The Fundamentals of Accounting
 
 

The Fundamentals of Accounting

Business Types

Before we dive into specific accounting terms, let us talk a little bit about business types. There are three major business types to choose from if you want to start your own business:

Individual/sole proprietorship: This is primarily for individuals in the "doing business as (DBA)" category. The benefits of a sole proprietorship include relative freedom from regulation, though you are not exempt from investigation and prosecution of criminal or unlawful activity. You have full control of the entire company, and all profits go right to the owner or individual. The drawback is that the owner/individual has unlimited personal liability, meaning in layman's terms that if you get sued, the party bringing suit can go after all of your personal assets, including your house, car, and pets.

Partnership: This is much like a sole proprietorship, except ownership is divided between two individuals. The disadvantages of sole proprietorship still remain; i.e., unlimited personal liability. In addition, control is divided.

Corporation: The main advantage to being a corporation is limited liability, meaning the company and the company alone is liable for anything that may happen, although this does not protect the owners from liability for criminal acts. Also, with a corporation, ownership can be transferred. Corporations have shares to divide up ownership. People who own shares, or stock, in the company are known as shareholders. The main drawbacks are potential restrictions by regulating agencies of the government and more tax implications. There are different types of corporations, such as a Class S and Class C, but we will not discuss these.

It is important to note that while the above are the types of business you could start, there is still another type of business that exists, and that is a government agency. These agencies are either elected and/or formed by elected individuals. Government agencies are run just like any other business when it comes to accounting, although specific rules may vary.
Accounting Defined

What is accounting? Accounting is commonly defined as the language of business. What does that mean? Accounting is an extremely general term which, used loosely, covers a system that accounts, records, summarizes, interprets, and reports all financial transactions of a single organization, as well as the design of that system and its internal controls. Because of the importance of understanding this definition, we will put it in a blue box. (For future reference, anything in a blue box needs to be carefully understood.)

Accounting: A system, including its design and internal controls, that accounts, records, summarizes, interprets, and reports all financial transactions of an organization.

Bookkeeping Defined

It is not surprising that many people use bookkeeping and accounting interchangeably, but they are quite different in the way they function. While accounting is an organization's entire system that accounts and reports all financial transactions, bookkeeping is a subset of accounting and refers to the actual process of how the books, or financial transactions, are kept. This usually refers to the ledgers that record credits and debits for specific accounts and may also refer to a computer program that is used to store and organize financial information (e.g., QuickBooks Accounting). While accounting includes bookkeeping, or the mechanics of how financial information is stored, bookkeeping does not define the broad system of accounting. Bookkeepers or bookkeeping clerks are the individuals who utilize the system in place for recording business transactions, while accountants are the individuals who oversee or manage the system, the bookkeeping, and the bookkeepers.

Public Accounting

Public accountants work for companies whose primary service is to provide accounting services, tax accounting, and auditing for other companies. Some examples of public accounting firms are Ernst & Young, Deloitte, and KPMG. Accountants who work for public accounting firms are usually Certified Public Accountants (CPAs).

CPA

This is the most important credential you can have if you are an accountant, but it is not necessary to have one. It is a credential that many companies recommend or require when hiring an accountant. It is important to note that all CPAs are accountants, but not all accountants are CPAs.

If a person is a CPA, it means that she or he has passed stringent state licensing tests, met a hefty sum of educational requirements, and logged a set number of years of full-time experience as an public accountant. The amount required can vary from state to state. Additionally, CPAs have sworn to account with the greatest of integrity and ethics, and they have extensive training and experience with tax laws.
If you are hiring an accountant for your company, you should determine whether you can afford a CPA or someone with extensive accounting experience. It is not the best practice to hire someone with only a couple of years of experience in accounting. These individuals, while they may in fact become excellent accountants over time, may not be able to see the big picture of how all systems work together, unless they have had the necessary education. Please keep in mind the distinction between bookkeepers and accountants when you are fulfilling your accounting needs. Make sure you are hiring an accountant with broad accounting experience, and not someone who has kept the books or ledgers for the last few years and is passing it off as disciplined accounting experience. In many smaller organizations, there is no difference between keeping the books and accounting; it is all handled by one individual. In larger organizations, there is a difference between the people that actually enter and maintain the books, or bookkeepers, and the actual accountants that oversee how the accounting process runs in its entirety.
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GAAP (Generally Accepted Accounting Principles)

In the accounting world you may hear the term "GAAP format." It is assumed that any financial statements generated by the accountant or accounting department conform to Generally Accepted Accounting Principles (GAAP). GAAP is a set of rules, standardizations, or principles that all financial information reported by a company must follow. If not, the report must clearly specify that the information does not follow GAAP. These standards are set by an independent agency called the Financial Accounting Standards Boards (FASB). When investors and auditors look at a company's financial statements, it is assumed that the summaries of numbers given all conform to the GAAP. If reports have been intentionally altered to not follow GAAP, also known as "cooking the books," then this is fraud. We can always look at Enron for an example of how the reporting of accounting information went bad.

