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What is Accounting?
Accounting is the system a business uses to identify, measure, and communicate financial information to others, inside and outside the organization.
Because outsiders and insiders use accounting information for different purposes, accounting has two distinct facets. Financial accounting is concerned with preparing financial statements and other information for outsiders such as stockholders and creditors (people or organizations that have lent a company money or have extended them credit); management accounting is concerned with preparing cost analyses, profitability reports, budgets, and other information for insiders such as management and other company decision makers. To be useful, all accounting information must be accurate, objective, consistent over time, and comparable to information supplied by other companies.
What Accountants Do
Some people confuse the work accountants do with bookkeeping, which is the clerical function of recording the economic activities of a business. Although some accountants do perform bookkeeping functions, their work generally goes well beyond the scope of this activity. Accountants design accounting systems, prepare financial statements, analyze and interpret financial information, prepare financial forecasts and budgets, and prepare tax returns. Some accountants specialize in certain areas of accounting, such as cost accounting (computing and analyzing production costs), tax accounting (preparing tax returns and interpreting tax law), or financial analysis (evaluating a company’s performance and the financial implications of strategic decisions such as product pricing, employee benefits, and business acquisitions).
Ten Most Important Accounting Skills
In addition to traditional accounting work, accountants may also help clients improve business processes, plan for the future, evaluate product performance, analyze profitability by customer and product groups, design and install new computer systems, assist companies with decision making, and provide a variety of other management consulting services. Performing these functions requires a strong business background and a variety of business skills beyond accounting.
Ten Most Important Accounting Skills
Besides having knowledge of accounting, today’s accountants need the right mix of personal and business skills to increase their chances for a successful career.
Types of Accountants
Most accountants (about 65 percent) are private accountants who work for a business, a government agency (such as the Internal Revenue Service, a school, or a local police department), or a nonprofit corporation (such as a church, charity, or hospital. Private accountants generally work under the supervision of the organization’s controller. Often, these accountants are internal auditors—employees who investigate and evaluate the organization’s internal operations.
certification is not required of private accountants, many are licensed certified
public accountants (CPAs), which means they have passed a rigorous
state-certified licensing exam. A growing number of private accountants are
becoming certified management accountants (CMAs); to do so they must
pass a two-day exam (given by the
Public accountants, by contrast, are independent of the businesses, organizations, and individuals they serve. Most public accountants are employed by public accounting firms that provide a variety of accounting and consulting services to their clients. Members of the firm generally are CPAs and must obtain CPA and state licensing certifications before they are eligible to conduct an audit—a formal evaluation of a company’s accounting records and processes to ensure the integrity and reliability of a company’s financial statements.
Typical Finance Department
The chart above outlines a typical finance department in a large company. In smaller companies, the controller may be the highest ranking accountant and report directly to the president.
The Role of Auditors
Companies whose stock
(ownership shares) is publicly traded in the
During an audit, CPAs who work for an independent accounting firm (also known as external auditors) review a client’s financial records to determine whether the statements that summarize these records have been prepared in accordance with generally accepted accounting principles (GAAP), basic accounting standards and procedures that have been agreed on by regulators, auditors, and companies over decades. GAAP aims to give a fair and true picture of a company’s financial position.
To assist with the auditing process, many large organizations employ internal auditors—company employees who investigate and evaluate the organization’s internal operations and data to determine whether they are accurate and whether they comply with GAAP, federal laws, and industry regulations.
Generally Accepted Accounting Principles (GAAP)
Financial Accounting Standards Board (FASB)
International Accounting Standards (IAS)
Securities and Exchange Commission (SEC)
During an audit, CPAs who work for an independent accounting firm (also known as external auditors) review a client’s financial records to determine whether the statements that summarize these records have been prepared in accordance with generally accepted accounting principles (GAAP), basic accounting standards and procedures that have been agreed on by regulators, auditors, and companies over decades.
