To ensure that users get the type of information they need, when they need it, the accounting information system has four related subsystems designed to provide relevant information to external and internal users. The accounting subsystems are:
The financial accounting subsystem, designed to communicate financial information to external users, primarily stockholders and creditors.
The management accounting subsystem, designed to provide information to internal users, primarily employees and managers.
The tax accounting subsystem, designed to provide tax and other information regarding taxes to governments.
The regulatory accounting subsystem, designed to provide required information (reports) to regulatory agencies such as the SEC.
The purpose of the financial accounting subsystem is to communicate relevant information to users through a company's financial statements. Both the form and content of these financial statements is determined by generally accepted accounting principles. The four primary financial statements of concern to external users are (1) the income statement, (2) the statement of owners' equity, or the statement of retained earnings, (3) the balance sheet (statement of financial position), and (4) the statement of cash flows. In addition, the annual report, which contains the financial statements, also includes notes to the financial statements, which provide supplementary information vital to the understanding of the statements.
Income Statement. The purpose of the income statement is to report to external users the revenues, expenses, and resulting net income for a particular period of time. External users often want to compare the results of one time period with those of previous periods. Therefore, companies often publish comparative financial statements that show the results of operations for three to five consecutive periods.
This statement is called a consolidated statement of income because it represents the income generated from many different companies in one total set of (consolidated) numbers.
Notice that the income statement reports other revenue and expense items such as interest expense and investment and interest income. These items represent revenues and expenses from sources other than continuing business operations.
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Statement of Owners' Equity. The statement of owners' equity is designed to show external users the changes that occurred in owners' equity for the period of time covered by the income statement. The statement of owners' equity provides a link between the income statement and the balance sheet. The income (loss) shown on the income statement is also presented in the statement of owners' equity as an increase (decrease) in owners' equity during the period. The ending balance in owners' equity is shown on the balance sheet. Sometimes companies do not present the changes in owners' equity as a formal statement. Rather, they present such information in the footnotes to the financial statements.
Other corporations present a statement of retained earnings rather than a statement of owners' equity. The statement of retained earnings shows only the changes that affected retained earnings during the period. Those changes affecting contributed capital are not shown.
Balance Sheet (Statement of Financial Position). The purpose of the balance sheet, or statement of financial position, is to show the assets, liabilities, and owners' equity that exist at the end of the period covered by the income statement. The balance sheet, then, is a snapshot of the company at a particular point in time. The balance sheet illustrates the accounting equation: Assets = Liabilities + Owners' equity.
Statement of Cash Flows. The statement of cash flows is designed to show the business's cash inflows and cash outflows as well as the net change in the business's cash balance for the same time period as the income statement. The cash inflows and outflows are divided into three sections depending on their source: (1) net cash flows from operating activities (activities required for the actual operations of the business), (2) net cash flows from investing activities.
TEXT 5. Business activities
Business activities are events that involve making and carrying out the operating, investing, and financing decisions that deal with business assets or obligations.
In a profit-seeking business, there are three types of business activities that correspond to the three types of business decisions. Operating activities are the profit-making activities of the enterprise. Business's profit (net income) results when revenues exceed expenses for a given period. So, operating activities include those business activities that generate revenues, such as selling merchandise for cash or on credit or providing services for a fee. They also include activities that result in increased expenses, such as purchasing goods for manufacture or resale, paying wages, or combining goods and labor to manufacture products.
Investing activities include the purchase and sale of long-term assets in addition to other major items used in a business's operations. For example, purchasing equipment and buildings that a company expects to use over two or more years is an investing activity. However, actually using the buildings and equipment to provide a service, or to make or sell a product, is an operating activity. Financing activities are activities that involve obtaining the cash or using other noncash means to pay for investments in long-term assets, and to repay money borrowed from creditors, and to provide a return to owners.
