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Ch.1 Fundamentals of Financial Accounting

PIDP 3240 Assignment 4 (Textbook Chapter)

Jaspal Singh, 398179

Vancouver Community College

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Ch.1 Fundamentals of Financial Accounting

Accounting: The Language of Business

Accounting is best defined as an “information system” which performs three essential functions
(Horngren, Harrison, Johnston, Meissner, and Norwood; 2014)

1. Measures business financial activities: Accounting systems keep track of key information which
can be used for reports and decision making. An example of this concept in action could be a
small business owner, Rachel, who keeps close track of her merchandise purchases and their
eventual sales prices. This process of maintaining financial records of transactions is called
bookkeeping.
2. Processes information into reports: By consolidating information into readable and
understandable formats, accounting helps the business communication and decision-making
processes. Imagine Rachel’s computer software can automatically add up the merchandise
orders for the month as well as the sales.
3. Communicates the results to decision makers: With key information available (from financial
statements, accounting ratios, trend analysis, etc), managers are able to make better business
decisions. Consider what Rachel can do with information about how her purchase costs are
changing compared to sales volume. With detailed reports on hand, she can make better
decisions about merchandise purchases, price levels, and marketing strategies.

Brainstorming time! Take a minute to come up with examples of businesses you know
which might use all of accounting’s three essential functions. What kinds of changes
might a business make while going through this process?

Financial statements

Financial statements are a key product of an accounting system which provide information to “users” to
help them make better business decisions. Some commonly used financial statements are the Income
Statement, Balance Sheet, and the Cash Flow Statement. These and other financial statements report on
a business in monetary terms. Important questions like the following are answered with financial
statements:

 Am I earning a profit?
 Am I in good shape to grow my business?
 Is my business performing better or worse this year compared to last year?
 How does my performance compare to my peers/competitors?
 Am I at financial risk right now?
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Ch.1 Fundamentals of Financial Accounting

Who are the “users” of financial statements?

This group can be small or large depending on the nature and size of the business. Some common users
are (Larsen & Jensen, 2016):

 Managers – Individuals and managing groups rely on accurate, timely, and relevant information
in their decision-making.

 Creditors/suppliers- Banks and other lenders analyze risk and business viability prior to
extending credit.

 Shareholders- Investors rely on assets, business performance, etc as a predictor of future

profitability.

 Government/regulatory authorities- taxation and regulation relies on financial results.

Financial Accounting vs Managerial Accounting

How do we distinguish between the two? Simple!

Financial Accounting
- Concerned with providing information to parties external to the organization (shareholders,
creditors, government bodies)
- Reporting is done on PAST happenings (ex. Last quarter’s financial results)
- Reporting usually follows a specific set of rules such as GAAP, ASPE, or IFRS.

Management Accounting
- Focuses on internal exchange of information in the organization, usually to managers
- Information is used to improve decision making with cost monitoring and improving
efficiency (future emphasis)
- Reporting can be customized to fit the user’s needs (relevant to an issue which a manager
would like to address)

Brainstorming time! Imagine a manager who is compensated based on the performance

of her company’s share price. Would she be more concerned with financial accounting
or management accounting? What business functions would she use each one for?
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Ch.1 Fundamentals of Financial Accounting

Ethics- Why do they matter?

There are currently four types of designated accountants in Canada- Chartered Accountants (CAs),
Certified General Accountants (CGAs), Certified Management Accountants (CMAs), and Chartered
Professional Accountants (CPAs). In 2013, a merger occurred to bridge CAs, CGAs, and CMAs to the CPA
designation (CPA Canada, 2018).

 Critical for an economy’s operational efficiency- confidence/trust factor for the company’s
customers, employees, suppliers

 Also very important for accountants- confidentiality, integrity, and objectivity

 Corporate governance- system by which a company is directed and controlled (performance

measurement), enhances shareholder confidence

 Corporate social responsibility- considering all stakeholders in decision making- “doing the right
thing”

Ethics in Financial Accounting

The previous diagram illustrates the ethical/regulatory structure surrounding a typical public
corporation. We have already identified certain decision makers as “users” of the financial statements
(creditors, investors, managers) who have a direct influence on a business. However, this diagram shows
two other parties which can exert significant influence.

