Accounting in organization

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Ministry of Higher and Secondary Education of the Republic of Uzbekistan

Tashkent State Economic University

Accounting in organization

Finished:

Group EC-25

Teshabaev Farrux

Introduction

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 the organization's managers to help them plan and control the organization's 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 organization; by governmental bodies to determine how much tax the organization must pay; and occasionally by customers to determine the price to be paid when contracts call for cost-based payments.

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

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 nations. The remainder of this article, however, will be devoted primarily to business accounting.

1. Company financial statements

Among the most common accounting reports are those sent to investors and others outside the management group. The reports most likely to go to investors are called financial statements, and their preparation is the province of the branch of accounting known as financial accounting. Three financial statements will be discussed: the balance sheet, the income statement, and the statement of cash flows.

The balance sheet A balance sheet describes the resources that are under a company's control on a specified date and indicates where these resources have come from. It consists of three major sections: (1) the assets: valuable rights owned by the company; (2) the liabilities: the funds that have been provided by outside lenders and other creditors in exchange for the company's promise to make payments or to provide services in the future; and (3) the owners' equity: the funds that have been provided by the company's owners or on their behalf.

The list of assets shows the forms in which the company's resources are lodged; the lists of liabilities and the owners' equity indicate where these same resources have come from. The balance sheet, in other words, shows the company's resources from two points of view, and the following relationship must always exist: total assets equals total liabilities plus total owners' equity.

This same identity is also expressed in another way: total assets minus total liabilities equals total owners' equity. In this form, the equation emphasizes that the owners' equity in the company is always equal to the net assets (assets minus liabilities). Any increase in one will inevitably be accompanied by an increase in the other, and the only way to increase the owners' equity is to increase the net assets.

Assets are ordinarily subdivided into current assets and noncurrent assets. The former include cash, amounts receivable from customers, inventories, and other assets that are expected to be consumed or can be readily converted into cash during the next operating cycle (production, sale, and collection). Noncurrent assets may include noncurrent receivables, fixed assets (such as land and buildings), and long-term investments.

The liabilities are similarly divided into current liabilities and noncurrent liabilities. Most amounts payable to the company's suppliers (accounts payable), to employees (wages payable), or to governments (taxes payable) are included among the current liabilities. Noncurrent liabilities consist mainly of amounts payable to holders of the company's long-term bonds and such items as obligations to employees under company pension plans. The difference between total current assets and total current liabilities is known as net current assets, or working capital.

The owners' equity of an American company is divided between paid-in capital and retained earnings. Paid-in capital represents the amounts paid to the corporation in exchange for shares of the company's preferred and common stock. The major part of this, the capital paid in by the common shareholders, is usually divided into two parts, one representing the par value, or stated value, of the shares, the other representing the excess over this amount. The amount of retained earnings is the difference between the amounts earned by the company in the past and the dividends that have been distributed to the owners.

A slightly different breakdown of the owners' equity is used in most of continental Europe and in other parts of the world. The classification distinguishes between those amounts that cannot be distributed except as part of a formal liquidation of all or part of the company (capital and legal reserves) and those amounts that are not restricted in this way (free reserves and undistributed profits).

accounting profit asset statement

2. The income statement

The company uses its assets to produce goods and services. Its success depends on whether it is wise or lucky in the assets it chooses to hold and in the ways it uses these assets to produce goods and services.

The company's success is measured by the amount of profit it earns--that is, the growth or decline in its stock of assets from all sources other than contributions or withdrawals of funds by owners and creditors. Net income is the accountant's term for the amount of profit that is reported for a particular time period.

The company's income statement for a period of time shows how the net income for that period was derived.

Net income summarizes all the gains and losses recognized during the period, including both the results of the company's normal, day-by-day activities and any other events. If net income is negative, it is referred to as a net loss.

The income statement is usually accompanied by a statement that shows how the company's retained earnings has changed during the year. Net income increases retained earnings; net operating loss or the distribution of cash dividends reduces it.