In this chapter, we focus on operating activities, which we divide into three cycles of events commonly found in businesses: (1) expenditure, (2) revenue, and (3) conversion. Our goal is to describe, in a coherent way, the activities that are planned, performed, and evaluated as part of business operations. We also discuss procedures that owners and managers use to ensure the accuracy of accounting information and to protect assets from theft or misuse. Then we relate operating activities to the documents found in most accounting systems to show the connection between the sources of information and the activities they describe, and how they help provide accountability. Later in the chapter, we discuss the cycle of planning, performing, and evaluating business activities as it applies to operating activities.
TEXT 6. Operating activities versus financing and investing activities
The distinction between operating activities and financing and investing activities is sometimes blurred. Though paying interest to lenders for use of their money is a financing activity, interest is considered to be an expense when calculating periodic income, which implies that it is an operating activity. In addition, financing can refer to payments for assets used in operations, such as inventory. Generally, when we refer to financing activities, we mean those activities associated with obtaining cash to pay for long-term assets and repaying amounts borrowed.
The term investing sometimes refers to purchasing assets used in operations as well as making operating expenditures. We use the term investing to refer to the purchase or sale of long-lived assets. The distinction involves whether the asset is a major resource the business intends to keep or an asset it consumes in a short period of time. Companies often buy insurance policies that cover multiple years. Although these insurance policies cover multiple years, their cost is not considered to be an investment because insurance is part of day-to-day profit-making activities rather than a major, long-lived asset.
Some operating activities have characteristics of both investing and financing activities. For example, think of a business that sells on credit to its customers. Sales on credit are like investments because the business has chosen a resource (payments due from customers) that will provide cash in the future rather than cash at the time of sale. Similarly, purchasing goods for resale, which is an operating activity, is also a financing transaction because the vendors lend the company the amount of the purchase until they receive subsequent payment from the company.
One characteristic that generally distinguishes selling and purchasing on credit from investing and financing activities is that selling and purchasing activities directly influence the amount of profit the firm makes. In addition, both selling and purchasing activities are a series of transactions that tend to be repeated regularly and frequently during business operations.
TEXT 7. Customers and the quantity demanded and competitors and the quantity supplied
Customers and the quantity demanded. A customer's willingness to purchase goods and services depends on the selling prices company charges for them. In simple terms, if the selling price of the product increases, the quantity of the product demanded decreases. On the other hand, if the selling price of the product decreases, the quantity of the product demanded increases.
These rules do not apply equally to all products, however. A company may be able to increase the selling price of a product if customers are loyal and unwilling to substitute other products
Also, consider the case of a product that is considered to be a staple (necessity) versus one that is considered to be a luxury. A staple's selling price does not affect the quantity demanded as much as the price of a luxury item does.
Finally, the quantity demanded is influenced heavily by product quality and service. Products with perceived high quality and service are in greater demand than products with lower quality and service that sell at the same, or perhaps even slightly lower, prices. Most companies try to differentiate their products in terms of quality and service.
Competitors and the Quantity Supplied. The selling price charged by a particular company is also influenced by the quantity of the product supplied by competitors and/or the selling prices charged by those competitors. Some companies operate in an environment where there is an abundance of suppliers whose products are almost identical. Companies in this situation are price takers, that is, the company "takes" the selling price from the market that establishes the price based on total supply and demand. In these markets, an individual company has little or no influence on the selling price. In the agricultural industry, for example, wheat produced by each wheat farming operation is almost identical. Therefore, wheat sellers are price takers who receive the price for wheat that the market determines. This type of environment where a large number of sellers produce and distribute virtually identical products and services is called pure competition.
Other companies operate in an environment in which there are many companies whose products are similar, but not identical. In this environment, called monopolistic competition, the market has a large impact on, but no control over, prices. Individual companies operating within this type of market can influence selling prices by advertising quality and service as well as price.
TEXT 8. What Are the Costs of Budgeting?
The budgeting process requires time and other resources, such as people. The results of the process impact the activities of departments and individuals. Thus, we discuss the costs of budgeting in terms of three important aspects: (1) time and resource requirements, (2) adaptability of departments or segments of the business, and (3) motivation and behavior of individuals.
