Chapter One: Welcome to the World of Accounting
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You likely have a general concept of accounting. Information about the transactions and events of a business is captured and summarized into reports that are used by persons interested in the entity. But, you likely do not realize the complexity of accomplishing this task. It involves a talented blending of technical knowledge and measurement artistry that can only be fully appreciated via extensive study of the subject.
The best analogy is to say that you probably know what a surgeon does, but you no doubt appreciate that considerable knowledge and skill is needed to successfully treat a patient. If you were studying to be a surgeon, you would likely begin with a basic anatomy class.
In this chapter, you will begin your study of accounting by looking at the overall structure of accounting and the basic anatomy of reporting. Be advised that a true understanding of accounting does not come easily. It only comes with determination and hard work. If you persevere, you will be surprised at how much you discover about accounting. This knowledge is very valuable in achieving business success.
It seems fitting to begin with a more formal definition of accounting: Accounting is a set of concepts and techniques that are used to measure and report financial information about an economic unit. The economic unit is generally considered to be a separate enterprise. The information is reported to a variety of different types of interested parties. These include business managers, owners, creditors, governmental units, financial analysts, and even employees. In one way or another, these users of accounting information tend to be concerned about their own interests in the entity.
Business managers need accounting information to make sound leadership decisions. Investors hope for profits that may eventually lead to distributions from the business (e.g., “dividends”). Creditors are always concerned about the entity’s ability to repay its obligations. Governmental units need information to tax and regulate. Analysts use accounting data to form opinions on which they base investment recommendations. Employees want to work for successful companies to further their individual careers, and they often have bonuses or options tied to enterprise performance. Accounting information about specific entities helps satisfy the needs of all these interested parties.
The diversity of interested parties leads to a logical division in the discipline of accounting. Financial accounting is concerned with external reporting to parties outside the firm. In contrast, managerial accounting is primarily concerned with providing information for internal management. One may have trouble seeing the distinction; after all, aren’t financial facts being reported? The following paragraphs provide a closer look at the distinctions.
Consider that financial accounting is targeted toward a broad base of external users, none of whom control the actual preparation of reports or have access to underlying details. Their ability to understand and have confidence in reports is directly dependent upon standardization of the principles and practices that are used to prepare the reports. Without such standardization, reports of different companies could be hard to understand and even harder to compare.
Standardization derives from certain well-organized processes and organizations. In the United States, a private sector group called the Financial Accounting Standards Board (FASB) is primarily responsible for developing the rules that form the foundation of financial reporting. The FASB’s global counterpart is the International Accounting Standards Board (IASB). The IASB and FASB are working toward convergence, such that there may eventually be a single harmonious set of international financial reporting standards (IFRS). This effort to establish consistency in global financial reporting is driven by the increase in global trade and finance. Just as standardization is needed to enable comparisons between individual companies operating within a single economy, so too is standardization needed to facilitate global business evaluations.
Financial reports prepared under the generally accepted accounting principles (GAAP) promulgated by such standard-setting bodies are intended to be general purpose in orientation. This means they are not prepared especially for owners, or creditors, or any other particular user group. Instead, they are intended to be equally useful for all user groups. As such, attempts are made to keep them free from bias (neutral). Standard-setting bodies are guided by concepts that are aimed at production of relevant and representationally faithful reports that are useful in investment and credit decisions.
Managerial accounting information is intended to serve the specific needs of management. Business managers are charged with business planning, controlling, and decision making. As such, they may desire specialized reports, budgets, product costing data, and other details that are generally not reported on an external basis. Further, management may dictate the parameters under which such information is to be accumulated and presented. For instance, GAAP may require that certain product development costs be deducted in computing income; on the other hand, management may see these costs as a long-term investment and stipulate that internal decision making be based upon income numbers that exclude such costs. This is their prerogative. Hopefully, internal reporting is being done logically and rationally, but it need not follow any particular set of mandatory guidelines.
Both financial accounting and managerial accounting depend upon a strong information system to reliably capture and summarize business transaction data. Information technology has radically reshaped this mundane part of the practice of accounting over the past 50 years. The era of the “green eye-shaded” accountant has been relegated to the annals of history. Now, accounting is more of a dynamic, decision-making discipline, rather than a bookkeeping task.
Accounting data are not absolute or concrete. Considerable amounts of judgment and estimation are necessary to develop the specific accounting measurements that are reported during a particular month, quarter, or year. For example, how much profit is actually earned when a car is sold with a 3-year warranty? It will be three years before the final costs of this warranty agreement are all known. One approach would be to wait three years before reporting on the profit or loss for this transaction. However, by the time the information could be reported with certainty, it would be so stale as to lose its usefulness. Thus, in order to timely present information, reasonable estimations are routinely embraced in the normal preparation of periodic financial reports.
