financial literacy improves, so does their ability to measure their return on investment, compare performances among competing firms in the same industry, and assess whether a company will continue as a going concern. Perhaps most importantly, financial literacy enables investors to formulate sensible valuations of stock prices and to become more adept at predicting changes in investment values over time.

Creditors (Lenders)

Unlike investors, creditors rarely have an ownership stake in publicly owned corporations. As the term implies, creditors extend credit to companies with an expectation of being repaid and they are often compensated with interest for doing so. Creditors include bankers, bondholders, suppliers, venture capitalists, and numerous other providers of debt financing.

Creditors rely heavily upon financial accounting information to evaluate the credit risk associated with a borrower’s likelihood of default. As such, they are especially interested in a borrower’s ability to generate enough cash flow to satisfy debt service obligations over the term of a loan agreement. High-credit-risk borrowers are charged higher rates of interest than low-credit-risk borrowers.

Investors and creditors both rely upon accounting reports to assess the amount, the timing, and the uncertainty associated with a company’s future cash flows.⁴ Given the importance of accounting information to both user groups, it is important that access to reliable information be readily available. The remainder of this chapter discusses the financial reporting requirements of publicly owned corporations and the integrity of the information that they provide.

Reporting Requirements of Publicly Owned Corporations

Publicly owned corporations are those whose stock is listed and traded on organized exchanges, such as the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ). The Securities and Exchange Commission (SEC) mandates by law that all publicly owned corporations make information freely available to everyone, including investors and creditors. The EDGAR link on the SEC website (www.sec.gov) provides open access to more than 20 million filings submitted by publicly owned entities. These enterprises are required to submit dozens of reports to the SEC on a regular basis. Of these reports, two are of primary importance to this book—the 10-Q and the 10-K. The 10-Q is a required quarterly report, whereas the 10-K is a much longer and more detailed annual report. Both provide valuable information about a corporation’s products, markets, employees, executive competition packages, and risk factors.⁵

At the heart of every 10-Q and 10-K is a rather lengthy section devoted to financial accounting and financial reporting. It is in this section that a corporation’s general purpose financial statements are presented. These statements typically include comparative balance sheets, income statements, statements of cash flows, and statements of retained earnings.⁶ Each of these reports is discussed in detail throughout this book. For now it is important to be aware of two things. First, they are called general purpose financial statements because their structure and content are somewhat generic and boilerplate across all reporting entities—in short, they provide a one size fits all function. Second, each statement has a unique purpose that makes it useful to investors, creditors, and other decision makers in assessing the amount, timing, and uncertainty of future cash flows.

A balance sheet reveals a corporation’s financial position at a point in time, meaning that it reports the resources of an entity (its assets), and the claims to those resources by investors and creditors, at a specific date. An income statement reports a corporation’s results of operations over a period of time—most often one quarter or one year. In essence, it reveals a corporation’s net income (its revenues less its expenses) between two balance sheet dates. A statement of cash flows reconciles a company’s cash balance at the beginning of the period with its cash balance at the end of the period. It does so by classifying sources and uses of cash into three types of business activities (operating activities, investing activities, and financing activities). Finally, a statement of retained earnings reveals periodic increases in a corporation’s equity attributed to being profitable, as well as periodic decreases in equity attributed to being unprofitable and/or to declaring dividends. Equity simply refers to the ownership claims of shareholders. Distinctions among the various financial statements will be discussed in greater detail throughout Chapters 2 through 4.

Generally Accepted Accounting Principles

It is essential that the accounting information presented in general purpose financial statements is consistent with a conceptual framework and comparable across reporting entities. To that end, publicly owned corporations must adhere to a formal set of standards, concepts, and practices that guide the preparation of the financial statements provided to investors, creditors, and other external stakeholders.

In the United States, these standards, concepts, and practices are commonly referred to as generally accepted accounting principles (GAAP), and since 1973, the rule-making body sanctioned by the SEC to create, guide, and promulgate GAAP has been the Financial Accounting Standards Board (FASB). Other boards and committees preceded the SEC’s formation of the FASB, but for a variety of reasons, they no longer exist. ⁷

The FASB is a private not-for-profit organization. Its seven full-time members—with the support of the SEC—are largely responsible for establishing an evolving body of reporting standards and for making continuous improvements to the overall usefulness of financial accounting information. The private sector status of the FASB prevents it from having any legal authority to enforce GAAP; however, failure by a publicly owned corporation to comply with GAAP can subject both it and its executive officers to legal prosecution.

