There is a common misconception about accounting that it is a math class, much like college algebra, calculus, or business statistics, but it is not a math class. Though it’s true that accounting uses numbers heavily, accounting is far more than adding, subtracting, and solving for unknown variables.
Accounting is “the language of business.” It is a system of maintaining records of a company’s operations and communicating this information to decision makers. The decision makers are people who make decisions about the company based on accounting information.
Accounting can be classified into two broad categories: managerial accounting and financial accounting. Managerial accounting deals with the methods accountants use to provide information to an organization’s internal users; that is, its own managers. It is not the subject of the course. The course focuses on financial accounting. The two primary functions of financial accounting are to measure business activities of a company and to communicate those measurements to external parties for decision-making purposes.
The functions of accounting are to measure the activities of the company and to communicate those measurements to people. The primary users or decision makers are investors and creditors. Besides this, a variety of other users make use of accounting information like customers, suppliers, managers, employees, competitors, regulators, and tax authorities.
It is important to understand the “framework” for financial accounting. Ask yourself these questions:How is the business activity being measured?How is it being communicated? These are the two functions of financial accounting. This will help you understand how the information communicated helps people make better decisions.
There are three kinds of common business structures or forms:Sole proprietorship: It is a business owned by one person.Partnership: It is a business owned by two or more persons.Corporation: It is a company that is separate from its owners. In a corporation, the owner-manager separation is typical, where managers are managing the resources of the company, but do not have claims on those resources. Since a corporation is legally separate from its owners, they have the advantage of limited liability and are not responsible for the financial obligations of the corporation. A corporation can involve outside investors in the business through issuance of shares. Thus, external funding is raised when individuals purchase shares of ownership (typically referred to as common stock) in the corporation. Each share of stock represents a unit of ownership.Unlike corporations, sole proprietorships and partners have fewer owners, and thus must have all sufficient personal funds to finance the business in addition to the ability to borrow money. Another disadvantage of a sole proprietorship or partnership form of business is that neither offers limited liability.Sole proprietorships and partnerships do offer the advantage of flow through taxes, which means lower taxes compared to corporations. This is because corporations suffer a form of double taxation. A corporation’s income is taxed twice—first when the company earns it and pays corporate income taxes on it, and then again when stockholders pay personal income taxes on amounts the firm distributes to them as dividends. In this book we will focus primarily on accounting from a corporation’s perspective.
A business engages in three fundamental activities – financing activities, investing activities, and operating activities.Financing activities include transactions the company has with investors and creditors, such as issuing stock and borrowing money from a local bank. Investing activities include transactions involving the purchase and sale of resources that are expected to benefit the company for several years, such as the purchase of equipment. With the necessary resources in place, the company is ready to begin operations. Operating activities will include transactions that relate to the primary operations of the company, such as providing products and services to customers and the associated costs of doing so, like utilities, taxes, advertising, salaries, rent, and utilities.
Investors and creditors want to know about the company’s resources and their claims to those resources. Accounting uses some conventional names to describe such resources and claims. Resources are referred to as assets and two parties have claims to those resources—investors and creditors.Amounts owed to creditors are liabilities, and amounts owed owners refers to stockholders’ equity. The relationship among the three measurement categories is called the basic accounting equation, which states that a company’s resources equal creditors’ and owners’ claims to those resources.The basic accounting equation can be used to explain that the value of a company to its owners equals total resources of the company minus amounts owed to creditors. Creditors expect to receive only amounts owed them. Stockholders, on the other hand, have claims to all resources in excess of the amount owed to creditors.Since stockholders claim all resources in excess of amounts owed to creditors, profits of the company are claimed solely by stockholders. Profits are calculated by comparing revenues and expenses. Revenues are the amounts earned from selling products or services to customers. Expenses are the costs of providing products and services. When revenues are greater than expenses, businesses earn net income, or profits. On the other hand, when expenses are greater than revenues, businesses incur a net loss. When a business has positive net income, it can either invest it back into the business or distribute it to its owners. Any distributions to owners are called dividends.
This list summarizes the business activities and the categories that measure them.
The second vital role of financial accounting is to communicate these business activities to those outside the company. The four primary financial statements used to communicate business activities are:Income statementStatement of stockholders’ equityBalance sheetStatement of cash flows
The income statement is a financial statement that reports the company’s revenues and expenses over an interval of time. It shows whether the company was able to generate enough revenue to cover the expenses of running the business.
