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Accounting for Non-Accountants

Sourcebooks, Inc.

Chapter One

What Is Accounting?

The purpose of accounting is to provide information that will help you make correct financial decisions. Your accountant's job is to give you the information you need to run your business as efficiently as possible while maximizing profits and keeping costs low.

Accounting plays a role in businesses of all sizes. Your kids' lemonade stand, a one-person business, and a multinational corporation all use the same basic accounting principles. Accounting is legislated; it affects your taxes; even the president plays a role in how accounting affects you. The list goes on and on.

Accounting is the language of business. It is the process of recording, classifying, and summarizing economic events through certain documents or financial statements. Like any other language, accounting has its own terms and rules. To understand how to interpret and use the information accounting provides, you must first understand this language. Understanding the basic concepts of accounting is essential tosuccess in business.

Different types of information furnished by accountants are shown in Figure 1.1 on the next page.

Accounting and Bookkeeping

Bookkeeping procedures and bookkeepers record and keep track of the business transactions that are later used to generate financial statements. Most bookkeeping procedures have been systematized, and, in many cases, can be handled by computer programs. Bookkeeping is a very important part of the accounting process, but it is just the beginning. There is currently no certification required to become a bookkeeper in the United States.

Accounting is the process of preparing and analyzing financial statements based on the transactions recorded through the bookkeeping process. Accountants are usually professionals who have completed at least a bachelor's degree in accounting, and often have passed a professional examination, like the Certified Public Accountant Examination, the Certified Management Accountant Examination, or the Certified Fraud Auditor Examination.

Accounting goes beyond bookkeeping and the recording of economic information to include the summarizing and reporting of this information in a way that is meant to drive decision making within a business.

Who Uses Accounting Information?

In the world of business, accounting plays an important role to aid in making critical decisions. The more complex the decision, the more detailed the information must be. Individuals and companies need different kinds of information to make their business decisions.

Let's start with you as an individual. Why would you be interested in accounting? Accounting knowledge can help you with investing in the stock market, applying for a home loan, evaluating a potential job, balancing a checkbook, and starting a personal savings plan, among other things.

Managers within a business also use accounting information daily to make decisions, although most of these managers are not accountants. Some of the decisions they might make for which they will use accounting information are illustrated below in Figure 1.2

Without the proper accounting information these types of decisions would be very difficult, if not impossible, to make.

Bankers continually use accounting information. They are in the business of taking care of your money and making money with your money, so they absolutely must make good decisions. Accounting is fundamental to their decision-making process. Figure 1.3 looks at some of the decisions bankers make using accounting information.

Government agencies such as the Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC), the Federal Trade Commission (FTC), and the Bureau of Alcohol, Tobacco, and Firearms (ATF) base their regulation enforcement and compliance on the accounting information they receive.

Accountability in Accounting

A business's financial statements can also be of great interest to other members of the local or national community. Labor groups might be interested in what impact management's financial decisions have on their unions and other employees. Local communities have an interest in how a business's financial decisions (for example, layoffs or plant closings) will impact their citizens.

As the economy becomes more complex, so do the transactions within a business, and the process of reporting them to various users and making them understandable becomes more complex as well. A solid knowledge of accounting is helpful to individuals, managers, and business owners who are making their decisions based on the information accounting documents provide.

Financial Statements

Accountants supply information to people both inside and outside the firm by issuing formal reports that are called financial statements.

The financial statements are usually issued at least once a year. In many cases they are issued quarterly or more often where necessary. A set of rules, called Generally Accepted Accounting Principles, govern the preparation of the financial statements. Generally Accepted Accounting Principles (GAAP) has been defined as a set of objectives, conventions, and principles to govern the preparation and presentation of financial statements. These rules can be found in volumes of documents issued by the American Institute of Certified Public Accountants (AICPA), the Financial Accounting Standards Board (FASB), the Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC), and other regulatory bodies. In chapter 2 we look at some of the overriding principles of accounting as they apply to all businesses and individuals.

The Basic Financial Statements

The basic financial statements include the Balance Sheet, the Income Statement, the Statement of Cash Flows, and the Statement of Retained Earnings. We will look at these in depth in the following chapters and see how they all interact with each other. As we discuss these financial statements, you will see they are not as scary as you might have thought they would be. Many of the concepts will already be familiar to you.

In the appendix, you can see examples of these financial statements from Station Casinos, Inc., a publicly traded company which operates several casinos and hotels in the Las Vegas, Nevada, area.

The Balance Sheet is the statement that presents the Assets of the company (those items owned by the company) and the Liabilities (those items owed to others by the company).

The Income Statement shows all of the Revenues of the company less the Expenses, to arrive at the "bottom line," the Net Income.

The Statement of Cash Flows shows how much cash we started the period with, what additions and subtractions were made during the period, and how much cash we have left over at the end of the period.

The Statement of Retained Earnings shows how the balance in Retained Earnings has changed during the period of time (year, quarter, month) for which the financial statements are being prepared. Normally there are only two types of events that will cause the beginning balance to change: 1) the company makes a profit, which causes an increase in Retained Earnings (or the company suffers a loss, which would cause a decrease) and 2) the owners of the company withdraw money, which causes the beginning balance to decrease (or invest more money, which will cause it to increase).

Financial statements vary in form depending upon the type of business they are used in. In general there are three forms of business operating in the United States-proprietorships, partnerships, and corporations.

How Different Business Entities Present Accounting Information

Proprietorships are businesses with a single owner like you and me. These types of businesses tend to be small retail businesses started by entrepreneurs. The accounting for these proprietorships includes only the records of the business-not the personal financial records of the proprietor of the business.