Auditing

Auditing is the review of a company's financial statements by an independent party to determine the validity of the statements and to confirm that the statements conform to GAAP. Public accounting firms are hired by the company to audit the transactions of an organization.

What Do Accountants Do?

Now that we have covered some basic accounting terms and ideas, it is time to look at the specifics of what accountants do. Obviously, accountants are responsible for accounting, summarizing, interpreting, and reporting all financial transactions of a company. With such a broad-based definition, let us look at the specific tasks an accountant in company XYZ would be responsible for:

- Accountants record and maintain all financial activities of an organization.
- Accountants create, maintain, and record payroll information.
- Accountants record all payments made by an organization.
- Accountants record all purchases made and maintain inventory counts.
- Accountants record and maintain all property records.
- Accountants record/process all local, state, and federal tax returns, including payroll and property tax returns.
- Accountants prepare all financial statements and reports.

As you can see from the list, the accountant records, maintains, and in many cases actually processes anything that involves money within an organization. This includes paying all taxes, processing all tax returns, and managing all company assets, including property or real estate and office equipment. It also covers inventory, including the products the company sells and how much company equity is in inventory, as well as all employee payroll and benefits. Additionally, any company investments, future development plans, loans, etc., are handled by the company's accountant or accounting department.

The Fundamental Accounting Equation

As crazy as it sounds, all accounting can be lumped into one standard equation. While we will discuss this equation in detail later, we will go over it now, as it is fundamental:

Assets = Liabilities + Owners' Equity

Please read, re-read, and memorize this equation. (Yes, you will be tested on this.) In order to understand this equation, we need to break down each part.

Assets:

Assets can be described as items your business owns, such as a building, a house, a car, office equipment, etc. An asset would be anything that you could sell.

Liabilities:

Liabilities refer to anything a business owes or has obligations to pay. A liability would include credit card debt, a bank loan, or buying merchandise on credit from another company.

Owners' Equity:

Owners' equity would be the capital or what the owner or investor has put up in terms of money and assets to run the company. This is commonly confused with an asset; but to make a clear distinction, we will say that assets refer to the office equipment that a company owns, while the owners' equity refers to the seed money the owner has given to or invested in the company, which usually is represented as cash in the company's bank account.

Owners' equity is further divided into revenues and expenses, which overall calculate the total profit or loss for the owners of the company. This final number is referred to as retained earnings. Thus, there are two distinct parts of owners' equity: contributed capital (investor/owner seed money) and retained earnings (which is the profit or revenue minus expenses).

If this all sounds confusing now, do not worry. It will all be explained in detail later. For now, you need to be aware of the fundamental accounting equation, and you need to have an understanding of what assets, liabilities, and owners' equity mean.

Basic Notation

Let us take this example of an income statement, and do not worry now if you do not know what an income statement is.

Here are a few crucial items to note when reading financial statements:

  1. Expenses are negative numbers. As such, we are using parentheses to show that they are negative numbers. However, it is quite common to not use any parentheses when showing expenses because obviously it is a negative number and you are supposed to know this. Financial statements are read from top to bottom. This might or might not seem obvious. Many people starting out are inclined to read everything left to right without seeing the big picture represented from top down. Therefore, when you read a financial statement, read from top to bottom.
  2. Usually, the first number in the statement and the final total number in a financial statement have the dollar sign ($). You do not need to continually place the dollar sign for every set of numbers.
  3. To show that a figure in a financial statement is the result of a numerical calculation, either from the above column or from another source, the number has a single underline. As you can see in this example, our total expenses are the sum of the above expenses and the number is underlined once.
  4. All final numbers in a financial report are shown with double-underlines. This is the bottom line of a financial statement and represents the final calculation.

Bookkeeping Terms and Associated Regulatory Agencies

While we have all heard financial phrases in the past such as reconciliation and accrual, do we know what they mean?

To confirm that we do indeed fully understand some of the most commonly used bookkeeping and accounting terms, we will now provide a brief list accompanied by a working definition.

It is helpful to have a basic working definition to refer to when attempting to understand some of the higher level activities within the world of finance management.

Terms

Accrual:

Within the world of accounting, the word "accrual" is used as an abbreviation of either the term accrued expense or accrued revenue. In either instance, accrual refers to the accumulation of things over time. Hence, an accrual could be an amassment of either financial extreme: wealth or profit, which is accrued revenue; or loss or debt, which is accrued expense.

Amortize:

This is an activity that indicates the tangible dollar value incurred based upon a single monetary value apportioned; i.e., the cost of the asset spread out over its expected lifespan. For example, if you bought a washing machine for $1,500 and it is said to have a lifespan of 10 years, then the cost of the machine could be apportioned or amortized to $150 per year and then could even be broken down further by the number of loads you do per month. Other ways of looking at amortization include considering how businesses often write off expenditures, such as new computer equipment, by prorating their costs over an extended period of time.

