Accounting

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.

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.

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.

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.

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.

The basic principle in cost finding is that the cost assigned to any object--an activity or a product--should represent the amount of cost that 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 separate production operation or process for a specified period of time. The total of these costs is then restated as an average by dividing it by the total output of the process during the same 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.

A second method, job order costing, is used when individual production centres or departments work on a variety of products rather than just one during a typical time period. Two categories of factory cost are recognized under this method: prime costs and factory overhead costs. Prime costs are those that can be traced directly to a specific batch, or job lot, of products. These are the direct labour and direct materials costs of production. Overhead costs, on the other hand, are those that can be traced only to departmental operations or to the factory as a whole and not to individual job orders. The salary of a departmental supervisor is an example of an overhead cost.

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.

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, one of which is illustrated in Table 4. This shows the profit that was planned for this period, the actual results received for this period, and the differences, or variances, between the two. It also gives an explanation of some of the reasons for the difference between a planned and an actual income.

The report in this exhibit employs the widely used profit contribution format, in which divisional results reflect sales and expenses traceable to the individual divisions, with no deduction for head office expenses. Company net income is then obtained by deducting head office expenses as a lump sum from the total of the divisional profit contributions. A similar format can be used within the division, reporting the profit contribution of each of the division's product lines, with divisional headquarters expenses deducted at the bottom.

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 cost while meeting the delivery schedules imposed by higher management.

In most cases, the labour rate variance would not be reported to the department head, because it is not subject to his or her control.

Standard costing systems no longer have the central importance they commanded in many industries up to the 1970s. One reason is that significant changes in management technology have shifted the focus of cost control from the individual production department to larger, more interdependent groups. Just-in-time production systems require changes in factory layouts to reduce the time it takes to move work from one station to the next. They also reduce the number of partly processed units at each work station, thereby requiring greater station-to-station coordination.

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.

Reducing set-up time, inspection time, and time spent moving work from place to place while maintaining or improving quality are some of the results of these programs. 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.

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 also must prepare documents that serve what might be called private information purposes, such as the employees' own records of their 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 accounting's biggest jobs.

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 the internal control 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. They may 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 the programs that are used to process data through electronic computers.

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 obey rules laid down for tax accounting by national tax laws and regulations, but no such requirement is imposed in the United States, and tabulations prepared for tax purposes often diverge from those submitted to shareholders and others. “Taxable income” is a legal concept rather than an accounting concept. Tax laws include incentives to encourage companies to do certain things and discourage 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.