In addition, accounting has not advanced to a state of being able to value a business. As such, many transactions and events are reported based on the historical cost principle (in contrast to fair value). For example, land is typically recorded and carried in the accounting records at the price at which it was purchased. The historical cost principle is based on the concept that it is best to report certain financial statement elements at amounts that are tied to objective and verifiable past transactions.
The alternative is to value (and periodically revalue) accounts based upon subjective assessments of current worth. Such adjustments are problematic and the subject of much debate. Nevertheless, the current trend in global standard setting is toward an increased acceptance of the circumstances under which fair value accounting is deemed acceptable for selected financial statement elements.
The ongoing debate about fair value versus historical cost is often cast in the context of a tradeoff between the “relevance” of fair value information and the “reliability” of historical cost information. This debate is apt to continue, and the related accounting standards will likely be in an evolutionary state for many years to come. Nevertheless, it is reasonable to expect that the accountant of the future will be increasingly skilled in valuation issues.
To decide to be an accountant is no more descriptive than deciding to be a doctor. There are many specialty areas. Many accountants engage in the practice of public accounting, which involves providing audit, tax, and consulting services to the general public. To engage in the practice of public accounting usually requires one to be licensed. In the United States, individual states issue a license called a CPA (Certified Public Accountant). Other countries offer similar designations such as the “Chartered Accountant.” Auditing involves the examination of transactions and systems that underlie an organization’s financial reports, with the ultimate goal of providing an independent report on the appropriateness of financial statements. Tax services relate to the providing of help in the preparation and filing of tax returns and the rendering of advice on the tax consequences of alternative actions. Consulting services can vary dramatically, and include such diverse activities as information systems engineering to evaluating production methods.
Many accountants are privately employed by small and large businesses (i.e., “industry accounting”) and not-for-profit agencies (such as hospitals, universities, and charitable groups). They may work in areas of product costing and pricing, budgeting, and the examination of investment alternatives. They may serve as internal auditors, who look at controls and procedures in use by their employer. Objectives of these reviews are to safeguard company resources and assess the reliability and accuracy of accounting information and accounting systems. They may serve as in-house tax accountants, financial managers, or countless other occupations.
It probably goes without saying that many accountants also work in the governmental sector, whether it be local, state, or national levels. Many accountants are employed at the Internal Revenue Service, General Accounting Office, Securities and Exchange Commission, and even the Federal Bureau of Investigation.
Because investors and creditors place great reliance on financial statements in making their investment and credit decisions, it is imperative that the financial reporting process be truthful and dependable. Accountants are expected to behave in an entirely ethical fashion. To help insure integrity in the reporting process, the profession has adopted a code of ethics to which its licensed members must adhere. In addition, checks and balances via the audit process, government oversight, and the ever vigilant “plaintiff’s attorney” all serve a vital role in providing additional safeguards against the errant accountant. Those who are preparing to enter the accounting profession should do so with the intention of behaving with honor and integrity. Others will likely rely upon accountants in some aspect of their personal or professional lives. They have every right to expect those accountants to behave in a completely trustworthy and ethical fashion. After all, they will be entrusting them with financial resources and confidential information.
The basic features of the accounting model in use today trace roots back over 500 years. Luca Pacioli, a Renaissance era monk, developed a method for tracking the success or failure of trading ventures. The foundation of that system continues to serve the modern business world well, and is the entrenched cornerstone of even the most elaborate computerized systems. The nucleus of that system is the notion that a business entity can be described as a collection of assets and the corresponding claims against those assets. The claims can be divided into the claims of creditors and owners (i.e., liabilities and owners’ equity). This gives rise to the fundamental accounting equation:
Assets = Liabilities + Owners’ Equity
Assets are the economic resources of the entity, and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangible assets like patents and other legal rights. Assets entail probable future economic benefits to the owner.
Liabilities are amounts owed to others relating to loans, extensions of credit, and other obligations arising in the course of business. Implicit to the notion of a liability is the idea of an “existing” obligation to pay or perform some duty.
Owners’ equity is the owner's stake in the business. It is sometimes called net assets, because it is equivalent to assets minus liabilities for a particular business. Who are the “owners?” The answer to this question depends on the legal form of the entity; examples of entity types include sole proprietorships, partnerships, and corporations. A sole proprietorship is a business owned by one person, and its equity would typically consist of a single owner’s capital account. Conversely, a partnership is a business owned by more than one person, with its equity consisting of a separate capital account for each partner. Finally, a corporation is a very common entity form, with its ownership interest being represented by divisible units of ownership called shares of stock. Corporate shares are easily transferable, with the current holder(s) of the stock being the owners. The total owners’ equity (i.e., “stockholders’ equity”) of a corporation usually consists of several amounts, generally corresponding to the owner investments in the capital stock (by shareholders) and additional amounts generated through earnings that have not been paid out to shareholders as dividends (dividends are distributions to shareholders as a return on their investment). Earnings give rise to increases in retained earnings, while dividends (and losses) cause decreases.