Financial Statement Integrity

Investors, creditors, and other external users of general purpose financial statements need assurance that the accounting information in these reports has been prepared in compliance with GAAP. Moreover, they have to be confident that the financial statements are free of material misstatements and represent fairly the financial activities of the reporting entity. To that end, the annual financial statements issued by all publicly owned corporations must be audited by licensed Certified Public Accountants (CPAs).⁸

Audits and Assurance

In their capacity as auditors, CPAs serve the public interest as independent third-party watchdogs responsible for providing reasonable assurance that a company’s financial statements are prepared in compliance with GAAP. It is their responsibility to render an opinion whether financial statements are reliable, complete, and fair representations of a company’s financial position, results of operations, and cash flow activities. As part of the audit process, CPAs conduct in-depth interviews with key members of a company’s management, evaluate the soundness of a company’s internal control systems, perform bank reconciliations, and statistically sample key accounts (such as inventory and accounts receivable) to ascertain whether their balances appear valid.

Audits play a critical role in maintaining financial reporting integrity. Yet, they are not 100 percent foolproof. Highly publicized business failures in recent years have given rise to questions concerning audit effectiveness and auditor independence. Although CPAs are entrusted to perform audits on behalf of the general public, the companies that they audit hire and pay them. Many believe that this arrangement compromises an auditor’s independence and creates potential for the fox guarding the henhouse. Other criticisms of auditor independence have arisen from CPA firms providing consulting and advisory services to their clients. As consultants and advisers, CPA firms clearly become their clients’ advocates.

Governmental Intervention

Congress passed the Sarbanes–Oxley Act (SOX) in 2002, shortly after the collapse of Enron. In addition to limiting the scope of consulting and advisory services that CPA firms can provide to audit clients, SOX requires CPAs to issue separate reports on the effectiveness of their clients’ systems of internal control. Moreover, SOX legislation holds CEOs and CFOs of publicly owned corporations personally responsible for certifying the fairness of their company’s financial statements. SOX legislation also resulted in the creation of the Public Company Accounting Oversight Board (PCAOB), which has the power to monitor the quality of audits conducted by public accounting firms and to administer penalties for substandard audits or malfeasance.

SOX and the creation of the PCAOB have made significant strides in restoring the confidence that external decision makers have in the financial reporting processes; nevertheless, there remains much room for improvement. It is important to emphasize that financial statement users have a responsibility to be financially literate and to exercise caution, due diligence, and sound judgment when making investment decisions.

Summary

Accounting has been discussed throughout this chapter in the context of a financial management system, the purpose of which is to transform unprocessed financial data into reports used by internal and external decision makers. Internal accounting reports are custom-designed and uniquely tailored for specific user groups. External accounting information is disseminated in the form of general purpose financial statements.

The SEC, the FASB, and CPAs play important roles in maintaining the integrity of general purpose financial statements issued to external users by publicly owned corporations. The structure and use of these statements will be examined in Chapters 2 through 4. Chapters 5 through 8 are devoted to managerial issues and the internal use of accounting information.

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¹Accounting information communicated to tax authorities requires specialized expertise in the area of tax accounting. Tax accounting issues are beyond the scope of this book.

²The terms financial management systems and accounting information systems are frequently used interchangeably.

³Managers are often shareholders of the corporations for whom they work; however, the vast majority of a corporation’s shareholders are typically not its employees.

⁴Being able to assess the amounts, timing, and risk associated with future cash flows enables investors and creditors to set realistic expectations about their potential returns.

⁵Many corporations also publish annual reports in hardcopy and/or digital formats. These reports are similar in content to the 10-K reports filed with the SEC; however, unlike the 10-Ks, they are usually full-color documents filled with glossy photographs featuring executives, manufacturing facilities, smiling customers, and other nonfinancial images. Their flashy designs have attracted criticism by some who contend they have evolved from being financial documents used primarily by investors and creditors, to being glitzy public relations materials used by a diverse audience for multiple purposes. Annual reports are not filed with the SEC; rather, they are sent directly by a corporation to interested parties that request them.

⁶General purpose financial statements are often referred to by alternative names. For instance, balance sheets can be called statements of financial position, whereas income statements can be called earnings statements or statements of operations. Also, many corporations provide a more detailed statement of shareholders’ equity instead of the simpler statement of retained earnings, and most corporations include a separate statement of comprehensive income among their general purpose financial reports.

⁷Accounting principles and standards vary by country. For instance, member countries of the European Union (and many others, as well) comply with standards, concepts, and practices established by the International Accounting Standards Board (IASB). The IASB is responsible for issuing International Financial Reporting Standards (IFRS). In response to an expanding global economy and to the growth of international capital markets, the London-based IASB has played a key role in attempting to harmonize accounting practices around the world. In particular, it has strived to improve the uniformity between US GAAP and IFRS. To date, a complex web of legal, economic, and philosophical obstacles impedes a convergence to a single set of global accounting standards; however, progress toward that end is being made.

⁸Many of the largest publicly owned corporations listed on the NYSE and NASDAQ exchanges are audited by one of four accounting firms. These giant international firms—referred to collectively as The Big 4—are Deloitte, EY, PwC, and KPMG.