3. The statement of cash flows

Companies also prepare a third financial statement, the statement of cash flows. Cash flows result from three major groups of activities: (1) operating activities, (2) investing activities, and (3) financing activities.

Cash from operations is not the same as net income (revenues minus expenses). For one thing, not all revenues are collected in cash. Revenue is usually recorded when a customer receives merchandise and either pays for it or promises to pay the company in the future (in which case the revenue is recorded in accounts receivable). Cash from operating activities, on the other hand, reflects the actual cash collected, not the inflow of accounts receivable. Similarly, an expense may be recorded without an actual cash payment.

The purpose of the statement of cash flows is to throw light on management's use of the financial resources available to it and to help the users of the statements to evaluate the company's liquidity, its ability to pay its bills when they come due.

4. Consolidated statements

Most large corporations in the United States and other industrialized countries own other corporations. Their primary financial statements are consolidated statements, reflecting the total assets, liabilities, owners' equity, net income, and cash flows of all the corporations in the group. Thus, for example, the consolidated balance sheet of the parent corporation (the corporation that owns the others) does not list its investments in its subsidiaries (the companies it owns) as assets; instead, it includes their assets and liabilities with its own.

Some subsidiary corporations are not wholly owned by the parent; that is, some shares of their common stock are owned by others. The equity of these minority shareholders in the subsidiary companies is shown separately on the balance sheet. The consolidated income statement also must show the minority owners' equity in the earnings of a subsidiary as a deduction in the determination of net income.

5. Disclosure and auditing requirements

A corporation's obligations to issue financial statements are prescribed in the company's own statutes or bylaws and in public laws and regulations. The financial statements of most large and medium-size companies in the United States fall primarily within the jurisdiction of the federal Securities and Exchange Commission (SEC). The SEC has a good deal of authority to prescribe the content and structure of the financial statements that are submitted to it. Similar authority is vested in provincial regulatory bodies and the stock exchanges in Canada; disclosure in the United Kingdom is governed by the provisions of the Companies Act.

A company's financial statements are ordinarily prepared initially by its own accountants. Outsiders review, or audit, the statements and the systems the company used to accumulate the data from which the statements were prepared. In most countries, including the United States, these outside auditors are selected by the company's shareholders. The audit of a company's statements is ordinarily performed by professionally qualified, independent accountants who bear the title of certified public accountant (CPA) in the United States and chartered accountant (CA) in the United Kingdom and many other countries with British-based accounting traditions. Their primary task is to investigate the company's accounting data and methods carefully enough to permit them to give their opinion that the financial statements present fairly the company's position, results, and cash flows.

6. Measurement principles

In preparing financial statements, the accountant has several measurement systems to choose from. Assets, for example, may be measured at what they cost in the past or what they could be sold for now, to mention only two possibilities. To enable users to interpret statements with confidence, companies in similar industries should use the same measurement concepts or principles.

In some countries these concepts or principles are prescribed by government bodies; in the United States they are embodied in "generally accepted accounting principles" (GAAP), which represent partly the consensus of experts and partly the work of the Financial Accounting Standards Board (FASB), a private body. The principles or standards issued by the FASB can be overridden by the SEC. In practice, however, the SEC generally requires corporations within its jurisdiction to conform to the standards of the FASB.

7. Asset value

One principle that accountants may adopt is to measure assets at their value to their owners. The economic value of an asset is the maximum amount that the company would be willing to pay for it. This amount depends on what the company expects to be able to do with the asset. For business assets, these expectations are usually expressed in terms of forecasts of the inflows of cash the company will receive in the future. If, for example, the company believes that by spending $1 on advertising and other forms of sales promotion it can sell a certain product for $5, then this product is worth $4 to the company.