The securities commissions serve as regulatory bodies in the sense that they oversee publicly traded
corporations and ensure certain reporting guidelines are followed. Part of the criteria for being listed on
any major securities exchange is usually to have audited financial statements to report quarterly results.
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Ch.1 Fundamentals of Financial Accounting

Brainstorming time! What if a local restaurant wasn’t ethical in how it conducted

business? What would happen? What if the entire local restaurant industry was
unethical? What would happen then?

Audit: a financial examination conducted by independent accountants who express on whether or not
the financial statements fairly reflect the economic events which occurred during the accounting period.
This audit process serves as assurance to financial statement users (mainly those external to the
organization) that the information being presented to them is accurate.

Generally Accepted Accounting Principles (GAAP): rules which govern how accountants measure,
process, and communicate financial information.

Historically, different countries have created and enforced their own GAAPs. However, the recent trend
with increasing globalization and worldwide flow of capital has pushed nations towards uniform
accounting standards. Imagine that Rachel wishes to grow her company and chooses to finance the
growth by issuing stocks on the American and Canadian stock exchanges. She would have to produce
financial statements which conform to both the American and Canadian GAAPs! This process is
redundant, time-consuming, and costly.

Now imagine that the two countries had the same set of accounting standards. Rachel would only have
to produce one set of financial statements and potential investors could easily compare her financial
performance to man similar businesses. This is especially true if the European and Asian stock exchanges
also demanded the same accounting standards!

International Financial Reporting Standards (IFRS): a set of global accounting standards developed by
the International Federation of Accountants. Since 2011, IFRS has been used by publicly traded Canadian
corporations to report their financial results to the public.

Accounting Standards for Private Enterprises (ASPE): Accounting standards designed for and generally
used by small to mid-sized privately-owned businesses.

Although smaller companies can use IFRS if they choose to (publicly traded corporations MUST use
IFRS), ASPE are usually the more cost-effective and convenient route for them. As mentioned earlier, the
users of the financial statements can be very different for a smaller privately owned business compared
to large publicly traded corporations.

A corner-store owner may need a business loan from his local bank to open a second location. To assess
risk for the loan, the bank would ask the owner for financial statements which conform to ASPE. Since
the bank can easily communicate with the owner, statements don’t need to be as detailed or
comprehensive as an IFRS-based annual report to thousands of shareholders. By having a less strict
reporting option, small businesses can often save a lot of money.
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Characteristics of Useful Financial Information

 Understandability: The information has to be understandable to users if they want to use it.
There is no benefit to having information which is too vast or complex to make sense of.

 Relevance: The information must be significant enough to make a difference in the user’s
decisions. To be relevant, the information should enable users to predict future outcomes or
provide feedback about previous management decisions, or both.

 Reliability: The information must accurately represent the impact of transactions summarized in
the financial statements. The primary purpose of an audit is to ensure the reporting is free of
error and bias.

 Comparability: Information is much more useful if it is comparable to other information.

Comparability can be useful in a historical context where a firm’s recent financial performance is
compared to past quarters/years. It can also be helpful to compare a business with other
industry participants. IFRS aims to help this cause with uniform reporting standards worldwide.

Chapter 1 Exercises
1. List and describe the three key functions of financial accounting.

2. Who are the various users of financial statements? What kinds of questions is each user
interested in answering?

3. What are the key differences between financial and management accounting? Which
accounting system (financial or management) seems more interesting to you? Why?

4. How do ethics for accountants differ from business ethics in general?

5. Find/create a scenario where confidentiality is violated. Do the same for integrity and
objectivity.

6. What are the key differences between corporate governance and corporate social
responsibility?

7. What would be the consequences of an audit process not being done correctly?

8. What are some reasons why a business may select ASPE over IFRS? Why would a business
choose IFRS over ASPE?

9. You are trying to convince a new online retailer to take accounting seriously. What are five
things you might tell the retailer to convince him of the benefits of accounting?
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References

CPA Canada. (2018). Unification status of the Canadian accounting profession. Retrieved from:
https://www.cpacanada.ca/en/the-cpa-profession/uniting-the-canadian-accounting-
profession/unification-status

Horngren, C., Harrison, W., Johnston, J., Meissner, C., & Norwood, P. (2014). Accounting Canadian Ninth
Edition, Volume 1. Toronto, Ontario. Pearson Canada Inc.

Larsen, K. & Jensen, T. (2016). Fundamental Accounting Principles (15th Canadian Edition), Volume 1.
McGraw-Hill Ryerson Limited.