CHAPTER 1

Introduction to accounting

Lecturer: Hyungjin Cho

Email: hcho@emp.uc3m.es / office: 6.0.23

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Chapter outline
 Economic activity and information needs
 Accounting: formal concept
 The flow of information
 Importance of accounting information
 Financial Accounting and Management
accounting
 Users of accounting information
 How does accounting work?
 Requirements of accounting information
 Accounting regulation

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 Economic activity and
information needs
 Imagine that you run the business.
 You are not so rich, then you need to borrow
from bank or to attract outside investor.
 Provide information to bank or investors

 Then, what information? -> Accounting info.

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Information needs: Shareholders

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 Accounting – The basis of
decision making

 Accounting is the “language of business”

 Accounting is the information system that
 Measures business activities
 Processes that information into reports
 Communicates the results to decision makers

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Definition of accounting
Working definition:
A system providing information to managers
and owners in order make business
decisions

Formal definition:
The process of identifying, measuring and
communicating economic information to
permit informed judgements and decisions
by users of the information
American Accounting Association (1966),
Statement of Basic Accounting Theory, p. 1
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 Nature of Accounting

 Accounting is about recording, preparing and

interpreting business transactions
 Enables key questions to be answered, such as how
much profit have we made?
 In small businesses, managers and owners are the
same people
 In large businesses, managers and owners will be
different
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 The Accounting System:
The Flow of Information
1. People make decisions

2. Business transactions occur

3. Businesses prepare reports to show the

results of their operations

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 The Notion of Accounting

Accountants:
measure, record communicate USERS

Economic Beliefs &

environment Perceptions

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 Accounting as Communication
of Financial Information
 Remember that managers and owners will be different
in large businesses because professional managers
tend to work for the benefit of owners.
 Academics call this as the “separation of ownership and
control.”
 Through accounting information, managers report their
performance to owners, and owners evaluate managers.

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 Accounting as Communication
of Financial Information

Purpose of financial
Management is the
statements is to provide
steward to whom capital
suppliers entrust control
a report to capital suppliers Income
to facilitate their evaluation
over a portion of their
of management’s measurement
financial resources
stewardship

Financial data have to Financial data have to

facilitate contracting
between parties such
facilitate decisions
makers in selecting the
Informational
as management and best action among approach
investors available alternatives

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Importance of Accounting
Information
 Money makes the world go round
 Businesses depend on cash and profit
 Unless you understand accounting, you will never
understand business
 Need to know basic terminology such as:
 Income
 Assets
 Expenses
 Liabilities
 Profit
 Capital
 Cash flow

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Internal vs. External Users

 Internal : management accounting

 More focused and detailed information
 No need to follow accounting
regulation
 External : financial accounting
(financial statements)
 Global information
 Need to follow accounting regulation

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Financial and Management
accounting
Financial accounting
 Provision of financial information on a
business’s recent financial performance
targeted at external users such as
shareholders
 Backwards-looking

 Double-entry bookkeeping

 Profit and loss account (income statement)

and balance sheet

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Financial and Management
accounting
Management accounting
 Internal needs of business

 Not required by law (unlike financial

accounting)
 Management accounting can be split
into cost accounting and decision-
making

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 Overview Financial and
Management Accounting

Accounting

Financial Management

Profit and Balance Cash flow Decision

Cost making
loss Account sheet statement making

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Financial vs. Management
accounting
 Financial accounting serves outsiders while
management accounting serves insiders
 The main work of financial accounting is to
prepare the financial statements
 Financial accounting is based upon double-
entry bookkeeping while management
accounting is not
 Financial accounting looks backwards while
management accounting looks forwards
 The product of each accounting is different
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 Users of Accounting Information
Outsiders:

regulators Tax officials

consumers lenders

Financial
suppliers
markets

FIRM

Management
Insiders:
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Employees
User Information Requirements
User group Information requirements
Internal users:
1. Management Information for costing, decision-making,
planning and control
2. Employees Information about job security and for collective
bargaining
External users
1. Shareholders and Information for buying and selling shares
analysts advisers
2. Lenders Information about assets and the company’s
cash position
3. Suppliers, and customers Information about long-term prospects and
survival of the business
4. Government and tax Information on profits to use as a basis for
authorities calculating tax

5. Public Information about the social and environmental

impact of corporate activities

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Financial Statements

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Understanding the Financial
Statements
 The income statement reports net income
or net loss for the period. It reflects the
wealth generated by the company in a given
period
 The balance sheet reflects the financial
position of the company at the end of a
period (assets and liabilities).
 The financial statements help managers
take decisions about the company (although
they may have different incentives)

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 Hewlett-Packard shares fall by 10% on lacklustre results
By Scott Morrison in San Francisco, Financial Times
Published: Aug 20, 2003

Hewlett-Packard shares fell 10 per cent in late trading yesterday after the computer and printer
maker reported disappointing third-quarter results.

