Luca Pacioli: The Father of Accounting - Essay Example

Accounting Information "Accounting information is produced only for certain user groups" Accounting Theory Luca Pacioli can be called the father ofaccounting as we know it today. The major concepts were first published in Italy in 1494. Incidentally they were discussed in a book he wrote on applied mathematics entitled "Summa de Arithmetica, geometria, proportioni et Proportionalita". Accounting can be termed as a means for measuring and recording the financial value of the assets and liabilities of a business. It also allows monitoring of these values as they change with the passage of time. (Ahmed Raihi-Belkaoui, 2004 p.10) Business assets are those things that belong to the business that have a positive financial value and are used by the business for carrying out its normal activities. Examples of assets include land, buildings, machinery, vehicles, equipment, stocks, Business liabilities are those things that belong to the business but contrasting to assets, have a negative financial value i.e. they require the payment of money by the business at some point in the future.Examples of liabilities include unpaid taxes, bills, wages, overdrawn bank accounts and creditor's money e.t.c. The equity of a business is the value of the assets less the value of the liabilities. So basically equity is the differential (usually monetary) value that would be left if all the assets were sold and used to pay off all the liabilities. (Ahmed Raihi-Belkaoui, 2004 p.11) The equity along with assets and liabilities are financial dimensions that are time specific. The financial statement that presents this information is known as the balance sheet.Therefore the balance sheet is a statement of the assets, liabilities and equity of a business at a particular point of time. (Donald E. Kieso. 2006 p.38) Now let us move to the relation between the three entities that is represented by what is called the "accounting equation". (Donald E. Kieso. 2006 p.38) OE = A - L Here OE - Owner's Equity A - Assets L - Liabilites So we can say that equity is the value of assets minus the value of liabilities. Rewriting the same equation we have: A = L + OE Meaning that the value of the assets is equal to the value of the liabilities plus the equity. So by definition the accounting equation holds true for all cases. Now a balance sheet is usually divided into two sections, one section for assets and the other section for the liabilities and the equity (according to the second equation). Since the balance sheet is time specific it is also known as the statement of financial position. Two other major financial dimensions that cover a period of time against a particular point of time are income and expenses. (Donald E. Kieso. 2006 p.50) The income or revenue of a business is the total of those items that increase the value of the assets without corresponding increase in liabilities or equity such as revenue from the sale of goods, services, equipment, interest received, rent and capital gains. The expenses of a business are those things that reduce the value of the assets without corresponding reduction in the liabilities or equity such as the cost of raw materials, wages, stock, rent, electricity bills, telephone, taxes, and depreciation. The income and expenses of a business are dimensions that relate to a specific period of time and the financial statement that is used for presenting this information is the "income statement" which is the statement of income and expenses of a business during a specific period. Now if we want to represent the relationship between the assets, the liabilities, the equity, the income and the expenses we can look at the equation given below: A = L + OE + (I - E) According to this equation the value of the assets is equal to the value of liabilities plus equity plus the excess of income over expenses.Rewriting this equation we have: A + E = L + OE + I This equation shows that assets plus expenses equals the value of the liabilities along with equity plus the income. The second equation is more useful for the income statement format which is divided into two sections; one section shows total income while the other section shows total expenses.Compared to the balance sheet the totals of each of the two sections are unlikely to be the same. If the total income exceeds expenses then it will be titled retained earnings / net profit / excess of income over expenditure.If total expenses exceed income then it will be titled retained loss / net loss / excess of expenditure over income. The income statement is also called the statement of financial performance as it describes the performance of a business during a specified period. Another important financial statement is the "cash flow statement" is an historical record of the cash flows of a business, distinguishing between different categories of cash receipts and payments. Financial Reporting Standard (FRS 1) requires most companies to publish a cash flow statement as part of their annual accounts. This statement reveals users how cash was generated and then applied by the company during the period under review. The items included in either the balance sheet or the income statement (or any other statement for that matter) have to be systematically recorded in the books of entry and this practice is referred to as bookkeeping, conventionally a report was prepared showing the total of the assets and expenses account balances and the total of the liabilities, owner's equity and income account balances to ensure that these totals were the same, it is known as the trial balance.The introduction and now the widespread use of computerized and automated computer accounting systems which do not allow entries to be posted unless the accounts remain in balance has nearly eliminated the need for a trial balance. (Penne Ainsworth, 2003, p 364) Users of Accounting Information Some people might think that the only users of accounting information are shareholders - since it is a legal mandatory requirement that shareholders receive periodic accounting statements. (John Christensen. 