This is “Making Good Financial Decisions about an Organization”, section 1.1 from the book Business Accounting (v. 2.0).
This book is licensed under a Creative Commons by-nc-sa 3.0 license. See the license for more details, but that basically means you can share this book as long as you credit the author (but see below), don't make money from it, and do make it available to everyone else under the same terms.
This content was accessible as of December 29, 2012, and it was downloaded then by Andy Schmitz in an effort to preserve the availability of this book.
Normally, the author and publisher would be credited here. However, the publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URI to be removed. Additionally, per the publisher's request, their name has been removed in some passages. More information is available on this project's attribution page.
For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. You may also download a PDF copy of this book (20 MB) or just this chapter (218 KB), suitable for printing or most e-readers, or a .zip file containing this book's HTML files (for use in a web browser offline).
At the end of this section, students should be able to meet the following objectives:
Question: In the June 30, 2011, edition of The Wall Street Journal, numerous headlines described the recent activities of various business organizations. Here are just a few:
“TMX and LSE Give Up on Planned Merger”
“Ally Financial Faces Charge for Mortgage Losses”
“HomeAway Jumps 49% in Debut”
“Ad-Seller Acquiring Myspace for a Song”
Millions of individuals around the world read such stories each day with rapt interest. From teen-agers to elderly billionaires, this type of information is analyzed obsessively. How are these people able to understand all the data and details being provided? For most, the secret is straightforward: a strong knowledge of financial accounting.
This textbook provides an introduction to financial accounting. A logical place to begin such an exploration is to ask the obvious question: What is financial accounting?
Answer: In simplest terms, financial accountingThe communication of financial information about a business or other type of organization to external audiences to help them assess its financial health and future prospects. is the communication of information about a business or other type of organization (such as a charity or government) so that individuals can assess its financial health and future prospects. No single word is more relevant to financial accounting than “information.” Whether it is gathering monetary information about a specific organization, putting that information into a format designed to enhance communication, or analyzing the information that is conveyed, financial accounting is intertwined with information.
In today’s world, information is king. Financial accounting provides the rules and structure for the conveyance of financial information about businesses (and other organizations) to maximize clarity and understanding. Although a wide array of organizations present financial information to interested parties, this book primarily focuses on the reporting of businesses because that is where the widest use of financial accounting occurs.organization → reports information based on the principles of financial accounting → interested individuals assess financial health and future prospects
At any point in time, some businesses are poised to prosper while others teeter on the verge of failure. Many people want to be able to evaluate the degree of success achieved to date by a particular organization as well as its prospects for the future. They seek information and the knowledge that comes from understanding that information. How well did The Coca Cola Company do last year, and how well should this business do in the coming year? Those are simple questions to ask, but the answers can make the difference between earning millions and losing millions.
Financial accounting provides data that these individuals need and want.
Question: Every semester, most college students are enrolled in several courses as well as participate in numerous outside activities. All of these compete for the hours that make up each person’s day. Why should a student invest valuable time to learn the principles of financial accounting? Why should anyone be concerned with the information communicated about an organization? What makes financial accounting important?
Answer: Many possible benefits can be gained from acquiring a strong knowledge of financial accounting because it provides the accepted methods for communicating relevant information about an organization. In this book, justification for the serious study that is required to master this subject matter is simple and straightforward. Obtaining a working knowledge of financial accounting and its underlying principles enables a person to understand the information conveyed about an organization so that better decisions can be made.
Around the world each day, millions of individuals make critical judgments about the businesses and other organizations they encounter. Developing the ability to analyze financial information and then making use of that knowledge to arrive at sound decisions can be critically important. Whether an organization is as gigantic as Walmart or as tiny as a local convenience store, individuals have many, varied reasons for studying the information that is available.
As just a single example, a recent college graduate looking at full-time employment opportunities might want to determine the probability that Company A will have a brighter economic future than Company B. Although such decisions can never be correct 100 percent of the time, knowledge of financial accounting and the information being communicated greatly increases the likelihood of success. As Kofi Annan, former secretary-general of the United Nations, has said, “Knowledge is power. Information is liberating.”See http://www.deepsky.com/~madmagic/kofi.html.
Thus, the ultimate purpose of this book is to provide students with a rich understanding of the rules and nuances of financial accounting so they can evaluate available information about organizations and then make good decisions. In the world of business, most successful individuals have developed this ability and are able to use it to achieve their investing and career objectives.
Question: Knowledge of financial accounting assists individuals in making informed decisions about businesses and other organizations. What kinds of evaluations are typically made? For example, assume that a former student—one who recently graduated from college—has been assigned the task of analyzing financial data provided by the Acme Company. What real-life decisions could a person be facing where an understanding of financial accounting would be beneficial?
Answer: The number of possible judgments that an individual might need to make about a business or other organization is close to unlimited. However, many of these decisions deal with the current financial health and prospects for future success. In order to analyze available data to make such assessments, a working knowledge of financial accounting is invaluable. The more in-depth the understanding is of those principles, the more likely the person will be able to use the information to arrive at the best possible choices. Common examples include the following:
Success in life—especially in business—frequently results from being able to make appropriate decisions. Many economic choices, such as those described earlier, depend on a person’s ability to understand and make use of financial information about organizations. That financial information is produced and presented in accordance with the rules and principles underlying financial accounting.