GAAP aims to give a
fair and true picture of a company’s financial position. In the
Recent proposals to develop a uniform set of global accounting rules known as International Accounting Standards (IAS) could help eliminate such differences and simplify the bookkeeping process for multinational companies. But such global rules are meeting strong resistance from the U.S. Securities and Exchange Commission (SEC) and other regulators, which are concerned that many of the International Accounting Standards are not as strict as GAAP.
How Strict is GAAP?
GAAP sets forth the principles and guidelines that companies and accountants must follow when preparing financial reports or recording accounting transactions. But, as with any rules, GAAP can be interpreted aggressively or conservatively. In other words, the rules give executives the freedom to use their judgment in areas that can dramatically affect the company’s bottom line without breaking any rules. Unfortunately, some companies take advantage of this flexibility by resorting to a number of accounting tricks that overstate expenses, puff up income, and hide problems from the public.
In most cases “accounting irregularities don’t start with dishonesty; rather they start with pressure for financial performance,” says one financial expert. Such pressure comes from employee-shareholders whose life savings are invested in company stock, executives whose bonuses are tied to a company’s bottom line, and financial managers who must meet Wall Street estimates or pump up a company’s stock price.
Fundamental Accounting Concepts
The Accounting Equation
The Matching Principle
In their work with financial data, accountants are guided by three basis concepts: the fundamental accounting equation, double-entry bookkeeping, and the matching principle.
The Accounting Equation
Assets – Liabilities = Owner’s Equity
Assets = Liabilities + Owner’s Equity
For thousands of years, businesses and governments have kept records of their assets—valuable items they own or lease, such as equipment, cash, land, buildings, inventory, and investments. Claims against those assets are liabilities, or what the business owes to its creditors—such as banks and suppliers. For example, when a company borrows money to purchase a building, the lender or creditor has a claim against the company’s assets. What remains after liabilities have been deducted from assets is owners’ equity:
Assets - Liabilities = Owners’ equity
Using the principles of algebra, this equation can be restated in a variety of formats. The most common is the simple accounting equation, which serves as the framework for the entire accounting process:
Assets = Liabilities + Owners’ equity
This equation suggests that either creditors or owners provide all the assets in a corporation. However, the equation must always be in balance; in other words, one side of the equation must always equal the other side.
Basic Accounting Concepts
To keep the accounting equation in balance, companies use a double-entry bookkeeping system that records every transaction affecting assets, liabilities, or owners’ equity.
The matching principle requires that expenses incurred in producing revenues be deducted from the revenue they generated during the same accounting period. This matching of expenses and revenue is necessary for the company’s financial statements to present an accurate picture of the profitability of a business.
Accountants match revenue to expenses by adopting the accrual basis of accounting, which states that revenue is recognized when you make a sale or provide a service, not when you get paid. Similarly, your expenses are recorded when you receive the benefit of a service or when you use an asset to produce revenue—not when you pay for it.
If a business runs on a cash basis, the company records revenue only when money from the sale is actually received. The trouble with cash-based accounting, however, is that it can be misleading. You can misrepresent expenses and income by the way you time payments. It’s easy to inflate income, for example, by delaying the payment of bills. For that reason, public companies are required to keep their books on an accrual basis.
How Are Financial Statements Used?
An accounting system is made up of thousands of individual transactions—debits and credits to be exact. During the accounting process, sales, purchases, and other transactions are recorded and classified into individual accounts. Once these individual transactions are recorded and then summarized, accountants must review the resulting transaction summaries and adjust or correct all errors or discrepancies before they can close the books, or transfer net revenue and expense items to retained earnings.
The slide above presents the process for putting all of a company’s financial data into standardized formats that can be used for decision making, analysis, and planning. To make sense of these individual transactions, accountants summarize them by preparing financial statements.
Understanding Financial Statements
Financial statements consist of three separate yet interrelated reports: the balance sheet, the income statement, and the statement of cash flows. Together these statements provide information about an organization’s financial strength and ability to meet current obligations, the effectiveness of its sales and collection efforts, and its effectiveness in managing its assets. Organizations and individuals use financial statements to spot opportunities and problems, to make business decisions, and to evaluate a company’s past performance, present condition, and future prospects. In sum, they’re indispensable.
