Accounting
Accounting is an information system. More precisely, it is the measurement methodology and communication system designed to produce selected quantitative data (usually in monetary terms) about an entity engaged in economic activity. Alternatively, accounting has been described as the art of classifying, recording, and reporting significant financial events to facilitate effective economic activity. The accounting entity (the focus of attention) may be a profit-seeking business enterprise, a governmental unit or activity, an eleemosynary institution, or any other organization for which financial data will be useful in determining the proper conduct of its economic affairs.
The major functions of accounting are (1) to provide summarized reports of the financial position and progress of the firm to a variety of groups who are not part of management, including those who furnish capital, and (2) to furnish detailed data that will facilitate the effective control and planning of operations by management. To fulfill the first function, a statement of financial position (balance sheet), a statement of operations (income statement or profit and loss statement), and a statement of fund flows (sources and applications of funds) are usually furnished. These statements are designed to indicate the current status and the changes during the period of the entity’s resources and of the relative position of the various claimants—owners (stockholders), creditors, employees, and the government in its regulatory and taxing role. The second function includes all the appurtenances of cost accounting that are useful in the efficient administration of an entity’s resources—for example, standard costs, flexible budgets, cost-profit volume analysis, and responsibility accounting.
Historical development. From the very earliest times, the levying and collection of taxes by government has called for record keeping and reports. Governmental reporting requirements have served since antiquity to reinforce business needs for accounting systems and controls. Clay tablets used by Babylonian businessmen to record their sales and money lending some four thousand years ago are still in existence. Egyptian papyri describing tax collections before 1000 b.c. are on exhibit in museums. The Greeks and Romans had welldeveloped record-keeping systems, especially for government affairs. The Emperor Augustus is said to have instituted a governmental budget in a.d. 5. Somewhat later, inspectors from the central government in Rome were sent out to examine the accounts of provincial governors.
During the Middle Ages, accounting, in company with most other elements of learning and trade, languished. With a barter, manorial economy, the financial transactions that are the lifeblood of accounting tended to disappear. Only the church and strong monarchs maintained and occasionally pushed forward the earlier systems of record keeping and control. Conspicuous developments during the medieval era included the annual inventory of property instituted by Charlemagne in the year 800 and the pipe rolls of various English rulers, which recorded the taxes and other obligations due the monarch. The pipe roll of Henry i in 1131 may be the most complete of these records.
The revival of Italian commerce in the thirteenth and fourteenth centuries created a need for records: to help merchants control their dealings with customers and employees, to indicate the relative interests of creditors and owners, and to apportion profits among partners. The first double-entry systems of bookkeeping evolved during this period; there are extant sets of double-entry records prepared in Genoa in 1340. The earliest systematic description of the double-entry procedure was provided by the Franciscan friar Luca da Bargo Pacioli in 1494 in his book Summa de arithmetica, geometria proportioni et proportionalita (which was, incidentally, the first published work on algebra). The system outlined by Pacioli in the section entitled “De computes et scriptures” (“Of Reckonings and Writings”) was a surprisingly complete one, and for four centuries almost all texts on accounting were closely patterned after it.
As it has developed in the more than four and a half centuries since Pacioli, the term “double entry” has probably referred to the two-sided nature of transactions, to the debit and credit aspects of each event. Some writers, however, have chosen to emphasize the dual steps in recording, i.e., the use of a book of original entry (the journal) and a classified record by accounts (the ledger). A more refined requirement of double-entry record keeping is the provision of separate accounts for the recording and analyzing of gains and losses, with a periodic reckoning of income and closing of these accounts into ownership capital. Pacioli’s treatise dealt with all these attributes of double entry, and it still serves as the basis for the far more complex accounting systems of today. The many modifications and elaborations that have been introduced have largely resulted from the desire for periodic financial statements of publicly held corporations and the need for additional financial data to facilitate the control and planning of operations of the large-scale firm.
Financial statements. Commencing in the nineteenth century, increasing emphasis was placed on the preparation of annual financial statements. The position statement (or balance sheet) was originally viewed as the most significant financial report and frequently was the only statement prepared. More recently, interest has shifted to the operating data of the income statement, and this now usually commands major attention.