When cash inflows are expected to be delayed, value is less than the anticipated cash flow. For example, if the company has to pay interest at the rate of 10 percent a year, an investment of $100 in a one-year asset today will not be worthwhile unless it will return at least $110 a year from now ($100 plus 10 percent interest for one year). In this example, $100 is the present value of the right to receive $110 one year later. Present value is the maximum amount the company would be willing to pay for a future inflow of cash after deducting interest on the investment at a specified rate for the time the company has to wait before it receives its cash.

Value, in other words, depends on three factors: (1) the amount of the anticipated future cash flows, (2) their timing, and (3) the interest rate. The lower the expectation, the more distant the timing, or the higher the interest rate, the less valuable the asset will be.

Value may also be represented by the amount the company could obtain by selling its assets. This sale price is seldom a good measure of the assets' value to the company, however, because few companies are likely to keep many assets that are worth no more to the company than their market value. Continued ownership of an asset implies that its present value to the owner exceeds its market value, which is its apparent value to outsiders.

8. Asset cost

Accountants are traditionally reluctant to accept value as the basis of asset measurement in the going concern. Although monetary assets such as cash or accounts receivable are usually measured by their value, most other assets are measured at cost. The reason is that the accountant finds it difficult to verify the forecasts upon which a generalized value measurement system would have to be based. As a result, the balance sheet does not pretend to show how much the company's assets are worth; it shows how much the company has invested in them.

The historical cost of an asset is the sum of all the expenditures the company made to acquire it. This amount is not always easily measurable. If, for example, a company has built a special-purpose machine in one of its own factories for use in manufacturing other products, and the project required logistical support from all parts of the factory organization, from purchasing to quality control, then a good deal of judgment must be reflected in any estimate of how much of the costs of these logistical activities should be "capitalized" (i.e., placed on the balance sheet) as part of the cost of the machine.

9. Net income

From an economic point of view, income is defined as the change in the company's wealth during a period of time, from all sources other than the injection or withdrawal of investment funds. Income is the amount the company could consume during the period and still have as much real wealth at the end of the period as it had at the beginning. For example, if the value of the net assets (assets minus liabilities) has gone from $1,000 to $1,200 during a period and dividends of $100 have been distributed, income measured on a value basis would be $300 ($1,200 minus $1,000, plus $100).

Accountants generally have rejected this approach for the same reason that they have found value an unacceptable basis for asset measurement: Such a measure would rely too much on estimates of what will happen in the future, estimates that would not be readily susceptible to independent verification. Instead, accountants have adopted what might be called a transactions approach to income measurement. They recognize as income only those increases in wealth that can be substantiated from data pertaining to actual transactions that have taken place with persons outside the company. In such systems, income is measured when work is performed for an outside customer, when goods are delivered, or when the customer is billed.

Recognition of income at this time requires two sets of estimates: (1) revenue estimates, representing the value of the cash that the company expects to receive from the customer; and (2) expense estimates, representing the resources that have been consumed in the creation of the revenues. Revenue estimation is the easier of the two, but it still requires judgment. The main problem is to estimate the percentage of gross sales for which payment will never be received, either because some customers will not pay their bills ("bad debts") or because they will demand and receive credit for returned merchandise or defective work.

Expense estimates are generally based on the historical cost of the resources consumed. Net income, in other words, is the difference between the value received from the use of resources and the cost of the resources that were consumed in the process. As with asset measurement, the main problem is to estimate what portion of the cost of an asset has been consumed during the period in question.

Some assets give up their services gradually rather than all at once. The cost of the portion of these assets the company uses to produce revenues in any period is that period's depreciation expense, and the amount shown for these assets on the balance sheet is their historical cost less an allowance for depreciation, representing the cost of the portion of the asset's anticipated lifetime services that has already been used. To estimate depreciation, the accountant must predict both how long the asset will continue to provide useful services and how much of its potential to provide these services will be used up in each period.