Let’s consider the case of “Eagle Golf Academy” which started its operations on December 1. For the first month of operations, Eagle Golf Academy reports its income statement as shown in the Illustration.Notice the heading of the income statement includes the company’s name, the title of the financial statement, and the time period covered by the financial statement. The three major captions in the income statement include revenues and expenses, discussed earlier, and the difference between them—net income.
The statement of stockholders’ equity is a financial statement that summarizes the changes in stockholders’ equity over an interval of time. Stockholders’ equity has two primary components—common stock and retained earnings. Common stock represents amounts invested by stockholders (the owners of the corporation) when they purchase shares of stock. Common stock is an external source of stockholders’ equity.Retained earnings represent the cumulative amount of net income earned over the life of the company that has not been distributed to stockholders as dividends. Since all profits of the company are owned by stockholders, any net income in excess of dividends paid to stockholders represents stockholders’ equity retained in the business. Retained earnings is an internal source of stockholders’ equity. Thus, both common stock and retained earnings make up total stockholders’ equity.
Suppose Eagle obtains financing in December by issuing common stock for $25,000. This transaction will distribute shares of common stock to investors in return for the company’s receiving cash of $25,000. At the end of January Eagle pays dividends of $200 to stockholders. When the company begins operations on December 1, the balances of common stock and retained earnings are $0. Once the company issues common stock, its balance increases to $25,000. The balance of retained earnings always increases by the amount of net income less any dividends paid to stockholders, in this case, $1,200 – $200 = $1,000. By adding common stock and the retained earnings of $1,000, we calculate the balance of total stockholders’ equity at December 31 to be $26,000. This amount represents the value of the firm to its owners, i.e. the stockholders, in accounting terms.
The balance sheet is a financial statement that presents the financial position of the company on a particular date. The financial position of a company is summarized by the basic accounting equation: assets = liabilities + stockholders’ equity. Assets are the resources owned by the company, whereas liabilities are amounts owed to creditors. This means that stockholders have equity (or net worth) to the extent that assets exceed liabilities.
The first thing to notice is the time period included in the heading. Recall that the income statement and statement of stockholders’ equity, both show activity over an interval of time, the balance sheet, in contrast, reports assets, liabilities, and stockholders’ equity at a point in time. Total assets equal $40,000 and include some of the typical resources owned by most businesses, such as cash, supplies, and equipment. Total liabilities equal $14,000 and include amounts owed to regular vendors (accounts payable), as well as amounts owed for other items such as employee salaries, interest, and utilities. The difference of $26,000 represents stockholders’ equity and it includes retained earnings from the statement of stockholders’ equity. Notice that the amounts listed in the balance sheet show that the accounting equation balances.
The statement of cash flows is a financial statement that measures activities involving cash receipts and cash payments over an interval of time. We can classify all cash transactions into three categories that correspond to the three fundamental business activities we discussed earlier: operating activitiesinvesting activitiesfinancing activities.Operating cash flowsinclude cash receipts and cash payments for transactions involving revenues and expenses.Investing cash flowsgenerally include cash transactions for the purchase and sale of investments and productive long-term assets. Financing cash flowsinclude cash transactions with lenders, such as borrowing money and repaying debt, and with stockholders, such as issuing stock and paying dividends.
Net cash flows from operating, investing, and financing activities equal the net change in cash during the period. To this change, we add the beginning balance of cash. Since this is the first month of operations for Eagle, cash at the beginning of the month is zero. The ending balance of cash is the same as that reported in the balance sheet. This reconciliation of the beginning and ending cash balances emphasizes that the statement of cash flows explains why the cash reported in the balance sheet changed.The statement of cash flows can be an important source of information to investors and creditors. For example, investors use the relationship between net income and operating cash flows to forecast a company’s future profitability. Creditors compare operating cash flows and investing cash flows to assess a company’s ability to repay debt. Financing activities provide information to investors and creditors about the mix of external financing of the company.
The figure portrays the link among financial statements of Eagle Golf Academy. The net income balance from the income statement will be used to calculate the stockholders’ equity. The balance of stockholders’ equity is then transferred to the balance sheet. Notice that cash balance in the balance sheet should match with ending cash balance in the statement of cash flows. Any transaction that affects the income statement ultimately affects the balance sheet through the balance of retained earnings.
Financial accounting information is essential to making good business decisions. The figure demonstrates that investors and creditors have cash they are willing to invest. How do they decide which investment option provides the better opportunity? Most often, they analyze companies’ financial accounting information in making their decision.
