IMPORTANCE OF ACCOUNTING RECORDS

Introduction

Accounting provides information for all these purposes through the maintenance of data, the analysis and interpretation of these data, and the preparation of various kinds of reports. Most accounting information is historical—that is, the accountant observes all activities that the organization undertakes, records their effects, and prepares reports summarizing what has been recorded; the rest consists of forecasts and plans for current and future periods.

Accounting is the systematic development and analysis of information about the economic affairs of an organization. This information may be used in a number of ways: by a firm's managers to help them plan and control ongoing operations; by owners and legislative or regulatory bodies to help them appraise the organization's performance and make decisions as to its future; by owners, lenders, suppliers, employees, and others to help them decide how much time or money to devote to the company; by governmental bodies to determine what taxes a business must pay; and occasionally by customers to determine the price to be paid when contracts call for cost-based payments.

Accounting information can be developed for any kind of organization, not just for privately owned, profit-seeking businesses.

One branch of accounting deals with the economic operations of entire countries.

The objectives and characteristics of financial reporting

In recent years, there has been a growing demand on the part of stakeholders for information concerning the social impacts of corporate decision making. Increasingly, companies are including additional information about environmental impacts and risks, employees, community involvement, philanthropic activities, and consumer safety.

The overarching objective of financial reporting, which includes the production and dissemination of financial information about the company in the form of financial statements, is to provide useful information to investors, creditors, and other interested parties. Ideally, accounting information provides company shareholders and other stakeholders (e.g., employees, communities, customers, and suppliers) with information that aids in the prediction of the amounts, timing, and uncertainty of future cash flows. In addition, financial statements disclose details concerning economic resources and the claims to those resources.

To accountants, the two most important characteristics of useful information are relevance and reliability. Information is relevant to the extent that it can potentially alter a decision. Relevant information helps improve predictions of future events, confirms the outcome of a previous prediction, and should be available before a decision is made. Reliable information is verifiable, representationally faithful, and neutral. The hallmark of neutrality is its demand that accounting information not be selected to benefit one class of users to the neglect of others. While accountants recognize a trade-off between relevance and reliability, information that lacks either of these characteristics is considered insufficient for decision making.

In addition, quantitative data are now supplemented with precise verbal descriptions of business goals and activities. In the United States, for example, publicly traded companies are required to furnish a document commonly identified as “management's discussion and analysis” as part of the annual report to shareholders. This document summarizes historical performance and includes forward-looking information.

In addition to being relevant and reliable, accounting information should be comparable and consistent. Comparability refers to the ability to make relevant comparisons between two or more companies in the same industry at a point in time. Consistency refers to the ability to make relevant comparisons within the same company over a period of time.

In general, financial reporting should satisfy the full disclosure principle—meaning that any information that can potentially influence an informed decision maker should be disclosed in a clear and understandable manner on the company's financial statement.

 

Importance of accounting records

Although published financial statements are the most widely visible products of business accounting systems and the ones with which the public is most concerned, they represent only a small portion of all the accounting activities that support an organization. Most accounting data and most accounting reports are generated solely or mainly for the company's managers. Reports to management may be either summaries of past events, forecasts of the future, or a combination of the two. Preparation of these data and reports is the focus of managerial accounting, which consists mainly of four broad functions: (1) budgetary planning, (2) cost finding, (3) cost and profit analysis, and (4) performance reporting.

Cost finding

A major factor in business planning is the cost of producing the company's products. Cost finding is the process by which the company obtains estimates of the costs of producing a product, providing a service, performing a function, or operating a department. Some of these estimates are historical (how much did it cost?), while others are predictive (what will it cost?).