James Esposito is a college student who has just completed a class in financial accounting. He earned a good grade and wants to make use of his knowledge. He wants to invest $10,000 that he recently inherited from a distant uncle. In which of the following decisions is Esposito most likely to have used his understanding of financial accounting?
The correct answer is choice b: He decides to buy ownership shares in Microsoft Corporation in hopes that they will appreciate in value.
All of these are potentially good economic decisions. However, financial accounting focuses on conveying data to help reflect the financial health and prospects of organizations. His decision to buy ownership shares of Microsoft rather than any other company indicates that he believes that Microsoft is poised to grow and prosper. This decision is exactly the type that investors around the world make each day with the use of their knowledge of financial accounting.
Question: A great number of possible decisions could be addressed in connection with any business. Is an understanding of financial accounting relevant to all decisions made about an organization? What about the following?
Answer: Decisions such as these three are extremely important for the success of any organization. However, these examples are not made about the reporting organization. Rather, they are made within the organization in connection with some element of its operations.
The general term “accounting” refers to the communication of financial information for decision-making purposes. Accounting is then further subdivided into (a) financial accounting and (b) managerial accountingThe communication of financial information within an organization so internal decisions can be made in an appropriate manner..Tax accounting is another distinct branch of accounting. It is less focused on decision making and more on providing information needed by a business to comply with all government rules and regulations. Even in tax accounting, though, decision making is important as businesses seek to take all possible legal actions to minimize tax payments. Financial accounting is the subject explored in this textbook. It focuses on conveying relevant data (primarily to external parties) about an organization (such as Motorola Mobility or Starbucks) as a whole so that wise decisions can be made. Thus, questions such as the following all fall within the discussion of financial accounting:
These decisions pertain to an overall evaluation of the financial health and future prospects of the Acme Company.
Managerial accounting is the subject of other books and other courses. This second branch of accounting refers to the communication of information within an organization so that internal decisions (such as whether to buy or rent a building) can be made in an appropriate manner. Individuals studying an organization as a whole have different goals than do internal parties making operational decisions. Thus, many unique characteristics have developed in connection with each of these two branches of accounting. Financial accounting and managerial accounting have evolved independently over the decades to address the specific needs of the users being served and the decisions being made. This textbook is designed to explain those attributes that are fundamental to attaining a useable understanding of financial accounting.
It is not that one of these areas of accounting is more useful or more important than the other. Financial accounting and managerial accounting have simply been created to achieve different objectives. They both do their jobs well, but they do not have the same jobs.
Janet Wineston is vice president of the State Bank of Main Street. Here are four decisions that she made at her job today. Which of these decisions was likely to have required her to make use of her knowledge of financial accounting?
The correct answer is choice c: She granted a $300,000 loan to one company but not another.
Financial accounting focuses on decisions about organizations. When money was loaned to one company but not the other, Wineston was making decisions about both. She must have viewed one as more financially healthy than the other. Her other three decisions all relate to internal operations. Accounting information can certainly help in arriving at proper choices for these three, but it is managerial accounting that is designed to produce the needed data for such decisions.
Question: Financial accounting refers to the conveyance of information about an organization as a whole and is most frequently distributed to assist outside decision makers. Does a person who is employed by an organization care about the financial accounting data that is reported? Why should an employee in the marketing or personnel department of the Acme Company be interested in the financial information that this business generates and distributes?
Answer: Financial accounting is designed to portray the overall financial condition and prospects of an organization. Virtually every employee should be interested in studying that information to judge future employment prospects. A business that is doing well will possibly award larger pay raises or perhaps significant end-of-year cash bonuses. A financially healthy organization can afford to hire new employees, buy additional equipment, or pursue major new initiatives. Conversely, when a business is struggling and prospects are dim, employees might anticipate layoffs, pay cuts, or reductions in resources.
Thus, although financial accounting information is directed to outside decision makers, employees should be keenly interested in the financial health of their own organization. No one wants to be clueless as to whether their employer is headed for prosperity or bankruptcy. In reality, employees are often the most avid readers of the financial accounting information distributed by employers because the results can have such an immediate and direct impact on their jobs and, hence, their lives.
Financial accounting encompasses the rules and procedures covering the conveyance of monetary information to describe a business or other organization. Individuals who attain a sufficient level of knowledge of financial accounting can then utilize this information to make decisions based on the organization’s perceived financial health and future prospects. Such decisions might include assessing employment potential, lending money, granting credit, and buying or selling ownership shares. However, financial accounting does not address issues that are purely of an internal nature, such as whether an organization should buy or lease equipment or the level of pay raises. Information to guide such internal decisions is generated according to managerial accounting rules and procedures that are introduced in other books and courses. Although financial accounting is not directed toward the inner workings of an organization, most employees are interested in the resulting information because it helps them assess the future of their employer.