The Balance Sheet
The balance sheet, also known as the statement of financial position, is a snapshot of a company’s financial position on a particular date. This statement includes all elements in the accounting equation and shows the balance between assets on one side and liabilities and owners’ equity on the other side.
Assets can consist of cash, things that can be converted into cash, and equipment. Current assets include cash and other items that will or can become cash within the following year. Fixed assets are long-term investments in buildings, equipment, furniture and fixtures, transportation equipment, land, and other tangible property used in running the business. Fixed assets have a useful life of more than one year.
Liabilities represent claims against the company’s assets. The balance sheet gives subtotals for current liabilities (obligations that will have to be met within one year of the date of the balance sheet) and long-term liabilities (obligations that are due one year or more after the date of the balance sheet), and then it gives a grand total for all liabilities.
The owners’ investment in a business is listed on the balance sheet under shareholders’ equity. Shareholders’ equity for a corporation is presented in terms of the amount of common stock that is outstanding, meaning the amount that is in the hands of the shareholders. Shareholders’ equity also includes a corporation’s retained earnings—the portion of shareholders’ equity that is not distributed to its owners in the form of dividends.
The Income Statement
Gross Sales – Returns and Allowances
Cost of Goods Sold
Beginning Inventory + Purchases – Cost of Goods – Ending Inventory
Selling Expenses + General Expenses
Net Operating Income
Gross Profit + Other Income – Operating Expenses
Net Income After Taxes
Net Income Before Taxes – Income Taxes
The income statement shows an organization’s profit performance over a specific period of time, typically one year. It summarizes all revenues (or sales), the amounts that have been or are to be received from customers for goods or services delivered to them, and all expenses, the costs that have arisen in generating revenues. Expenses and income taxes are then subtracted from revenues to show the actual profit or loss of a company, a figure known as net income—profit, or the bottom line.
The Cash-Flow Statement
In addition to preparing a balance sheet and an income statement, all public companies and many privately owned companies prepare a statement of cash flows to show how much cash the company generated over time and where it went.
The statement tracks cash flows from operations, investments, and financing. It reveals the increase or decrease in the company’s cash for the period and summarizes (by category) the sources of that change.
From a brief review of this statement you should have a general sense of the amount of cash created or consumed by daily operations, the amount of cash invested in fixed or other assets, the amount of debt borrowed or repaid, and the proceeds from the sale of stock or payments for dividends. In addition, an analysis of cash flows provides a good idea of a company’s ability to pay its short-term obligations when they become due.
Analyzing Financial Statements
The process of comparing financial data from year to year in order to see how they have changed is known as trend analysis. You can use trend analysis to uncover shifts in the nature of the business over time. Of course, when you are comparing one period with another, it’s important to take into account the effects of extraordinary or unusual items such as the sale of major assets, the purchase of a new line of products from another company, weather, or economic conditions that may have affected the company in one period but not the next.
Ratio analysis compares two elements from the same year’s financial figures. They are called ratios because they are computed by dividing one element of a financial statement by another. The advantage of using ratios is that it puts companies on the same footing; that is, it makes it possible to compare different-size companies and changing dollar amounts.
Before reviewing specific ratios, consider two rules of thumb: First, avoid drawing too strong a conclusion from any one ratio. Second, once ratios have presented a general indication, refer back to the specific data involved to see whether the numbers confirm what the ratios suggest. In other words do a little investigating, because statistics can be misleading.
Types of Financial Ratios
You can analyze how well a company is conducting its ongoing operations by computing profitability ratios, which show the state of the company’s financial performance or how well it’s generating profits.
Liquidity ratios measure the ability of the firm to pay its short-term obligations. As you might expect, lenders and creditors are keenly interested in liquidity measures.
