Introduction to Accounting
Description of Accounting
Accounting is an information and measurement system that identifies, records, and communicates relevant, reliable, and comparable information about an organization’s business activities.
Identifying accounting information entails observing transactions and activities within a business. Recording encompasses generating records related to observations and communicating entails preparing, presenting and analyzing results and reports.
Accounting is called the language of business because all organizations set up an accounting system to communicate data that help people make better decisions. There are two user groups, external users and internal users.
External Information Users Do not directly run the organization and have limited access to its accounting information. They include shareholders (investors), lenders, directors, customers, suppliers, regulators, lawyers, brokers, and the press. Their business decisions depend on information that is reliable, relevant, and comparable.
Financial accounting is the area of accounting aimed at serving external users by providing them with general-purpose financial statements
- the balance sheet
- income statement
- statement of retained earnings
- statement of cash flows.
The term general-purpose refers to the broad range of purposes for which external users rely on these statements.
Internal Information Users Directly manage and operate the organization such as the chief executive officer (CEO), chief financial officer (CFO), chief audit executive (CAE), treasurer, and other executive or managerial-level employees.
Managerial accounting is the area of accounting that serves the decision-making needs of internal users. Internal reports are not subject to the same rules as external reports and instead are designed with the unique needs of internal users in mind. Following is a partial list of internal users and some decisions they make with accounting information.
- Research and development managers
- Purchasing managers
- Human resource managers
- Production managers
- Distribution managers
- Marketing managers
- Service managers
Opportunities in Accounting
Accounting has four broad areas of opportunities: financial, managerial, taxation, and accounting-related.
- Financial accountants are primarily focused on external auditing, preparing financial statements, and compliance with regulators such as the Securities and Exchange Commission (SEC).
- Managerial accountants focus on preparing internal data to aid in company management such as costs, budgeting, etc. They also assist the internal auditors.
- Tax accountants focus on tax laws and tax planning.
The majority of opportunities are in private accounting, which are employees working for businesses. Public accounting offers the next largest number of opportunities, which involve accounting services such as auditing and taxation. Opportunities also exist in government and not-for-profit agencies, including business regulation and investigation of law violations.
Accounting specialists are highly regarded and their professional standing is often denoted by a certificate. Certified public accountants (CPAs) must meet education and experience requirements, pass an examination, and exhibit ethical character. Many accounting specialists hold certificates in addition to or instead of the CPA. Two of the most common are the certificate in management accounting (CMA) and the certified internal auditor (CIA). Employers also look for specialists with designations such as certified bookkeeper (CB), certified payroll professional (CPP), personal financial specialist (PFS), certified fraud examiner (CFE), and certified forensic accountant (CrFA).
Expectations for Accountants
Ethics are the key to trust. Trust is key to accepting the accounting information prepared by accountants. Accountants face ethical choices when preparing financial records. A key concept is to understand the fraud triangle.
The fraud triangle asserts that three factors must exist for a person to commit fraud: opportunity, pressure, and rationalization.
- A person must envision a way to commit fraud with a low risk of getting caught.
- Pressure,or incentive. A person must feel pressure to commit fraud.
- Rationalization,or attitude. A person rationalizes the fraud and fails to see its criminal nature or justifies the fraud.
The key to dealing with fraud is to focus on prevention. It is less expensive and more effective to prevent fraud from happening than it is to detect it. By the time a fraud is discovered, the money is often gone and chances for recovery are slim.
Both internal and external users rely on internal controls to reduce the likelihood of fraud. Internal controls are procedures set up to protect company property and equipment, ensure reliable accounting, promote efficiency, and encourage adherence to policies. Examples are good records, physical controls (locks, passwords, guards), and independent reviews.
Generally Accepted Accounting Principles
Financial accounting is governed by concepts and rules known as generally accepted accounting principles (GAAP). GAAP aims to make information relevant, reliable, and comparable. Relevant information affects decisions of users. Reliable information is trusted by users. Comparable information aids in contrasting organizations.
In the United States, the Securities and Exchange Commission (SEC) has the authority to set GAAP. The SEC oversees proper use of GAAP by companies that raise money from the public through issuance of stock and debt. The SEC has largely delegated the task of setting U.S. GAAP to the Financial Accounting Standards Board (FASB), which is a private-sector group that sets both broad and specific principles.
Our global economy creates demand by external users for comparability in accounting reports. To that end, the International Accounting Standards Board (IASB), an independent group (consisting of individuals from many countries), issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices. If global standards were harmonized, one company could potentially use a single set of financial statements across financial markets. Differences between U.S. GAAP and IFRS have been decreasing in recent years.
Principles and Assumptions of Accounting
Accounting principles (and assumptions) are of two types. General principles are the basic assumptions, concepts, and guidelines for preparing financial statements. Specific principles are detailed rules used in reporting business transactions and events. General principles stem from long-used accounting practices. Specific principles arise more often from the rulings of authoritative groups.
- General principles and assumptions underlie all of the concepts we will learn.
- The specific principles are rules related to specific accounting records for inventory, cash, accounts receivable, etc.–chapters after chapters 1 through 3.