The accounting equation is the backbone of the accounting and reporting system. It is central to understanding a key financial statement known as the balance sheet (sometimes called the statement of financial position). The following illustration for Edelweiss Corporation shows a variety of assets that are reported at a total of $895,000. Creditors are owed $175,000, leaving $720,000 of stockholders’ equity. The stockholders’ equity section is divided into the $120,000 that was originally invested in Edelweiss Corporation by stockholders (i.e., capital stock), and the other $600,000 that was earned (and retained) by successful business performance over the life of the company.
Does the stockholders’ equity total mean the business is worth $720,000? No! Why not? Because many assets are not reported at current value. For example, although the land cost $125,000, Edelweiss Corporation's balance sheet does not report its current worth. Similarly, the business may have unrecorded resources, such as a trade secret or a brand name that allows it to earn extraordinary profits. Alternatively, Edelweiss may be facing business risks or pending litigation that could limit its value. If one is looking to buy stock in Edelweiss Corporation, they would surely give consideration to these important non-financial statement valuation considerations. This observation tells us that accounting statements are important in investment and credit decisions, but they are not the sole source of information for making investment and credit decisions.
Assets ($895,000) = Liabilities ($175,000) + Stockholders’ equity ($720,000)
The preceding balance sheet for Edelweiss represented the financial condition at the noted date. But, each new transaction brings about a change in financial condition. Business activity will impact various asset, liability, and/or equity accounts without disturbing the equality of the accounting equation. How does this happen? To reveal the answer to this question, look at four specific cases for Edelweiss. See how each impacts the balance sheet without upsetting the basic equality.
If Edelweiss Corporation collected $10,000 from a customer on an existing account receivable (i.e., not a new sale, just the collection of an amount that is due from some previous transaction), then the balance sheet would be revised to show that cash (an asset) increased from $25,000 to $35,000, and accounts receivable (an asset) decreased from $50,000 to $40,000. As a result total assets did not change, and liabilities and equity accounts were unaffected, as shown in the following illustration.
If Edelweiss Corporation purchased $30,000 of equipment, agreeing to pay for it later (i.e. taking out a loan), then the balance sheet would be further revised. The Case B illustration shows that equipment (an asset) increased from $250,000 to $280,000, and loans payable (a liability) increased from $125,000 to $155,000. As a result, both total assets and total liabilities increased by $30,000.
What would happen if Edelweiss Corporation did some work for a customer in exchange for the customer’s promise to pay $5,000? This requires further explanation; try to follow this logic closely! Retained earnings is the income of the business that has not been distributed to the owners of the business. When Edelweiss Corporation provided a service to a customer, it can be said that it generated revenue of $5,000. Revenue is the enhancement resulting from providing goods or services to customers. Revenue will contribute to income, and income is added to retained earnings. Examine the resulting balance sheet for Case C and notice that accounts receivable and retained earnings went up by $5,000 each, indicating that the business has more assets and more retained earnings. Note that assets still equal liabilities plus equity.
Expenses are the outflows and obligations that arise from producing goods and services. Imagine that Edelweiss paid $3,000 for expenses. This transaction reduces cash and income (i.e., retained earnings), as shown in the Case D illustration.
In day-to-day conversation, some terms are used casually and without precision. Words may incorrectly be regarded as synonymous. Such is the case for the words “income” and “revenue.” However, each term has a very precise meaning. Revenues are enhancements resulting from providing goods and services to customers. Conversely, expenses can generally be regarded as costs of doing business. This gives rise to another accounting equation:
Revenues - Expenses = Income
Revenue is the “top line” amount corresponding to the total benefits generated from business activity. Income is the “bottom line” amount that results after deducting expenses from revenue. In some countries, revenue is also referred to as “turnover.”
One’s future will undoubtedly be marked by numerous decisions about investing money in the capital stock of some corporation. Another option that will present itself is to lend money to a company, either directly, or by buying that company’s debt instruments known as “bonds.” Stocks and bonds are two of the most prevalent financial instruments of the modern global economy. The financial press and television devote seemingly endless coverage to headline events pertaining to large public corporations. Public companies are those with securities that are readily available for purchase/sale through organized stock markets. Many more companies are private, meaning their stock and debt is in the hands of a narrow group of investors and banks.
If one is contemplating an investment in a public or private entity, there is certain information that will logically be sought to guide the decision process. What types of information is desired? What does one want to know about the companies in which one is considering an investment? If one were to prepare a list of questions for the company’s management, what subjects would be included? Whether this challenge is posed to a sophisticated investor or to a new business student, the listing almost always includes the same basic components.