The income statement is a systematic array of revenues, expenses (including depreciation), income taxes, and interest charges, culminating in the net income. The disposition of net income between dividends and reinvested earnings is usually shown either at the bottom of the income statement or in a separate statement of retained earnings (surplus). One major problem of income statement presentation is the treatment to be accorded unusual gains and losses, especially where the event giving rise to the gain or loss relates to a different or longer time period than that of the income statement. Many accountants feel that these items should be treated as adjustments of capital, but the more common view is to include them in the income statement, segregating them in a nonoperating category.
The balance sheet is a schedule of financial position or financial condition; and one of these two terms is being increasingly used as the title of the statement. The balance sheet contains a list of the entity’s assets (economic resources), divided into current and longterm categories. Cash, marketable securities, receivables, and inventories are the major current asset items. Land, buildings, and equipment are usually the major items in the longterm (fixed) asset section. Intangible assets, such as patents, copyrights, and purchased goodwill, are often accorded a separate classification. Like other assets, they are valued at cost. The “going value” of the entity is not listed as an asset and must be judged by the ability of the firm to earn a higher than normal rate of return.
Total assets are equal to the total liabilities (the rights and claims of all creditors) plus the ownership equity. The ownership equity indicates the interest of the proprietor or partners of an unincorporated entity or the equity of the stockholders of a corporation. If there are several classes of stockholders, it is customary to show the interests of each group separately. It is common to stress the distinction between contributed capital and reinvested earnings portions of the stockholders’ equity.
A recent development is an alternative form of balance sheet presentation that emphasizes the entity’s current position. This is accomplished by deducting current liabilities from current assets and labeling the difference net working capital; to this subtotal, long-term assets are added and other liabilities deducted. The resulting figure is the excess of all assets over all liabilities. The components of the ownership equity are then listed, and their summation is equal to this total net asset figure.
The most recent of the three major accounting reports is the statement of fund flows (sources and applications of funds statement). Its general nature is well described by the title originally applied to it by Cole—a “where got, where gone” statement. The major sources of fund inflows for the period covered are shown (operating transactions with customers and clients, proceeds of the issuance of securities and debt instruments, and occasional sales of noninventory assets), and these are compared with the major uses of funds (distributions to investors, reduction of long-term debt, retirement of stock, and investment in plant and equipment). Funds are usually defined as net working capital (current assets minus current liabilities). An alternative definition that would exclude inventories from the funds total has been suggested. If this suggestion were adopted, change in inventories during the period under consideration would be shown explicitly as a source, or use, of funds. Other alternatives, such as defining funds as cash (or cash plus marketable securities), are occasionally used. The result, practically speaking, is to trace the flows of cash of the business.
Income determination. The usual economic concept of income relates it to the enhancement of wealth. Focusing on the business entity, periodic income can be described as the amount of wealth that can be distributed to the owners during a certain period without making the entity’s prospects less than they were at the start of the period. To make such a concept operational, it would be necessary to have well-defined rules for measuring the firm’s prospects or wealth at the start and close of the period. This requires a measure of the discounted value of the entity’s anticipated net cash inflows. Such a measure would be highly subjective, depending wholly on the measurer’s current prognosis of the likely amount, and timing, of future inflows and on the appropriate discount rate to employ.
A more restricted definition of wealth would limit it to the sum of the values of individual tangible assets, rather than the worth of the firm as a whole. With this definition of wealth, income would be determined by intertemporal differences in total asset values (adjusted for changes in liabilities and capital contributions and withdrawals). This view of income was widely accepted in accounting until the end of the first decade of the twentieth century. About that time, it became more and more apparent that there would be continuing increases in the significance of specialized long-lived assets that would be difficult to value; also, and perhaps more important, a graduated income tax was imposed in the United Kingdom in 1909, and the sixteenth (income tax) amendment and related legislation were adopted in the United States in 1913. These developments led to the gradual displacement of the increase in value view of income by one that emphasized market transactions. Early tax decisions of the U.S. Supreme Court that held that there was no income without “severance” of property from the firm added support to the newer view. This was reinforced by the unhappy experience of many firms with appraisal values during the late 1920s and early 1930s.
For several decades now, the emphasis has been shifted toward evaluation of enterprise operating performance and a more restricted view of income measurement that focuses on the matching of asset inflows (revenues) and asset outflows (expenses) in the rendering of services. The following four concepts play central roles in the income reporting process:
(1) Realization. Reflects accounting’s preference for objectivity. Only events that have come to fruition by a market transaction or some ascertainable change in an asset or liability are recorded in the accounts.