The basic principle in cost finding is that the cost assigned to any object—an activity or a product—should represent all the costs that the object causes. The most fully developed methods of cost finding are used to estimate the costs that have been incurred in a factory to manufacture specific products. The simplest of these methods is known as process costing. In this method, the accountant first accumulates the costs of each production operation or process for a specified time frame. This sum is then restated as an average by dividing the total costs of production by the total output in the period. Process costing can be used whenever the output of individual processes is reasonably uniform or homogeneous, as in cement manufacturing, flour milling, and other relatively continuous production processes.

Direct materials and labour costs are recorded on the job order cost sheets for each job. Although not traceable to individual jobs, overhead costs are generally assigned to them by means of overhead rates—i.e., the ratio of total overhead cost to total production volume for a given time period. A separate overhead rate is usually calculated for each production department, and, if the operations of a department are varied, it is often subdivided into a set of more homogeneous cost centres, each with its own overhead rate. Separate overhead rates are sometimes used even for individual processing machines within a department if the operating costs of machines differ widely in such factors as power consumption, maintenance cost, and depreciation.

Because output within a cost centre is not homogeneous, production volume must be measured by something other than the number of units of product; common measures include the number of machine hours and direct labour hours. Once the overhead rate has been determined, a provision for overhead cost can be entered on each job order cost sheet on the basis of the number of direct labour hours or machine hours used on that job.

Many production costs are incurred by departments that do not actually produce goods or provide salable services. Instead, they provide services or support such as equipment maintenance, quality control, cleaning, or the production of power to run the machinery. Estimates of these costs are included in the estimated overhead costs of the production departments by a process known as allocation—that is, estimated service department costs are allocated among the production departments in proportion to the amount of service or support each receives. The departmental overhead rates then include provisions for these allocated costs.

A third method of cost finding, activity-based costing, is based on the fact that many costs are driven by factors other than product volume. The first task is to identify the activities that drive costs. The next step is to estimate the costs that are driven by each activity and to state them as averages per unit of activity. Management can use these averages to guide its efforts to reduce costs. In addition, if management wants an estimate of the cost of a specific product, the accountant can estimate how many of the activity units are associated with that product and multiply those numbers by the average costs per activity unit.

Product cost finding under activity-based costing is almost always a process of estimating costs before production takes place. The method of process costing and job-order costing can be used either in preparing estimates before the fact or in assigning costs to products as production proceeds. Even when job-order costing is used to tally the costs actually incurred on individual jobs, the overhead rates are usually predetermined—that is, they represent the average planned overhead cost at some production volume. The main reason for this is that actual overhead cost averages depend on the total volume and efficiency of operations and not on any one job alone. The relevance of job-order cost information will be impaired if these external fluctuations are allowed to change the amount of overhead cost assigned to a particular job.

Many systems go even farther than this. Estimates of the average costs of each type of material, each operation, and each product are prepared routinely and identified as standard costs. These are then readily available whenever estimates are needed and can also serve as an important element in the company's performance-reporting system, as described below.

Similar methods of cost finding can be used to determine or estimate the cost of providing services rather than physical goods. Most advertising agencies and consulting firms, for example, maintain some form of job cost records, either as a basis for billing their clients or as a means of estimating the profitability of individual jobs or accounts.

The methods of cost finding described in the preceding paragraphs are known as full, or absorption, costing methods, in that the overhead rates are intended to include provisions for all manufacturing costs. Both process and job-order costing methods can also be adapted to variable costing in which only variable manufacturing costs are included in product cost. Variable costs rise or fall in proportion to the quantity of output. Total fixed costs, in contrast, are the same at all volume levels within the normal range.

Unit cost under variable costing represents the average variable cost of making the product. Compared to the average full cost, the average variable cost is more useful when making short-term managerial decisions. In deciding whether to manufacture goods in large lots, for example, management needs to estimate the cost of carrying larger amounts of finished goods in inventory. More variable costs will have to be incurred to build the inventory to a higher level; fixed manufacturing costs presumably will be unaffected.

