Lecture 1

Introduction to Accounting
Accounting is the measurement (or quantification) of the economic activities of an entity, and
the communication of this information to users.
The objective of all accounting is to provide information that is useful for decision-making.
The users of accounting information include

• investors;
• lenders;
• managers and employees;
• tax authorities, courts, regulators and other government agencies;
• suppliers, customers, and competitors;
• boards of directors;
• interest groups (labor unions, consumer organizations, environmental groups);
Managerial Accounting vs Financial Accounting:

• For managerial (i.e., internal) use, companies may use whatever accounting rules they
find most useful.
• For reporting to external constituencies, regulatory bodies determine the accounting
rules according to which financial reports are prepared  securities markets regulators,
lenders and other users may require the submission of financial statements prepared in
accordance with generally accepted accounting principles (GAAP)
Essentially, every country has its own version of GAAP (Generally Accepted Accounting
Principles), e.g. Italian GAAP is known as OIC; in the US there is the US GAAP, on which we
focus.
In addition, there exist the International Financial Reporting Standards (IFRS, formerly known
as IAS, International Accounting Standards), which are in use in most countries in the world.
The authors and sources of GAAP can be either:

• governmental bodies and acts of law (France, Germany, Russia); or
• private organizations with members from the accounting profession,
Both IFRS and US GAAP are issued by private standard setting boards:
• the International Accounting Standards Board (IASB)  IFRS
• the Financial Accounting Standards Board (FASB)  US GAAP
The most common reason to prepare GAAP-basis financial statements is being listed on a stock
exchange or other public securities market.
Financial Statements
Preparing financial statements is only possible if we impose some conceptual structure on the
world. In particular, we need the following constructs and assumptions:
• Accounting entity  economic activity can be attributed to a particular unit of
accountability (a business or other organization), separate from its owners.
• Monetary unit  economic activity can be measured (quantified) in monetary amounts
• Going concern  the business will continue operating in the future
• Periodicity  the entity’s economic activity can be measured over specified time
periods (years, quarters,...)
A typical set of financial statements has six components:

• a balance sheet (or statement of financial position);
• an income statement (or profit and loss statement, or statement of earnings, or
statement of comprehensive income);
• a statement of changes in owners’ equity (or shareholders’ equity);
• a cash flow statement,
• footnotes to the above financial statements;
• an audit opinion
The total value assigned to the assets on the left side must always equal the total value of all
claims listed on the right side  Assets = Liabilities + Owners’ Equity (the accounting equation).
The most interesting information is not in the balance sheet values but in the explanation how
and why the balances have changed since last period.
Three financial statements explain these changes in detail.
• The statement of changes in owners’ equity shows the transactions and activities that
affect equity accounts on the balance sheet
• The income statement shows a detailed list of those changes in owners’ equity that are
part of the entity’s net income
• The statement of cash flows explains the inflows and outflows of cash during the period
Connecting the 3 financial statements:

Financial Statement Footnotes:
• Most footnotes explain the various line items of the four main financial statements in
further detail, particularly the balance sheet items
• Of particular importance is the footnote on the entity’s critical accounting policies,
usually found at the top of the footnote section
• The footnotes are an integral part of the financial statements. The most useful
information is often found there
The audit opinion  provides the external auditor’s conclusion about the quality of the firm’s
financial statements:
• The firm, not its auditor, prepares the financial statements; the auditor expresses an
opinion on them, after conducting audit procedures
• Auditors cannot test every transaction, and regular audits are not designed to detect
fraud. Audits provide ‘reasonable assurance,’ not a guarantee, that the financial
statements meet the required standards
• The audit opinion is unqualified if the auditor believes that the financial statements
‘present fairly, in all material respects, the firm’s financial situation under the applicable
financial reporting standards
• Beware if the opinion is not unqualified (i.e., qualified, adverse, or disclaimer)
The Sarbanes-Oxley Act in 2001 imposed substantial additional regulation on firms with publicly
traded securities in the US and on their auditors.
• CEO and CFO must personally attest to the accuracy and completeness of the company’s
financial statements and the effectiveness of the company’s internal control over
financial reporting.
• Auditors must additionally test (and opine on) the effectiveness of companies’ internal
control over financial reporting.
• The auditing profession is now regulated by the Public Company Accounting Oversight
Board (PCAOB)
Basic principles of accounting
Most decisions when and how to recognize an economic event (by making changes to account
balances) rest on a few basic principles and concepts.
Two fundamental principles:

• Revenue recognition  revenue is only recognized when two conditions occur:
o revenue is earned  revenue is earned when the firm performs its part of the
deal (deliver a good or provide a service)
o and revenue is realized or realizable  either the firm has already been paid or it
expects to be paid in the future
• Matching principle  expenses are recognized at the same time as the revenue that
they helped generate
Other principles:
• Historical cost  assets and liabilities are accounted for on the basis of their acquisition
prices (than accounts can change over time)
• Conservatism (prudence)  when in doubt, choose the accounting treatment that least
likely overstates assets
Basic accounting principles arose by historical convention and have not been designed to form
an integrated and consistent whole.
Formal accounting standards have therefore adopted conceptual frameworks to fill this gap.
Conceptual frameworks determine:
• what the goal of financial accounting is; and
• how the accounting standards intend to achieve it.
The goal of financial accounting  “The objective of general purpose financial reporting is to
provide financial information about the reporting entity that is useful to existing and
potential investors, lenders, and other creditors in making decisions about providing resources
to the entity.”
How to achieve this goal  the conceptual framework identifies two fundamental qualitative
characteristics of decision-useful accounting information:
• Relevance  the information ‘makes a difference’ in users’ decisions, i.e., it is material
and has predictive and/or confirmatory value:
o Material  the user would have changed his mind if the number were different
o Predictive or confirmatory value  every accounting number should have the
future anticipated in it
• Faithful representation  a representation of financial information is faithful if it is
complete, neutral, and free from error
The conceptual framework further identifies several enhancing qualitative characteristics of

decision-useful accounting information.
• Comparability: information can be compared across time and entities. To achieve
comparability, consistency is important, i.e., the same accounting methods must be
applied across time and entities.
• Verifiability: different knowledgeable and independent observers could reach
consensus that the information is faithfully represented.
• Timeliness: generally, the older the information, the less useful it is.
• Understandability: information is as clear and concise as possible, to areasonably
knowledgeable user.
... but all subject to the cost constraint: accounting information should only be prepared if the
cost of collecting, processing, verifying and disseminating it is outweighed by its benefits.

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Introduction to Accounting

The users of accounting information include

Managerial Accounting vs Financial Accounting:

The authors and sources of GAAP can be either:

A typical set of financial statements has six components:

Connecting the 3 financial statements:

Two fundamental principles:

The conceptual framework further identifies several enhancing qualitative characteristics of

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