(2) Consistency. Indicates that comparable events are treated in similar fashion from period to period. Although some alternative procedures may be acceptable, consistency minimizes the yearto-year effects of different procedures by requiring that the same alternative be selected each period.
(3) Conservatism. Relates to the feeling that where a choice exists it is better to understate, rather than overstate, income and ownership equity.
(4) Disclosure. Emphasizes the need to furnish all relevant information about the firm’s financial position and operations. It accepts the fact that some financial events are difficult to express adequately in the formal reports; footnotes are integral parts of the reports, and significant information that is not indicated in the body of the report is disclosed by footnote.
In considering when to recognize revenue, there is controversy among experts about how liquid the asset received in a sales transaction must be. In some cases, especially for income tax reporting, it is held that revenue recognition should be deferred until the cash is in hand (the installment method). Usually, however, revenue is recognized when a bona fide sale results in a legally enforceable receivable. Neither the receipt of orders nor activity in the productive process is normally accepted as a basis for recognizing revenue; instead, the realization concept suggests that all revenue from a transaction should be recorded at the time of sale.
The measurement of expense is largely a matter of recognizing the expiration of the economic usefulness of assets. All purchases are made to acquire services that will benefit the production of revenue; in fact, the most operational definition of an asset is simply that of a service potential or an unutilized service that will render a future benefit to the firm. As services are utilized, assets become expenses. Determining when, or what portion of, service potential has expired is the difficult practical problem. Conservatism has long been a guiding principle in external financial reporting; in doubtful cases, accountants have tended to minimize recognition of anticipated future benefits. Under a conservative approach, costs of such items as research and development, advertising, and employee training are charged to expense in the period during which they are incurred. The extreme form of this view results in recording assets only when their physical presence makes it embarrassing to ignore them.
In the income determination process, the cost of purchased merchandise must be divided between expense (cost of goods sold) and asset (inventory); the operational rule for measuring remaining service potential (asset) in this area is the acquisition cost of units physically present in final inventory. Costs of long-lived assets, like plant, must similarly be apportioned between depreciation expense and asset valuation. Operating procedures for handling assets in this category stress a systematic apportionment of plant costs, based to some extent on the relative expiration of service potential during this period compared to estimated total service potential available from the asset.
At the time of acquisition, the present value of anticipated services from an asset must be at least equal to its acquisition cost, or the purchase would not be made. Thus minimum initial value is established by acquisition cost, and acquisition cost remains the basis for the accounting valuation of the asset as long as the asset retains its power of rendering services. As service expirations occur, the original cost valuations are charged to expense. In periods of rapidly changing prices, some expense figures may lag significantly behind current values. Since revenues tend to adjust to changing prices more rapidly, the matching process may result in the comparison of revenues stated in current price terms with expenses stated in prices of a different vintage.
To cope with this problem, some accountants have recommended that expenses be recognized on a replacement cost basis. This view has not received general acceptance, but partial approaches to the same goal have received some approval. The last-in, first-out (LIFO) inventory procedure has come to be generally accepted in the United States. By charging the cost of the most recent purchases to expense, it results in an expense figure that approximates current costs in most cases. The firstin, first-out procedure (FIFO) is based, in most cases, on a more realistic assumption about inventory flows, but the expense amount is stated in less current terms. In the late 1940s, efforts by a few American firms to base depreciation on replacement cost failed to win general approval, and advocacy of this method has waned. However, acceleration of depreciation charges based on acquisition cost, by recognition of a faster rate of service expiration, has won acceptance both in financial reporting and in the income tax laws; this may offset, in part, the effect of price level changes.
The use of replacement costs for expenses implies a concept of wealth measured by physical resources or productive capacity; income emerges only after resources or capacity are maintained. An alternative correction for price changes would apply an index of general price level change to all assets and then charge these restated costs to expense in the traditional fashion. This approach implies a purchasing power concept of wealth.
