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ACCOUNTING 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
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.
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
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
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
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.
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.
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
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
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.
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.
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
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
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.
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,
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
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
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.
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
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
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.
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)
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
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,
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.
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 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.
Direct materials and direct labour costs are recorded directly on the job
order cost sheets, one 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
machines differ widely in such factors as power consumption,
maintenance cost, and depreciation.
Many production costs are incurred in departments that don't actually
produce goods or provide salable services. Instead, they provide services
or support to the departments that do produce products. Examples include
maintenance departments, quality control departments, and internal
power plants. 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 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
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 are those that will be greater in total in the
upper portions of the company's normal range of volumes than in the
lower portion. 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. The main argument for the variable costing approach
is that average variable cost is more relevant to short-horizon managerial
decisions than average full cost. 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 assume without question that average fixed cost can be used to
estimate changes in 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 because
generally accepted accounting principles in the United States and in most
other countries require that inventories be measured at full product cost
for external financial reporting.
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.
Once the budgetary plan has been adopted, accounting's next task is to
prepare information on the results of company activities and make it
available to management. The manager's main interest in this information
centres on three questions: Have his or her own actions had the results
expected, and, if not, why not? How successful have subordinates been in
managing the activities entrusted to them? What problems and
opportunities seem to 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, 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
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
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.
Other purposes of accounting systems
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
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
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
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.
Finally, accounting systems in some companies must provide cost data in the forms
required for submission to customers who have agreed to reimburse the companies for the
costs they have incurred on the customers' behalf. The primary example of these is work
performed under cost-based contracts with U.S. military agencies. The measurement rules
for this purpose are contained in the Armed Services Procurement Regulations, which
embody standards issued by the Cost Accounting Standards Board. In general, these
standards conform to the principles underlying conventional product costing systems, but
they go beyond them in incorporating provisions for corporate and divisional head office