The failure to meet analysts' expectations was a setback for the company, which has reported
several quarters of operational improvements following its $19bn (£12bn) acquisition of
Compaq Computer last year.

HP blamed the results on overly aggressive pricing for personal computers and weak sales of
its corporate computers.

Carly Fiorina, chairman and chief executive, said: "The third quarter is always tough, but we still
should have done better. Nevertheless, we are confident in our strategy and the actions we're
taking. We expect to deliver a strong fourth quarter."

The company reported a net profit of $297m, or 10 cents per share, for the quarter ended July
31, compared with a loss of $2bn, or 67 cents per share, last year which including hefty
restructuring and acquisition charges.

Excluding special items, the company reported earnings of $700m, or 23 cents per share,
compared with a profit of $420m, or 14 cents per share, last year.

Revenue totalled $17.35bn, up 5 per cent from $16.54bn last year and down 4 per cent from the
previous quarter. Analysts had expected earnings of 26 cents per share on revenue of $17.5bn,
according to Thomson First Call.

HP's PC unit reported an operating loss of $56m, just one quarter after posting its first profit in
years. The company said PC sales fell because of seasonal factors while gross margins were
22 hit by aggressive pricing, aimed at fending off rival group Dell's bid for increased market share.
 The demand and supply of financial
information

 The Demand for financial information will depend

upon:
 Tastes and preferences (risk attitudes)
 Beliefs about the future
 Access to financial information
 The supply of financial information will depend
upon:
 Incentives companies have to voluntarily disclose financial
information
 Regulatory framework

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 Need for Regulation
The role of capital markets
as fund providers

Economic consequences Managerial incentives to

of financial information suppress unfavorable
information

Need for regulation

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 Financial Information and Financial
Markets
 The relationship between financial information and
security prices can influence investors’ direct demand
for financial information
 Evidence shows:
 Annual earnings are not timely information and are
preempted by alternative, more timely sources
 However, significant price reaction was found in the week of
the anouncement of annual earnings
 Prices act as if earnings anouncements alter investors’ belief
in such a way as to alter the price of security

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 Overview of Information
Characteristics

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 Decision-Making
4. Information Characteristics
1. Content
Relevance - Does it affect users’ decisions?
Reliability - Is it representationally faithful, neutral, free
from material error, prudent and complete?

2. Presentation
Comparable - Inter-and intra-company comparisons
Understandable - Presented as understandably as possible

Information must also be:

 Material
 Timely

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 Accounting Principles and
Concepts
 Generally accepted accounting principles (GAAP)
are
 The rules that govern how accountants operate
 Based upon a conceptual framework

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Key Spanish Accounting
Organizations
 ICAC
 Treasury Ministry
 Bank of Spain
 AECA
 UE Comission
 CNMV

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 Accounting regulation in Spain
There are two different regulatory regimes in place in
Spain:

INTERNACIONAL NACIONAL REGULATION

REGULATION
For the rest of companies. These
For Group Accounts of listed follow the National regulation.
companies. The international
regulation is based on the rules
issued by the IASB approved by
the European Commission.

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 Regulatory Bodies Issuing
Accounting Rules in Spain

ICAC (Instituto de
Contabilidad y Auditoría de
Cuentas)
Public organization linked to
the Ministry of Economy. It
issues regulation (compulsory
for companies).
http://www.icac.meh.es
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AECA (Asociación
Española de
Contabilidad y
Administración de
Empresas).
Private body. Profesionals
and academic are part of
this organization which
although it is influencial, it
cannot regulate in
accounting issues.
http://www.aeca.es
 International Accounting
Standards
Since 2005, all quoted companies within the EU have to prepare
their accounts following the International Accounting Standards
issued by the IASB. (CE 1606/2002)

The IASB (International Accounting Standards Board) is the

regulatory body of the IASC (International Accounting
Standards Committee)
http://www.iasb.org

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 International Accounting
Standards
Until 2001, the standards issued by the IASB are denominated
IAS (or NIC in Spanish). Eg. IAS 2: Inventory

From 2001 the new standards are denomnated IFRS (NIIF in

Spanish). E.g. IFRS Insurance Contracts

Benefits of IAS-General common standards

Need to improve comparability of accounting information
The objective is to have a common standard capital market
Expand investment possibilities of European citizens
Macroeconomic
33 benefits: employment, economic growth,
prosperity
Learning outcomes

 Nature and importance of accounting

 Main users of accounting and their
information needs
 Different types of accountancy

 Requirements of accounting
information
 Main accounting organizations

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 Bibliography

 Harrison and Horngren: Financial Accounting. 6th or 7th

edition (Prentice Hall)
 Vilardell, Ortín and Solá: Introducción a la contabilidad
general (McGraw-Hill)
 Jones (2006). Accounting. 2nd Edition. Ed. Wiley
 UK GAAP (2000). Ernst and Young, Butterworth

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