All measurements of income for periods shorter than the life of the entity are tentative. The shorter the time period of the income statement, the more difficult the measurement of income. Many asset acquisitions represent joint costs of long periods of service, and there is no known logical way of allocating their costs to shorter periods of income reporting. The date of expiration of service benefits of many other assets cannot be determined exactly. There are alternative, acceptable procedures in many areas. Reported income for relatively short periods is, at best, a rough indicator of enterprise performance. The seeming accuracy indicated by reporting income to the nearest dollar (or in larger firms to the nearest thousand dollars) gives an improper impression of precision. Since the income data have their greatest significance in guiding investment decisions and facilitating evaluation of management, a knowledge that income of a firm falls within a relatively narrow range may be virtually as satisfactory as knowing its exact amount. The effort of the accounting profession to reduce the number of permissible alternative procedures reflects the desire to narrow this range and increase the usefulness of income reporting.
Cost accounting. Cost accounting (managerial accounting) is chiefly concerned with measuring, analyzing, and reporting the operating costs of specific centers of activity. Early developments in cost accounting were associated almost exclusively with manufacturing operations. They focused on measuring the cost of products, processes, and departments for inventory valuation and pricing purposes. Since about 1930, there has been an enormous expansion in cost-accounting activity. It has been extended to administrative and distributive activities, and it has become clear that the more significant uses of cost accounting are found in the areas of cost control and cost planning, rather than in product costing for purposes of inventory valuation and income determination.
Cost accounting operates as a branch of the general financial accounting system. It provides a detailed analysis of the costs associated with specific products or processes that are important enough to warrant such attention. If costs are accumulated by departments or operating centers, the system is described as a process-cost system; if accumulated by jobs or products, it is known as a job-order system. Most existing systems, however, are hybrids that contain some aspects of both the process-cost system and the job-order system.
Certain costs, like production labor and raw materials, can be assigned directly to jobs or processes with little question. These costs usually vary with the level of operations. The jobs or processes responsible for the incurring of these costs can be identified, and they receive all of the benefits of the services used. However, there frequently are many costs that are not directly associated with individual jobs or processes but, instead, are joint to several activities. For the most part, these costs are fixed. Under a “full-costing” procedure, these common costs (fixed overhead) are also assigned, somewhat arbitrarily, to jobs or processes. The basis for assignment is usually some subjective estimate of relative benefit as measured by labor cost, labor hours, machine hours, or some other measure of activity.
There is a growing tendency to question the desirability of assigning indirect fixed costs to jobs and activities. The advocates of the direct-costing (variable-costing) view argue that the assignment serves no useful decision-making purpose and may distort the data that are relevant for short-run price, and output, decisions. They stress that in making short-period decisions the significant figure is the excess of additional revenues over variable costs, rather than over “full costs”. They describe the excess of revenue over variable costs as the “contribution” to the meeting of fixed costs and the earning of profit.
The control aspect of cost accounting is based upon the use of operating budgets and performance standards. Budgets have been used in government finance for many years, but their major purpose has been to place a limit on authority to spend. In contrast, managerial accounting views the budget as a financial plan and a control over future operations, a means whereby it is determined whether operations are proceeding in accord with management’s plans and policies. Recently some government budget practice has come closer to this view [
seeBudgeting]. By combining performance standards (standard costs) with estimates of physical activity, the budget spells out the position that the firm should achieve at the end of the budget period. Comparison of the results of operations with budgeted figures indicates the areas where managerial attention and action may be needed.
To be effective as a control device, the budget must be prepared in sufficient detail for estimated and actual costs to be assigned to those areas specifically responsible for their incurrence. To prevent individual managers being charged with responsibility for costs that are not under their control, careful preliminary studies and even modification of organizational structure may be necessary before the installation of a budget and a standard-cost system.
Standard costs for units of performance are a central part of the control process. Standard costs have connotations of normative behavior and indicate what the effort expended (assets given up) to attain the entity’s production objectives should be. The development of appropriate standards is a complex task, which may require the cooperative effort of industrial engineers, psychologists, statisticians, personnel men, and accountants. Standards are usually expressed in terms of both prices and usage, and they frequently contain more detail than is found in the budget.
In a standard-cost system, actual costs are recorded for each activity, and differences between actual and standard costs are isolated in variance accounts; separate variance accounts for the cost of materials, materials usage, labor wage rates, labor effectiveness, idle capacity, and overhead expenditures are commonly provided. These are usually expressed in monetary units, although a minority view holds that the conversion of physical variances, that is, materials usage and labor effectiveness, to dollar terms serves no useful purpose. The investigation and analysis of major variances is a prime task of the internal accounting staff.
