Business managers, investors, and others who depend on financial statements and other accounting reports should be willing to meet accountants halfway. People who use accounting information should know the basic rules of play and how the score is kept (much like spectators at a football game). 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 when you 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 their return on invested capital. And every organization, profit-motivated or not, needs to know how it stands financially.

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

KEY CONCEPT

Accounting is necessary in a 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, institutions, and other players 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 (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.

For example, accountants measure the profit or loss of a business for the period and communicate the determinants of the profit or loss in a formal financial statement called the income statement.

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 3). Accounting requires bookkeeping, which refers to the painstaking and detailed recording of economic activity and business transactions. But accounting is a much broader term than bookkeeping. Accounting 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 interested parties in a clear manner. Business managers and investors, and many other people, depend on financial reports for vital information they need to make economic decisions.

KEY CONCEPT

Accountants design the internal controls for the 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 are relied on to 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 reports 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 that shows totals, not each individual activity making up the total. Managers occasionally need to search through a detailed list of all the specific transactions that make up the total. But, generally, 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. Outside investors see only summary-level financial statements. For example, in the income statement, investors 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:

Continuing with 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 balance.

Double-entry bookkeeping is based on the accounting equation-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. I discuss double-entry bookkeeping in Chapter 3.

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

The balance sheet, income statement, and statement of cash flows 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. The managers of a business, to keep informed about what's going on and the financial position of the business, also use these three key financial statements. 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 the chaos 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 in 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 generally accepted accounting principles (GAAP)

The authoritative standards and rules that govern financial accounting and financial reporting are called generally accepted accounting principles (GAAP). I explain who creates and catalogues these principles in the section "Enforcing Accounting Rules" later in this chapter.

When reading the financial statements of a business you're entitled to assume that the business has used GAAP in reporting its cash flows and profit and its financial condition at the end of a financial period-unless the business makes very clear that it has prepared its financial report on a comprehensive basis of accounting other than GAAP.

TIP

The word comprehensive here is very important. A financial report should be comprehensive, or all-inclusive-reflecting all the financial activities and aspects of the entity. If not, the burden is on the business to make very clear that it is presenting something less than a complete and comprehensive report on its financial activities and condition. But, even if the financial report of a business is comprehensive, its financial statements may be based on accounting methods other than GAAP.

If GAAP are not the basis for preparing its financial statements, a business should make very clear which other basis of accounting is being used and should avoid using titles for its financial statements that are associated with GAAP. For example, if a business uses a simple cash receipts and cash disbursements basis of accounting-which falls way short of GAAP-it should not use the terms income statement and balance sheet. These terms are part and parcel of GAAP, and their use as titles for financial statements implies that the business is using GAAP.

(Continues...)

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