Recall that accounting serves two main functions: It (1) measures business activities and (2) communicates those measurements to investors and creditors so they can make decisions.
Formal standards for reporting financial accounting information have been established, and all companies that publish financial statements must follow these rules because it allows investors and creditors to accurately compare financial information among companies when they are making decisions about where to lend or invest their resources. The rules of financial accounting are called Generally Accepted Accounting Principles,often abbreviated as GAAP.The fact that all companies use these same rules is critical to financial statement users. It allows them to accurately compare financial information among companies when they are making decisions about where to lend or invest their resources.
Today, financial accounting and reporting standards in the United States are established primarily by the Financial Accounting Standards Board (FASB). The FASB is an independent, private sector body with seven full-time voting members and a very large support staff. The global counterpart to the FASB is the International Accounting Standards Board.The standard-setting body responsible for this convergence effort is the International Accounting Standards Board (IASB).Securities and Exchange Commission (SEC), a government agency created in 1934, has both the power and the responsibility for setting accounting and reporting standards for companies whose securities are publicly traded. The SEC has delegated the primary responsibility for setting accounting standards to FASB.
Auditors are not full-time employees of the company they are auditing. Instead, auditors are trained individuals hired by a company as an independent party to express a professional opinion of the accuracy of that company’s financial statements. If they find mistakes or fraudulent reporting behavior, auditors require the company to correct all significant information before issuing financial statements.Thus, the role of auditors is to help ensure that management has in fact appropriately applied GAAP in preparing the company’s financial statements. Also, they play a major role in investors’ and creditors’ decisions by adding credibility to the financial statements.
The FASB has explicitly stated the following as specific objectives of financial accounting:1. is useful to investors and creditors in making decisions.2. helps to predict cash flows.3. tells about economic resources, claims to resources, and changes in resources and claims.
Accounting majors need to realize the many different options available upon graduation. Those who do not plan to major in accounting need a solid understanding of the many different business decisions involving accounting information.If you do major in accounting, the job prospects are numerous.
Because of the high demand for accounting graduates, the wide range of job opportunities, and increasing salaries, this is a great time to obtain a degree in accounting.The first big decision a student makes as an accounting graduate is the choice between a career in public accounting and a career in private accounting. Public accounting firms are professional service firms that traditionally have focused on three areas: auditing, tax preparation/planning, and business consulting. “Big 4” public accounting firms are Deloitte, Ernst & Young, PricewaterhouseCoopers, and KPMG. You can work either with Big 4 or Non-Big 4. A career in private accounting means providing accounting services to the company that employs you.
The conceptual framework provides an underlying foundation for the development of accounting standards and interpretation of accounting information. To be useful for decision making, accounting information should have relevance and faithful representation.
The FASB establishes financial accounting standards based on a conceptual framework, which you can think of as the “theory” of accounting. The FASB’s conceptual framework prescribes the “correctness” of financial accounting rules. The conceptual framework provides an underlying foundation for the development of accounting standards and interpretation of accounting information. The figure provides a graphical depiction of the qualitative characteristics of accounting information. Notice that the main focus is on decision usefulness—the ability of the information to be useful in decision making. The two primary decision-specific qualities that make accounting information useful are relevanceand faithful representation. Both are critical. No matter how representative, if information is not relevant to the decision at hand, it is useless. Conversely, relevant information is of little value if it does not accurately represent the underlying activity.Four enhancing qualitative characteristics are comparability, verifiability, timeliness, and understandability.
The four basic assumptions underlying GAAP are (1) the economic entity assumption, (2) the monetary unit assumption, (3) the periodicity assumption, and (4) the going concern assumption.The economic entity assumptionstates that we can identify all economic events with a particular economic entity. Another key aspect of this assumption is the distinction between the economic activities of owners and those of the company. For example, Michael Dell’s personal residence is not an asset of Dell Incorporated.According to the monetary unit assumption, to measure financial statement elements, we need a unit or scale of measurement. The dollar in the United States is the most appropriate common denominator to express information about financial statement elements and changes in those elements. The periodicity assumption relates to the qualitative characteristic of timeliness. External users need periodic information to make decisions. The periodicity assumption divides the economic life of an enterprise (presumed to be indefinite) into artificial time periods for periodic financial reporting. Corporations like Dell, whose securities are publicly traded, are required to provide financial information to the SEC on a quarterly and an annual basis.Thegoing concern assumptionstates that, in the absence of information to the contrary, a business entity will continue to operate indefinitely. It provides justification for measuring many assets based on their original costs.