2002. P.96) However, in reality there are many users of accounting information. We will look at each user group below along with examples of their areas of interest, and then decide whether the information so produced is meant for all user groups or not. Investors The investors look at a company's profitability and risk and return in relation to their investments. They require accounting information to decide on whether to put their money in the business or not. They also have to bear in mind the ability of a business to pay dividends, and to measure the performance of the business' management overall. The key accounting information for an investor is therefore: Information about growth - sales, volumes Profitability (profit margins, overall level of profit) Investment (amounts invested, assets owned) Business value (share price) Comparative information of competitors Since the primary objective of investors is to form an opinion about the value of companies and their equity securities they can use accounting information coupled with a variety of approaches such as: Apply a multiple to a company's current or projected earnings, cash flows. Add or subtract the estimated values of non-operating assets or liabilities. Identify latest positive or adverse developments that are not yet reflected in the market price. Identify possible temporary price changes through indicators involving fiscal measurements. The outcome of these approaches obtained using accounting information can be used individually or they could be combined as well. Also the approaches may be performed both on a companywide basis and/or separately for individual segments. Creditors Suppliers and trade creditors require accounting information to help determine understand and analyze the 'short-term' liquidity of a business. Whether the business be able to pay short-term debts The accounting information needed therefore is: - Cash flow - Management of working capital - Payment policy Lenders Lenders such as banks who lend money to a business require information to determine whether loans and interest will be paid on time. Lenders focus on 'Long-term liquidity'. The key accounting information for lenders is therefore: Cash flow Security of assets against which the lending may be secured Investment requirements in the business Employees Employees (and representative organizations such as the employee unions) are interested in the stability and continuing profitability of the business. Their main focus is on information about employment prospects, pay and rewards such as bonuses and the protection and continuation of pension funding and retirement benefits. Therefore employees will look for: - Revenue and profit growth - Levels of investment in the business - Overall employment data (numbers employed, wage and salary costs) - Status and valuation of company pension schemes / levels of company pension contributions Customers Customers' information requirement focuses on the ability of the business to survive and prosper. As consumers of the company's products, they have a long-term interest in the range of products and services that the company could provide. Customers can include other organizations as well, which may be dependant on the business. Customer will be particularly interested in: Sales growth New product development Investment in the business (e.g. production capacity) Government Many government agencies and departments need accounting information for varied purposes. For example, the U.S IRS and Inland Department needs information for revenue and tax collection. Also there are multiple regulatory agencies such as the Monopoly Control Authority, Competition Commission and the Environment Agency that need information for regulatory purposes. Competitors Competitors need information on the relative strengths and weaknesses of their competition and for comparative and benchmarking purposes. Analysts Investment analysts are an important user group - specifically for companies quoted on a stock exchange. They require very detailed financial and other information in order to analyze the competitive performance of a business and its relevant sector. Much of this is provided by the detailed accounting disclosures that are required by stock exchanges. Asset management companies also hire such analysts. General Public Interest groups, Social activists that are formed by various groups of individuals who have a specific interest in the activities and performance of businesses, will also require accounting information. Diverse information needs of users Since all users have diverse information needs the information required will depend on: the approach followed, the instrument being evaluated, the company's various businesses and circumstances, and the user's personal preferences. We will now look at these factors with the help of an example of investors and creditors. The approach The information needs of an investor looking for short term gains will follow the earnings momentum approach to predict near future stock prices, on the other hand long term vision investors will follow the fundamentals approach to predict long-term stock price. Nature of Instrument The nature of instrument also affects user's