Time and Resource Requirements. Budgeting is time consuming. A typical yearly budgeting sequence may take as long as three or four months. During this time, management must coordinate its activities with others in the organization. A large organization typically appoints a budget director, often the controller, who determines how to collect the data and prepare the budget. The budget director works closely with various department managers who provide the information necessary to complete the budgets. The budget director typically reports to a budget committee, a group of key executives who are responsible for overseeing the budget process. The budget committee reports to the board of directors who approve the budget. Thus, because many people are involved in the budgeting process, the cost, in terms of human capital, is large.
Adaptability of Departments and Segments. Another cost associated with budgeting occurs when the budget is so rigidly adhered to that it inhibits a department or business segment from responding to the changes in the environment. For example, if a business segment is only allocated a specific amount of resources, it may be forced to forgo profitable opportunities due to lack of available resources.
Motivation and Behavior of Individuals. The budget also has an effect on the motivation and behavior of individuals, both during the budget process and after the budget has been formalized. During the budgeting process, individuals who develop budgets (employees, lower-level managers, and/or upper-level managers) are influenced by the communication and coordination aspects of budgeting. If communication between departments is inadequate, the budgeting process can result in inaccurate departmental budgets. For example, if the marketing department and the production department at Ford do not communicate effectively, either, or both, of their department budgets may not reflect the expected activities of the coming period.
In addition, the budgeting process may lead to dysfunctional behavior on the part of those individuals involved in determining the budget numbers. Managers and other employees may be motivated to report budget numbers that they know are not accurate representations of future expectations. We call this budgetary slack, which is the difference between what a person with input into the budget process chooses as an estimate of revenues or expenses and what is actually a realistic estimate. In other words, budgetary slack can be viewed as a deliberately introduced bias.
TEXT 9. What Are Budgetary Strategies?
A budgetary strategy is the manner in which a company approaches the budgeting process. The strategy adopted by the company impacts who is involved in the budgeting process and how the budget numbers are derived. Each of the various budgeting strategies is an attempt to minimize the motivational and behavioral costs associated with budgeting. Two budgetary strategies that involve different groups of people are mandated budgeting and participative budgeting.
Mandated Budgeting Mandated budgeting relies on predetermined standards set by upper-level managers for its budget levels. It is also known as top-down budgeting because top management develops the budgets and passes them down the organizational hierarchy to various divisions and/or departments without input from lower levels of management and employees.
The purpose of mandated budgeting is to set operating budgets that are in line with the goals and objectives of upper-level management. The predetermined standards on which such budgets are based are estimates of the quantity and cost of operating inputs and can be either ideal or normal. An ideal standard can be achieved if operating conditions are almost perfect; it does not allow for any operating inefficiencies. A normal standard can be achieved under practical operating conditions and allows for some "normal" operating inefficiencies.
There is a great deal of debate among psychologists, behavioral scientists, and managers as to which standard is a better motivator for employees. Some professionals think that ideal standards give employees something to aim for. Such ideal standards are viewed as being motivational, whereas normal standards are thought to be too easily achieved and, therefore, not conducive to encouraging improvement. For example, if you could achieve an A in a course without studying, how motivated would you be to study? Employees also may be unmotivated by standards that are too easy to achieve.
Others think that ideal standards do not motivate because they are too hard to achieve, causing employees to give up. They believe that normal standards that can be achieved give employees a sense of accomplishment and, consequently, serve to motivate them. For example, if you felt as though you could not achieve an A in a course no matter how hard you studied, how motivated would you be to study?
Participative Budgeting Participative budgeting allows individuals who are affected by the budget to have input into the budgeting process. It is also known as bottom-up budgeting because the budgeting process begins at lower levels of the organizational hierarchy and continues up through the organization to top management. Upper-level management and the budget director are responsible for coordinating the information received from the employees and for developing a comprehensive budget plan.