Cost accounting contributes to cost control in other ways as well. The timekeeping and payroll systems that are required for cost assignments help to assure management that workers are actually on the job and being paid according to wage agreements. Control of issuance of materials is usually built into the cost-accounting system, as are detailed records of machine and tool availability and maintenance costs.
Special studies utilizing data produced by the cost-accounting system play a central role in many planning decisions of management. Decisions on equipment replacement, size of production runs or quantities ordered, discontinuance of “unprofitable” products or territories, as well as make-or-buy decisions, are frequently guided by reports relying on cost-accounting information. The analysis underlying management decisions in these areas is based on incremental cost data rather than full costs. Proper classification of costs into fixed and variable categories for cost-measurement and cost-control purposes ensures that much of the needed information will be available for these special studies. Not all costs that are significant for measurement and control purposes are relevant for management planning. An effective cost-accounting system will have the capability of providing the data that are needed for all three purposes.
Auditing and public accounting. Auditing is concerned with the independent verification of the statement of financial position and the results of operations of an entity. An audit is an outside expert’s professional attestation that the financial reports have been prepared in conformity with generally accepted accounting principles on a basis consistent with that of the preceding period. This independent appraisal of the fairness of the financial statements has traditionally been the major function of the public accounting profession. The growth of large-scale enterprise, with its separation of ownership and management, emphasizes the need for an external verification so that present and potential investors may rely on the published financial statements.
Since 100 per cent checking of records would be prohibitively expensive, auditing necessarily uses sampling procedures. In the analysis of a firm’s activities and records, the independent public accountant examines selected documents and transactions until he is satisfied professionally that the financial statements prepared by management “present fairly” the position and results of operation of the firm. (The quoted words are from the standard auditor’s report in the United States; the British wording is a “true and fair view.”) In recent years, professional accountants have often relied on probability theory and formal statistical sampling techniques in deciding on how much testing and evidence is needed before an opinion on the financial statements can be rendered.
Public accounting and auditing have a long history in the commercial and industrial world, but the dramatic growth of the public accounting profession has been a fairly recent phenomenon. The first New York Directory, compiled in 1786, listed only three accountants in public practice in New York. At about the same time, similar directories prepared in Great Britain showed 14 public accountants in Edinburgh, 10 in Glasgow, and 5 each in London and Liverpool. The substantial growth of corporations in the nineteenth century demanded expanded and improved public accounting services for the protection of investors and the effective operation of securities markets. In order to improve standards, professional organizations evolved in most industrialized nations. Accreditation for public identification of professional competence and status developed somewhat later. Accreditation procedures take one of two general forms—acceptance to membership in a government-approved professional society, as in Great Britain; or state designation under an applicable statutory enactment, as in the United States.
The first British accounting society was founded in Edinburgh in 1854, followed in the next year by a similar society in Glasgow. These two societies form the basis of the Institute of Chartered Accountants of Scotland. The Institute of Accountants was formed in London in 1870 and ten years later was incorporated by royal charter as The Institute of Chartered Accountants in England and Wales. The Society of Incorporated Accountants was formed five years later and merged into the English and Scottish Institutes in 1957. The Association of Certified and Corporate Accountants came into being shortly after the turn of the century.
The Companies Act and various other legal enactments in the United Kingdom list certain responsibilities that may be discharged only by members of one of the institutes or societies. Each of the groups imposes an experience requirement for membership. To become a member of a chartered institute the experience must be acquired in an articled clerkship under the direction of an accountant who is a member of the group. In addition, satisfactory written examinations in accounting theory and practice, as well as related subjects, are required by each of the groups. By 1965, membership in these British organizations totaled more than fifty thousand.
In the United States, the title of certified public accountant (CPA) is conferred by each of the states. In 1896 New York became the first state to provide for such certification, followed in 1899 by Pennsylvania. By 1923, all the states provided for the legal designation of CPA’s. Each state has its own education and experience requirements for the certificate; many states require some college education and a small, but growing, number require a college degree as a prerequisite for certification. All the states use a uniform CPA examination, prepared and graded by the American Institute of Certified Public Accountants. In 1965 the number of CPA’s in the United States was approximately 90,000, compared with 38,000 in 1950, 13,000 in 1930, and 250 in 1900.
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