Furthermore, when a management decision changes the company's fixed costs, the change is unlikely to be proportional to the change in volume; therefore, average fixed cost is seldom a valid basis for estimating the cost effects of such decisions. Variable costing eliminates the temptation to use average fixed cost in estimating changes in the total fixed cost. When variable costing is used, supplemental rates for fixed overhead production costs must be provided to measure the costs to be assigned to end-of-year inventories.

Budgetary planning

The first major component of internal accounting systems for management's use is the company's system for establishing budgetary plans and setting performance standards. The setting of performance standards also requires a system for measuring actual results and reporting differences between actual performance and the plans.

i.               Budget planning and performance reporting:  The planning process leads to the establishment of explicit plans, which then are translated into action. The results of these actions are compared with the plans and reported in comparative form (performance reports). Management can then respond to substantial deviations from plan, either by taking corrective action or, if outside conditions differ from those predicted or assumed in the plans, by preparing revised plans.

Although plans can range from broad, strategic outlines of the company's future to detailed schedules for specific projects, most business plans are periodic plans—that is, they outline company operations for a specified period of time. These periodic plans are summarized in a series of projected financial statements, or budgets.

The two principal budget statements are the profit plan and the cash forecast. The profit plan is an estimated income statement for the budget period. It summarizes the planned level of selling effort, shown as selling expense, and the results of that effort, shown as sales revenue and the accompanying cost of goods sold. Separate profit plans are ordinarily prepared for each major segment of a company's operations.

ii.             Relationship of company profit plan to responsibility structure:  The details underlying the profit plan are contained in departmental sales and cost budgets, each part identified with the executive or group responsible for carrying it out.

Many companies also prepare alternative budgets if the projected operating volume deviates from the volume anticipated for the period. A set of such alternative budgets is known as the flexible budget. The practice of flexible budgeting has been adopted widely by factory management to facilitate the evaluation of cost performance at different volume levels and has also been extended to other elements of the profit plan.

The second major component of the annual budget, the cash forecast or cash budget, summarizes the anticipated effects on cash of all the company's activities. It lists the anticipated cash payments, cash receipts, and amount of cash on hand, month by month throughout the year. In most companies, responsibility for cash management rests mainly in the head office rather than at the divisional level. For this reason, divisional cash forecasts tend to be less important than divisional profit plans.

Companywide cash forecasts, on the other hand, are just as important as company profit plans. Preliminary cash forecasts are used in deciding how much money will be made available for the payment of dividends, for the purchase or construction of buildings and equipment, and for other programs that do not pay for themselves immediately. The amount of short-term borrowing or short-term investment of temporarily idle funds is then generally geared to the requirements summarized in the final, adjusted forecast.

Other elements of the budgetary plan, in addition to the profit plan and the cash forecast, include capital expenditure budgets, personnel budgets, production budgets, and budgeted balance sheets. They all serve the same purpose: to help management decide upon a course of action and to serve as a point of reference against which to measure subsequent performance. Planning is the responsibility of managers—not accountants; to plan is to decide, and only the manager has the authority to choose the direction the company is to take.

Accounting personnel are nevertheless deeply involved in the planning process. First, they administer the budgetary planning system, establishing deadlines for the completion of each part of the process and seeing that these deadlines are met. Second, they analyze data and help management compare the possible outcomes of different courses of action. Third, they collect the plans and proposals from the individual departments and divisions, reviewing them for consistency, feasibility, and desirability. Lastly, they assemble the final plans management has chosen and ensure that these plans are understood by the department heads and managers.

 

Performance reporting

Once the budgetary plan has been adopted, the accounting department's next task is to prepare and provide to management information on the results of company activities. A manager's main interest in this information centres on three questions: Have his or her own actions led to the expected results—and, if not, why not? How successfully have subordinates managed the activities entrusted to them? What problems and opportunities have arisen since the budgetary plan was prepared? For these purposes, the information must be comparative, relating actual results to the level of results that management regards as satisfactory. In each case, the standard for comparison is provided by the budgetary plan.