Balance:

This term applies to both banking and accounting. The outstanding balance, also known as negative balance or liability, reflects the amount of money that is owed or past due. Once this money is accounted for, the account should then return to a balanced state, which is zero, or a positive status, which reflects overpayment.

Consolidated financial statements:

These demonstrate how the holding company is doing as a collective group. The consolidated accounts factor in the holding company's subsidiaries into its aggregated accounting figure.

Deferral:

Almost akin to a delay, a deferral refers to assets or liabilities that do not come to fruition until a future date. Included within the deferral group are such financial entities as annuities, charges, taxes, and income.

Depreciation:

This term is used to account for the reduction of a value that occurs over time to assets on account of normal wear and tear. Depreciation tends to apply most often to items requiring insurance, such as cars, jewelry, and other material goods, or property that has estimated values, such as real estate. In general, depreciation tends to be most applicable when dealing with assets that have a limited, fixed lifespan.

Double-entry bookkeeping system:

Within the world of accounting, particularly that of record-keeping, the double-entry bookkeeping or accounting system paved the way for all higher-level accounting principles that followed. The foundation for standard financial recording systems, the double-entry bookkeeping model works upon the notion that a business's dealings are best represented by a number of variables, also known as accounts, each of which symbolizes a particular aspect of the business as a monetary value.

The basis for the system's name, "double entry," stems from the fact that each transaction is entered twice. Therefore, each debit value needs to have a corresponding credit value; this is to ensure all transactions balance out in the end. Thus, when you add up all the debit balances, the total must equal the total of all the credit balances.

In the traditional sense, a general ledger consists of debit entries recorded on the left side and credit values on the right. The ledger accounts are set up as "T" accounts because when the account is void of data, it resembles the letter "T."

Financial reports: In the most basic sense, these types of disclosure documents include a balance sheet and an income statement.

Fiscal year:

Akin to a regular year, a fiscal year is a 12-month business period that is used to calculate annual financial reports (see above definition). The difference between fiscal years and calendar years is that the two tend to differ in terms of start and stop dates. This is purposely done so that the end of the accounting year does not run interference with the regular year-end holiday activities or popular vacation periods when employees opt to be out of the office.

General ledger, also known as the nominal ledger: This holding site for data serves as the principal accounting record of any business that uses the double-entry bookkeeping system. A typical ledger usually includes accounts representative of the following seven categories: current assets, fixed assets, liabilities, revenue and expense items, gains, and losses.

Gross profit,

also known as sales profit or gross operating profit: This is the result of subtracting the cost to make a product or provide a service from the monies earned for the item. The gross profit is tabulated before deducting such related costs as overhead, payroll, taxation, and interest payments.

Matching principles:

This is an accounting term that addresses the idea that whenever possible and appropriate the expense column should equal, or match, the revenue column. Yet when expenses do match revenues, they are not recognized until the associated revenue is also recognized.

Here is an example: When wages are paid to workers in the manufacturing industry, they are not formally identified as expenses until the products are actually sold. Once the products are sold, the expenses are recognized as the cost of doing business, in this case, selling goods.

Net profit:

This is a commonly used term within the business arena that identifies the gross revenue for a given time period less any associated expenses.

Operating cash flow:
Known as OCF, operating cash flow refers to the funds that come about as a result of operating activities; thus, the amount of revenue it generates less those costs associated with long-term investments on capital items or securities' investment.
Finance-accounting Regulatory Agencies and GAAP

The American Institute of Certified Public Accountants (AICPA) is the central regulating body within the U.S. in terms of training and providing ongoing guidance to CPAs.

The AICPA operates under the auspices of the following core purpose: to make sense of a changing and complex world.

In accordance with its prevailing concept, the AICPA views CPAs as trusted professionals who contribute to shaping the future for both individuals and business entities. As such, the AICPA believes CPAs should embody the core values of lifelong learning; competence; integrity; and objectivity. They also should be attuned to the "macro" realities of the business environment more than the "micro" details.

Further, the AICPA stresses the idea that it is the CPA's duty to deliver such premium services as:

  • communication of the total picture with clarity and objectivity;
  • translation of complex information into critical knowledge;
  • anticipation and creation of new opportunities;
  • design of pathways to transform visions into reality.

The Federal Accounting Standards Advisory Board (FASAB) establishes accounting principles for federal entities and monitors their compliance. The AICPA Council appointed the FASAB as the body to implement and oversee such a structural framework.

GAAP rulings create the manual to which the U.S. accounting and financial procedures adhere. Hence, all financial statements produced for publicly traded U.S. companies, as well as many privately held companies, need to comply with the GAAP or face fines and/or other penalties.

GAAP: Basic Objectives

At a most basic level, the objectives of GAAP are to ensure financial reports provide information that is:

  • helpful to current or potential investors, creditors, et al., who may use it as an aid in forming financial investment and credit decisions;
  • helpful to current or potential investors, creditors, et al., in calculating the specific quantities, timing, and uncertainty of forthcoming cash receipts;
  • useful in learning about economic resources, the claims already made on those resources, and the changes in their allocations.
 
 
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