information needs. Consider the information needs of a banker evaluating a loan request and the same bank's trust department working on the same thing. The bank officer will need to analyze the credit risk while the trust department will look at the company's stock prices forecasts. Organizational Circumstances An organization's circumstances can affect the extent to which investors need historical information. For some companies, recent circumstances may have changed so that past information is not as helpful in forecasting the future. Users' Preferences Last but not the least the user preferences themselves determine their needs. Take two investors for example, they evaluate the same security/asset, use the same approach, and yet they can have different information needs simply because they appraise the facts differently and focus on diverse aspects than the other. Until the recent past the needs of different user groups had not been surveyed on a large scale (AICPA, 1994a, p.12). In 1994, the Jenkins report presented an extensive survey of the information needs of investors and creditors in the United States. The study focused on professional investors and creditors and their advisors but these users could not compel companies to produce the information they needed for analysis. The report (AICPA, 1994a, p.25) identified five broad categories of business information which are required by users: Financial and non-financial data; Management's analysis of financial and non-financial data; Forward-looking information; Information about management and shareholders; Background to the company. The financial information provides a means of evaluating and comparing the results and position of businesses by measuring transactions or events in financial terms. But in this case the users would like more information on operations, as users would prefer not to rely only on financial results. They require operating data in order to understand the environment of the business and its performance relative to competitors. (Paul Collier, 2006, p.184) The report noted that users found that management's analysis improved their understanding of the business reasons for changes in the financial information. Apart from this users also require the perspectives of management on the future, especially on the opportunities and risks due to changes in the environment of the organization. It also helps users in identification of the most probable future opportunities and risks facing the enterprise, and the most likely responses of the enterprise. Future-looking information should include information on the nature of competition, threat of substitute products, and changes in the bargaining power of customers and suppliers e.t.c. (Thomas L. Albright, 2005, 224) The study found that users require background information about the business in order to understand how the company operates and what the nature of its business is. Such as the objectives and strategy of the company, the scope and description of business and property and the characteristics of a company such as innovation, introduction of new products and product life cycles (AICPA, 1994a, p.31). This information can be used to predict the future performance of the company. Since any organization does not operate in isolation to its environment, the users also do not assess the performance of companies in isolation, but rather seeks to compare these companies with there competitors and the industry on the whole. It is therefore important that reported information should be comparable and of the same pattern. In addition to the five broad categories above, the following areas according to the study need improvement in terms of disclosure: Business segment information; Innovative financial instruments; Off balance sheet financing arrangements; The separation of core and non-core activities; The uncertainty inherent in the measurement of certain assets and liabilities; Quarterly reporting. Conclusion The problem with Jenkins report is that it only surveyed the needs of investors and creditors. More research is definitely required to identify the particular needs of other user groups. The results of the Jenkins Report indicate that the provision of only financial information (usually in financial reports) does not satisfy the requirements of even the basic creditor and investor user groups let alone all other user groups. Some analysts say that currently there is no direct material relationship between financial information and investment actions which implies that investment actions cannot be linked to the release of financial reports. It is likely that inclusion of more operating and non-financial information as well as future information (e.g. management plans) would not only influence investment decisions but also make accounting information more sensible to all user groups. All this requires more research in accounting. But for the present it can be said that "Accounting Information is produced only for certain user groups", and it might even not be fulfilling their (the select few groups) requirements. Works Cited 1. Ahmed Raihi-Belkaoui. Accounting Theory. 2004 2. AICPA. 1994 3. Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield. Intermediate Accounting 2006 4. John Christensen , Joel Demski. Accounting Theory: An Information Content Perspective 1st edition 2002 5. Paul Collier. Accounting for Managers: Interpreting Accounting Information for Decision-Making, 2006 6. Penne Ainsworth and Dan Deines. Introduction to Accounting: An Integrated Approach 2003 7. Thomas L. Albright, Robert W. Ingram, and John S. Hill. Managerial Accounting: Information for Decisions, 2005 Read More