In short, accountants are much more than bookkeepers - they provide the numbers that are so critical in helping business managers make the informed decisions that keep a business on course toward its financial objectives.

Business managers, investors, and others who depend on financial statements should be willing to meet accountants halfway. People who use accounting information, like spectators at a football game, should know the basic rules of play and how the score is kept. The purpose of this book is to make you a knowledgeable spectator of the accounting game.

Accounting Everywhere You Look

Accounting extends into virtually every walk of life. You're doing accounting when you make entries in your checkbook and fill out your federal income tax return. When you sign a mortgage on your home, you should understand the accounting method the lender uses to calculate the interest amount charged on your loan each period. Individual investors need to understand some accounting in order to figure the return on capital invested. And every organization, profit-motivated or not, needs to know how it stands financially. Accounting supplies all that information.

Many different kinds of accounting are done by many different kinds of persons or entities for many different purposes:

Accounting is necessary in any free-market, capitalist economic system. It's equally necessary in a centrally controlled, socialist economic system. All economic activity requires information. The more developed the economic system, the more the system depends on information. Much of the information comes from the accounting systems used by the businesses, individuals, and other institutions in the economic system.

Some of the earliest records of history are the accounts of wealth and trading activity, and the need for accounting information was a main incentive in the development of the numbering system we use today. Professor William A. Paton, a well-known accounting professor at the University of Michigan for many years (and who lived to be over 100), expressed the purpose of accounting very well in his classic book, Essentials of Accounting (Macmillan):

In a broad sense accounting has one primary function: facilitating the administration of economic activity. This function has two closely related phases: (1) measuring and arraying economic data; [and] (2) communicating the results of this process to interested parties.

The Basic Elements of Accounting

I like Professor Paton's short definition because it articulates the basic purpose of accounting. However, the definition does sidestep one aspect of accounting - bookkeeping (which you can find more about in Chapter 2). Accounting involves bookkeeping, which refers to the painstaking and detailed recording of economic activity and business transactions. But accounting is a much broader term than bookkeeping because accounting refers to the design of the bookkeeping system. It addresses the many problems in measuring the financial effects of economic activity. Furthermore, accounting includes the financial reporting of these values and performance measures to non-accountants in a clear and concise manner. Business managers and investors, as well as many other people, depend on financial reports for vital information they need to make good economic decisions.

Accountants design the internal controls in an accounting system, which serve to minimize errors in recording the large number of activities that a business engages in over the period. The internal controls that accountants design can detect and deter theft, embezzlement, fraud, and dishonest behavior of all kinds. In accounting, internal controls are the ounce of prevention that is worth a pound of cure.

An accountant seldom prepares a complete listing of all the details of the activities that took place during a period. Instead, he or she prepares a summary financial statement, which shows totals, not a complete listing of all the individual activities making up the total. Managers may occasionally need to search through a detailed list of all the specific transactions that make up the total, but this is not common. Most managers just want summary financial statements for the period - if they want to drill down into the details making up a total amount for the period, they ask the accountant for this more detailed backup information. Also, outside investors usually only see summary-level financial statements. For example, they see the total amount of sales revenue for the period but not how much was sold to each and every customer.

Financial statements are prepared at the end of each accounting period. A period may be one month, one quarter (three calendar months), or one year. One basic type of accounting report prepared at the end of the period is a "Where do we stand at the end of the period?" type of report. This is called the Statement of Financial Condition or, more commonly, the balance sheet. The date of preparation is given in the header, or title above this financial statement. A balance sheet shows two sides of the business.

On the one side are listed the assets of the business, which are its economic resources being used in the business. On the other side of the balance sheet is a breakdown of where the assets came from, or the sources of the assets. The asset values reported in the balance sheet are the amounts recorded when the assets were originally acquired. For many assets these values are recent - only a few weeks or a few months old. For some assets their values as reported in the balance sheet are the costs of the assets when they were acquired many years ago.

Assets are not like manna from the heavens. They come from borrowing money in the form of loans that have to be paid back at a later date and from owners' investment of capital (usually money) in the business. Also, making profit increases the assets of the business; profit retained in the business is the third basic source of assets. If a business has, say, $2.5 million in total assets (without knowing which particular assets the business holds), I know that the total of its liabilities, plus the capital invested by its owners, plus its retained profit, adds up to $2.5 million.

In this example suppose that the total amount of the liabilities of the business is $1.0 million. This means that the total amount of owners' equity in the business is $1.5 million, which equals total assets less total liabilities. Without more information we don't know how much of total owners' equity is traceable to capital invested by the owners in the business and how much is the result of profit retained in the business. But we do know that the total of these two sources of owners' equity is $1.5 million.

The financial condition of the business in this example is summarized in the following accounting equation (in millions):

$2.5 Assets = $1.0 Liabilities + $1.5 Owners' Equity

Looking at the accounting equation you can see why the statement of financial condition is also called the balance sheet; the equal sign means the two sides have to balance.

Double-entry bookkeeping is based on the accounting equation - or the fact that the total of assets on the one side are counter-balanced by the total of liabilities, invested capital, and retained profit on the other side. Double-entry bookkeeping is discussed in Chapter 2.

Other financial statements are different than the balance sheet in one important respect: they summarize the significant flows of activities and operations over the period. Accountants prepare two types of summary flow reports for businesses:

The balance sheet, income statement, and cash flow statement constitute the hard core of a financial report to those persons outside a business who need to stay informed about the business's financial affairs. These individuals have invested capital in the business, or the business owes them money; therefore they have a financial interest in how well the business is doing. These three key financial statements are also used by the managers of a business to keep informed about what's going on and the financial position of the business. They are absolutely essential to helping managers control the performance of a business, identify problems as they come up, and plan the future course of a business. Managers also need other information that is not reported in the three basic financial statements. (Part III of this book explains these additional reports.)

Accounting and Financial Reporting Standards

Imagine if every business could invent its own accounting methods and terminology for measuring profit and for presenting financial statements. As an example from the academic world, what if I give a student an A for a course and a professor at another university gives a student a K? Keeping track of academic performance would be pretty tough without some recognized and accepted standards.

Experience and common sense have taught business and financial professionals that uniform financial reporting standards and methods are critical in a free-enterprise, private, capital-based economic system. A common vocabulary, uniform accounting methods, and full disclosure in financial reports are the goals. How well the accounting profession performs in achieving these goals is an open question, but few disagree that they are worthy goals to strive for.

The supremacy of GAAP (generally accepted accounting principles)

The most important financial statement and financial reporting standards and rules are called generally accepted accounting principles (GAAP), which describe the basic methods to measure profit and to value assets and liabilities, as well as what information should be disclosed in those financial statements released outside a business. Suppose you're reading the financial statements of a business.

Continues...

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