Accounting Principles General principles consist of at least four basic principles, four assumptions, and two constraints.
The measurement principle, also called the cost or historical cost principle, prescribes that accounting information is based on actual cost. Cost is measured on a cash or equal-to-cash basis. This means if cash is given for a service, its cost is measured by the cash paid. If something besides cash is exchanged (such as a car traded for a truck), cost is measured as the cash value of what is given up or received. The cost principle emphasizes reliability and verifiability, and information based on cost is considered objective. Objectivity means that information is supported by independent, unbiased evidence; it demands more than a person’s opinion.
Example: A company pays $5,000 for land. The cost principle requires that this purchase be recorded at $5,000. It makes no difference if the land is now worth $50,000.
- Revenue recognition
Revenue (sales) is the amount received from selling products and services. The revenue recognition principle provides guidance on when a company must record revenue. (1) Revenue is recognized when goods or services are provided to customers and (2) is based on the amount expected to be received from the customer. If the customer uses credit to pay for an item, the sale is recognized on the date of the transaction not when the cash is ultimately received.
Example: A lawn service bills a customer $1,000 on June 1 for two months of mowing (June and July). The customer pays the bill on Aug 1. When is revenue recorded? When the lawns were cut in June and July not when the money is received in Aug.
- Expense recognition
The expense recognition principle, also called the matching principle, prescribes that a company record the expenses required to generate revenue. The principles of matching and revenue recognition are key to modern accounting. You must record the expenses
Example: Credit cards are used to pay $400 in gas for a lawn mowing business during June and July. The cards are paid off in August. When is expense recorded? Expenses are recorded when the in June and July not in Aug..
- Full disclosure
The full disclosure principle prescribes that a company report the details behind financial statements that would impact users’ decisions. Those disclosures are often in footnotes to the statements.
Accounting Assumptions There are four accounting assumptions: the going-concern assumption, the monetary unit assumption, the time period assumption, and the business entity assumption.
- Going concern
The going-concern assumption means that accounting information reflects a presumption that the business will continue operating instead of being closed or sold.
- Monetary unit
The monetary unit assumption means that we can express transactions and events in dollars for the US or the monetary unit monetary where the company operates.
- Time period
The time period assumption presumes that the life of a company can be divided into time periods, such as months and years, and that useful reports can be prepared for those periods.
- Business entity
The business entity assumption means that a business is accounted for separately from other business entities, including its owner. The reason for this assumption is that separate information about each business is necessary for good decisions.
A business entity can take one of three legal forms: proprietorship, partnership, or corporation.
- A sole proprietorship,or simply proprietorship, is a business owned by one person. The business is a separate entity for accounting purposes. However, a proprietorship is not a separate legal entity from its owner. This means, for example, that a court can order an owner to sell personal belongings to pay a proprietorship’s debt. This unlimited liability of a proprietorship is a disadvantage.
- A partnershipis a business owned by two or more people, called partners, who are jointly liable for tax and other obligations. Like a proprietorship, no special legal requirements must be met in starting a partnership. A partnership, like a proprietorship, is not legally separate from its owners. This means that each partner’s share of profits is reported and taxed on that partner’s tax return. It also means unlimited liability for its partners. However, at least three types of partnerships limit liability. A limited partnership, (LP), a limited liability partnership (LLP) and a limited liability company(LLC)
Most proprietorships and partnerships are now organized as LLCs.
- A corporation is a business legally separate from its owner or owners, meaning it is responsible for its own acts and its own debts. Separate legal status means that a corporation can conduct business with the rights, duties, and responsibilities of a person. A corporation acts through its managers, who are its legal agents. Separate legal status also means that its owners, who are called shareholders(or stockholders), are not personally liable for corporate acts and debts. This limited liability is its main advantage. Ownership of all corporations is divided into units called shares or When a corporation issues only one class of stock, we call it common stock (or capital stock).
Constraints of Accounting
Accounting Constraints There are two basic constraints on financial reporting.
The materiality constraint prescribes that only information that would influence the decisions of a reasonable person need be disclosed. This constraint looks at both the importance and relative size of an amount.
- Benefit exceeds cost
The cost-benefit constraint prescribes that only information with benefits of disclosure greater than the costs of providing it need be disclosed.
Two other “constraints” are often present in accounting.
Accounting by its nature is conservative and will seek to record a lower value.
- Industry practices
Accounting generally tends to follow the industry practices of peers.
Recent Accounting regulation.
Congress passed the Sarbanes-Oxley Act, also called SOX, to help curb financial abuses at companies that issue their stock to the public. SOX requires that these public companies apply both accounting oversight and stringent internal controls. The desired results include more transparency, accountability, and truthfulness in reporting transactions.
To reduce the risk of accounting fraud, companies set up governance systems. A company’s governance system includes its owners, managers, employees, board of directors, and other important stakeholders, who work together to reduce the risk of accounting fraud and increase confidence in accounting reports.
Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd-Frank, to (1) promote accountability and transparency in the financial system, (2) put an end to the notion of “too big to fail,” (3) protect the taxpayer by ending bailouts, and (4) protect consumers from abusive financial services.