Much of this information is contained in periodic financial reports. At the top management and divisional levels, the most important of these is the comparative income statement.

By far the greatest number of reports, however, are cost or sales reports, mostly on a departmental basis. Departmental sales reports usually compare actual sales with the volumes planned for the period. Departmental cost performance reports, in contrast, typically compare actual costs incurred with standards or budgets that have been adjusted to correspond to the actual volume of work done during the period. This practice reflects a recognition that volume fluctuations generally originate outside the department and that the department head's responsibility is ordinarily limited to minimizing costs while meeting the delivery schedules imposed by higher management.

Significant changes in management and production technology have shifted the focus of cost control from the individual production department to larger, more interdependent groups. Standard cost systems have largely been replaced by just-in-time production systems; although just-in-time systems require changes in factory layouts, they significantly reduce the time it takes to move work from one station to the next, and they also reduce the number of partly processed units at each work station, thereby requiring greater station-to-station coordination. All these measures increase the efficiency of production.

At the same time, management's emphasis has shifted from cost control to cost reduction, quality enhancement, and closer coordination of production and customer deliveries. Most large manufacturing companies and many service companies have launched programs of total quality control and continuous improvement, and many have replaced standard costs with a more flexible approach using prior period results as current performance standards. Management is also likely to focus on the amount of system waste by identifying and minimizing activities that contribute nothing to the value that customers place on the product.

Real-time technology, based on the coordinated data used to monitor results and indicate the need for adjustments, helps improve a company's productivity. Advances in computer-based models have enabled companies to tie production schedules more closely to customer delivery schedules while increasing the rate of plant utilization. Some of these changes actually increase variances from standard costs in some departments but are undertaken because they benefit the company as a whole.

The overall result is that control systems are likely to focus in the first instance on operational controls (real-time signals to operating personnel that some immediate remedial action is required), with after-the-fact analysis of results focusing on aggregate comparisons with past performance and the planned results of current improvement programs.

Cost and profit analysis

Accountants share with many others in an organization—such as financial officers or strategic planners—the task of analyzing cost and profit data in order to provide guidance in managerial decision making. Even if the analytical work is done largely by others, accountants must understand the analytical methods because the systems they design must collect data in forms suitable for analysis.

Managerial decisions are based on comparisons of the estimated future results of the alternative courses of action. Recorded historical accounting data, in contrast, reflect conditions and actions of the past. Furthermore, the data are absolute, not comparative, in that they show the effects of one course of action but do not indicate whether these were better or worse than those that would have resulted from some other course.

For decision making, therefore, historical accounting data must be examined, modified, and placed on a comparative basis. Even estimated data, such as budgets and standard costs, must be examined to see whether the estimates are still valid and relevant to managerial comparisons. To a large extent, this job of review and restatement is an accounting responsibility. Accordingly, a major part of the accountant's preparation for the profession is devoted to the study of methods and principles of analysis that are used in managerial decision making.

Other importance of accounting records

Accounting systems are designed mainly to provide information that managers and outsiders can use in decision making. They also serve other purposes: to produce operating documents, to protect the company's assets, to provide data for company tax returns, and, in some cases, to provide the basis for reimbursement of costs by clients or customers.

The accounting organization is responsible for preparing documents that contain instructions for a variety of tasks, such as payment of customer bills or preparing employee payrolls. It prepares confidential documents, such as records of employees' salaries and wages. Many of these documents also serve other accounting purposes, but they would have to be prepared even if no information reports were necessary. Measured by the number of people involved and the amount of time required, document preparation is one of the biggest jobs performed by an organization's accounting department.

Accounting systems must provide means of reducing the chance of losses of assets due to carelessness or dishonesty on the part of employees, suppliers, and customers. Asset protection devices are often very simple; for example, many restaurants use numbered meal checks so that waiters will not be able to submit one check to the customer and another, with a lower total, to the cashier. Other devices entail a partial duplication of effort or a division of tasks between two individuals to reduce the opportunity for unobserved thefts.