What are the corporate assets? Where does the company operate? What are the key products? How much income is being generated? Does the company pay dividends? What is the corporate policy on ethics and environmental responsibility? Many such topics are noted within the illustrated “thought cloud.” Some of these topics are financial in nature (noted in blue). Other topics are of more general interest and cannot be communicated in strict mathematical terms (noted in red).
Financial accounting seeks to directly report information for the topics noted in blue. Additional supplemental disclosures frequently provide insight about subjects such as those noted in red. One would also need to gain additional information by reviewing corporate websites (many have separate sections devoted to their investors), filings with securities regulators, financial journals and magazines, and other such sources. Most companies will have annual meetings for shareholders and host webcasts every three months (quarterly). These events are very valuable in allowing investors and creditors to make informed decisions about the company, as well as providing a forum for direct questioning of management.
One might even call a company and seek “special insight” about emerging trends and developments. Be aware, however, that the company will likely not be able to respond in a meaningful way. Securities laws have very strict rules and penalties that are meant to limit selective or unique disclosures to any one investor or group. It is amusing, but rarely helpful, to review “message boards” where people anonymously post their opinions about a company. Company specific reports are often prepared by financial statement analysts. These reports may contain valuable and thought provoking insights but are not always objective.
Financial accounting information is conveyed through a standardized set of reports. The balance sheet has already been introduced. The other financial statements are the income statement, statement of retained earnings, and statement of cash flows. There are many rules that govern the form and content of each financial statement. At the same time, those rules are not so rigid as to preclude variations in the exact structure or layout. For instance, the earlier illustration for Edelweiss was first presented as a “horizontal” layout of the balance sheet. The subsequent Edelweiss examples were representative of “vertical” balance sheet arrangements. Each approach is equally acceptable.
A summary of an entity’s results of operation for a specified period of time is revealed in the income statement, as it provides information about revenues generated and expenses incurred. The difference between the revenues and expenses is identified as the net income or net loss.
The income statement can be prepared using a single-step or a multiple-step approach, and might be further modified to include a number of special disclosures relating to unique items. These topics will be amplified in a number of subsequent chapters. For now, take careful note that the following income statement illustration relates to activities of a specified time period (e.g., year, quarter, month), as is clearly noted in its title:
Previous illustrations showed how retained earnings increases and decreases in response to events that impact income. A company's overall net income will cause retained earnings to increase and a net loss will result in a decrease. Retained earnings is also reduced by shareholder dividends.
The statement of retained earnings provides a succinct reporting of these changes in retained earnings from one period to the next. In essence, the statement is nothing more than a reconciliation or “bird’s-eye view” of the bridge between the retained earnings amounts appearing on two successive balance sheets.
If one examines very many sets of financial statements, one will soon discover that many companies provide a statement of stockholders’ equity in lieu of the statement of retained earnings. The statement of stockholders’ equity portrays not only the changes in retained earnings, but also changes in other equity accounts. An expanded statement of stockholders’ equity is presented in a future chapter.
The balance sheet focuses on the accounting equation by revealing the economic resources owned by an entity and the claims against those resources (liabilities and owners’ equity). The balance sheet is prepared as of a specific date, whereas the income statement and statement of retained earnings cover a period of time. Accordingly, it is sometimes said that balance sheets portray financial position (or condition) while other statements reflect results of operations. Quartz’s balance sheet is as follows:
The statement of cash flows details the enterprise’s cash flows. This operating statement reveals how cash is generated and expended during a specific period of time. It consists of three unique sections that isolate the cash inflows and outflows attributable to (a) operating activities, (b) investing activities, and (c) financing activities.
Notice that the cash provided by operations is not the same thing as net income found in the income statement. This result occurs because some items hit income and cash flows in different periods. For instance, remember how Edelweiss (from the earlier illustration) generated income from a service provided on account. That transaction increased income without a similar effect on cash. These differences tend to even out over time. Other cash flow items may never impact operations. For instance, dividends paid are an important financing cash outflow for a corporation, but they are not an expense. They are a distribution of income. The proceeds of a loan would be an example of a nonoperating cash inflow. It would be shown as a financing cash flow item.
The statement cash flows require a fairly complete knowledge of basic accounting. Do not be concerned by a lack of complete comprehension at this juncture. Comprehension develops as studies progress, and a future chapter is devoted to the statement of cash flows.
In closing this chapter it is important to note that the income statement, statement of retained earnings, and balance sheet articulate. This means they mesh together in a self-balancing fashion. The income for the period ties into the statement of retained earnings, and the ending retained earnings ties into the balance sheet. This final tie-in causes the balance sheet to balance. These relationships are illustrated in the following summary diagram.
It may seem almost magical that the final tie-in of retained earnings will exactly cause the balance sheet to balance. This is reflective of the brilliance of Pacioli’s model, and is indicative of why it has survived for centuries.