Partnerships are very similar to proprietorships, except that instead of one owner, there are two or more owners. In general most of these businesses are small to medium-sized. However, there are some exceptions, such as large national or even international accounting or law firms that may have thousands of partners. As with the proprietorships, accounting treats these organizations' records as separate and distinct from those of the individual partners.

Finally, there are corporations. These are businesses that are owned by one or more stockholders. These owners may or may not have a managerial interest in the company. Many of these stockholders are simply private citizens who have money invested in the company by way of stocks that they have purchased.

In a corporation a person becomes an owner by buying shares in the company and thus becomes a stockholder. The stockholders may or may not have a vote in the company's long-term planning depending on the type of stock they have purchased. However, simply by being stockholders (owners), they do not have decision-making authority in the day-to-day operations. These investors (or stockholders) are not much different than the bankers that loan money to a proprietorship or a partnership. These bankers have a financial interest in the business, but no daily managerial decision-making power. As is the case with the stockholders who have invested money into the corporation, in general they have a nonmanagerial interest in the business. As with the other two types of business organizations discussed here, the accounting records of the corporation are maintained separately from those of the individual stockholders or owners.

The accounting records of a proprietorship are less complex than those of a corporation in that there is a simple capital structure and only one owner. In the case of a corporation, there are stockholders who buy a piece of the ownership of a company by buying stock. As we will discuss later, because of this stock ownership, the financial statements become more complex. Some of the basic differences between these three types of businesses are shown in Figure 1.4.

In this chapter you have learned what accounting is, why you and other people in business need to understand accounting, what businesses use accounting for, and what the basic financial statements used in these businesses are. In chapter 2 you will learn about the practical and ethical principles accountants use on a regular basis.

Chapter Two

* Generally Accepted Accounting Principles (GAAP)

It is important that you understand the concepts of Generally Accepted Accounting Principles (GAAP), which form the basis of accounting and are part of the language of accounting and business.

This chapter will introduce the agencies responsible for standardizing the accounting principles that are used in the United States and it will describe those principles in full detail. Once you understand these guiding principles, you will have a solid foundation on which to build a complete set of accounting skills. It is useful and necessary that whether an international company is reporting to its stockholders or a proprietor is presenting information to a bank for a loan, these reports follow a consistent set of rules that everyone understands and agrees to.

Who Are the SEC, AICPA, and the FASB? (or What Is This, Alphabet Soup?)

Congress created the Securities and Exchange Commission (SEC) in 1934. At that time, the Commission was given the legal power to prescribe the accounting principles and practices that must be followed by the companies that come within its jurisdiction. Generally speaking, companies come under SEC regulations when they sell securities to the public, list their securities on any one of the securities exchanges (New York Stock Exchange or American Exchange for example), or when they become greater than a specified size as measured by the firm's Assets and number of shareholders. Thus, since 1934, the SEC has had the power to determine the official rules of accounting practice that must be followed by almost all companies of any significant size.

Instead, for the most part, the SEC assigned the responsibility of identifying or specifying GAAP to the American Institute of Certified Public Accountants (AICPA). That role has now been transferred to the Financial Accounting Standards Board (FASB). All rulings from the FASB are considered to be GAAP. The FASB is currently collaborating on a project with the International Accounting Standards Board to make it easier for companies to report financial statements, so that separate statements are not needed for U.S. and international markets.

A firm must adopt the accounting practices recommended by the FASB or the SEC unless they can identify an alternative practice that has "substantial authoritative support." Even when a company can find "substantial authoritative support" for a practice it uses which differs from the one recommended, the company must include in the financial statement footnotes (or in the auditor's report) a statement indicating that the practices used are not the ones recommended by GAAP. Where practicable, the company must explain how its financial statements would have been different if the company had used Generally Accepted Accounting Principles.

Generally Accepted Accounting Principles (GAAP)

Financial statements must present relevant, reliable, understandable, sufficient, and practicably obtainable information in order to be useful.

Relevant Information

Relevant information is that information which helps financial statement users estimate the value of a firm and/or evaluate how well the firm is being managed. The financial statements must be stated in terms of a monetary unit, since money is our standard means of determining the value of a company.

In the United States, accountants use the stable monetary unit concept, which means that even though the value of the dollar changes over time (due to inflation), the values that appear on the financial statements normally are presented at historical cost. Historical cost presents the information on the financial statements at amounts the individual or company paid for them or agreed to pay back for them at the time of purchase. This method of accounting ignores the effect of inflation. In many other countries throughout the world, the accounting profession does account for inflation.

Not all information about a firm is relevant for estimating its value or evaluating its management. For example, you don't need the information of how many individuals over forty years of age work for the company, or what color the machinery is painted in order to make financial decisions about a company. Even some financial information is not relevant, like how much money the owner of a corporation has in the bank, because as we reviewed in chapter 1, the business's accounting records are kept separate from its owner's, and the owner's financial information is irrelevant to the business.

Reliable Information

Reliable information is key in accounting. Sufficient and objective evidence should be available to indicate that the information presented is valid. In addition, the information must not be biased in favor of one statement user or one group of users to the detriment of other statement users. The need for reliable information has caused the federal government to pass laws requiring public companies to have their records and financial statements examined (audited) by independent auditors who will make sure that what companies report is accurate. This will be the topic of chapter 11.

Verifiable Information

The need for verifiable information does not preclude the use of estimates and approximation. If you were to eliminate from accounting all estimates, the resulting statements would not be useful primarily because the statements would not provide sufficient information. The approximations that are used, however, cannot be "wild guesses." They must be based on sufficient evidence to make the resulting statements a reliable basis for evaluating the firm and its management.

(Continues...)

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Excerpted from Accounting for Non-Accountants by WAYNE A. LABEL Copyright © 2006 by Wayne A. Label. Excerpted by permission.
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