For example, suppose that rather than having upper management determine the standard time allowed to produce a car, the production managers at Ford asked production employees for their input. Since the employees affected by the budget are given input into the process, this is a participative budget process.
Participative budgeting is most appropriate for divisions whose product lines are in the development or growth stages. In the development stage, the environment is particularly uncertain, and input from employees is necessary since they have a better understanding of the product than does upper management. In addition, employee input into the budgeting process may increase their motivation, which is essential to develop products and markets.
Since most companies have divisions in all the product stages from development to decline, the overall budgeting process is typically both participative and mandated. In these circumstances, employees have input into the budgeting process, the budget is revised by upper management after careful consideration of all employee input, and the final budget is prepared by the budget director and approved by the board of directors.
The second aspect of budgeting strategy concerns how to determine the budget numbers. Some companies begin a period's budgeting process by referring to the current period's budget, while others begin each budgeting period anew.
Incremental Budgeting Incremental budgeting is a strategy whereby the company uses the current period's budget as a starting point in preparing the next period's budget. The resource requirements of the current period are increased or decreased based on the changes expected during the coming period. The advantage of this strategy is that it is less time consuming and may involve fewer individuals within the organization. The disadvantage is that an increase in resource requirements is often proposed without considering whether the increase is really necessary.
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Zero-Based Budgeting In contrast, a zero-based budgeting strategy in which the company begins each budget period with a zero budget requires consideration of every activity undertaken by the department or segment. Rather than beginning with the current period's budget, the manager must determine if the activity is necessary, the alternative ways of conducting the activity, and the amount of resources needed to conduct the activity.
The advantage of zero-based budgeting is that it requires managers to carefully consider the activities undertaken by their respective departments and to determine if activities add value. The disadvantage of zero-based budgeting is that it is time consuming and, therefore, requires more resources than incremental budgeting.
Many companies have adopted a budgeting strategy that is both incremental and zero-based. In this strategy, a zero-based budget strategy is followed in a two- to three-year cycle with an incremental budgeting strategy in the intervening years. In this way, it is possible to obtain the best of both strategies.
TEXT 10. What types of budgets do companies prepare?
The type of budgets prepared by a particular company depends on the time horizon and the nature of the business activities under consideration. The time horizon considered is a continuum between strategic and operational budgets, while the nature of the business activities determines whether there is a need for a project or master budget.
A strategic budget, also known as a forecast, is typically prepared for a 5- to 10-year period. This type of budget considers the long-term planning of the company and is usually more general in nature than an operating budget. A strategic budget considers questions such as: Should the company expand its product lines? Should it change its inventory policy? Should the company expand its markets?
In contrast, an operational budget is prepared for a much shorter period of time, typically, a year or less. An operational budget is more specific than the strategic budget. It considers questions such as: How many units should the company produce this year? How much does the company expect to spend on material purchases this year? How much labor cost is expected this year? Operating budgets are related to strategic budgets because the operating budget is the current plan for achieving the long-term goals and objectives of the company.
Project budgeting is the process of ascertaining the specific resources provided by, and needed for, a specific project or activity. Often companies need to budget a particular project to determine whether it should be undertaken or to determine a bid price in a contracting situation. A company uses a project budget to determine what subset of the company's resources is necessary to complete the project. A project budget may be long term or short term in duration, but it considers only the resources required for one particular project.
In contrast, master budgeting is the process of compiling all the budgets prepared during the revenue, conversion, and expenditure cycles that culminates with the cash budget and pro forma financial reports. The sales budget is related to the production budget, selling and administrative costs budget, and cash receipts schedule as well as the pro forma financial reports. The production budget, in turn, is related to the direct materials budget as well as the direct labor and manufacturing overhead budget. These budgets, in turn, are related to the cash disbursements schedule and the pro forma financial reports. The selling and administrative costs budget, which flows from the sales budget, is related to the cash disbursements schedule and the pro forma financial reports. Finally, the cash receipts and cash disbursements schedules along with the planned financing and investing cash flows become input for the cash budget and the related amount shown on the pro forma balance sheet.
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