A number of activity ratios may be used to analyze how well a company is managing its assets.
You can measure a company’s ability to pay its long-term debts by calculating its debt ratios, or leverage ratios. Lenders look at these ratios to determine whether the potential borrower has put enough money into the business to serve as a protective cushion for the loan.
Return on Sales = Net Income
Return on Equity = Net Income
Total Owner’s Equity
Earnings per Share = Net Income
Average Shares Outstanding
Three of the most common profitability ratios are return on sales, or profit margin (the net income a business makes per unit of sales); return on investment (ROI), or return on equity (the income earned on the owner’s investment); and earnings per share (the profit earned for each share of stock outstanding).
This slide shows how to compute these ratios.
Working Capital = Current Assets – Current Liabilities
Current Ratio = Current Assets
Quick Ratio =Current Assets – Liabilities
A company’s working capital (current assets minus current liabilities) is an indicator of liquidity because it represents current assets remaining after the payment of all current liabilities. The dollar amount of working capital can be misleading, however. For example, it may include the value of slow-moving inventory items that cannot be used to help pay a company’s short-term debts.
A different picture of the company’s liquidity is provided by the current ratio—current assets divided by current liabilities. This figure compares the current debt owed with the current assets available to pay that debt. The quick ratio, also called the acid-test ratio, is computed by subtracting inventory from current assets and then dividing the result by current liabilities.
This slide shows how to compute these ratios.
Inventory Turnover = Cost of Goods Sold
Receivables Turnover = Sales
Average Accounts Receivable
The most common is the inventory turnover ratio, which measures how fast a company’s inventory is turned into sales; in general, the quicker the better, because holding excess inventory can be expensive. Another popular activity ratio is the accounts receivable turnover ratio, which measures how well a company’s credit and collection policies are working by indicating how frequently accounts receivable are converted to cash.
This slide shows how to compute these ratios.
Debt to Equity Total Liabilities
Debt to Total Assets = Total Liabilities
The debt-to-equity ratio (total liabilities divided by total equity) indicates the extent to which a business is financed by debt, as opposed to invested capital (equity). The debt-to-total-assets ratio (total liabilities divided by total assets) also serves as a simple measure of a company’s ability to carry long-term debt.
This slide shows how to compute these ratios.
Accounting - measuring, interpreting, and communicating financial information to support internal and external decision making
Accounting equation - basic accounting equation stating that assets equals liabilities plus owners' equity
Accounts receivable turnover ratio - measure of time a company takes to turn its accounts receivable into cash, calculated by dividing sales by the average value of accounts receivable for a period
Accrual basis - accounting method in which revenue is recorded when a sale is made and expense is recorded when it is incurred
Activity ratios - ratios that measure the effectiveness of the firm's use of its resources
Assets - any things of value owned or leased by a business
Audit - formal evaluation of the fairness and reliability of a client's financial statements
Balance sheet - statement of a firm's financial position on a particular date; also known as a statement of financial position
Bookkeeping - record keeping, clerical aspect of accounting
Calendar year - twelve-month accounting period that begins on January 1 and ends on December 31
Cash basis - accounting method in which revenue is recorded when payment is received and expense is recorded when cash is paid
Certified management accountants (CMAs) - accountants who have fulfilled the requirements for certification as specialists in management accounting
Certified public accountant (CPA) - professionally licensed accountant who meets certain requirements for education and experience and who passes a comprehensive examination
Controller - highest-ranking accountant in a company, responsible for overseeing all accounting functions
Cost accounting - area of accounting focusing on the calculation of manufacturing and storage costs of products for use or sale in a business
Cost of goods sold - cost of producing or acquiring a company's products for sale during a given period
Current assets - cash and items that can be turned into cash within one year
Current Liabilities - amounts owed by the company that are to be repaid within one year.