Depreciation is usually computed by some simple formula. The two most popular formulas in the United States are straight-line depreciation, in which the same amount of depreciation is recognized each year, and declining-charge depreciation, in which more depreciation is recognized during the early years of life than during the later years, on the assumption that the value of the asset's service declines as it gets older.

The role of the independent accountant (the auditor) is to see whether the company's estimates are based on formulas that seem reasonable in the light of whatever evidence is available and whether these formulas are applied consistently from year to year. Again, what is "reasonable" is clearly a matter of judgment.

Depreciation is not the only expense for which more than one measurement principle is available. Another is the cost of goods sold. The cost of goods available for sale in any period is the sum of the cost of the beginning inventory and the cost of goods purchased in that period. This sum then must be divided between the cost of goods sold and the cost of the ending inventory.

Accountants can make this division by any of three main inventory costing methods: (1) first in, first out (FIFO), (2) last in, first out (LIFO), or (3) average cost. The LIFO method is widely used in the United States, where it is also an acceptable costing method for income tax purposes; companies in most other countries measure inventory cost and the cost of goods sold by some variant of the FIFO or average cost methods. Average cost is very similar in its results to FIFO, so only FIFO and LIFO need be described.

Each purchase of goods constitutes a single batch, acquired at a specific price. Under FIFO, the cost of goods sold is determined by adding the costs of various batches of the goods available, starting with the oldest batch in the beginning inventory, continuing with the next oldest batch, and so on until the total number of units equals the number of units sold. The ending inventory, therefore, is assigned the costs of the most recently acquired batches.

Under LIFO, the cost of goods sold is the sum of the most recent purchase, the next most recent, and so on, until the total number of units equals the number sold during the period.

The LIFO cost of the ending inventory is the cost of the oldest units in the cost of goods available.

10. Problems of measurement

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, construction of a superhighway may increase the value of a company's land, but neither the income statement nor the balance sheet will report this holding gain. Similarly, introduction of a successful new product increases the company's anticipated future cash flows, and this increase makes the company more valuable. Those additional future sales show up neither in the conventional income statement nor in the balance sheet.

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. For example, if the wholesale price of an item has risen from $100 to $150 between the time the company bought it and the time it is sold, many accountants claim that $150 is the better measure of the amount of resources consumed by the sale. They also contend that the $50 increase in the item's wholesale value before it is sold is a special kind of holding gain that should not be classified as ordinary income.

When inventory purchase prices are rising, LIFO inventory costing keeps many gains from the holding of inventories out of net income. If purchases equal the quantity sold, the entire cost of goods sold will be measured at the higher current prices; the ending inventory will be measured at the lower prices shown for the beginning-of-year inventory. The difference between the LIFO inventory cost and the replacement cost at the end of the year is an unrealized (and unreported) holding gain.

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 (dollars, francs, lire, etc.), 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.

11. Managerial accounting

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 are only the tip of the iceberg. 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.

12. 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 requires also a system for measuring actual results and reporting differences between actual performance and the plans (see below 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. 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 be either broad, strategic outlines of the company's future or schedules of the inputs and outputs associated with specific independent programs, most business plans are periodic plans--that is, they refer to 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 the company's operations.

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 out that part.

Many companies also prepare alternative budgets for operating volumes other than 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 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 budgetary plan, 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.

Company-wide 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 a management responsibility, not an accounting function. 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 at various levels compare the estimated effects of different courses of action. Third, they are responsible for collating the tentative plans and proposals coming from the individual departments and divisions and then reviewing them for consistency and feasibility and sometimes for desirability as well. Finally, they must assemble the final plans management has chosen and see that these plans are understood by the operating executives.

13. Cost and profit analysis

Accountants share with many other people 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, they have an interest in 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 that the decision maker is choosing among. Recorded historical accounting data, in contrast, reflect conditions and experience of the past. Furthermore, they are absolute, not comparative, in that they show the effects of one course of action but not 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 for managerial decision making.

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