These are all part of the company's system of internal controls. Another important element in this system is internal auditing. The task of internal auditors is to see whether prescribed data handling and asset protection procedures are being followed. To accomplish this, they usually observe some of the work as it is being performed and examine a sample of past transactions for accuracy and fidelity to the system. Internal auditors might also insert a set of fictitious data into the system to see whether the resulting output meets a predetermined standard. This technique is particularly useful in testing the validity of new computer systems.

The accounting system must also provide data for use in the completion of the company's tax returns. This function is the concern of tax accounting. In some countries financial accounting must conform to tax accounting rules laid down by national tax laws and regulations, and tabulations prepared for tax purposes often diverge from those submitted to shareholders and others. “Taxable income,” it should be remembered, is a legal concept rather than an accounting concept, and tax laws typically contain incentives that encourage companies to do certain things while discouraging them from doing others. Accordingly, what is “income” or “capital” to a tax agency may be far different from the accountant's measures of these same concepts. Finally, accounting systems in some companies must provide cost data in the forms required for submission to customers who have agreed to reimburse the company for costs incurred on the customers' behalf.

Problems of measurement and the limitations of financial reporting

Accounting income does not include all of the company's holding gains or losses (increases or decreases in the market values of its assets). For example, the construction of an expressway nearby may increase the value of a company's land, but neither the income statement nor the balance sheet will reflect this holding gain. Similarly, the introduction of a successful new product increases the company's anticipated future cash flows. While this increase makes the company more valuable, those additional future sales will not show up in the conventional income statement or in the balance sheet until they are recorded as transactions.

Accounting reports have also been criticized on the grounds that they confuse monetary measures with the underlying realities when the prices of many goods and services have been changing rapidly.

The amount of inventory holding gain that is included in net income is usually called the “inventory profit.” The implication is that this is a component of net income that is less “real” than other components because it results from the holding of inventories rather than from trading with customers.

When most of the changes in the prices of the company's resources are in the same direction, the purchasing power of money is said to change. Conventional accounting statements are stated in nominal currency units—not in units of constant purchasing power. Changes in purchasing power—that is, changes in the average level of prices of goods and services—have two effects. First, net monetary assets (essentially cash and receivables minus liabilities calling for fixed monetary payments) lose purchasing power as the general price level rises. These losses do not appear in conventional accounting statements. Second, holding gains measured in nominal currency units may merely result from changes in the general price level. If so, they represent no increase in the company's purchasing power.

In some countries that have experienced severe and prolonged inflation, companies have been allowed or even required to restate their assets to reflect the more recent and higher levels of purchase prices. The increment in the asset balances in such cases has not been reported as income, but depreciation thereafter has been based on these higher amounts. Companies in the United States are not allowed to make these adjustments in their primary financial statements.

As international economies evolve at an accelerating rate, financial accounting faces some daunting challenges. One of the most important questions facing accountants is the problem of assigning value to so-called “soft” assets such as brand image, corporate reputation, goodwill, and human capital. These can be among the most valuable assets controlled by the entity, yet they might be undervalued or ignored altogether under current practices.

In addition, accountants need to develop reliable ways to express forward-looking information; although this kind of information is more speculative than the information represented in financial statements, it is often the most relevant to decision makers. It is difficult to obtain, however, in part because of the uncertain nature of the information and in part because too much information could benefit competitors and harm the company. Furthermore, it is difficult to measure social performance, but this type of information is useful in evaluating organizational effectiveness as it is broadly conceived. While many companies are experimenting with alternative methods to measure and disclose employee and customer satisfaction data, environmental performance, and safety reports, increased standardization will enhance comparability and consistency.

Finally, a global economy demands dramatically enhanced international accounting standards. In order to improve the efficient allocation of capital resources across international boundaries, investors and creditors need to make reasonable comparisons among companies in different countries.