Current liabilities - obligations that must be met within a year
Current ratio - measure of a firm's short-term liquidity, calculated by dividing current assets by current liabilities
Debt ratios - ratios that measure a firm's reliance on debt financing of its operations (sometimes called leverage ratios)
Debt-to-equity ratio - measure of the extent to which a business is financed by debt as opposed to invested capital, calculated by dividing the company's total liabilities by owners' Equitydebt-to-total-assets ratio - measure of a firm's ability to carry long-term debt, calculated by dividing total liabilities by total assets
Depreciation - accounting procedure for systematically spreading the cost of a tangible asset over its estimated useful life
Dose the books - the act of transferring net revenue and expense account balances to retained earnings for the period
Double-entry bookkeeping - way of recording financial transactions that requires two entries for every transaction so that the accounting equation is always kept in balance
Earnings per share - measure of a firm's profitability for each share of outstanding stock, calculated by dividing net income after taxes by the average number of shares of common stock outstanding
Expenses - costs created in the process of generating revenues
Financial accounting - area of accounting concerned with preparing financial information for users outside the organization
Financial analysis - process of evaluating a company's performance and analyzing the costs and benefits of a strategic action
Fiscal year - any 1 2 consecutive months used as an accounting period
Fixed Assets - long-term investments in buildings, equipment, furniture, and any other tangible property expected to be used in running the business for a period longer than one year.
General expenses - operating expenses, such as office and administrative expenses, not directly associated with creating or marketing a good or a service
Generally accepted accounting principles (GAAP) - professionally approved u.s. standards and practices used by accountants in the preparation of financial statements
Gross profit - amount remaining when the cost of goods sold is deducted from net sales; also known as gross margin
Income statement - financial record of a company's revenues, expenses, and profits over a given period of time
Internal auditors - employees who analyze and evaluate a company's operations and data to determine their accuracy
Inventory turnover ratio - measure of the time a company takes to turn its inventory into sales, calculated by dividing cost of goods sold by the average value of inventory for a period
Lease - legal agreement that obligates the user of an asset to make payments to the owner of the asset in exchange for using it
Liabilities- claims against a firm's assets by creditors
Liquidity ratios - ratios that measure a firm's ability to meet its short-term obligations when they are due
Long-Term Liabilities - debts that are due a year or more after the date of the balance sheet.
Long-term liabilities - obligations that fall due more than a year from the date of the balance sheet
Management accounting - area of accounting concerned with preparing data for use by managers within the organization
Matching principle - fundamental principle requiring that expenses incurred in producing revenue be deducted from the revenues they generate during an accounting period
Net income - profit earned or loss incurred by a firm, determined by subtracting expenses from revenues; also called the bottom line
Operating expenses - all costs of operation that are not included under cost of goods sold
Owners' equity - portion of a company's assets that belongs to the owners after obligations to all creditors have been met
Private accountants - in-house accountants employed by organizations and businesses other than a public accounting firm; also called corporate accountants
Profitability ratios - ratios that measure the overall financial performance of a firm
Public accountants - professionals who provide , accounting services to other businesses and individuals for a fee
Quick ratio - measure of a firm's short-term liquidity, calculated by adding cash, marketable securities, and receivables, then dividing that sum by current liabilities; also known as the acid-test ratio
Ratio analysis - use of quantitative measures to evaluate a firm's financial performance
Retained earnings - the portion of shareholders' equity earned by the company but not distributed to its owners in the form of dividends
Return on investment (ROn - ratio between net income after taxes and total owners' equity; also known as return on equity
Return on sales - ratio between net income after taxes and net sales; also known as profit margin
Revenues - amount earned from sales of goods or services and inflow from miscellaneous sources such as interest, rent, and royalties
Selling expenses - all the operating expenses associated with marketing goods or services
Shareholders' Equity - money contributed to the company for ownership interests, as well as the accumulation of profits that have not been paid out as dividends (retained earnings).
Statement of cash flows - statement of a firm's cash receipts and cash payments that presents information on its sources and uses of cash
Tax accounting - area of accounting focusing on tax preparation and tax planning
Working capital - current assets minus current liabilities
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